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.
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:
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| 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:
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.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.
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.
I have a hard time with this:
ReplyDelete"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."
What is good for the individual should be good for collective society assuming all participate. Increased savings has economic implications, but if everyone were to save then the economy would transition/adjust.
We cannot rely on policy-makers, who do not have a long-term incentive to over influence behavior at the level of the individual. If everyone were to save, our economy may not expand as robustly/quickly....but people would have margin and something to fall back on in good times and bad.
I agree with you that savings are a good thing over the long haul for everyone. Perhaps, I did not get my point across, that drastic adjustments of everyone's savings rate at the same time acts as a shock to the system and makes things worse off than if people already had ample savings rates in the first place.
ReplyDeleteBasically, I think the more margin people build into their lives, the better (which I think is the point you are bringing). It can potentially have a negative impact in the short run if we all decide to change our behavior
Also, I don't necessarily agree what you said that "What is good for the individual should be good for collective society assuming all participate." For example, people may decide to drive big SUVs because they are supposed to be "safer" for the driver. This is good for the individual. However, if everyone goes with that logic, then the roads end up being filled with large SUVs and we are all collectively "less safe" than if everyone drove smaller cars.
And I now see what you meant, "drastic adjustments of everyone's savings rate at the same time acts as a shock to the system and makes things worse off than if people already had ample savings rates in the first place."
ReplyDeleteAnd good point on the SUVs.