Okay, don't argue with a Nobel Laureate economists. As soon as I posted this under the heading "I Think Paul Krugman is Wrong", I realized he is of course... correct in his interpretation. The overall thought of whether this is the reason for the decline in savings is up for interpretation.
First, I'll let Paul summarize what the paradox of thrift is:
The paradox of thrift is one of those Keynesian insights that largely dropped out of economic discourse as economists grew increasingly (and wrongly) confident that central bankers could always stabilize the economy. Now it’s back as a concept. But is it actually visible in the data? The answer is, and how!
The story behind the paradox of thrift goes like this. Suppose a large group of people decides to save more. You might think that this would necessarily mean a rise in national savings. But if falling consumption causes the economy to fall into a recession, incomes will fall, and so will savings, other things equal. This induced fall in savings can largely or completely offset the initial rise.
Which way it goes depends on what happens to investment, since savings are always equal to investment. If the central bank can cut interest rates, investment and hence savings may rise. But if the central bank can’t cut rates — say, because they’re already zero — investment is likely to fall, not rise, because of lower capacity utilization. And this means that GDP and hence incomes have to fall so much that when people try to save more, the nation actually ends up saving less.
Sure enough, the sharp increase in personal saving has been accompanied by a decline in overall national saving — partly via reduced corporate savings, largely via increased public deficits.
Reader Matt Stiles with an alternative view:
Saving is investment. The very act of saving is nothing more than a postponement of current consumption in exchange for future consumption. While in between, the money is used to lend to entrepreneurs. The rate of interest is what regulates this process.
Of course, if you throw in government tampering with 200 year old property laws. (GM, Chrysler) and allow banks to operate without traditional legal accounting principles then sure, savers will be less likely to invest where they otherwise would (early stages of production).
Additionally, Krugman take the Keynesian approach and advocates for enormous deficit spending. And subsequently, when this pulls down the "overall" level of investment in the economy, this somehow supports his "paradox of thrift?" Seems suspect to me...