Paradox of thrift
Encyclopedia
The paradox of thrift is a paradox
of economics
, popularized by John Maynard Keynes
, though it had been stated as early as 1714 in The Fable of the Bees
, and similar sentiments date to antiquity. The paradox states that if everyone tries to save more money during times of recession, then aggregate demand
will fall and will in turn lower total savings in the population because of the decrease in consumption and economic growth. The paradox is, narrowly speaking, that total savings may fall even when individual savings attempt to rise, and, broadly speaking, that increase in savings may be harmful to an economy. Both the narrow and broad claims are paradoxical within the assumption underlying the fallacy of composition
, namely that what is true of the parts must be true of the whole. The narrow claim transparently contradicts this assumption, and the broad one does so by implication, because while individual thrift is generally averred to be good for the economy, the paradox of thrift holds that collective thrift may be bad for the economy.
The paradox of thrift is a central component of Keynesian economics
, and has formed part of mainstream economics
since the late 1940s, though it is criticized on a number of grounds.
, ceteris paribus
, will move the equilibrium point at which income equals output and investment equals savings to lower values.
In this form it represents a prisoner's dilemma
as saving is beneficial to each individual but deleterious to the general population. This is a "paradox" because it runs contrary to intuition. One who does not know about the paradox of thrift would fall into a fallacy of composition
wherein one generalizes what is perceived to be true for an individual within the economy to the overall population. Although exercising thrift may be good for an individual by enabling that individual to save for a "rainy day", it may not be good for the economy as a whole.
This paradox can be explained by analyzing the place, and impact, of increased savings in an economy. If a population saves more money (that is the marginal propensity to save
increases across all income levels), then total revenues for companies will decline. This decrease in economic growth means fewer salary increases and perhaps downsizing. Eventually the population's total savings will have remained the same or even declined because of lower incomes and a weaker economy. This paradox is based on the proposition, put forth in Keynesian economics
, that many economic downturns are demand based.
verse:
which has found occasional use as an epigram in underconsumptionist writings.
Keynes himself notes the appearance of the paradox in The Fable of the Bees
: or, Private Vices, Publick Benefits (1714) by Bernard Mandeville, the title itself hinting at the paradox, and Keynes citing the passage:
Keynes suggests Adam Smith
was referring to this passage when he wrote "What is prudence in the conduct of every private family can scarce be folly in that of a great Kingdom."
The problem of underconsumption and oversaving, as they saw it, was developed by underconsumption
ist economists of the 19th century, and the paradox of thrift in the strict sense that "collective attempts to save yield lower overall savings" was explicitly stated by John M. Robertson
in
his 1892 book The Fallacy of Saving, writing:
Similar ideas were forwarded by William Trufant Foster
and Waddill Catchings in the 1920s in The Dilemma of Thrift.
Keynes distinguished between business activity/investment ("Enterprise") and savings ("Thrift") in his Treatise on Money
(1930):
and stated the paradox of thrift in The General Theory, 1936:
The theory is referred to as the "paradox of thrift" in Samuelson's
influential Economics
of 1948, which popularized the term.
, non-Keynesian economists, particularly neoclassical economists
, criticize this theory on three principal grounds.
The first criticism is that, following Say's law
and the related circle of ideas, if demand slackens, prices will fall (barring government intervention), and the resulting lower price will stimulate demand (though at lower profit or cost – possibly even lower wages). This criticism in turn has been questioned by Keynesian economists, who reject Say's law and instead point to evidence of sticky prices
as a reason why prices do not fall in recession; this remains a debated point.
The second criticism is that savings represent loanable funds
, particularly at banks, assuming the savings are held at banks, rather than currency itself being held ("stashed under one's mattress"). Thus an accumulation of savings yields an increase in potential lending, which will lower interest rates and stimulate borrowing. So a decline in consumer spending is offset by an increase in lending, and subsequent investment and spending.
Two caveats are added to this criticism. Firstly, if savings are held as cash, rather than being loaned out (directly by savers, or indirectly, as via bank deposits), then loanable funds do not increase, and thus a recession may be caused – but this is due to holding cash, not to saving per se. Secondly, banks themselves may hold cash, rather than loaning it out, which results in the growth of excess reserves
– funds on deposit but not loaned out. This is argued to occur in liquidity trap
situations, when interest rates are at a zero lower bound (or near it) and savings still exceed investment demand. Within Keynesian economics, the desire to hold currency rather than loan it out is discussed under liquidity preference
.
Third, the paradox assumes a closed economy in which savings are not invested abroad (to fund exports of local production abroad). Thus, while the paradox may hold at the global level, it need not hold at the local or national level: if one nation increases savings, this can be offset by trading partners consuming a greater amount relative to their own production, i.e., if the saving nation increases exports, and its partners increase imports. This criticism is not very controversial, and is generally accepted by Keynesian economists as well, who refer to it as "exporting one's way out of a recession". They further note that this frequently occurs in concert with currency devaluation (hence increasing exports and decreasing imports), and cannot work as a solution to a global problem, because the global economy is a closed system – not every nation can increase exports.
, the paradox was criticized by the Austrian School
economist and Nobel Prize
winner Friedrich Hayek
in a 1929 article, "The 'Paradox' of Savings", attacking the paradox as proposed by Foster and Catchings. Hayek and later Austrian School economists agree that if a population saves more money, total revenues for companies will decline, but they deny the assertion that lower revenues lead to lower economic growth.
Austrian School economists believe the productivity of the economy is determined by the consumption-investment ratio, and the demand for money only tells us the degree to which people prefer the utility of money (protection against uncertainty) to the utility of goods. They argue that hoarding of money (an increase in the demand for money) does not necessarily lead to a change in the population's consumption-investment ratio; instead, it may simply be reflected in the price level
. For example, if spending falls by half and prices also uniformly fall by half, the consumption-investment ratio and productivity would be left unchanged.
theory of economic crises, being called "the paradox of debt" – people save not to increase savings, but rather to pay down debt. As well, a paradox of toil
has been proposed: wage flexibility in a liquidity trap may lead not only to lower wages, but lower employment.
" showed a fictional situation in which the paradox of thrift came to fruition.
Paradox
Similar to Circular reasoning, A paradox is a seemingly true statement or group of statements that lead to a contradiction or a situation which seems to defy logic or intuition...
of economics
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...
, popularized by John Maynard Keynes
John Maynard Keynes
John Maynard Keynes, Baron Keynes of Tilton, CB FBA , was a British economist whose ideas have profoundly affected the theory and practice of modern macroeconomics, as well as the economic policies of governments...
, though it had been stated as early as 1714 in The Fable of the Bees
The Fable of the Bees
The Fable of The Bees: or, Private Vices, Public Benefits is a book by Bernard Mandeville, consisting of the poem The Grumbling Hive: or, Knaves turn’d Honest and prose discussion of it. The poem was published in 1705 and the book first appeared in 1714...
, and similar sentiments date to antiquity. The paradox states that if everyone tries to save more money during times of recession, then aggregate demand
Aggregate demand
In macroeconomics, aggregate demand is the total demand for final goods and services in the economy at a given time and price level. It is the amount of goods and services in the economy that will be purchased at all possible price levels. This is the demand for the gross domestic product of a...
will fall and will in turn lower total savings in the population because of the decrease in consumption and economic growth. The paradox is, narrowly speaking, that total savings may fall even when individual savings attempt to rise, and, broadly speaking, that increase in savings may be harmful to an economy. Both the narrow and broad claims are paradoxical within the assumption underlying the fallacy of composition
Fallacy of composition
The fallacy of composition arises when one infers that something is true of the whole from the fact that it is true of some part of the whole...
, namely that what is true of the parts must be true of the whole. The narrow claim transparently contradicts this assumption, and the broad one does so by implication, because while individual thrift is generally averred to be good for the economy, the paradox of thrift holds that collective thrift may be bad for the economy.
The paradox of thrift is a central component of Keynesian economics
Keynesian economics
Keynesian economics is a school of macroeconomic thought based on the ideas of 20th-century English economist John Maynard Keynes.Keynesian economics argues that private sector decisions sometimes lead to inefficient macroeconomic outcomes and, therefore, advocates active policy responses by the...
, and has formed part of mainstream economics
Mainstream economics
Mainstream economics is a loose term used to refer to widely-accepted economics as taught in prominent universities and in contrast to heterodox economics...
since the late 1940s, though it is criticized on a number of grounds.
Overview
The argument is that, in equilibrium, total income (and thus demand) must equal total output, and that total investment must equal total saving. Assuming that saving rises faster as a function of income than the relationship between investment and output, then an increase in the marginal propensity to saveMarginal propensity to save
The marginal propensity to save refers to the increase in saving that results from an increase in income i.e. The marginal propensity to save might be defined as the proportion of each additional dollar of household income that is used for saving. It is also used as an alternative term for the...
, ceteris paribus
Ceteris paribus
or is a Latin phrase, literally translated as "with other things the same," or "all other things being equal or held constant." It is an example of an ablative absolute and is commonly rendered in English as "all other things being equal." A prediction, or a statement about causal or logical...
, will move the equilibrium point at which income equals output and investment equals savings to lower values.
In this form it represents a prisoner's dilemma
Prisoner's dilemma
The prisoner’s dilemma is a canonical example of a game, analyzed in game theory that shows why two individuals might not cooperate, even if it appears that it is in their best interest to do so. It was originally framed by Merrill Flood and Melvin Dresher working at RAND in 1950. Albert W...
as saving is beneficial to each individual but deleterious to the general population. This is a "paradox" because it runs contrary to intuition. One who does not know about the paradox of thrift would fall into a fallacy of composition
Fallacy of composition
The fallacy of composition arises when one infers that something is true of the whole from the fact that it is true of some part of the whole...
wherein one generalizes what is perceived to be true for an individual within the economy to the overall population. Although exercising thrift may be good for an individual by enabling that individual to save for a "rainy day", it may not be good for the economy as a whole.
This paradox can be explained by analyzing the place, and impact, of increased savings in an economy. If a population saves more money (that is the marginal propensity to save
Marginal propensity to save
The marginal propensity to save refers to the increase in saving that results from an increase in income i.e. The marginal propensity to save might be defined as the proportion of each additional dollar of household income that is used for saving. It is also used as an alternative term for the...
increases across all income levels), then total revenues for companies will decline. This decrease in economic growth means fewer salary increases and perhaps downsizing. Eventually the population's total savings will have remained the same or even declined because of lower incomes and a weaker economy. This paradox is based on the proposition, put forth in Keynesian economics
Keynesian economics
Keynesian economics is a school of macroeconomic thought based on the ideas of 20th-century English economist John Maynard Keynes.Keynesian economics argues that private sector decisions sometimes lead to inefficient macroeconomic outcomes and, therefore, advocates active policy responses by the...
, that many economic downturns are demand based.
History
While the paradox of thrift was popularized by Keynes, and is often attributed to him, it was stated by a number of others prior to Keynes, and the proposition that spending may help and saving may hurt an economy dates to antiquity; similar sentiments occur in the BibleBible
The Bible refers to any one of the collections of the primary religious texts of Judaism and Christianity. There is no common version of the Bible, as the individual books , their contents and their order vary among denominations...
verse:
which has found occasional use as an epigram in underconsumptionist writings.
Keynes himself notes the appearance of the paradox in The Fable of the Bees
The Fable of the Bees
The Fable of The Bees: or, Private Vices, Public Benefits is a book by Bernard Mandeville, consisting of the poem The Grumbling Hive: or, Knaves turn’d Honest and prose discussion of it. The poem was published in 1705 and the book first appeared in 1714...
: or, Private Vices, Publick Benefits (1714) by Bernard Mandeville, the title itself hinting at the paradox, and Keynes citing the passage:
- As this prudent economy, which some people call Saving, is in private families the most certain method to increase an estate, so some imagine that, whether a country be barren or fruitful, the same method if generally pursued (which they think practicable) will have the same effect upon a whole nation, and that, for example, the English might be much richer than they are, if they would be as frugal as some of their neighbours. This, I think, is an error.
Keynes suggests Adam Smith
Adam Smith
Adam Smith was a Scottish social philosopher and a pioneer of political economy. One of the key figures of the Scottish Enlightenment, Smith is the author of The Theory of Moral Sentiments and An Inquiry into the Nature and Causes of the Wealth of Nations...
was referring to this passage when he wrote "What is prudence in the conduct of every private family can scarce be folly in that of a great Kingdom."
The problem of underconsumption and oversaving, as they saw it, was developed by underconsumption
Underconsumption
In underconsumption theory in economics, recessions and stagnation arise due to inadequate consumer demand relative to the amount produced. The theory has been replaced since the 1930s by Keynesian economics and the theory of aggregate demand, both of which were influenced by...
ist economists of the 19th century, and the paradox of thrift in the strict sense that "collective attempts to save yield lower overall savings" was explicitly stated by John M. Robertson
J. M. Robertson
John Mackinnon Robertson was a prolific journalist, advocate of rationalism and secularism, and Liberal Member of Parliament in the United Kingdom for Tyneside from 1906 to 1918.- Biography :...
in
his 1892 book The Fallacy of Saving, writing:
Similar ideas were forwarded by William Trufant Foster
William Trufant Foster
William Trufant Foster , was an American educator and economist, whose theories were especially influential in the 1920s. He was the first president of Reed College.- Career :...
and Waddill Catchings in the 1920s in The Dilemma of Thrift.
Keynes distinguished between business activity/investment ("Enterprise") and savings ("Thrift") in his Treatise on Money
A Treatise on Money
A Treatise on Money is a work on economics by English economist John Maynard Keynes. In the Treatise Keynes drew a distinction between savings and investment, arguing that where saving exceeded investment, recession would occur....
(1930):
and stated the paradox of thrift in The General Theory, 1936:
The theory is referred to as the "paradox of thrift" in Samuelson's
Paul Samuelson
Paul Anthony Samuelson was an American economist, and the first American to win the Nobel Memorial Prize in Economic Sciences. The Swedish Royal Academies stated, when awarding the prize, that he "has done more than any other contemporary economist to raise the level of scientific analysis in...
influential Economics
Economics (textbook)
Economics is an influential introductory textbook by American economists Paul Samuelson and William Nordhaus. It was first published in 1948, and has appeared in nineteen different editions, the most recent in 2010. It was the best selling economics textbook for many decades and still remains...
of 1948, which popularized the term.
Criticisms
Within mainstream economicsMainstream economics
Mainstream economics is a loose term used to refer to widely-accepted economics as taught in prominent universities and in contrast to heterodox economics...
, non-Keynesian economists, particularly neoclassical economists
Neoclassical economics
Neoclassical economics is a term variously used for approaches to economics focusing on the determination of prices, outputs, and income distributions in markets through supply and demand, often mediated through a hypothesized maximization of utility by income-constrained individuals and of profits...
, criticize this theory on three principal grounds.
The first criticism is that, following Say's law
Say's law
Say's law, or the law of market, is an economic principle of classical economics named after the French businessman and economist Jean-Baptiste Say , who stated that "products are paid for with products" and "a glut can take place only when there are too many means of production applied to one kind...
and the related circle of ideas, if demand slackens, prices will fall (barring government intervention), and the resulting lower price will stimulate demand (though at lower profit or cost – possibly even lower wages). This criticism in turn has been questioned by Keynesian economists, who reject Say's law and instead point to evidence of sticky prices
Sticky (economics)
Sticky, in the social sciences and particularly economics, describes a situation in which a variable is resistant to change. Sticky prices are an important part of macroeconomic theory since they may be used to explain why markets might not reach equilibrium right away. Nominal wages are often said...
as a reason why prices do not fall in recession; this remains a debated point.
The second criticism is that savings represent loanable funds
Loanable funds
In economics, the loanable funds market is a hypothetical market that brings savers and borrowers together, also bringing together the money available in commercial banks and lending institutions available for firms and households to finance expenditures, either investments or consumption...
, particularly at banks, assuming the savings are held at banks, rather than currency itself being held ("stashed under one's mattress"). Thus an accumulation of savings yields an increase in potential lending, which will lower interest rates and stimulate borrowing. So a decline in consumer spending is offset by an increase in lending, and subsequent investment and spending.
Two caveats are added to this criticism. Firstly, if savings are held as cash, rather than being loaned out (directly by savers, or indirectly, as via bank deposits), then loanable funds do not increase, and thus a recession may be caused – but this is due to holding cash, not to saving per se. Secondly, banks themselves may hold cash, rather than loaning it out, which results in the growth of excess reserves
Excess reserves
In banking, excess reserves are bank reserves in excess of the reserve requirement set by a central bank. They are reserves of cash more than the required amounts. Holding excess reserves is generally considered costly and uneconomical as no interest is earned on the excess amount...
– funds on deposit but not loaned out. This is argued to occur in liquidity trap
Liquidity trap
A liquidity trap is a situation described in Keynesian economics in which injections of cash into an economy by a central bank fail to lower interest rates and hence to stimulate economic growth. A liquidity trap is caused when people hoard cash because they expect an adverse event such as...
situations, when interest rates are at a zero lower bound (or near it) and savings still exceed investment demand. Within Keynesian economics, the desire to hold currency rather than loan it out is discussed under liquidity preference
Liquidity preference
In macroeconomic theory, Liquidity preference refers to the demand for money, considered as liquidity. The concept was first developed by John Maynard Keynes in his book The General Theory of Employment, Interest and Money to explain determination of the interest rate by the supply and demand...
.
Third, the paradox assumes a closed economy in which savings are not invested abroad (to fund exports of local production abroad). Thus, while the paradox may hold at the global level, it need not hold at the local or national level: if one nation increases savings, this can be offset by trading partners consuming a greater amount relative to their own production, i.e., if the saving nation increases exports, and its partners increase imports. This criticism is not very controversial, and is generally accepted by Keynesian economists as well, who refer to it as "exporting one's way out of a recession". They further note that this frequently occurs in concert with currency devaluation (hence increasing exports and decreasing imports), and cannot work as a solution to a global problem, because the global economy is a closed system – not every nation can increase exports.
Austrian School criticism
Within heterodox economicsHeterodox economics
"Heterodox economics" refers to approaches or to schools of economic thought that are considered outside of "mainstream economics". Mainstream economists sometimes assert that it has little or no influence on the vast majority of academic economists in the English speaking world. "Mainstream...
, the paradox was criticized by the Austrian School
Austrian School
The Austrian School of economics is a heterodox school of economic thought. It advocates methodological individualism in interpreting economic developments , the theory that money is non-neutral, the theory that the capital structure of economies consists of heterogeneous goods that have...
economist and Nobel Prize
Nobel Memorial Prize in Economic Sciences
The Nobel Memorial Prize in Economic Sciences, commonly referred to as the Nobel Prize in Economics, but officially the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel , is an award for outstanding contributions to the field of economics, generally regarded as one of the...
winner Friedrich Hayek
Friedrich Hayek
Friedrich August Hayek CH , born in Austria-Hungary as Friedrich August von Hayek, was an economist and philosopher best known for his defense of classical liberalism and free-market capitalism against socialist and collectivist thought...
in a 1929 article, "The 'Paradox' of Savings", attacking the paradox as proposed by Foster and Catchings. Hayek and later Austrian School economists agree that if a population saves more money, total revenues for companies will decline, but they deny the assertion that lower revenues lead to lower economic growth.
Austrian School economists believe the productivity of the economy is determined by the consumption-investment ratio, and the demand for money only tells us the degree to which people prefer the utility of money (protection against uncertainty) to the utility of goods. They argue that hoarding of money (an increase in the demand for money) does not necessarily lead to a change in the population's consumption-investment ratio; instead, it may simply be reflected in the price level
Price level
A price level is a hypothetical measure of overall prices for some set of goods and services, in a given region during a given interval, normalized relative to some base set...
. For example, if spending falls by half and prices also uniformly fall by half, the consumption-investment ratio and productivity would be left unchanged.
Related concepts
The paradox of thrift has been related to the debt deflationDebt deflation
Debt deflation is a theory of economic cycles, which holds that recessions and depressions are due to the overall level of debt shrinking : the credit cycle is the cause of the economic cycle....
theory of economic crises, being called "the paradox of debt" – people save not to increase savings, but rather to pay down debt. As well, a paradox of toil
Paradox of toil
The paradox of toil is the economic hypothesis that employment will continue to shrink when "the short-term nominal interest rate is zero and there aredeflationary pressures and output contraction"...
has been proposed: wage flexibility in a liquidity trap may lead not only to lower wages, but lower employment.
Popular culture
The South Park episode "MargaritavilleMargaritaville (South Park)
"Margaritaville" is the third episode of the thirteenth season of the American animated television series South Park, and the 184th overall episode of the series. It originally aired on Comedy Central in the United States on March 25, 2009. The episode is a satire and commentary on the global...
" showed a fictional situation in which the paradox of thrift came to fruition.
See also
- Capitol Hill Baby-Sitting Co-op
- FrugalityFrugalityFrugality is the quality of being frugal, sparing, thrifty, prudent or economical in the use of consumable resources such as food, time or money, and avoiding waste, lavishness or extravagance....
- List of paradoxes
- Social trapSocial trapSocial trap is a term used by psychologists to describe a situation in which a group of people act to obtain short-term individual gains, which in the long run leads to a loss for the group as a whole...
- Vicious circleVicious CircleVicious Circle is an album released in 1994 by L.A. Guns. Most of the songs have Phil Lewis on lead vocals, but the track "Nothing Better to Do" features Kelly Nickels on lead vocals, and "Tarantula" is instrumental. MC Bones drums on several songs. Lewis and Bones also played together in the band...
External links
Criticisms
- The Paradox of Thrift: RIP, by Clifford F. Thies, The Cato Journal, Volume 16, Number 1
- Consumers don't cause recessions by Robert P. MurphyRobert P. MurphyRobert P. "Bob" Murphy is an Austrian School economist and anarcho-capitalist.-Education and personal life:Murphy completed his Bachelor of Arts in economics at Hillsdale College in 1998. He then moved back to his home state of New York to continue his studies at New York University. Murphy earned...
(an Austrian SchoolAustrian SchoolThe Austrian School of economics is a heterodox school of economic thought. It advocates methodological individualism in interpreting economic developments , the theory that money is non-neutral, the theory that the capital structure of economies consists of heterogeneous goods that have...
critique of the paradox of thrift)