Explaining the Paradox of Thrift

Tuesday, October 06, 2009

Dugie Young looks at the paradox of thrift and its relevance to today’s financial and economic crisis.

The Paradox of Thrift is an economic concept which was made famous by John Maynard Keynes, though it is thought to have originated in the early 18th century.

The basic concept is that if people save more in a recession, it will reduce consumption and thus aggregate demand will fall, impeding economic growth and, in fact, lowering the general level of savings. It rather resembles the Prisoner’s Dilemma in the sense that saving is advantageous to the individual but detrimental to the general population.

Keynes first fully explained the idea in The General Theory of Employment, Interest and Money in 1936, being the first to popularise the idea. The process is very simple: as the marginal propensity to save increases, total revenue for firms falls which stunts economic growth and can prolong the downturn, though this is based on the idea that most economic recessions are demand-based.

However, the theory has drawn much criticism from many including Austrian economist Friedrich Hayek, for example. Firstly, deflation in a downturn will stimulate demand and, in fact, saving funds investment which can then trigger the multiplier effect. The increased funds in the financial sector will also stimulate borrowing which will increase demand. The level of saving required to be damaging to an economy is also thought by many to be unrealistic in a recession, thus diminishing the relevance of the paradox.

Finally, the major assumption is that the economy is closed and without international investment, which would offset the impact of mass saving. It is clear that in the current recession, the government is keen to encourage a higher degree of saving (before the recession the savings ratio was negative, people spending more than they had) while shifting the focus of consumption from expensive imports to domestic products.