What Is the Paradox of Thrift?

What Is the Paradox of Thrift?

Let me explain the paradox of thrift to you directly: it's a concept introduced by John Maynard Keynes, and it points out that while saving money is generally a smart move for you as an individual, it can actually hurt the economy as a whole during a recession. When you save more, you're spending less, which means businesses produce less, jobs get cut, and the downturn gets worse. You need to understand this contradiction because it shows why ramping up savings in tough times might make things even harder instead of helping.

How the Paradox of Thrift Affects Economic Growth

According to Keynesian theory, the right way to handle a recession is to increase spending, take more risks, and save less. I want you to know that Keynesians see a recessed economy as one not operating at full capacity because resources like land, labor, and capital are sitting idle.

They also emphasize that consumption, or spending, is what really drives economic growth. It might feel logical for you and your household to cut back on spending during hard times, but that's actually the wrong approach for the economy at large.

Here's a fast fact for you: if consumers pull back on spending overall, businesses might produce even less, which deepens the recession. This gap between what's rational for you individually and what's best for everyone is the core of the savings paradox.

During the Great Recession after the 2008 financial crisis, the average American household's savings rate went up from 2.9% to 5%. The Federal Reserve responded by cutting interest rates to encourage spending.

Bernard Mandeville might have been the first to describe this idea in his 1714 work, 'The Fable of the Bees,' where he pushed for more spending over saving as the path to prosperity. Keynes gave him credit for it in his 1936 book, 'The General Theory of Employment, Interest, and Money.'

The Circular Flow Model and Its Role in the Paradox of Thrift

Keynes helped bring back the circular flow model of the economy, and I'll tell you how it works: an increase in current spending leads to more spending in the future. When you spend now, it generates income for producers, who then use that income to expand their businesses, hire workers, and keep the cycle going with more income and spending.

To counter high savings, Keynes pushed for lower interest rates to make borrowing and spending more appealing. If that didn't work, he recommended government deficit spending to step in and boost the economy.

Criticisms and Limitations of the Paradox of Thrift

The circular flow model doesn't account for Say's law, which says goods have to be produced before they can be exchanged. Capital machinery increases production and needs more savings and investment to happen. This model really only applies in an economy without capital goods.

The theory also skips over inflation or deflation possibilities. If higher spending now just leads to higher prices later, production and jobs won't change. And if saving during a recession lowers future prices, things might not decline as Keynes thought.

Importantly, the paradox overlooks how saved money can be lent out by banks. When people save more, interest rates drop, and banks issue more loans.

Keynes pushed back on these criticisms, saying Say's law is wrong and prices are too sticky to adjust fast. Economists still argue about sticky prices today, and many think Keynes got Say's law wrong in his arguments.

Examples Illustrating the Paradox of Thrift

Consider Ivan, who owns a factory making computer parts—it's one of the biggest employers in town XYZ. They were set to expand with new machines and hires, but a recession hits, and Ivan switches to saving mode. The factory lays off workers, cuts night shifts, and those unemployed folks start saving too since they have no income, which drops demand for Ivan's products even more. This adds to the town's social benefits costs and weakens the economy overall.

In the real world, during the Great Recession, the percentage of 25- to 29-year-olds moving in with parents jumped from 14% in 2005 to 19% in 2011. This saved families money on rent and expenses, but it cost the economy up to $25 billion a year in lost activity.

What Was the Savings Rate During the COVID-19 Pandemic?

During the COVID-19 pandemic, the personal savings rate shot up to nearly 30% in 2020, with U.S. households holding about $2.3 trillion in savings. Those numbers started dropping by the end of 2021.

Who Is Credited With Say's Law?

Say's Law is credited to Jean-Baptiste Say, a French economist. In 1803, he said, 'It is worthwhile to remark that 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.'

What Is a Recession?

Some define a recession as two straight quarters of falling GDP, but that's not official since there are no set quantifiable terms. The National Bureau of Economic Research describes it as a significant decline in economic activity spread across the economy that lasts more than a few months.

The Bottom Line

To wrap this up, the paradox of thrift, made famous by John Maynard Keynes, tells you that saving is smart for you personally, but during a recession, it can damage the wider economy by cutting spending. Keynesian ideas suggest lowering interest rates to promote spending as a fix. Critics say it misses things like inflation, Say's law, and the need for capital investment. By understanding the theory and its limits, you can better manage your savings while considering broader economic goals.