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Thrift is No Paradox

I have an op-ed in today’s AFR refuting the paradox of thrift as a rationale for short-term fiscal stimulus measures.  In particular, I highlight the origins of the idea in the discredited ‘secular stagnation’ hypothesis of the1930s.  Text over the fold (may differ slightly from edited AFR version).

Greg Mankiw makes related arguments in the US context.

The Rudd government has urged Australians to spend-up in an effort to ward-off an economic downturn.

This follows the government’s $10.4 billion Economic Security Package, which was deliberately targeted at those deemed most likely to open their wallets in the lead-up to Christmas: pensioners and families.

The injunction to spend is based on an old-fashioned Keynesian notion, the so-called paradox of thrift.  The paradox holds that while increased saving might be virtuous for the individual, at the collective level, it might be ruinous.  If everyone saves rather than spends, incomes will be reduced, employment will fall, leading to further reductions in spending, creating a self-reinforcing downturn.

John Maynard Keynes thought that saving was problematic because the advanced economies were at risk of exhausting the investment opportunities available to them.  These economies would then become permanently stuck below full employment, as the marginal efficiency of capital was driven to zero.

Keynes’ General Theory thus looked forward to ‘the euthanasia of the cumulative oppressive power of the capitalist to exploit the scarcity-value of capital.’ 

Far from providing a rationale for short-term fiscal stimulus, this view mandated permanent government intervention to maintain fully employment as a counter-weight to what Keynes saw as a secular tendency toward stagnation.

This ‘secular stagnation’ hypothesis became enormously influential from the mid-1930s until well into the 1960s, even against the backdrop of a rapid post-war economic expansion that provided abundant empirical refutation for the idea.

As economist W. H. Hutt argued ‘the building up physical productive power has no greater tendency to force interest toward zero than has the growth of population a tendency to reduce the value of labor to zero.’

The paradox of thrift is based on the idea that saving is a ‘leakage’ from the flow of income in the economy.  But the circumstances in which this might occur are quite limited, even in a Keynesian framework.

The hoarding of cash under mattresses might result in the disintermediation of saving from the financial system, which would then be unavailable to fund increased investment spending.

This might occur in a deflationary environment where consumer prices are falling and hoarded cash increases in purchasing power, providing a positive rate of return that might not be available from other non-cash assets in a severely recessed economy. 

However, a deflationary environment is a problem for monetary policy, not an argument against increased saving.

Far from putting cash under the mattress, the most likely destinations for household saving in the current environment are paying down debt, increased bank deposits, or the acquisition of other forms of financial assets. 

The latest national accounts data imply that the increase in household disposable income due to the 1 July 2008 tax cuts and growth in the economy has been saved rather than spent.  The household saving ratio rose from 1.3% in the June quarter to 3.9% in the September quarter of last year, well up on the negative household saving ratio seen just a few years ago. 

This suggests that households have been paying down debt in response to the uncertainties associated with the global financial crisis.

But this does not mean that these funds are lost to economy.  Rather than being a ‘leakage’ from the flow of income, such saving becomes part of the life blood of the economy, increasing the capacity of banks and other financial institutions to lend.

By reducing their borrowing from financial institutions, households increase the capacity of financial institutions to lend for a given level of capital. 

Increased saving via bank deposits has provided a much needed boost to the ability of banks and financial institutions to continue lending in the context of the credit crisis, lowering the cost of funds to these institutions and their borrowers.

Households also strengthen their own balance sheets through increased saving.  A lower household debt burden adds to disposable income and consumption.

By increasing the availability of capital, an increase in saving by households supports aggregate spending and the investment opportunities that Keynesians wrongly believed to have been all but exhausted by the 1930s.

It is hardly surprising that consumers and businesses should moderate their spending in the context of an economic downturn.  But recessions are not made worse via increased saving, so long as the financial system continues to put that saving to work.  By making capital more abundant and lowering the cost of funds, increased saving is one of the mechanisms by which economic growth is sustained. 

The ‘paradox of thrift’ is thus no paradox at all.  What is individually virtuous is also socially virtuous.  As the great 19th century French economic journalist Frederic Bastiat said, ‘to save is to spend.’

However, there is one sense in which governments do need to be wary of increased household saving.  If households anticipate a higher future tax burden as a result of unfunded fiscal stimulus measures, then households will have every incentive to increase their saving to offset reductions in their future disposable income.  Public sector dissaving would then be offset by increased private sector saving, leaving national saving unchanged. 

The irony is that fiscal stimulus measures may unintentionally promote private saving rather than spending, but with no benefit to overall national saving.  This is why fiscal policy is generally ineffective as a demand management tool and there are very few historical examples of successful fiscal stimulus.

posted on 12 January 2009 by skirchner in Economics, Fiscal Policy

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Comments

Nice piece!

Posted by .(JavaScript must be enabled to view this email address)  on  01/13  at  01:11 PM


Did you read John M Legge’s letter in response to your article in today’s AFR?

Posted by .(JavaScript must be enabled to view this email address)  on  01/13  at  11:09 PM


Legge seems to think banks face no capital constraint.

Legge is a well-known advocate of protectionism and interventionism.

Posted by skirchner  on  01/14  at  01:28 AM


If households anticipate a higher future tax burden as a result of unfunded fiscal stimulus measures, then households will have every incentive to increase their saving to offset reductions in their future disposable income

Mate, what you smoking?  People are saving money because they are worried about losing their jobs.  I can absolutely guarantee you they are not worrying about “unfunded stimulus measures”.

Go to a pub and ask ten people why they are saving more than they were six months ago.  If anyone says “because I’m worried the government is spending too much” I’ll send you my first born.

Posted by .(JavaScript must be enabled to view this email address)  on  01/14  at  07:24 AM


David, can’t they be worried about both?

Posted by skirchner  on  01/14  at  10:14 AM


No.

Go to a pub and ask ten people for ten reasons why why they are saving more than they were six months ago.  If “unfunded stimulus measures” appears anywhere in any list, I’ll send you my left leg.

Posted by .(JavaScript must be enabled to view this email address)  on  01/14  at  12:40 PM


But recessions are not made worse via increased saving, so long as the financial system continues to put that saving to work.

But surely the point here is the financial system is not putting that saving to work at the moment.  The banks are hoarding cash provided by savers and central banks, and not lending it to businesses and consumers.  While this situation continues the paradox of thrift is a very real problem.

The situation in Australia is better than it is the US and Europe, but we are yet to feel the full effects of the collapse in trade in Asia.  We can only hope the credit freeze thaws before the economic tsunami hits our shores.

Posted by .(JavaScript must be enabled to view this email address)  on  01/14  at  10:34 PM


“surely the point here is the financial system is not putting that saving to work at the moment”

Increased saving makes that situation better not worse, by easing capital constraints on banks, increasing the supply of funds and lowering interests rates, supporting spending and growth.  Without the increased saving from the household sector via bank deposits, the credit crunch would have been worse.

Posted by skirchner  on  01/14  at  11:30 PM


Are libertarians surrounded by a cone-of-silence, where only data that supports their religion (sorry, ideology) penetrates?

Increased saving makes that situation better not worse, by easing capital constraints on banks, increasing the supply of funds and lowering interests rates, supporting spending and growth.

That would be true if it were actually happening.  Banks are certainly rebuilding their balance sheets, interest rates are lower, and the (potential) supply of funds is increasing, but the fact remains the banks still aren’t lending, so they aren’t supporting spending and growth.

While the banks continue to hoard cash the paradox-of-thrift is a very real problem.  Credit has evaporated, consumers and businesses are saving every penny, and the banks are hoarding the money.  The net result is less spending and less growth.

Posted by .(JavaScript must be enabled to view this email address)  on  01/15  at  12:28 AM


Private sector credit growth shows that banks are still lending.  The pace has slowed and could even turn negative in the future, but increased saving is one of the few things that works against that tendency.  If household saving had not increased, things would be much worse.  It is no accident that the banks that are outperforming have larger retail deposits bases.

Posted by skirchner  on  01/15  at  01:32 AM


Again you are talking about the Australian situation, whereas I tend to focus on the US/European situation because that’s where my income comes from.

In the US the Fed is throwing money at the banking system, and the US savings rate has turned positive, but the money is staying in the banks.  If consumers and businesses save more and the banks don’t lend, the paradox-of-thrift is real.

I agree that increased saving is not necessarily a bad thing, but the key to turning around this mess is to get the banks lending again.

Posted by .(JavaScript must be enabled to view this email address)  on  01/15  at  06:53 AM


You may find this of interest.

Steve Fazzari, of Washington University in St. Louis, talks with EconTalk host Russ Roberts about Keynesian economics. Fazzari talks about the paradox of thrift, makes the case for a government stimulus plan, and weighs the empirical evidence for a Keynesian worldview.

http://www.econtalk.org/archives/2009/01/fazzari_on_keyn.html

Posted by .(JavaScript must be enabled to view this email address)  on  01/15  at  10:48 PM


I usually listen to Econtalk, but I’m about a week behind at the moment, so haven’t heard him yet.  Russ said he was going to get a Keynesian on to respond to Pete Boetkke.

Posted by skirchner  on  01/15  at  11:01 PM


David,

Apparently, there are data showing that lending in the US may have slowed down, but has not stopped.  For example:

PARIS (Reuters) - The credit crunch is not nearly as severe as the U.S. authorities appear to believe and public data actually suggest world credit markets are functioning remarkably well, a report released on Thursday says…

http://www.reuters.com/article/email/idUSTRE4BA47420081211

...Banks are in the lending business: They do not need to be forced to lend. And contrary to popular and political opinion, banks have not stopped lending. Despite the recent financial market turmoil, a declining GDP, and an increase in loan-loss reserves, commercial bank lending actually grew $336 billion, or 4.9%, from August to Dec. 24, according to Federal Reserve data (see chart above).

http://online.wsj.com/article/SB123120666040256163.html?mod=djemEditorialPage

Stephen,

What about the role of prices? In a worst case scenario where people are saving yet banks are not lending, that would surely push down prices and thus increase consumer purchasing power. At some point, lower prices would re-stimulate demand.

PS. I am still having problems with the following line repeated a gazillion times at the top of your page (OK, actually around 60 times):

Notice: Undefined index: UP85 in /home/pmh3086/public_html/system/core/core.localize.php on line 166

Am I the only one experiencing this?

Posted by .(JavaScript must be enabled to view this email address)  on  01/16  at  12:55 AM


“That would be true if it were actually happening.  Banks are certainly rebuilding their balance sheets, interest rates are lower, and the (potential) supply of funds is increasing, but the fact remains the banks still aren’t lending, so they aren’t supporting spending and growth.”

Carbonsink - I’m not sure you are looking at the appropriate counterfactual.  Even if lending had fallen the comparison is between what “would have happened” in the absense of rising private savings and what wouldn’t have happened.

Rising private savings in Aussie and NZ has been instrumental in preventing a stronger increase in business lending rates in our two countries - that is an important fact.

Posted by Matt Nolan  on  01/16  at  01:09 AM


ED, I would be cautious interpreting the lending data.  It may represent firms drawing down existing credit lines in anticipation they may not be available later, as well as the shift from capital markets to banks as a source of funds.

Price declines are not necessarily a bad thing, depending on what’s driving them. 

You are the only one to report this issue.  Try upgrading to IE7 (I think you are on IE6) or using Firefox and see if it goes away.  Site looks better in Firefox anyway.

Posted by skirchner  on  01/16  at  01:13 AM



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