Showing posts with label paradox of thrift. Show all posts
Showing posts with label paradox of thrift. Show all posts

Sunday 15 February 2009

Paradox of thrift

Go ahead and save. Let the government spend.
By Robert H. Frank

Sunday, February 15, 2009
A psychotherapist friend says that several of her patients are fretting about whether they have an obligation to help the nation spend its way out of the current downturn. Some of them are having a hard time making ends meet, she said, yet are reluctant to cut back for fear they would cause the economy to slide further.

The role of consumers has had considerable attention in the press because the economy desperately needs additional spending right now. But it is not — and should not be — the responsibility of middle-income families to provide that spending. If financially comfortable families want to support their favorite restaurants during hard times by eating out more often, who could object? But if others are inclined to pay down their bills or save a little more, concerns about the economy shouldn't stop them.

Government is in a far better position to provide immediate economic stimulus. It is in fact the only player that can significantly alter the economy's short-run trajectory. In a recession, as in ordinary times, a family's first economic priority should be to spend its income prudently.

The "paradox of thrift," a celebrated chestnut first described by John Maynard Keynes in the 1930s, has been the source of much confusion about how saving affects the health of the economy. Intuition suggests, correctly, that if any one family saves an extra $100 this year, its bank balance at year's end will be higher by that amount. According to the paradox of thrift, however, if everyone tries to save more at once, total savings will actually fall.

How could that happen? The explanation begins with the observation that, to save more, a family must spend less. Because consumption spending is part of national income, which in turn is the total amount spent by everyone in the economy, more saving causes national income to fall. Income will actually fall by more than the initial decline in consumption, because when one family spends less, other families earn less and respond by cutting their own consumption. When the dust settles, the story concludes, each family ends up saving less than before.

But that doesn't mean that people should stop saving for retirement or their children's education. If we're going to ask people to make sacrifices, it should be for something that will actually make a difference. (My colleague David Leonhardt wrote a column on Wednesday suggesting that by making certain kinds of investments — like making their homes more energy efficient — families could boost current spending while also increasing their long-run savings, despite the paradox of thrift.)

But even by mortgaging itself to the hilt (as many families have indeed already done during the recent national spending spree), no family could spend enough to affect the current downturn.

Nor is it reasonable to demand that individual businesses pick up the slack, since most of them already have more capacity than they currently need. At moments like these, government is the only actor with both the motivation and the ability to jump-start the economy.

Passage of a robust stimulus bill has rightly been the Obama administration's highest priority since taking office last month. As Keynes explained during the Great Depression, increased public spending would help end the downturn even if it were for useless activities like digging holes and filling them back up. It would obviously be better if the extra spending went for something useful. And as it happens, decades of infrastructure neglect, combined with huge state and local government budget shortfalls, provide more than enough valuable projects to put everyone back to work.

Bizarrely, however, some congressional critics have denounced the administration's stimulus proposals as "mere spending programs." Of course they're spending programs! More spending is exactly what we need. The imperative is to get this legislation passed and get the spending started right away.

The paradox of thrift has been a pernicious idea. By casting saving in such a negative light, it has encouraged people to think that thrift no longer matters. And most Americans have been only too happy to spend more freely. Household savings rates have fallen sharply for several decades. For two of the past three years, they have actually been negative, meaning that spending has exceeded income.

By fueling the housing bubble, this spending not only helped cause the current crisis, but also led to substantially increased borrowing from abroad. We're poorer each year by the hundreds of billions of dollars that we must pay in interest on these loans.

The "paradox of thrift" applies only during economic downturns, and even then only when government fails to stimulate spending. Most of the time, however, the economy operates near full employment. Before long, it will again. Under those circumstances, if every family saved a little more, extra money would flow into the capital market, causing interest rates to fall and investment spending to rise.

Because the fall in consumption from increased savings would be exactly offset by the rise in investment, total demand would still be sufficient to maintain full employment. The extra investment would boost productivity, causing national income to grow faster in the long run. As a result of the spending spree of recent decades, however, our growth rate has fallen sharply. Much of the nation's credit-card debt is now carried at annual interest rates of 20 percent or more. In just five years, each dollar invested in paying down such debt would support more than $2.50 of additional consumption; in just 10 years, more than $6. It is unreasonable to ask families to spend more when government can stimulate the economy so much more efficiently.

THE financial health of the nation and the financial health of individual families are not conflicting goals. A family that wants to help put the economy back on its feet while increasing its own future standard of living should consider saving a little more or paying down debt. Those who want a tangible symbol of their patriotism can buy additional government bonds, which will help repair an extra bridge or hire an extra math teacher.




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