It is hard to disagree with the fact that individual thrift is a good thing. However, collective thrift can be a bad thing, as we are seeing right now. Economists call this the
paradox of thrift, and the idea is credited to John Maynard Keynes. In the following discussion of this paradox, it is important to distinguish between the short-run and the long-run.
In the short-run, sudden increases in the aggregate savings rate can be harmful to economic growth. We saw this happen during the Great Recession, and it is still and issue right now. According to the
BEA, the personal savings rate was 5.4% of disposable income in June of this year. From 2005 to 2007, the savings rate averaged between 1.6% and 2.2% of disposable income (depending on the measure used.) When the savings rate more than doubles in a short period of time, it will be felt throughout the economy.
 |
| Data from http://www.bea.gov/national/nipaweb/Nipa-Frb.asp?Freq=Qtr |
The pre-recession savings rate turned out to be unsustainable as many people had nothing to fall back on. Since the financial crisis and the related bursting of the housing bubble, consumers have held onto more of their money out of both fear and necessity. The sudden increase in the savings rate that occurred in 2008 is akin to a shock to aggregate demand. A shock to AD decreases national income, which in turn decreases savings despite the increase in the
marginal propensity to save. Economist Paul McCulley of Pimco
described the paradox like this:
If we all individually cut our spending in an attempt to increase individual savings, then our collective savings will paradoxically fall because one person's spending is another's income--the fountain from which savings flow.
This is an excellent description of the paradox of thrift in the short-run. Essentially, the paradox of thrift says that saving more of your money can be good for the individual, but if we all decide to do it at the same time, it can actually be worse for all of us than if we did nothing at all. This reminds me of game theory's famous
prisoner's dilemma. Now, let's shift our view to the long-run.
In the long-run, collective thrift (i.e. a higher marginal propensity to save) is a usually a good thing, which is consistent with most people's intuition. To borrow Paul McCulley's lingo, savings are the fountain from which investment flows, assuming people aren't simply hoarding money.
So, what can we do about the the paradox that we face? My conclusion is that policymakers should encourage consumers to avoid having extremely low savings rates during economic expansions. Yes, low savings rates can stimulate growth in the short-term since more money is being quickly funneled back into the economy via consumption. However, low savings rates are counter-productive in the long-run. We still live in a world with business cycles, and when recessions rear their ugly heads, individuals and households need a financial buffer. When someone loses a job, past savings can be shifted to cover bills and living expenses if needed. In addition to individuals having this essential buffer, higher collective savings over the long-run are good for the economy since savings is the mechanism for investment. Policymakers can help over the long-run by limiting uncertainty and maintaining trust, so that savings are invested productively.
While the paradox of thrift does have some valid criticisms (
here and
here), it is an interesting concept that has important implications for our economy.
