The Paradox of Thrift - A Keyensian Myth Debunked

     We all know that saving money is good: you can afford that vacation, retire early, fund your kids college education, etc. However, most of us think that saving money is bad for the economy at large. We think that people spending money is ipso facto good for the economy. There is a popular Keynesian concept, based on this premise, that has permeated our culture. It is termed “The Paradox of Thrift.” It can be simply summed up as follows: saving money is good for the individual, but bad for the economy. Spending money is bad for the individual, but good for the economy. Hence the supposed paradox.

     This seems plausible on the surface. However, think deeper: if people are saving, then that means that those who are saving are creating value for others, and that banks have more money to lend out. The money saved eventually makes its way into the economy. This makes borrowing easier. Then people will be incentivized to buy more, especially things that are normally bought on credit, like houses and cars. So, this system is self-correcting: if people save more, then others will borrow more. If people are spending more, than others will be incentivized to save more. If lenders are liberal with their capital, then returns will decrease, incentivizing more conservatism, and vice versa. An equilibrium is reached, and the economy is steady, people are happy.

     So where does the Paradox go wrong? We have to start with a general premise accepted by proponents of the Paradox of Thrift. They believe that the economy is generally based on aggregate demand, or in other words, the total demand for goods and services. They believe that recessions occur because aggregate demand decreases: that people suddenly stop wanting stuff.

     It should be intuitively obvious that demand does not change much. I want a condo at the Ritz. I want a new car. Most people want a mansion, an education for their children, etc. The problem is that we cannot all afford these things. Our demand for them doesn’t change much.

Here’s what’s really happening: entrepreneurs use the savings of others to create either new products and services to satisfy consumer demand, or they create new efficiencies in the production of existing products and services. When entrepreneurs make new products or services, the resulting goods can be quite expensive at first, and only a select few can afford these luxuries. 

    An historical example is spices. Before the invention of the refrigerator, spices and salts were in high demand in order to preserve and make food more palatable. Only the rich could afford them, but EVERYONE wanted them. Today, I can go to Stop and Shop and buy all the spices I want for just a few bucks!

   A recent example is cell phones. When cells phones first came out in the 1980s, only rich people like celebrities could afford them. Also, they were big, bulky, and didn’t work well. Remember Zack Morris’ gigantic phone that everyone thought was so cool? Over time, cell phones became cheaper and better. This is a natural economic phenomenon: entrepreneurs know that there is huge DEMAND for cell phones, but the problem is that the price is too high, keeping potential customers out of the market. So, the entrepreneurs figure out ways to make the production process more efficient, and therefore cheaper and available to more people. When the price gets low enough, more people will be willing to buy one (or two or three for their kids). The reason why an entrepreneur can make the investments of time and money to figure out these new efficiencies (and the creation of the product itself) is because someone saved enough money to fund the endeavor. Now we all have cell phones (and computers) that are far better and cheaper than those available not long ago.

    

     The point here is that demand doesn’t change much. What changes is the amount of capital (money, land, and labor) needed to make the product or service. The lower the cost, the more people will buy (duh!).

     So, the Paradox of Thrift isn’t a paradox at all. Saving is always good, because it ipso facto requires someone else to spend, and for the seller to underconsume so that more can be consumed in the future (in his own self-interest, mind you). People don’t suddenly decide they don’t need a refrigerator anymore, or that they don’t need plumbing, food, housing, a cell phone, etc. When a product or service is brought down to a certain price level, then demand for that good is PERMANENTLY elevated. In terms of legitimate aggregate demand, new efficiencies that make existing products cheaper, and hence more affordable, permanently raise "aggregate demand."

     Where do the Keynsians get confused? They confuse the effects of artificial extension of credit for a reduction in aggregate demand. Ben Bernanke, a Keynesiand “economist” and Chairman of the Federal Reserve, once said in a speech that “deflation is in almost all cases a side effect of a collapse of aggregate demand.” He is dead wrong. Deflation, at least in modern history, is almost always caused by an artificial extension of credit by central banks. When the debt can’t be repaid, then there is an inevitable contraction of credit, which leads to deflation (think housing 2008). This can seem like a decrease in aggregate demand, but it is in reality a reflection of the fact that people were spending beyond their means of repayment. Subsequent profits then go to repayment of debt that was already consumed, rather than to current or future products.

     The “Paradox of Thrift” is wrong: saving is good for the economy. The more people save, the better, because entrepreneurs will have more capital available to make new products and services, and to make existing products and services cheaper and, hence, available to more people. With more capital available, the new products and efficiencies are therefore cheaper to figure out, resulting in faster increases in the standard of living. If we’re going to incentivize either saving or borrowing, we should incentivize saving: savings are the seeds of economic growth. People will always buy what they need, so incentivizing more spending is detrimental to a healthy economy, as it raises the cost of making new and better goods and services.

     Don’t be fooled by this supposed “paradox:” saving is good, artificial extension of credit is bad. Aggregate demand doesn’t change much, but can appear to when credit is artificially expanded.