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Debunking the paradox of thrift


Chandan Hegde

By

October 15th, 2014


Chandan Hegde offers an Austrian take on whether the paradox of thrift and its accompanying Keynesian policies are appropriate.


John Maynard Keynes, during his work in the 1930s, popularised a concept taught in many macroeconomics classes known as the paradox of thrift, where he outlined the harsh consequences when individuals choose to save a greater proportion of their income in a recession. The logic employed by Keynes here is that an increase in saving, or synonymously a decrease in spending will lead to decreasing employment as fewer goods and services are being purchased in the economy. Through the Keynesian multiplier effect this will continue to accelerate further decreases in spending and further unemployment creating a depressing spiral effect. In the end, because of these conditions Keynes suggests that despite the intention of greater saving, the lower income in the economy will result in lower actual saving and lower production. From here Keynes’ paradox of thrift becomes particularly destructive, as his solution to this issue is fiscal stimulus.

What the paradox of thrift fails to consider is the complex nature of an economy. Simply considering consumption or demand as the driving factor for the economy is the issue in this instance. Let us consider what happens when the government employs fiscal stimulus by pumping billions of dollars into the economy. Keynesians argue that simply this extra spending, and as such increased demand for goods and services, will lead to an increase in production. It is this claim which I believe to be particularly problematic. Simply demanding something that does not exist will not bring it into fruition. As Murphy suggests, this might be possible in an economy where only human expertise is being used such as an economy full off masseuses. Consumers demanding massages could easily drive an increase in the amount of massages as masseuses could simply work more. But most modern goods are formed from complex procedures, requiring intermediate goods from multiple countries and most importantly, requiring the use of capital.

It is this complex procedure that I believe renders Keynes’ “throw money at it” type solution absurd. During a recession different companies are affected differently so we cannot simply expect that increasing consumer demand will restore a sustainable increase in output in every sector to again reach full employment. The reason for this is that either now or later, certain sectors will lack the capital to produce relevant goods and services. For example even if consumers demand mobile phones, the mobile phone company must acquire more circuit boards, and the circuit company must acquire more metal and so on. This is the Austrian Theory of Capital. In order to increase sustainable consumption, savings must first be made in order to accumulate capital, which paves the way for increased production and then increased consumption. This idea is consistent with Say’s Law, that supply creates its own demand not vice versa.

Instead, what Keynes’ solution will do is create confusion for companies, such that they cannot distinguish between increasing consumption trends and artificially induced consumption patterns. The result of this will be companies using their limited capital, or diverting resources from capital production, to make poor production decisions. This is the phenomenon of malinvestment, which simply reduces the pool of capital and hinders the economy’s production potential. For this reason I assert that consumption which is driven from artificial stimuli only occurs at the expense of capital consumption and eventually has devastating consequences for the economy. This is a similar concept that occurred with households during the housing boom in America. Consumers were encouraged to spend, through the central bank encouraging consumption by setting funds rate as low as 1%, consumers rampantly increased expenditure on primarily housing and imported goods. This activity continued for many years as consumers felt the rising house prices would compensate for their increased spending. Of course, this consumption was happening at the expense of capital consumption (less saving) and as we later saw when house prices plummeted, this wiped out much of household’s equity and subsequently caused the Global Financial Crisis.

This idea of the detrimental effects of government stimulus are not simply theoretical, as there is a growing body of empirical studies to reinforce this claim. To cite just one, a Wall Street Journal Study stated that government spending was approximately 25% of GDP where OECD countries achieved an average real growth rate of 6.6%. As the spending rose a negative relationship was seen, leading to a mere real growth rate of 1.6% when spending was 60% of GDP. Of course there is a limitation to this data as it simply shows a correlation, however this is not simply an isolated pattern given the mounting evidence collated by the Heritage Foundation.

Now let us consider the other side of the coin: when consumers and businesses actually save. The increase in supply of money which can be loaned for capital expenditure will increase and encourage businesses to increase their investment. Without consumption distortions resulting from fiscal stimulus, households and businesses can start saving and by extension the economy will accumulate capital. At this point the Keynesian argument would intervene and suggest that it is fine to have investment, but when new goods are formed as a result of these new capital goods, then we have a problem. The consumption levels are so low that these goods will remain unsold or will have to be sold under cost price. To refute this we will employ the logic of Hayek. The implication that new investment is simply results in an increase in production is false and more appropriately it is very unlikely in recession conditions. Instead this investment will be directed towards reducing the cost of existing production allowing prices of goods to fall. This decrease in prices represents an increase in the purchasing power of individuals and thus an increase in the real wage. This means that if we allow companies to save we will eventually see permanent developments for the economy. Finally this increased investment will lead to increased production when business owners feel consumption patterns are going to increase, thus achieving long run growth.

It is for these reasons I believe that Keynes’ attack on savings in a recession is nonsensical. What Keynesians fail to realise is that money is simply an agent through which existing goods are exchanged, so simply pumping more money through the economy will not in fact lead to higher production. In order to do that, we require capital which can only come from savings. Keynes once stated that the government should pay people to dig holes and fill them back up in order to provide more wages to the unemployed, and in doing so will increase demand and production. Notice here that nobody ever really demanded this hole digging and filling up. This is simply unsustainable artificial demand concocted by the government to supposedly stimulate the economy. But what Keynesians do not realise is that this senseless activity is deteriorating the capital being used and setting the economy up for decreases in production. It is for this reason I believe that the Austrian solution to recessions, which is to allow increased saving and capital accumulation, is the correct one as it establishes the economy for future growth and brings about permanent development.

The views expressed within this article are those of the author and do not represent the views of the ESSA Committee or the Society's sponsors. Use of any content from this article should clearly attribute the work to the author and not to ESSA or its sponsors.

  • Yannis Goutzamanis

    Hey mate, interesting article. You argue theoretically well against the usefulness of fiscal stimulus but I have one simple question: if fiscal stimulus is so useful how do you explain the fact that the countries which employed the largest fiscal stimulus came out of the GFC stronger than those who employed little fiscal stimulus?

    Take for instance China which had fiscal expansion of 3.1% of GDP in 2009 and 2.7% of GDP in 2010. When you contrast that to countries like Italy which had 0.2% of GDP in 2009 and 0.1% of GDP in 2010 (numbers from IMF Fiscal Monitor). Is it just a coincidence that the countries that fared the best through the GFC like China and Australia had the biggest fiscal stimuluses compared to the Europeans?

    • Chandan Hegde

      Thank you Yannis!

      Regarding China, I question whether fiscal stimulus has really worked in the country, like I argued in the article there may be a temporary increase in output, which is brought on by businesses consuming capital as a result of artificial demand, but the lack of savings are a huge hindrance for the economy in the long run. If we look at China’s Real GDP growth over the last couple of years this is evidence of it. Although, immediately after the GFC it spiked, since then it has been steadily decreasing till we reach near GFC levels again. The fiscal stimulus just delayed the consequences. http://si.wsj.net/public/resources/images/WO-AU123B_CBANK_16U_20141017180913.jpg

      In terms of Australia, I don’t think that fiscal stimulus was the reason our economy fared well during GFC times either. Fiscal stimulus instead resulted in some of the most inefficient investment, including the school halls and pink batts program, which I also described would occur in a scenario of fiscal stimulus (malinvestment). The reason we fared so well during GFC times was the spark in our net exports as a result of a low exchange rate.

      Regarding Italy, I must admit I do not know too much about their economy. However, what seems apparent to me is although they cut spending slightly immediately after the GFC, their spending increased by larger than the previous reduction afterwards. And along with much of Europe, we saw unproductive taxation increases which occurred simultaneously.

  • Marco Madzzar

    Hey mate, I really enjoyed the theoretical aspect of your article – the paradox of thrift, Keynesian v’s Austrian economics are very interesting topics. Given that complex nature of a modern economy, we cannot unequivocally state which theory is right and which is wrong. Although I do find your argument that increase in savings leads to an “increase in supply of money which can be loaned for capital expenditure will increase and encourage businesses to increase their investment” to be slightly unconvincing in the context of a depression. During a depression or recession, interests rates will most likely be at the zero lower bound – so why would increase money supply influence a business’s decision to borrow? It appears to be more logical to me that a business’s decision whether or not to borrow will depend on their forecast of economic activity – whether consumers will by their products, the cost of inputs, interest rates etc. So during a recession, if businesses believe demand will be soft, they clearly wouldn’t invest in more capital. If they did, it would simply be unutilised.

    Rather during a deep recession with deficient demand and no government intervention, I would expect to see the effects of hysteresis. Businesses would close down factories and sell capital at fire sales, leading to the destruction of the pool of capital in the economy.

    I do concede to your argument that fiscal stimulus can be wasteful, however, governments can implement spending programs that actually increase the pool of productive capital. Instead of digging up holes and filling them up again, why don’t we provide greater tax incentives to innovative start-up companies, provide tax rebates for business that buy machinery and equipment (which the Rudd Government implemented during the GFC), invest in infrastructure and improve supply chains with new railways and ports.

    As you’d know, most of Keynes’ theories were based on the Great Depression – demand was severely deficient and economists/government were desperate to do something about it. If you study Keynesian economics with this in mind, it makes a lot more sense.

    Anyway, great job in addressing the big questions which I believe economics has not fully answered yet.

  • ApeVictim

    I don’t think Keynes attacked savings per say, rather analysed the effect of every household increasing their savings RATE. So the paradox lies in increased savings RATE of each household paradoxically reduces overall savings in the economy due to a reduced overall income. You can look at it this way that increased savings leads to increased investment, as savings = investment, but I would look at it as increased investment leads to increased savings. If households (consumers) start saving more by for example a) not eating out at a restaurant, b) not going to the cinema, c) not going to see the local footie team, d) not buying new clothes, then businesses will not respond by a) opening/expanding restaurants, b) upgrading/opening a new cinema C) adding new seats/upgrading footie stadium d) making/designing new clothes. This leads to a drop in Investment and thus savings, hence the paradox!

    • ApeVictim

      “Consumers were encouraged to spend, through the central bank encouraging
      consumption by setting funds rate as low as 1%, consumers rampantly
      increased expenditure on primarily housing and imported goods. This
      activity continued for many years as consumers felt the rising house
      prices would compensate for their increased spending. Of course, this
      consumption was happening at the expense of capital consumption (less
      saving)”
      This excess consumption you speak of did not happen at the expense of capital consumption, it’s just that the capital consumption mainly occured in China and not the US, where Factories/laboratories/ports/railroads/houses/airports/power stations were built. These would not have been built without the aid of the US consumer!!!!!

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