The paradox of thrift (or paradox of saving) is a paradox of economics. The paradox states that an increase in autonomous saving leads to a decrease in aggregate demand and thus a decrease in gross output which will in turn lower total saving. The paradox is, narrowly speaking, that total saving may fall because of individuals' attempts to increase their saving, and, broadly speaking, that increase in saving may be harmful to an economy. [1] The paradox of thrift is an example of the fallacy of composition, the idea that what is true of the parts must always be true of the whole. The narrow claim transparently contradicts the fallacy, and the broad one does so by implication, because while individual thrift is generally averred to be good for the individual, the paradox of thrift holds that collective thrift may be bad for the economy.
It had been stated as early as 1714 in The Fable of the Bees , [2] and similar sentiments date to antiquity. [3] [4] It was popularized by John Maynard Keynes and is a central component of Keynesian economics.
The argument begins from the observation that in equilibrium, total income must equal total output. Assuming that income has a direct effect on saving, an increase in the autonomous component of saving, other things being equal, will move the equilibrium point at which income equals output to a lower value, thereby inducing a decline in saving that may more than offset the original increase.
In this form it represents a prisoner's dilemma as saving is beneficial to each individual but deleterious to the general population. This is a "paradox" because it runs contrary to intuition. Someone unaware of the paradox of thrift would fall into a fallacy of composition and assume that what seems to be good for an individual within the economy will be good for the entire population. However, exercising thrift may be good for an individual by enabling that individual to save for a "rainy day", and yet not be good for the economy as a whole.
This paradox can be explained by analyzing the place, and impact, of increased savings in an economy. If a population decides to save more money at all income levels, then total revenues for companies will decline. This decreased demand causes a contraction of output, giving employers and employees lower income. Eventually the population's total saving will have remained the same or even declined because of lower incomes and a weaker economy. This paradox is based on the proposition, put forth in Keynesian economics, that many economic downturns are demand-based.
While the paradox of thrift was popularized by Keynes, and is often attributed to him, [3] it was stated by a number of others prior to Keynes, and the proposition that spending may help and saving may hurt an economy dates to antiquity; similar sentiments occur in the Bible verse:
There is that scattereth, and yet increaseth; and there is that withholdeth more than is meet, but it tendeth to poverty.
which has found occasional use as an epigram in underconsumptionist writings. [3] [5] [6] [7]
Keynes himself notes the appearance of the paradox in The Fable of the Bees: or, Private Vices, Publick Benefits (1714) by Bernard Mandeville, the title itself hinting at the paradox, and Keynes citing the passage:
As this prudent economy, which some people call Saving, is in private families the most certain method to increase an estate, so some imagine that, whether a country be barren or fruitful, the same method if generally pursued (which they think practicable) will have the same effect upon a whole nation, and that, for example, the English might be much richer than they are, if they would be as frugal as some of their neighbours. This, I think, is an error.
Keynes suggests Adam Smith was referring to this passage when he wrote "What is prudence in the conduct of every private family can scarce be folly in that of a great Kingdom."
The problem of underconsumption and oversaving, as they saw it, was developed by underconsumptionist economists of the 19th century, and the paradox of thrift in the strict sense that "collective attempts to save yield lower overall savings" was explicitly stated by John M. Robertson in his 1892 book The Fallacy of Saving, [3] [8] writing:
Had the whole population been alike bent on saving, the total saved would positively have been much less, inasmuch as (other tendencies remaining the same) industrial paralysis would have been reached sooner or oftener, profits would be less, interest much lower, and earnings smaller and more precarious. This ... is no idle paradox, but the strictest economic truth.
— John M. Robertson, The Fallacy of Saving, pp. 131–132
Similar ideas were forwarded by William Trufant Foster and Waddill Catchings in the 1920s in The Dilemma of Thrift. [9]
Keynes distinguished between business activity/investment ("Enterprise") and savings ("Thrift") in his Treatise on Money (1930):
... mere abstinence is not enough by itself to build cities or drain fens. ... If Enterprise is afoot, wealth accumulates whatever may be happening to Thrift; and if Enterprise is asleep, wealth decays whatever Thrift may be doing. Thus, Thrift may be the handmaiden of Enterprise. But equally she may not. And, perhaps, even usually she is not.
He stated the paradox of thrift in The General Theory, 1936:
For although the amount of his own saving is unlikely to have any significant influence on his own income, the reactions of the amount of his consumption on the incomes of others makes it impossible for all individuals simultaneously to save any given sums. Every such attempt to save more by reducing consumption will so affect incomes that the attempt necessarily defeats itself. It is, of course, just as impossible for the community as a whole to save less than the amount of current investment, since the attempt to do so will necessarily raise incomes to a level at which the sums which individuals choose to save add up to a figure exactly equal to the amount of investment.
— John Maynard Keynes, The General Theory of Employment, Interest and Money , Chapter 7, p. 84
The theory is referred to as the "paradox of thrift" in Samuelson's influential Economics of 1948, which popularized the term.
The paradox of thrift formally can be well described as a circuit paradox using the terms of Balances Mechanics developed by the German economist Wolfgang Stützel (German: Saldenmechanik): It is about saving by cut of expenses, which always leads to a revenue surplus of the individual, so to saving of money. But once the totality (in the meaning of every each) saves at expenses, the revenues of economy only decline.
The paradox of thrift has been related to the debt deflation theory of economic crises, being called "the paradox of debt" [11] – people save not to increase savings, but rather to pay down debt. As well, a paradox of toil and a paradox of flexibility have been proposed: A willingness to work more in a liquidity trap and wage flexibility after a debt deflation shock may lead not only to lower wages, but lower employment. [12]
During April 2009, U.S. Federal Reserve Vice Chair Janet Yellen discussed the "Paradox of deleveraging" described by economist Hyman Minsky: "Once this massive credit crunch hit, it didn’t take long before we were in a recession. The recession, in turn, deepened the credit crunch as demand and employment fell, and credit losses of financial institutions surged. Indeed, we have been in the grips of precisely this adverse feedback loop for more than a year. A process of balance sheet deleveraging has spread to nearly every corner of the economy. Consumers are pulling back on purchases, especially on durable goods, to build their savings. Businesses are cancelling planned investments and laying off workers to preserve cash. And, financial institutions are shrinking assets to bolster capital and improve their chances of weathering the current storm. Once again, Minsky understood this dynamic. He spoke of the paradox of deleveraging, in which precautions that may be smart for individuals and firms—and indeed essential to return the economy to a normal state—nevertheless magnify the distress of the economy as a whole." [13]
Sectoral Balances analysis shows the effect of net savings by the private sector. It must either be funded by a public sector deficit or a by a foreign sector deficit which is equivalent to exports being higher than imports for the country analyzed. Therefore, there exists two types of possible equilibriums for a growing economy. Either the public sector is funding the growth of the private sector via a slight deficit or its current account balance is positive and the country is a net exporter of goods and services.
Within mainstream economics, non-Keynesian economists, particularly neoclassical economists, criticize this theory on three principal grounds.
The first criticism is that, following Say's law and the related circle of ideas, if demand slackens, prices will fall (barring government intervention), and the resulting lower price will stimulate demand (though at lower profit or cost – possibly even lower wages). This criticism in turn has been questioned by New Keynesian economists, who reject Say's law and instead point to evidence of sticky prices as a reason why prices do not fall in recession.
The second criticism is that savings represent loanable funds, particularly at banks, assuming the savings are held at banks, rather than currency itself being held ("stashed under one's mattress"). Thus an accumulation of savings yields an increase in potential lending, which will lower interest rates and stimulate borrowing. So a decline in consumer spending is offset by an increase in lending, and subsequent investment and spending.
Two caveats are added to this criticism. Firstly, if savings are held as cash, rather than being loaned out (directly by savers, or indirectly, as via bank deposits), then loanable funds do not increase, and thus a recession may be caused – but this is due to holding cash, not to saving per se. [14] Secondly, banks themselves may hold cash, rather than loaning it out, which results in the growth of excess reserves – funds on deposit but not loaned out. This is argued to occur in liquidity trap situations, when interest rates are at a zero lower bound (or near it) and savings still exceed investment demand. Within Keynesian economics, the desire to hold currency rather than loan it out is discussed under liquidity preference.
Third, the paradox assumes a closed economy in which savings are not invested abroad (to fund exports of local production abroad). Thus, while the paradox may hold at the global level, it need not hold at the local or national level: if one nation increases savings, this can be offset by trading partners consuming a greater amount relative to their own production, i.e., if the saving nation increases exports, and its partners increase imports. This criticism is not very controversial, and is generally accepted by Keynesian economists as well, [15] who refer to it as "exporting one's way out of a recession". They further note that this frequently occurs in concert with currency devaluation [16] (hence increasing exports and decreasing imports), and cannot work as a solution to a global problem, because the global economy is a closed system – not every nation can increase net exports.
The Austrian School economist Friedrich Hayek criticized the paradox in a 1929 article, "The 'Paradox' of Savings", questioning the paradox as proposed by Foster and Catchings. [17] Hayek, and later Austrian School economists agree that if a population saves more money, total revenues for companies will decline,[ citation needed ] but they deny the assertion that lower revenues lead to lower economic growth, understanding that the additional savings are used to create more capital to increase production. Once the new, more productive structure of capital has reorganized inside of the current structure, the real costs of production is reduced for most firms.[ citation needed ] Some criticisms argue that using accumulated capital to increase production is an act which requires spending, and therefore the Austrian argument does not disprove the paradox.[ citation needed ] However, this confuses spending on capital goods with spending on consumer goods. The paradox only refers to saving by not spending on consumer goods and ignores the productive use of those savings.
Keynesian economics are the various macroeconomic theories and models of how aggregate demand strongly influences economic output and inflation. In the Keynesian view, aggregate demand does not necessarily equal the productive capacity of the economy. It is influenced by a host of factors that sometimes behave erratically and impact production, employment, and inflation.
In economics, a recession is a business cycle contraction that occurs when there is a general decline in economic activity. Recessions generally occur when there is a widespread drop in spending. This may be triggered by various events, such as a financial crisis, an external trade shock, an adverse supply shock, the bursting of an economic bubble, or a large-scale anthropogenic or natural disaster.
Within the budgetary process, deficit spending is the amount by which spending exceeds revenue over a particular period of time, also called simply deficit, or budget deficit: the opposite of budget surplus. The term may be applied to the budget of a government, private company, or individual. Government deficit spending was first identified as a necessary economic tool by John Maynard Keynes in the wake of the Great Depression. It is a central point of controversy in economics, as discussed below.
The General Theory of Employment, Interest and Money is a book by English economist John Maynard Keynes published in February 1936. It caused a profound shift in economic thought, giving macroeconomics a central place in economic theory and contributing much of its terminology – the "Keynesian Revolution". It had equally powerful consequences in economic policy, being interpreted as providing theoretical support for government spending in general, and for budgetary deficits, monetary intervention and counter-cyclical policies in particular. It is pervaded with an air of mistrust for the rationality of free-market decision making.
In classical economics, Say's law, or the law of markets, is the claim that the production of a product creates demand for another product by providing something of value which can be exchanged for that other product. So, production is the source of demand. In his principal work, A Treatise on Political Economy, Jean-Baptiste Say wrote: "A product is no sooner created, than it, from that instant, affords a market for other products to the full extent of its own value." And also, "As each of us can only purchase the productions of others with his/her own productions – as the value we can buy is equal to the value we can produce, the more men can produce, the more they will purchase."
Underconsumption is a theory in economics that recessions and stagnation arise from an inadequate consumer demand, relative to the amount produced. In other words, there is a problem of overproduction and overinvestment during a demand crisis. The theory formed the basis for the development of Keynesian economics and the theory of aggregate demand after the 1930s.
A liquidity trap is a situation, described in Keynesian economics, in which, "after the rate of interest has fallen to a certain level, liquidity preference may become virtually absolute in the sense that almost everyone prefers holding cash rather than holding a debt which yields so low a rate of interest."
In economic policy, austerity is a set of political-economic policies that aim to reduce government budget deficits through spending cuts, tax increases, or a combination of both. There are three primary types of austerity measures: higher taxes to fund spending, raising taxes while cutting spending, and lower taxes and lower government spending. Austerity measures are often used by governments that find it difficult to borrow or meet their existing obligations to pay back loans. The measures are meant to reduce the budget deficit by bringing government revenues closer to expenditures. Proponents of these measures state that this reduces the amount of borrowing required and may also demonstrate a government's fiscal discipline to creditors and credit rating agencies and make borrowing easier and cheaper as a result.
Household debt is the combined debt of all people in a household, including consumer debt and mortgage loans. A significant rise in the level of this debt coincides historically with many severe economic crises and was a cause of the U.S. and subsequent European economic crises of 2007–2012. Several economists have argued that lowering this debt is essential to economic recovery in the U.S. and selected Eurozone countries.
In macroeconomic theory, liquidity preference is the demand for money, considered as liquidity. The concept was first developed by John Maynard Keynes in his book The General Theory of Employment, Interest and Money (1936) to explain determination of the interest rate by the supply and demand for money. The demand for money as an asset was theorized to depend on the interest foregone by not holding bonds. Interest rates, he argues, cannot be a reward for saving as such because, if a person hoards his savings in cash, keeping it under his mattress say, he will receive no interest, although he has nevertheless refrained from consuming all his current income. Instead of a reward for saving, interest, in the Keynesian analysis, is a reward for parting with liquidity. According to Keynes, money is the most liquid asset. Liquidity is an attribute to an asset. The more quickly an asset is converted into money the more liquid it is said to be.
In macroeconomics, a general glut is an excess of supply in relation to demand, specifically, when there is more production in all fields of production in comparison with what resources are available to consume (purchase) said production. This exhibits itself in a general recession or depression, with high and persistent underutilization of resources, notably unemployment and idle factories. The Great Depression is often cited as an archetypal example of a general glut.
At the micro-economic level, deleveraging refers to the reduction of the leverage ratio, or the percentage of debt in the balance sheet of a single economic entity, such as a household or a firm. It is the opposite of leveraging, which is the practice of borrowing money to acquire assets and multiply gains and losses.
In macroeconomics, particularly in the history of economic thought, the Treasury view is the assertion that fiscal policy has no effect on the total amount of economic activity and unemployment, even during times of economic recession. This view was most famously advanced in the 1930s by the staff of the British Chancellor of the Exchequer. The position can be characterized as:
Any increase in government spending necessarily crowds out an equal amount of private spending or investment, and thus has no net impact on economic activity.
Macroeconomic theory has its origins in the study of business cycles and monetary theory. In general, early theorists believed monetary factors could not affect real factors such as real output. John Maynard Keynes attacked some of these "classical" theories and produced a general theory that described the whole economy in terms of aggregates rather than individual, microeconomic parts. Attempting to explain unemployment and recessions, he noticed the tendency for people and businesses to hoard cash and avoid investment during a recession. He argued that this invalidated the assumptions of classical economists who thought that markets always clear, leaving no surplus of goods and no willing labor left idle.
The Capitol Hill Babysitting Cooperative (CHBC) is a cooperative located in Washington, D.C., whose purpose is to fairly distribute the responsibility of babysitting between its members. The co-op is often used as an allegory for a demand-oriented model of an economy. The allegory illustrates several economic concepts, including the paradox of thrift and the importance of the money supply to an economy's well-being. The allegory has received continuing attention, particularly in the wake of the late-2000s recession.
The paradox of toil is the economic hypothesis that, under certain conditions, total employment will shrink if there is an increased desire among the population to take on paid work. According to the macroeconomist Gauti Eggertsson, this occurs when "the short-term nominal interest rate is zero and there are deflationary pressures and output contraction". When wages are pushed down by the simultaneous efforts of everyone in the labor force to work more even at lower wages, with interest rates against the zero bound, demand must fall because the only source of added demand would be added credit to compensate for those lower wages, credit which cannot be made available on any looser terms; this loss of demand from lower wages leads to a loss of jobs. The belief that there must necessarily be more work available if wages drop is an example of the fallacy of composition.
The paradox of flexibility is that a debt deflation shock can create a situation where increased price and wage flexibility results in decreased total demand. This term was introduced by economists Paul Krugman and Gauti Eggertsson in the paper Debt, Deleveraging, and the Liquidity Trap: A Fisher-Minsky-Koo Approach. The term was intended to complement the "paradox of thrift", a concept resurrected by John Maynard Keynes and Eggertsson's earlier work on the "paradox of toil". Krugman and Eggertsson proposed that the paradox of toil and the paradox of flexibility mean that wage and price flexibility do not facilitate recovery from recessions during a liquidity trap, but actually exacerbate them.
The Return of Depression Economics and the Crisis of 2008 is a non-fiction book by American economist and Nobel Prize winner Paul Krugman, written in response to growing socio-political discourse on the return of economic conditions similar to The Great Depression. The book was first published in 1999 and later updated in 2008 following his Nobel Prize of Economics. The Return of Depression Economics uses Keynesian analysis of past economics crisis, drawing parallels between the 2008 financial crisis and the Great Depression. Krugman challenges orthodox economic notions of restricted government spending, deregulation of markets and the efficient market hypothesis. Krugman offers policy recommendations for the prevention of future financial crises and suggests that policymakers "relearn the lessons our grandfathers were taught by the Great Depression" and prop up spending and enable broader access to credit.
The sectoral balances are a sectoral analysis framework for macroeconomic analysis of national economies developed by British economist Wynne Godley.
A balance sheet recession is a type of economic recession that occurs when high levels of private sector debt cause individuals or companies to collectively focus on saving by paying down debt rather than spending or investing, causing economic growth to slow or decline. The term is attributed to economist Richard Koo and is related to the debt deflation concept described by economist Irving Fisher. Recent examples include Japan's recession that began in 1990 and the U.S. recession of 2007-2009.
