What Is the Paradox of Thrift?

The paradox of thrift is an economic theory that personal savings are a net drag on the economy during a recession. Also referred to as the paradox of savings, this theory relies on the assumption that prices don't clear or that producers fail to adjust to changing conditions, contrary to the expectations of 澳洲幸运5官方开奖结果体彩网:classical 澳洲幸运5官方开奖结果体彩网:microeconomics.

Th🦂e paradox of thrift was popularized by British economist John Maynard Keynes.

Understanding the Paradox of Thrift

The proper response to an economic recession is more spending, more risk-taking, and fewer savings, according to 澳洲幸运5官方开奖结果体彩网:Keynesian theory. Keynesians believe that a recessed economy doesn't produce at full capacity because some of its fa♛ctors of production such as land, labor, and capital are unemployed.

Keynesians also argue that consumption or spending drives economic growth. It's the wrong prescription for the larger economy even though it makes sense for individuals and households to reduce consumption during tough times.

The savings rate for the average American household increased from 2.9% to 5% during the Great Recession that followed the 澳洲幸运5官方开奖结果体彩网:financial crisis of 2008. The 澳洲幸运5官方开奖结果体彩网:Federal Reserve slashed interest rates to boost spending in the American economy.

The first conceptual description of the paradox of thrift may have been written in Bernard Mandeville’s The Fable of the Bees in 1714. Mandeville argued for increased expenditure rather than savings as the key to prosperity. Keynes credited Mandeville for the concept in his book The General Theory of Employment, Interest, and Money in 1936.

Circular Flow Economic Model

Keynes helped revive the 澳洲幸运5官方开奖结果体彩网:circular flow model of the ec🎶onomy. This theory states that an increase in current spending driveꦜs future spending. Current spending results in more income for current producers that rationally deploy their new income, sometimes expanding business and hiring new workers. These new workers earn new income that can then be spent.

Keynes argued for lower interest rates to lower current 澳洲幸运5官方开奖结果体彩网:savings rates and boost current spending.𒁃 Keynes said that the government could engage in deficit spending to fill the gap if low interest rates didn't create more borrowing and spending.

Limitations of the Paradox of Thrift

The circular flow model ignores the lesson of 澳洲幸运5官方开奖结果体彩网:Say’s law which states that goods must be produced before they can be exchanged. Capital machines drive higher levels of production and require additiona🌊l savings and investment. The circular flow model only works in a framewor൩k without capital goods.

The theory also ignores the potential for 澳洲幸运5官方开奖结果体彩网:inflation or 澳洲幸运5官方开奖结果体彩网:deflation. Future production and employment will remain unchanged if higher current spending causes future prices to rise concordantly. Future production and employment needn't decline as Keynes predicted if current thri♏ft during a recession forces futureꩲ prices to fall.

Keynes met these objections by arguing that Say’s law was wrong and prices are too rigid to adjust efficiently. Economists remain divided about sticky prices. It's widely accepted that Keynes misrepresented Say’s law in his refutation.

Examples of the Paradox of Thrift

Ivan owns a factory that produces parts for computers. The factory is among town XYZ's biggest employers. They've been planning to expand their production capacity by installing more machines and hiring new workers.

But a recession strikes and Ivan reverts to savings mode. The factory lays off workers and discontinues operating the machines at night. Unemployed factory workers who don't have income to spend also begin saving, reducing demand for goods produced by Ivan's factory. The unemployed factory workers also add to the town's overall spending on social benefits and its🎐 econ🍰omy becomes weak.

A real-world example of the savings paradox was the case of 25- to 29-year-olds who moved in with their parents during the Great Recession. Their percentage increased from 14% in 2005 to 19% in 2011. The move helped families save money on rent and other expenses but it caused estimated damages to the economy of as much as $25 billion per year.

The Bottom Line

The paradox of thrift is an economic theory espoused by British Economist John Maynard Keynes. It holds that personal savings hurt overall economic health and growth. The theory urges lowering interest rates to increase spending and combat an economic recession and it ౠhas its critics. It doesn’🦩t address inflation or deflation in prices. Your savings are a highly personal matter and should meet your personal circumstances and needs.