Wednesday, January 6, 2010

The Paradox of Thrift (Pt. 1)

"If you want to know where the global crisis came from, then, think of it this way: we're looking at the revenge of the (savings) glut. And the saving glut is still out there. In fact, it's bigger than ever, now that suddenly impoverished consumers have rediscovered the virtues of thrift and the worldwide property boom, which provided an outlet for all those excess savings, has turned into a worldwide bust. One way to look at the international situation right now is that we're suffering from a global paradox of thrift: around the world, desired saving exceeds the amount businesses are willing to invest. And the result is a global slump that leaves everyone worse off."

-Paul Krugman, 2009

Perhaps the centerpiece of Keynesian economics, the Paradox of Thrift presents the argument that, particularly during a recession, an increase in individual savings does not increase the available investment for capital formation. The Paradox goes something like this: say that a given family, the Smiths, decides not to eat out at Paul's Pizzeria anymore and to put the former dining money into savings. The argument is that the investment capital of the system has not increased, since the savings of the Smith family was the revenue of Paul's Pizzeria, and now Paul and his employees will be unable to save as much money as they could before.

This seemingly simple, almost banal argument is actually the basis for a whole range of policy prescriptions, most notably the concept of government fiscal stimulus packages to "jump-start" the economy. It must be noted here that Keynes was specifically concerned with fiscal answers to recessions; central bank intervention through major loosening of monetary policy was not his focus, and is included in the "new Keynesian synthesis" of modern economics mainly because of the work of monetarists like Milton Friedman. The original Keynesian argument is that when consumers increase savings and lower consumption, as they might do when confronted with a recession and increased uncertainty about employment, the increase in savings will not provide an increase in investment capital available to businesses because of the Paradox of Thrift. To maintain aggregate spending levels, government should come in and engage in deficit spending, usually on public works projects.

Because it is vital to get the money flowing as quickly as possible, Keynes did not really concern himself with the question of which projects should be funded---indeed, he is dismissive of this aspect of the issue, and seems to encourage spending practically for its own sake. Thus we often find that Keynesian deficits and expansionary fiscal policies are associated with a bacchanalia of value-destroying, negative-NPV public project initiatives, some with staggering price tags. The Paradox of Thrift argues that extending prudent behavior for an individual household---increasing savings rates---to the economy as a whole is a fallacy of composition: what is good for the parts is not what is good for the whole.

Since I find much of Keynesianism distasteful, I must take great pains here not to oversimplify or misstate the Paradox of Thrift in order to create a straw man. The strongest and most elegant analogy for the argument presented by the Paradox of Thrift that I can personally come up with employs the example of soldiers marching towards a bridge. As they approach the bridge, the command to "route step" will be given and the soldiers will deliberately fall out of normal, left-right-left coordinated lockstep. This is done because a large group that marches in step will cause the bridge to oscillate, mildly at first and then with greater intensity and violence, until there is in fact a risk of structural limits being breached and the bridge collapsing to the detriment of all concerned. By breaking lockstep and walking independently, the soldiers avoid creating the mechanical resonance that can cause the bridge to crumble if the rhythm of synchronized footfalls resonates with the frequency of the bridge.

Keynes was concerned not with the particular behaviors of any one household, but with a vector of simultaneous savings rate increases that swept across the economy as a whole, so that the ensuing demand destruction---created by household "soldiers" marching in lockstep across the bridge and resonating---triggered a recession, perhaps even a depression. His solution was for the government to act counter-cyclically as the "spender of last resort", and to cut taxes and raise spending levels in order to maintain aggregate demand as private households and business cut back.

According to Keynes, the spending by government will then be amplified through the private economy via the so-called Keynesian multiplier (usually stated as 1/x, with x being the "slippage rate" due to savings, taxes, and so on. So, for example, if the slippage rate is estimated to be 25%, the Keynesian multiplier will be 1/.25, or 4...every dollar spent by government will create an aggregate demand stimulus of $4, presumably measured by a corresponding increase in GDP).

Extensions of the Paradox of Thrift are used for a variety of purposes, including as one of the justifications for progressive income taxation. Under the conditions of this argument, high-income earners begin to have a greater propensity to save, which endangers the economy as a whole because it reduces consumption (aggregate demand). Thus, the tax code should penalize this *alleged* increasing appetite for savings before it damages the economy (we will deal with this proposition shortly). It is my understanding that the Keynesian prescription for counter-cyclical, expansionary fiscal policies also implicitly assumed that A) deficits would be funded, in the case of the United States, by selling Treasury securities to U.S. citizens and then taxing them for the debt later, when the economy had improved ("we'd owe the debt to ourselves"), and B) the government would be able to run a surplus during the times of plenty. As we will see, these conditions have not been supported.

In my next entry I will bring up a handful of serious concerns that I have with the Paradox of Thrift and its policy implications, both conceptually and in terms of empirical observation.

3 comments:

  1. I vaguely recall reading about an experimental city-state in the Mediterranean that attempted to actually implement the regress-to-zero scenario by printing money with short-term expiration dates. The results were predictably poor. At first I thought this might have been the proto-fascist Republic of Fiume, but Wikipedia makes no mention of monetary experiments. Ever heard of this?

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  2. I hadn't heard of that "experiment" before, but Keynes does talk about doing things like this. It does seem like the kind of madness that could ensue from an aggregate-demand-crazed, savings=hoarding=naughty mentality taken to its final conclusion.

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  3. And to make them more angry, people like me attempt to help others - especially Christians - to be more thrifty!

    Mark
    ThriftyTimes.com

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