Email this article
Print this article
If you’ve been paying attention lately, you might have heard that throughout the economic recession, Americans have been saving more of their income. Some economists worry that saving, while good for the individual, can be harmful to the economy as a whole. This is commonly called, “the paradox of thrift,” a theory developed by John Maynard Keynes, a popular economist who in the early 20th century saw spending as the basis of an economy.
Keynes looks at a recession as a vicious cycle, illustrated here:
- Less money is being spent by consumers.
- Demand for products and services decreases.
- Businesses reduce production and eliminate jobs to meet demand.
- Unemployment increases, resulting in less income for saving or spending.
- Rinse and repeat.
In this model, it is theorized that saving more money can eventually result in having less money to save on an aggregate level. The only thing that can break this cycle is something external. In our case, it is the government. The first treatment was “stimulus,” payments given to taxpayers (from current or future tax receipts) to help “stimulate” the economy.
The reaction, when this didn’t work, was that this wasn’t enough to break the cycle, and more stimulus was needed to noticeably affect the economy. The government decided to go directly to businesses, providing them with the capital needed to finance shovel-ready projects, hire more employees, and keep aggregate income up so consumers would feel that their money is better spent spent.
The easiest argument against the validity of the paradox of thrift is that, for the most part, there is no such thing as saving money. Money is either spent now or it is spent later. Another possibility is that it is invested now and transferred to a business, and the business either spends it now or spends it later. When you decide to spend money later, in almost all cases, you put the money into a bank account, which provides the bank with more funds with which to provide loans to businesses now.
As long as banks to continue to loan out money, the economy doesn’t decline. But as we see now, thanks to the “credit crunch” (which we haven’t been hearing about as much recently), that’s not happening.
In short, it’s not consumer spending or saving, but the financial industry’s refusal to lend money to credit-worthy businesses that is keeping us amidst the recession.
The paradox of thrift, the idea that saving more money was bad for the economy, was invented when personal rates of saving were much higher and consumer credit was all but nonexistent. At this time in American history, “saving money” meant keeping cash under a mattress outside of the banking system. Perhaps the paradox of thrift was a reality at that time, but despite its popularity in the news recently, it probably no longer applies to America’s modern economy. Many economists now agree that this aspect of Keynesian economics has seen better days.
Does the government need to step in to break the cycle, like Keynes suggested? Probably, but it needs to take the right actions. Helping tax payers with $400 over two years is not enough because it doesn’t have a large enough effect for the majority of Americans in order to restore consumer confidence.
The economy is broken at the lending level, and that’s where the government should focus. Banks need to lend money to credit-worthy customers. If they refuse, the government can step in, and they have a number of options, with approaches ranging from near-socialism to capitalism, including:
- buying the banks, nationalizing the industry, and changing the way banks do business
- buying controlling shares in the banks and making management decisions to lend (responsibly)
- investing in the banks with the requirement that the money be used to increase lending
- providing tax incentives for institutions that decide to increase responsible lending
- creating a federal bank that accepts deposits and lends its funds to compete directly with private banks
Continue to save money and spend less than you earn. It’s not a patriotic duty to spend it on products and services you don’t need, despite what you might hear. There is no need to sacrifice your future financial well-being for the sake of the greater good. It wouldn’t work, anyway. The economy will be sorted out with or without the house you buy now rather than a year from now.
Some interesting reading on the paradox of thrift: Paradox of thrift on Wikipedia, Frugal living is bad for the economy from Associated Press, Consumers Don’t Cause Recessions from the Mises Institute, and The Paradox of Thrift: RIP from Cato Journal.
{ 15 comments }
Acts of nature. In New Orleans prior to Hurricane Katrina, residents wary about hurricane damage to their homes were encouraged to buy insurance policies covering wind and rain damage. Many insurance policies provided no relief following Katrina because the damage done to homes was determined to be due to flooding. According to 
Car accidents. Auto insurance is generally helpful when it comes to covering for damage due to car accidents, whether caused by you or another party. Often, insurance won’t cover everything you need. Your emergency fund may need to at least cover your deductibles, but also fill in any gaps left after payments arrive. The fund can help pay for a new car if needed.
Vacation. It’s great to get away from your daily responsibilities for a time, but even if your therapist recommends an immediate vacation, you shouldn’t dip into the money set aside to cover emergencies.
