What is the Paradox Of Thrift?

The paradox of thrift, or paradox of savings, is an economic theory which 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.

Understanding the Paradox Of Thrift

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 succeeded the financial crisis of 2008. During that time, savings rate for the average American household increased from 2.9 percent to 5 percent. 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” (1936).

Key Takeaways

  • The paradox of thrift is an economic theory which argues that personal savings can be detrimental to overall economic growth. It is based on a circular flow of the economy in which current spending drives future spending.
  • It calls for a lowering of interest rates to boost spending levels during an economic recession.
  • Critics of the theory state that it ignores Say's law, which calls for investment in capital goods before any level of spending can be achieved, and does not take into account inflation or deflation in prices.

Circular Flow Economic Model

Keynes helped revive the so-called “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 incomes, 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.

Problems with Paradox of Thrift

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.

Also, 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. Similarly, if current thrift during a recession forces future prices to fall, future production and employment need not decline as Keynes predicted.

Finally, the Paradox of Thrift ignores the potential for saved income to be lent out by banks. When some individuals increase their savings, interest rates tend to fall, and banks make additional loans.

Keynes met these objections by arguing Say’s law was wrong and prices are too rigid to adjust efficiently. Economists remain divided about sticky prices. It is widely accepted that Keynes misrepresented Say’s law in his refutation.

Examples of Paradox of Thrift

Ivan owns a factory which produces component parts for computers. The factory is among town XYZ's biggest employers. He has been planning to expand his production capacity by installing more machines and hiring new workers. However, a recession strikes and Ivan reverts to savings mode. He lays off workers and discontinues operating the machine at night time. Unemployed factory workers, who do not have income to spend, also begin saving, reducing demand for goods produced by Ivan's factory. The unemployed factory workers also add to the town's overall spending on social benefits and its economy becomes weak.

Another example of the savings paradox during the Great Recession was the case of 25- to 29-year-olds who moved in with their parents. The percentage of such people increased from 14 percent in 2005 to 19 percent in 2011. While the move helped families save money on rent and other expenses, it caused estimated damages of as much as $25 billion per year to the economy.