Paradox of Thrift
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Overview
The idea is this: in equilibrium, total income must equal total output and total savings must equal total investments. If savings rise, this destroys income (I make what you spend and vice versa), so while savings and investments rise, income is decreased. This decrease in income decreases total output, which means there's less available for everyone. One summation of the paradox being that broad attempts by individuals to save more can result in lower overall savings because there's less to save.
Real World Application
Keynesian economics are now very much in vogue (again) and it is this idea which has everyone on TV talking about how we need to get consumer spending back up. The way to bounce back from a recession is to increase "aggregate demand". Our spending translates into our income which which equals aggregate output (under the formal definitions of the model). So the more we spend, the more we make, and the better the economy does.
This was the reason why interest rates have been kept low (in modern times) in the face of recession. In bad times, people tend to save more and spend less, but the paradox predicts that this will only compound the problem.[notes 1] The solution: make borrowing "cheap" and increase aggregate demand, shifting the curves and avoiding or lessening the destruction of income that would occur if you did nothing.
Problems
Loanable Funds
The single biggest problem with the paradox is that savings don't just sit there. If people started hoarding money, that would be one thing and--everyone agrees?--disastrous.[notes 2] Saving, however, is not hoarding money, it's really just investment. When you give your money to the bank, that money goes back and becomes spending for some business or home owner or car buyer, etc.
This argument isn't lost on Keynesians as most would, I'm sure, agree with the statement that "Without forgoing consumption, there can be no economic growth."[notes 3] In simplest terms, you can't just sleep and eat and spend. You have to work to at least break even, and to get ahead, you actually have to work more than sleep, eat, and spend. Not necessarily in temporal terms, but certainly in economic terms.[notes 4]
Thus, it seems to me, that savings don't really destroy income, they just shift it. Which leads us to the next problem.
Efficient Spending
If we assume an economy where all savings are loaned[notes 5] and all loans are spent, then savings is really just transfered spending. Effectively, you're saying, "I believe the bank (or bond holder) can spend this money more effectively than I can. Individual consumption goes down, but business consumption (investment) goes up, and the economy improves.
Superficially, this makes a lot of sense to me. Is the economy made better by me buying baubles at the mall, or by me letting a business use my money to buy capital equipment and improve their operations? A naive reading of Keynesian economics would seem to indicate that "spending is spending". If you think in terms of my example, that seems ridiculous.
Modern Day Hoarding
Personally, I believe very strongly that the stock market is--by and large--the modern day equivalent of stuffing money under the mattress. To understand how this works, first you have to understand what I mean when I say Stock Markets aren't Real. The idea in a nutshell is this: buying stock in the secondary market is purely an issue of pricing. There is no investment because the company doesn't get any of that money. The money doesn't go to capital development of any kind. It doesn't increase output. It doesn't do anything but price the stock.
The metaphor of mattress stuffing is obviously quite limited. I can buy a stock and end up with more or less money than I had before. In fact, it's almost certain. Money in the mattress won't ever change (I'm talking nominal terms here).
The point of the metaphor, however, is to say that if stocks don't do anything except price stocks, then from an economic point of view you might as well be stuffing money into your mattress. The fact that the stock market gets bigger and bigger every year[notes 6] simply means that we're removing more and more money from the real economy.
Two Economic Views
The Real vs Monetary Economic Models also have a great deal to do with it. (TODO: can I embed another article in this article?)
Summary
We have some evidence that this idea of aggregate demand and moving the curves and total output and what not are real. It really does seem like moving monetary policy to increase aggregate demand can smooth out recessions and help us avoid depressions. We won't know for quite awhile (read decades) what effect the current stimulus and monetary policy had on reducing the current economic problems and we'll never know for sure since practical economics is fuzzy at best. But still, it looks like there's some truth to this.
On the other hand, if spending where all it took, then bubbles should only lead to greater economic growth. One thing we do know for sure is that our current economic woes are in large part cause by insufficient savings.[notes 7] A Keynesian--or anyone really--could argue that this is a tad unfair because the economy was out of equilibrium to begin with. The paradox of thrift doesn't say "always spend, never save" because the story pre-supposes an economy in equilibrium which means you start with appropriate saving and spending (whatever that is) and ask, "What happens if we change the aggregate rates?"
So we might say that it looks like the "paradox of thrift" is true, but only in an economy in equilibrium. Equilibrium, in practical terms, means you don't spend more than you make and you carry sufficient reserves to smooth out rough patches.
The other critical factor in understanding and applying the paradox of thrift is to realize that it's fundamentally a monetarist economic model. A pure "real side" economist must dismiss the paradox of thrift because it only makes sense in an monetarist model (as far as I can tell). For myself, it's silly to think that a money is just "a veil" which covers the "real economics" underneath (hence, real side economics). At the same time, the fact that the Fed and other monetary policies always seem to under-deliver makes it clear that we've given the monetary effects more credit than they deserve.
Notes
- ↑ Eventually prices fall far enough that demand picks up again and that's when recover begins, but, Keynesians argue, when the economy has had a sever jolt, demand must fall drastically and you can end up with a depression.
- ↑ This happened in the Depression, but--as far as I know--never since.
- ↑ I make this statement partially based on a quote from one Keynesian, and partially because I do believe that this is a general tenant of economic theory of all stripes. However, I'd love to do a general survey.
- ↑ Unless of course your rich... which is probably the best definition of rich there is. But this presents a whole other issue.
- ↑ Given that banks loan out most of the money on deposit and the bond market is actually larger than the stock market, it can be argued that our economy approximates this world. I've been trying for a month to find the average reserve funds rate of banks (the requirement is--or was--just 3%), but what seems like a very important statistic has been impossible to find.
- ↑ Assuming, as I do, that the increase is due to more dollars chasing stocks rather than IPOs, which do represent actual investment.
- ↑ I'm talking specifically about the rash of low or no equity loans that made it easy for mortgages to go upside down and directly led to spiraling housing costs.
References
- Fazzari on Keynesian Economics; an interesting talk but--and I hesitate to say this because the quality of the show is generally rather high--does a poor job of representing the paradox of thrift. The problem is that the paradox of thrift is a macroeconomic concept, but is discussed almost entirely in microeconomic terms. Not surprising for the show, but the issue is that the key idea in the paradox of thrift is that a rise in savings moves the equilibrium point itself in the wrong direction. On the other side, the Austrian-microeconomist Russ Roberts fails to adequately hit home the strongest problem with the paradox: Loanable Funds.
