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:
- The seller
- PayPal (I would have used it to pay for the 100 billion dollar bill)
- UPS (The seller would have shipped this thing to me using UPS)
- A Random Gas Pump Owner (The seller would have needed to drive to UPS)
- 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 fillÂ 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.