NOTE: This will be a much longer and slightly more technical entry than is normal, but the subject matter is very serious---one of the great issues in political economy of our time---and I think a discussion is quite timely.
A day or two ago we briefly discussed the Paradox of Thrift and how it is used to justify expansionary government fiscal policies when the economy faces recession. Extensions of the Paradox of Thrift have served as the armamentarium for a host of other Keynesian prescriptions, including progressive income taxation (although advocates of progressive income taxes can also argue on aesthetic grounds) and a general hostility towards household savings increases unless they are created by a rise in incomes, rather than an increase in the percentage of income saved (which would lead to the Paradox of Thrift, of course).
I think there are several potential problems with this line of thinking, and I would separate them into a few basic categories: the "regress to zero" problem, the "innovation" problem, the "capital budgeting" problem, and the "empirical observation" problem.
1. The Regress to Zero Problem
Following our original scenario from the last post, we have the Smiths, a family that has decided to stop eating out at Paul's Pizza in order to save more money. The Paradox of Thrift argument is that the system is not better off in terms of capital formation (wherein savings=delayed consumption available as investment capital), because the money the Smiths were saving would have been Paul's income. When the Smiths save, Paul is not able to save.
On the other hand, the system is not worse off, either---from the perspective of savings, nothing has really changed in this simple, closed model of the economy. The Smiths save money, which is available for investment in some other project, and Paul loses money.
To create a sense of urgency, Keynes instituted a special case of inert savings, wherein the money the Smiths withhold from Paul's Pizza is not really available for deployment to some other investment opportunity in the economy (say, for Dick's Movie Theater or Art's Coffee Shop to use for expansion). Keynes had to get away from the savings=investment issue because it would mean that a decrease in consumption might cause a temporary dislocation today, perhaps even some liquidations, but the result was that resources from saving would be available for investment (and thus for future consumption). Keynes argued that "There has been a chronic tendency through human history (for savings to exceed investment)."
So keep in mind that when Keynes talks about savings, he really means a kind of sinister "hoarding"---the Smith family savings are basically placed under a mattress or hoarded using some other economically-inert technique for withdrawing money from the active economy. Given the hoarding definition of saving, the situation becomes more serious: Paul's Pizza may still have to close down, but Dick's Movie Theater or Art's Coffee Shop will not be able to expand via newly-available investment capital.
However, we can take this a bit further: ANY attempt to save money in the system Keynes has described is going to involve denying income to someone else. The argument, taken to an absurd---but still internally consistent--- conclusion, is that no household should have any savings, since savings are denying income and employment opportunities to existing businesses (please note that there is no discussion of using savings to provide funding to businesses that do not exist yet---the Keynesian approach is a general equilibrium model, which allows for the use of differential equations because all of the system components---like internal workings of a fine clock---are "closed" and available to the analyst at the beginning).
In other words, taking the Paradox of Thrift argument and iterating through, backwards and forwards in time, we converge on a case where individual household savings hurt business income, business savings hurt other business income, and other business savings hurt household income. Therefore, infinite regress leads to an effective savings rate of zero being optimal. I do not believe Keynes would have been comfortable suggesting this, although it is possible.
To make the Paradox of Thrift operational, I think the Keynesian analyst needs some kind of normative model for the ideal savings rate at the start, and then he can start talking about Krugman's "savings gluts" as saving rates increase beyond this optimal level. The analyst should also technically be able to talk about "savings starvation" if savings rates fall below this ideal level---for instance, if households in the United States had a negative real savings rate, presumably there would be an alarm system in the Keynesian apparatus that would say that the rates should increase. Without a way to calculate what the optimal savings rate is, there is no way to determine whether or not people are saving *too much* or *too little*. What can occur is a non-falsifiable mechanism wherein virtually any recession is automatically blamed on a savings glut---this in fact was attempted as a way to explain the 2008 crisis, as we will shortly see. .
In practice, the Paradox of Thrift tends to run one way---against any savings rate increases, regardless of the previous benchmark. Keynes said that "...the more virtuous we are, the more determinedly thrifty, the more obstinately orthodox...the more our incomes will have to fall...Obstinacy can bring only penalty and no reward. For the result is inevitable."
Without a model for the ideal savings rate, the Paradox of Thrift-minded analyst will have to start measuring savings at some arbitrary point in time and then say that any increases in savings rates from that point are subject to critique. While the Paradox is itself neutral on the point of savings increases being good or bad for the economy, the Keynesian interpretation and the special redefinition of savings as "hoarding" cash in inert, outside-the-economy forms leads to a pathological distrust of savings generally. Inexorably, by logical regress, we get a savings rate that heads to zero.
Keynes does discuss the savings issues with a switch in perspective to a more easily aggregated metric, unemployment, and suggested that investment would fall below savings (the difference being the true hoarding effect of savings) if the economy was operating below full employment, but this really just shifted the requirement from calculating the optimal rate of savings to calculating the optimal rate of unemployment for the economy (which in turn is highly sensitive to the methods by which unemployment is calculated).
An obvious problem with a very low savings rate is that banks will have little to be able to lend, even with a fractional-reserve multiplier system in place to aid with credit expansion. Interest rates for loans would be very high. Keynes had a solution to this: the central bank can print money for the banks and this will really juice those rates down---Keynes, in print, desired a targeted interest rate of zero.
Clearly everyone realized that this would ignite some inflationary flames, and various contrivances were created to mitigate this risk, too. The most important argument was popularized by disciples of Keynes and known as the Phillips Curve. Named after the Kiwi economist W.A. Phillips, the Curve portrays an inverse relationship between the rates of inflation and unemployment, a sort of core macroeconomic trade-off: an increase in the inflation rate will bring down unemployment, while attempts to fight inflation by raising interest rates will result in higher unemployment. The Phillips Curve trade-off was very important to the Keynesian model, not only because it helped to justify the loose monetary policy that Keynes liked, but because it actually did make a testable prediction: high rates of inflation and high rates of unemployment could not occur simultaneously in a world in which the Phillips Curve was true. We will return to the Phillips Curve soon, as its predictions have been tested.
2. The Innovation Problem
If the Smiths decided to save money because they have decided that a new, capital-intensive product---perhaps a computer, a washer-dryer, a hovercraft, whatever---would increase their productivity and standard of living more than eating at Paul's Pizza would, then a simplistic Paradox of Thrift argument is failing to capture this. It would be like arguing that the revenue that was going to horseshoe manufacturers was tragically lost from the system when people started saving for cars. In other words, the Keynesian aggregates approach assumes a kind of closed economy that has all of the goods and services it will need already contained within it. There is little mention of the role of the individual entrepreneur in creating an innovative new technology that would have widespread appeal (Schumpeter's famous "gales of creative destruction").
Keynesian economics does not easily allow for redeployment of capital along Schumpeterian lines. The regress problem leads to a low savings rate, the printing press enthusiasm leads to artificially low interest rates (and inflationary risks, particularly in sectors of the economy like housing), and Keynes himself openly stated that his goal was to annihilate the incentives for private risk capital formation: "...(the owner of savings) will no longer receive a bonus...the owner of capital is functionless...he can obtain interest because capital is scarce. But...there can be no intrinsic reason for the scarcity of capital since government can always print and distribute more of it."
This is one of those areas where Keynes is very slippery. It seems remarkable that he would go so far as to suggest that all savings should be discouraged by negative interest rates, but it appears that his primary goal was in reaching a state of full employment in a closed-system, low-innovation economy through any means necessary, and then maintaining this happy, unchanging world through fiscal and monetary stimulus. He does not appear to believe that serial malinvestment or overcapacity due to distortions created by government policy could ever be a problem (a chief argument of the Austrian school), nor does he believe that inflation could ever be a serious threat until well after an economy had achieved full (100%?) employment. The notion that household savings could rationally increase as a delay in consumption in favor of the purchase of capital-intensive, productivity-enhancing goods (i.e., new technology) in the future is not considered, and Keynes makes recourse to psychological shamanism and mysterious "animal spirits" to help explain the propensity to save.
3. The Capital Budgeting Problem
It is not clear whether or not Keynes takes for granted that government projects will actually be positive investments in terms of their long-term economic effects, because his levels of aggregation and abstraction are so high that the projects themselves are less important than is the model of a government-controlled fiscal firehose that dispenses "aggregate demand" (cash spending) upon command. As the economy recovers from an excess savings-induced recession, the government can turn off the firehose and begin soaking up excess water with its sponges (i.e., tax policy), which in turn will lead to a refilling of the tanks (i.e., a fiscal surplus) so that the firehose system is loaded and ready for the next emergency.
This strikes me as a level of abstraction that is so high that it completely ignores the actual realities of government fiscal deployment. For one thing, if the projects are value-destroying (negative net present value), they will either require additional funding to keep them alive down the road, or they will have to be killed. The idea of a medicinal, one-time fiscal stimulus package is not accurate---many of these emergency programs will live on as zombies, well after the emergency has passed, stalking the economy like the undead and just as difficult to kill (in part because of the martingale betting progression problem discussed in an earlier post).
Keynes seemingly expects government decision-makers to make at least as good capital budgeting decisions as private individuals and firms, despite the lack of compatible incentives, the different time horizons, and the "other people's money for my re-election" principal-agent problem. This assertion, if Keynes ever did make it, would be difficult to service.
Quick, helicopter drops of fiscal cash are historically likely to go to those projects that are politically connected---this is why foreign aid is so often spent on corruption-laden, major public works projects, since the discretion of the politico will turn towards his friends for reliable reasons that we will explore later when we get into the Public Choice School, as well as the research efforts of Bruce Bueno de Mesquita and Bill Easterly.
Even if a government agency goes to great lengths to make sure that only the best, most justified projects get the funds, there can be dead-weight costs. For instance, one can conceive of a major public transportation initiative as being a bit like an auction of tax revenues, with various local and state jurisdictions competing for, say, a light rail subsidy package. Let's say that the package is worth $100 million, and that ten cities are competing. If each city spends $10 million in lobbying, planning, consultants, studies, and so on, the system has no net gain.
Lest the reader think that my example is a cruel, utterly fictitious parody designed to advance the agenda of a feral anarcho-capitalist, I can state that, unfortunately, my scenario may be far too generous: Mike Munger of Duke University has related a story about his experience with city planners in Charlotte, who found that 25% of all gains from federal HUD grants had to be spent in city tax funding to adequately prepare application packages that could even have a chance at winning one of the HUD funding beauty contests. If we used this as our guide, the ten cities competing for light rail funding in the prior example would spend $250 million in total, all so that one could win a $100 million federal public works grant or subsidy package. Once again the system, on a net basis, is ultimately made far worse off than it would have been with no subsidy award being offered, and this is even with the best of intentions being displayed by all concerned.
The need to hurdle these dead costs makes for a thorny dilemma---on the one hand, Keynesian fiscal policymakers can deploy cash quickly, which results in increased opportunities for negative-NPV projects, rent-seeking behaviors, and corruption; or, on the other hand, they can attempt to make sure that the very best, most deserving projects get funded, which increases the costs incurred by each applicant in the process, possibly resulting in a net loss of productive resource use to the system when the smoke finally clears, and which also takes up time, time which the Keynesian fiscal-deployment model specifically says the policymakers do not have.
For the fiscal stimulus model to work, then, policymakers need to be able to initiate and cut programs adroitly, so that the stimulus projects cavort and leap like playful dolphins and killer whales performing in their pools at Sea World. Even Keynes ultimately admitted that the public works fiscal deployment option was permanently, perhaps fatally flawed: "Organized public works...are not capable of sufficiently rapid organization, (and above all cannot be reversed or undone at a later date), to be the most serviceable instrument for the prevention of the trade cycle."
Unfortunately, no other instruments have been found, despite the warnings of Keynes himself, and massive public works spending, often on infrastructure, remains the policy tool of choice for those seeking Keynesian remedies. As would be predicted by Public Choice Theory, these projects---and Keynesianism generally---are very attractive to politicians because they justify the distribution of nationally-collected taxpayer money (with many of the ultimate taxpayers being too young to vote, assuming they have even been born yet) to current, local constituent beneficiaries in the form of various grants and subsidies, which of course allows politicians to gather votes by claiming to have somehow "brought home the bacon". Under a Keynesian regime, bringing home the bacon is not just good for a local economy, it is good for the country as a whole as it is heroically providing counter-cyclical fiscal stimulus to prevent a recession.
4. The Empirical Observation Problem
There are any number of empirical observations that, in my opinion, greatly weaken the Paradox of Thrift argument and the Keynesian approach more generally. I will just touch on a few.
-The savings glut argument. If the Paradox of Thrift was responsible for the last recession, we would expect to have seen an increase in household savings rates in advance of the crisis. In the U.S., savings rate went effectively negative, so that would seem to be a major problem for the Paradox. However, Paul Krugman and others have argued that the true savings glut was overseas, particularly in Europe and parts of Asia. Economist Stephen Roach reports that, in actuality, worldwide nominal savings rates have declined from 25.5% in 1974 to 22.8% in 2006. John Taylor of the previously discussed Taylor Rule fame agrees with Roach.
Once again, we would need some relatively accurate, explicit tool for calculating the ideal savings rate of society---a Taylor Rule for savings---before we can really begin to safely use the Paradox of Thrift as an explanation for economic downturns.
-The Phillips Curve. The Phillips Curve was wholly unable to account for the simultaneously high inflation and unemployment rates of the 1970s---a period of macroeconomic behavior that is commonly termed "stagflation." The inability of the Keynesian models to anticipate the Phillips Curve led to the success of Milton Friedman and the Monetarists in arguing for a central bank core competency in inflation-targeting, rather than the coordinated fiscal and monetary expansions in response to unemployment that Keynesians prescribed. The Keynesian approach would have had Fed Chairman Paul Volcker continuing to lower rates, perhaps even to engage in exotic quantitative easing techniques after the lower bound of 0% was achieved, even as the U.S. faced double-digit inflation (!).
-The problem of chronic fiscal deficits. This may not be so much a problem of Keynes as a problem of those (mis)interpreting Keynes and thinking that they are executing his policies. The Keynesian approach to fiscal stimulus and deficit spending required that the government run surpluses during the times of plenty. If a healthy economic growth rate was achieved over a long period, this discipline would ensure that the period featured a parade of fiscal surpluses.
The United States economy has grown at a very healthy rate of approximately 3% over the last four decades. Since 1970, there have been only four years of fiscal surplus---the second term of Bill Clinton, when a combination of unexpectedly high tax receipts (from the dot-com bubble), gridlock created by Republican control of Congress, various scandals, and a "peace dividend" combined to result in receipts exceeding spending.
The nature of the fiscal deficits has also changed, and I believe that this is an area where Keynes would have been very concerned. Keynes had been strongly opposed to the imposition of heavy war reparations on the defeated Germany at the end of World War I. I propose here that one way of looking at war reparations would be to see them as debt imposed on a country by its creditors, in order to pay for exports (violence) that the debtor nation had received on credit terms. From this perspective, I think Keynes would have differentiated between internally- and externally-funded deficits and would have been worried about possible adverse consequences: the U.S. fiscal deficit situation of today is very different from one in which federal debt is owned by American citizens. With large groups of foreign creditors owning our paper, could the Keynesian Paul Samuelson's famous comment that the deficit was not a concern because "we owe it to ourselves" ("the interest on an internal debt is paid by Americans to Americans; there is no direct loss of goods and services") be replaced by one in which caution is warranted?
-Progressive income taxation. Keynes argued that with rising incomes came an increasing propensity to save (i.e., hoard). He recommended progressive income and estate taxation as a way to help maintain a high-consumption society and avoid recessions created by the Paradox of Thrift (as incomes rose because of economic growth, people would tend to save more, which would in turn trigger recessions and unemployment). Nobel laureate Simon Kuznets conducted an exhaustive study and found that, since 1899, the percentage of income saved has remained remarkably constant despite large increases in real income.
For another, more anecdotal perspective on this, we can turn to the "Crashproofing" personal finance strategy discussion of an earlier blog post. Keeping in mind that the blueprint we discussed there is considered a very conservative approach to private fiscal discipline, and that the relatively high savings rate (10%) component of the basic model would certainly have the money placed in a bank rather than under the mattress, we find that the plan calls for the bank savings allocation to be redeployed towards explicit investment or consumption (slush fund) accounts as soon as approx. 6-12 months of living expenses have been saved. So, even following an extremely disciplined, almost survivalist fiscal policy, even if we assume that the savings account avoids banks entirely and consists of cash placed in a black Pelican case under the bed next to the ones containing the FN FAL, chemical/biological warfare suits, and Dungeon Master's Guide, we still have the individual or household spending more and more on investments and consumption after a few years, not on some psychotic desire to increase cash hoardings under the bed.
There are many other problems and concerns related to Keynesian economics and the Paradox of Thrift, including work that suggests that the Keynesian multiplier is actually closer to 1 than to 4 (and occasionally less than 1), but these should not diminish our admiration for Keynes (or a man like Paul Krugman, for that matter) as an intellectual. Hayek, ever the Old World gentleman, had this to say about his friend and occasional nemesis: "I am fully aware that I am claiming that perhaps the most impressive intellectual figure I have ever encountered and whose general intellectual superiority I have readily acknowledged was wholly wrong in the scientific work for which he is chiefly known...indeed, I am convinced that, through his denial of conventional morals and his haughty 'in the long run we are all dead' approach, his influence was disastrous."
In terms of actively debating skilled Keynesians in a courteous environment of mutual respect and truth-seeking, I would suggest that any readers so inclined be aware that the prototypical Keynesian argument style involves abrupt jumps from accessible and intuitive microeconomic models, such as those typically employed by the Austrian school, to the immediate use of satellite-view macroeconomic aggregates (terms like "C" and "G" and "I") that require very high levels of homogeneity, controlling assumptions, and abstraction. Frequently the answers will work only if you operate within a Keynesian analytical framework to begin with, at which point many of the important terms---such as the Paradox of Thrift---have been pre-defined to the point that they become essentially tautologies. If you share my free market views and wish for a satisfying discussion with a Keynesian, you cannot allow him or her to control the narrative or the center of gravity of the debate will quickly shift to the self-enforcing Keynesian vocabulary and analytical apparatus, and then it becomes quite difficult to escape.