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.

Update:

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...

8 comments:

Irrational Doomsday Blog said...

I'd argue against this based on the fact that I think we're in a nonholonomic system- where we are matters, but the path we took to get here also matters.

Debt growth has displaced productive growth to a large degree over a long time- it is a creeping problem.

The notion that some sector will always be able to temporarily run a deficit to cover another could only be true if sectors retrenched- and even that is debatable from a rational expectations point of view.

And there has been no retrenchment for a long, long time, just ever expanding borrowing. At some point there is a limit to this, and I think we're going to see it.

Jake said...

i completely agree. that can be thought of as the paradox of deleveraging. it makes sense for every indivual to delever, but when everyone delevers at the same time, the economy is toast.

at some point the entire system (now or in the future) will NEED to delever, thus debt growth which was long thought of as productivity, will revert back down.

Matt Stiles said...

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...

Best,

Jake said...

matt- well said. that was my main argument (that krugman advocated for the government spending the keep the larger pie whole)

dblwyo said...

Actually there are at least three interacting paradoxes at work but fortunately the other Paul (Kasriel) of Northern Trust explains it all:
http://www.nytimes.com/2009/07/07/health/07mind.html?ref=health

1. Paradox of Thrift - true. But in a current events, macro-static context.
2. Deficits - no crowding out nor investment pressure when neither consumers nor businesses are spending or investing. In fact in that situation (our current one) a) the only source of demand is gov't spending, b)when there's plenty of slack no displacement either and c) (in the right conditions, like now)it's the only when from stopping a cyclic decline from taking us over the abyss.
3. Long-term Savings - as consumer preferences reset and we all save more investment is increased which results in shifting the economy to a higher growth path; thereby increasing incomes, savings, business spending and investment and gov't tax revenues in a virtuous cycle. Of course the short-term adjustment process can be a bit painful.
Paul does a much more eloquent job but the bottomline is Golden Path (puns intended)or Abyss (o.k. doldrums declines but the first is more poetic)

Joe said...

All Krugman proves with this post is that by following his preferred policy prescription we end up with reduced national savings. We don't know what would have happened to national savings if we hadn't run the deficit. I would call this the paradox of Keynesianism. In trying to avoid the alleged paradox of thrift by deficit spending, we create the very thing we are trying to avoid.

Angry Saver said...

Jake,

There is no paradox. The C+I... formula is simplistic and rests on flawed assumptions. It is an accounting identity that does not always reflect the facts in the real world. End demand by consumers is the key. When end demand shrinks, so does the pie. When future income shrinks, so does the pie. Adding gov't debt will create false demand and may keep the debt system from imploding, but it will also limit future end demand.

Too many spent too much based on misperceptions of future wealth (wall street lies). Much of the so-called investment/savings were borrowed from abroad and wwere actually malinvestments as they exceeded ability to pay and were not based on end demand. The bills for all that excess/mis spending are now due. A rude awakening. Debt repayments and debt defaults at the houshold level will accelerate.

Despite propaganda to the contrary, U.S. consumers are now realizing that their future incomes will be less than previously thought. Lower savings/investment is to be expected as our economic futute will be smaller than previously assumed.

Jake said...

All- great points and I appreciate the feedback.

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