Paradox of thrift

The paradox of thrift, or paradox of savings, is an economic theory that posits that personal savings are a net drag on the economy during a recession. This theory relies on the assumption that prices do not clear or that producers fail to adjust to changing conditions, contrary to the expectations of classical  microeconomics.

The paradox of thrift was popularized by British economist John Maynard Keynes. According to Keynesian theory, the proper response to an economic recession is more spending, more risk-taking, and fewer savings. Keynesians believe a recessed economy does not produce at full capacity because some of its factors of production (land, labor, and capital) are unemployed.

Keynesians also argue that consumption, or spending, drives economic growth. Thus, even though it makes sense for individuals and households to reduce consumption during tough times, this is the wrong prescription for the larger economy.

A pullback in aggregate consumer spending might force businesses to produce even less, deepening the recession. This disconnect between individual and group rationality is the basis of the savings paradox. An example of this was witnessed during the Great Recession that followed the financial crisis of 2008. During that time, the savings rate for the average American household increased from 2.9 per cent to 5per cent. The Federal Reserve slashed interest rates in order to boost spending in the American economy.

The first conceptual description of the paradox of thrift may have been written in Bernard Mandeville’s “The Fable of the Bees” (1714). Mandeville argued for increased expenditure as the key to prosperity, rather than savings. Keynes credited Mandeville for the concept in his book “The General Theory of Employment, Interest, and Money”. Keynes helped revive the circular flow model of the economy. This theory states that an increase in current spending drives future spending. Current spending, after all, results in more income for current producers. Those producers rationally deploy their new income, sometimes expanding business and hiring new workers; these new workers earn new income, which then may be spent.

To boost current spending, Keynes argued for lower interest rates to lower current savings rates. If low interest rates do not create more borrowing and spending, Keynes said, the government could engage in deficit spending to fill the gap. The circular flow model ignores the lesson of Say’s law, which states goods must be produced before they can be exchanged. Capital machines, which drive higher levels of production, require additional savings and investment. The circular flow model only works in a framework without capital goods.

The theory ignores the potential for inflation or deflation. If higher current spending causes future prices to rise concordantly, future production and employment will remain unchanged. If current thrift during a recession forces future prices to fall.

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