Paradox of Thrift

by Manshu on March 6, 2009

in Articles

A few weeks ago I talked about my desire to buy a 100 billion dollar Zimbabwe currency bill from eBay for $15, and how I suppressed that desire because of the recession.

I saved those 15 dollars by suppressing my desire to spend, and that was good for me. However, there were a lot of people who were impacted by my decision to save those $15 dollars.

A few that I can readily think of:

  1. The seller
  2. eBay
  3. PayPal (I would have used it to pay for the 100 billion dollar bill)
  4. UPS (The seller would have shipped this thing to me using UPS)
  5. A Random Gas Pump Owner (The seller would have needed to drive to UPS)
  6. A Stationery Company (The seller would have used some sort of an envelope)

Although I saved money – others lost out on an income opportunity. If everyone in the country did this – the aggregate demand in the economy would go down.

So, while individuals would save money – the economy as a whole would suffer with lower demand and income.

This is known as the – Paradox of Thrift.

Now, thrift is not always bad because whatever I save goes to the bank and then the bank loans that out to businesses to start up ventures and create economic activity. So, to that extent savings are needed to finance investments and create capital.

In recessionary times, the willingness of businesses to invest reduces drastically. There are job cuts, slashing of capital expenditures and such. So it is quite likely that in such a situation – savings exceed investments.

If savings exceed investments then theoretically the economy is much better off having that “extra” savings – spent, as that would create demand and provide stimulus.

As you can well imagine, in recessionary times – if everyone starts saving more and spending less this would create a downward spiral and can ultimately lead to the bad effects of deflation.

To avoid such a spiral and fill  the gap in demand left by private individuals and households – governments spend during recessions. And this is what we see today in the form of stimulus packages from governments all over the world.

The government spends because it wants to fill in the gap temporarily. Once the recession subsides – people will start spending again and the overall demand levels in the economy will rise to their former levels (most times anyway). At that time there will be no more need for a stimulus and people would be back to their former selves.

So, seen in that light the – Paradox of Thrift is at best a temporary phenomenon, which is applicable only during recessions, and that too can be set off by government spending.

That effectively means that people are better off saving money, if that is what suits their financial position rather than spending it motivated by an illusion of patriotism.

{ 9 comments… read them below or add one }

Dana March 6, 2009 at 2:34 am

I was talking about this also over at the Money and Such site, and I will say the same here. Saving should be a rational reflection of one’s ability to do so, subjected to the cost and constraints of current versus future consumption, and also the underlying social welfare structures that either support or discourage you from saving.

I agree with you on that, and think that balance will come when American debts are paid down, liquidity is restored, housing prices have come down to a sane level, and people generally believe there is sustainable social security and medicare. Before those problems start to patch up, any bullishness might be sectoral, purely temporary, or government propped.

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manshuv March 6, 2009 at 5:47 am

Dana,

I think I will take your sentence and replace one word with another to see how it looks:

SPENDING should be a rational reflection of one’s ability to do so, subjected to the cost and constraints of current versus future consumption, and also the underlying social welfare structures that either support or discourage you from SAVING.

Yes, that makes sense too 🙂

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Ancella March 6, 2009 at 7:36 am

The analogy you drew with buying Zimbabwaen billion Dollar note and spending is pretty much what is happening right now. I came across an article in the news not long ago which mentions that Finalnd is actually running ads on TV to influence consumers to spend during this recession, with a hope of reviving the economy to some extent.

I am psting a link to this article I found…

http://www.pbs.org/newshour/businessdesk/2009/02/web-extra-finlands-unusual-tak.html

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Manshu March 6, 2009 at 8:30 am

Thanks for the link Ancella, if I were Finnish, I wouldn’t take that advice to alter my spending or saving habits.

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Miss M March 6, 2009 at 1:00 pm

We’re simply adjusting downward to a sustainable level of spending, the problem is we got used to an inflated level powered by debt. It was fun in the short term, now we get to experience the painful fallout. Then the cycle starts over and in 30 years we’ll have this conversation all over again. Now that I’m out of debt I’ll probably start spending a little more each month, not out of patriotism, just for my own personal enjoyment!

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manshuv March 7, 2009 at 9:54 am

Miss M – I am glad to hear that there are smart people like you who have the means to spend a little more in these times.

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Dana March 7, 2009 at 1:33 pm

Haha, I think your re-interpretation of my comment is way better! And yes, very clever 😉

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BM March 7, 2009 at 8:03 pm

My belief is that if enough people saved during the good economic times, then they would be able to buy homes and cars during a recession that would keep the economy humming along. I may be wrong, but I think we may never have a recession, if enough people saved and the economy would adjust itself to reduced consumption.

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manshuv March 8, 2009 at 9:42 am

BM, I know what you are saying but I think the way humans are wired; there is no way to avoid booms and busts. They have been happening for centuries – with the Tulip bubble going as far as the 16th or 17th century I think.

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