Understanding the Paradox of Thrift

Taking a suggestion from DTM, it’s probably worth attempting a layman’s explanation of “the paradox of thrift” in the current situation. So here goes:

I get a paycheck direct deposited into my bank account every two weeks, which is my salary less deductions for taxes and less money diverted into retirement savings. And every month, about as much money comes out of that account—to pay the mortgage, to pay utility bills, to pay credit card bills, and as ATM withdrawals for cash that I spend. I also have coming in a less-regular flow of checks for various freelance assignments I pick up here and there. Those freelance assignments don’t come with taxes deducted, so I always winding up owing money when I do my taxes so I try to make sure I have money saved to pay that off when April comes around. Beyond that, I’m usually saving up some money to take a trip (to Spain, for example) or to buy something somewhat expensive (a new Macbook, for example). But those kind of savings are a pretty small portion of the overall pie. The money I’m not saving for taxes or MacBooks gets spent on goods and services. That spending provides jobs for other people around the world. And those people, in turn, probably spend most of the money they make on other goods and services thus providing more jobs.

So what happens if I decide to cut back and save more, maybe because I want to buy a car or just because I feel a bit nervous and want to build up a cushion? Well, if there’s some particular business that depends crucially on my patronage, that might be bad news for them. But even though the economy as a whole depends on consumers like me spending me, my personal decision to cut back shouldn’t particularly have any macroeconomic impact. And not just because the amount of money is small. It won’t have much impact because if I increase the amount of money I have in my savings account, the bank can increase the amount of money it lends out. And just as my spending led to economic activity and jobs, whatever it is other people borrow money from the bank to do will also generate economic activity.

But now suppose a bunch of people lose their jobs in the construction business and start spending less money. And also a bunch of people in finance lose their jobs and start spending less money. And some restaurants and bars that catered to the finance crowd start having less business so they employ staff for fewer hours and those guys all start spending less money.

Now it’s not just me looking to build a bigger cushion by cutting back on spending, it’s a whole bunch of people looking around and feeling nervous and deciding to cut back. Well, with all that cutting back there’s a lot less stuff flying off the shelves. So retailers start laying off workers (who need to reduce spending and whose friends start feeling nervous and reducing their own spending) and discounting the merchandise. Maybe the sales are so impressive that everyone changes their mind, decides that the bargains are too good to pass up, and goes and buys a bunch of stuff rather than increasing savings. If so, the economy just had a minor hiccup and life goes on. But maybe the accelerating wave of discounts just makes people feel more nervous. And maybe I see all this discounting and decide not to buy that new MacBook after all, because it’s not on sale yet and I’m betting it will be soon.

Now we’ve entered “paradox of thrift” territory. People are saving more. And the increased saving isn’t being cycled back into the economy as new investment. In part, that’s because of problems in the financial system. But in part, it’s because with short-term demand slumping so much, there’s not a lot of worthwhile investing to be doing. The economy needs someone to decide to borrow some money and start a new firm that employs these newly unemployed people. But with the volume of consumption going down so rapidly, nobody’s really in the mood to start a new business. And existing businesses are busy scaling back production, not interested in borrowing money to ramp it up. The result of this is an overall fall in the average level of income. And that means that even with the share of income being saved going up, the actual level of savings can be going down and we can truly end up in the toilet.

The ultimate point of a fiscal stimulus policy is to avoid that toilet scenario. To get money flowing in the economy again, so that savings gets translated into investment which gets translated into jobs which pay salaries which, in turn, are spent and saved in ways that create jobs.