Tuesday, July 7, 2009

The Paradox of Thrift

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.

In other words, if ALL consumers increase their savings in a consumption based economy, the overall pie (i.e. economy) shrinks. Thus, while individuals save more as a percent of income, overall savings decrease as the pie decreases at a faster rate.

Paul then shows a chart, which is similar to the following (his is just the difference in each of these categories from Q4 '07 --> Q1 '09) pulled from the same BEA database.

He sees the data and declares:

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.
What matters for the economy is the aggregate savings (my mistake, my point was that the individual consumer still has the incentive to save as they have been able to raise their "personal" level of savings). Since savings must equal investment (the I in C + I + G + NX = GDP equation), the decrease in savings has impacted the size of the overall economy, thus income. The issues that Paul details (and again, I missed) is that even though individuals have increased savings rapidly, overall investment is STILL down.

Of course, the counter-argument is that we need government spending to take the place of personal spending until the consumer is able to bounce back.


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...