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The Paradox of The Paradox of Thrift

This article was written by in Best Of, Saving. 17 comments.


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:

  1. Less money is being spent by consumers.
  2. Demand for products and services decreases.
  3. Businesses reduce production and eliminate jobs to meet demand.
  4. Unemployment increases, resulting in less income for saving or spending.
  5. 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.

Updated December 20, 2011 and originally published February 16, 2009. If you enjoyed this article, subscribe to the RSS feed or receive daily emails. Follow @ConsumerismComm on Twitter and visit our Facebook page for more updates.

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About the author

Luke Landes, also known as Flexo, is the founder of Consumerism Commentary. He has been blogging and writing for the internet since 1995 and has been building online communities since 1991. Find out more about him and follow Luke Landes on Twitter. View all articles by .

{ 17 comments… read them below or add one }

avatar The Weakonomist

My friend you are being too nice to Keynes. He was a brilliant man but his worshipers today simply don’t account for how different the mechanicals to the economy are today. I’ve been working on a post that is very critical of the modern Keynesian economist.

Good post though, I thoroughly enjoyed discussing this paradox in college.

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avatar RedMaven

Thank you…thank you…thank you! Finally someone sees the paradox in this macro economic situation. I was just discussing this topic with my good friend, and was going to write a blog post on my website

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avatar Nate @ Money Young

Flexo, great information! I learned a ton from this article.

Of your options for banks, I like #4 or #5. Not sure which one, but I def. don’t want to see the government in control of banking… just another way they can mess things up.

-Nate

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avatar CorkyAgain

“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 important word in this sentence is “credit-worthy”. Many of the proposals we’ve been hearing are about getting lenders to loan money to people who are not credit-worthy — or at least, not worthy enough in the eyes of the lender.

There isn’t necessarily any racism or other prejudice in that judgment of credit-worthiness. When almost everyone is losing money on their investments, and in particular when lenders have already lost huge amounts, there’s a natural tendency to be extra cautious and only loan money to those who are most likely to be able to pay it back. Those who can’t point to a reliable income stream of their own get ruled out. So arises the old paradox that only those who don’t need credit can get it.

The government bailouts seem designed to change lenders’ perception of the risks involved in lending. By promising (or seeming to promise) to make the lender whole, the government is substituting its income streams (taxation, inflation) for the borrower’s. If lenders still refuse to make even slightly questionable loans, perhaps it’s because they don’t think the government’s income is any more reliable than the borrower’s? How long can the government keep increasing taxes before there’s a taxpayer revolt or before the tax burden itself smothers the economy? As for inflation, why should lenders accept a promise to be paid back with hyperinflated dollars worth far less than the amount they loaned?

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avatar Craig

Individuals should worry about their own finances and not that their spending should affect the economy. I don’t like that theory and it shouldn’t be put on the consumer. Despite the economy, consumer spending is still relatively high. People need to worry about their own situations.

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avatar Writer's Coin

I wrote about this at the end of January and I’m with Craig here: don’t worry about what you can’t control—your job is to deal with what you can control and that’s your own spending and saving.

The theories will work themselves out (or not) on their own down the road.

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avatar TheMightyQuinn

Thrift IS good for the economy. Yes, it’s harmful to the economy in the short-term as people increase their thriftiness, but there is a limit to how thrifty people can become and how thrifty they WANT to become. Once we get past that point, and thrift is instilled in people, then spending will be responsible and less susceptible to fluctuations compared to spending on credit, and the economy can grow smoothly and slowly.

Of course the caveat is that no one knows how to get everyone to spend responsibly. :)

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avatar Emily

It definitely is a vicious cycle! In times like this, I feel like I should be obligated to save more since there is less job security and times are tough, and that’s just what people do — save more. But at the same time, I read all the reports of retail companies doing poorly and going out of business, and I think maybe I shouldn’t be a spendthrift and should not focus so much on saving. I’m trying to just strike a happy medium by saving more than usual for my emergency fund, but not cutting back too extensively on spending. I feel like I have a lot of job security at the moment, though I’d definitely be saving more and spending less if I was in an industry like automotive, where job security is very shaky.

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avatar Frank

Keynes was talking about deflation, which is what sank the US economy in the 1930′s and threatens ours now. When optimism turns to pessimism then everybody, consumers, businesses, banks, etc., naturally hold on to their cash “just in case.” That harms the economy further, and so the downward spiral begins.

This is not thriftiness or frugality as we usually think of it. The problem is not that people are spending money more efficiently by using coupons or turning off lights. The problem is that they are not spending money the way they would if they thought the economy was normal: cancelling vacations, not buying new clothes, etc.

I also think that banks are not sitting on vast piles of cash they arbitrarily refuse to lend to credit-worthy borrowers. Banks, remember, are borrowers almost as much as they are lenders. With nobody willing to lend the banks money, they need to hoard cash to stay solvent. And let’s not forget that in these economic conditions not too many sound business want to borrow money to invest anyway. (Unsound ones, on the other hand, would like to borrow to stay in business and are quick to blame the credit crunch for their problems.)

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avatar Mike

I can’t believe I read this article.. WOW.

Read this site to fix the economy: http://mises.org
Basically, they prove Keynes to be EXACTLY WRONG!!

As of this moment, because of this article, i’m deleting this site from my bookmarks and NEVER returning. Government continuing to steal money from us (bailout, stimulus, etc), and giving them free reign to do whatever they want is not the way to go, this site promoting that retoric is not helping.

Good bye.
Mike

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avatar Customers Revenge

Your discussion of this puzzle is a little puzzling itself. I’m not sure how you disprove that saving hurts the economy.

When people save, they don’t spend. You say that this is ok because the bank will have deposits to lend … but what a business needs is revenue not loans. Most businesses have a lot of loans already because businesses are financed by loans. They need revenue to pay the interest, and other expenses. Given poor revenues, a business can’t usually get more loans to survive simply because it can’t pay it’s bills.

A business is the same as a person. You wouldn’t say that if a person has a low-paying job then that person should finance a high-flying lifestyle on credit cards. You would say that the person should reduce the lifestyle. For a business, this means reducing expenses which usually means lay-offs or closure.

The economy is definitely not broken at the lending level, except due to the crazy mortgages that originally started this. Banks do not lend even to each other because they no longer know the risks of the loans and they have to ensure that they have enough money themselves to remain solvent. Assets are worth much less now and risks are much higher. In those situations there is simply no money to lend, not that the bank is refusing to lend.

Again, think of your personal situation. If you had a good job, a working car, and $500 in the bank then you might lend your friend $100 for a few days without worry. But if you just lost your job, your car suddenly died and needed $800 of repairs, then with the same money in the bank you probably wouldn’t lend your friend the money because you really no longer had it available to lend.

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avatar Margaret

One time my brother told me (I’ve never verified this) that the USSR (think communist Russia and it’s satellites, young ‘uns) did not produce chewing gum. It was considered a waste of resources. I’ve often thought that a lot of the things that we can buy in our society are exactly that — a waste of resources, and also sources of garbage and pollution. It makes one wonder whether it is better to have people buying a new pair of crappy $10 boots every year and throwing them out when the fall apart or saving up and buying one really good pair of $80 boots that will last for 10 years. Think of the dollar store toys and trinkets. Think of throwaway ikea furniture versus solid pieces that last a lifetime and more. It’s tough, but I believe it would be ultimately better if we got off our credit and junk addiction and started saving for purchases and then buying quality.

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avatar matt @ Thrive

To be fair, I’m not an economist. And in a strictly rational economy, it seems like Keynes would be right: saving everything as an extreme would result in the downfall of the modern economy. But the economy isn’t rational, and there is the strong hedonic pressure to not save on the other end of that equation.

But there is something to be said, I think, about when too much saving is a bad thing. I told a reporter the other day what I call “The Mustard Story”. Basically, my dad makes homemade sweet-hot mustard that is possible the best condiment on the planet. It is the crack of mustards. I used to just eat it on a spoon. It is the condiment that doesn’t need actual food to go with it.

And every Christmas, my dad gives me a jar of it that is supposed to last me for the year. This little jar of yellow gold. Now a normal, balanced person would treat that jar as special. They would eat it slowly, make it last a month or two, saving it for those really important things, like 2am sandwiches when you’ve just returned home from work on a Tuesday.

But not me. I have three jars on my shelf. Three years without actually eating any of this stuff. Because the mustard is so good, so precious, that I can’t actually convince myself to eat it. It is entirely irrational, but I save that stuff because I don’t want to run out. I deny myself the pleasure it brings simply because I don’t want to suffer the pain of NOT having it.

Folklore and such is full of tales such as these, meant to caution us against hording things imply for the sake of having them. “You can’t take it with you,” they always say. And while I don’t think we’re in any imminent danger of this happening in our culture, I do think we need to adjust our saving message just a little bit. It isn’t just “save for something big”, like a house or your retirement. Because if you do that, then when you get enough for a $200,000 house, you want a $250,000 house. You always want to save just a little bit more, because it becomes so painful to let go of what you have.

Instead, I think the message has to be “save, and spend, for satisfaction”. Hurt a little bit when you’re young, don’t get everything you want, so that you can own a home later on. But equally, don’t starve to do it. Don’t make yourself miserable. Spend the occasional twenty dollars on a really good pizza. Your financial life is like the rest of your life: balance matters.

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avatar dajolt

@Matt

your mustard example is better than you think: mustard loses a lot if stored for over a year, so once you will open your saved three year old mustard you will not have the enjoyment you could have had earlier. same goes for saved money which is saved the hard way…

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avatar Margaret

Yeah, Matt. Eat the mustard!

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avatar Medaille

The problem isn’t savings. The problem is that our money is debt based. The only way money flows freely is when people are continually taking out ever larger loans and thus gaining debt. If people stop taking on more debt then the money supply shrinks and there isn’t enough to go around.

Even above you have stated that “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 problem lies in that money shouldn’t be based on debt in the first place.

The only solution out of this is to remove usuary from our society. And to create money ourselves rather than have the banks do it for us with interest.

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avatar Laure ♦198 (Cent)

We have to look at what were the variables in the Keynesian model. As noted above, savings rates were much higher at that time, with savings often being done with cash under a mattress. However, another huge difference today are the various bubbles – real estate, etc – created by intervention. So the Keynes model seems not so much to hold or not hold, as to not be fully applicable to the artificial economy we had created before the recession…

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