Let’s All Save More, But Not All at Once

The economy is facing quite a dilemma-or paradox. Actually, John Maynard Keynes called it the Paradox of Thrift, but most economists I know don't talk about it much for fear of being labeled a Keynesian. The paradox is this: most of us need to save more, i.e., consume less of our disposable income. Yet, if all or most of us try to save more at the same time, income will fall. The paradox comes in because out of the lower income we will likely end up saving less, not more.

The problem for the economy is this: consumption makes up about 70 percent of total spending, and consumption has been supporting the economy for years even though the personal saving rate is close to zero. The reason is that individual consumers who have experienced capital gains in their homes and in their stock or mutual fund portfolios (including those in their pension funds, 401Ks, IRAs, and the like) have thought of those capital gains as saving and thus have been willing to consume virtually all of their current income. (This is legit for individuals, but not for the nation as a whole since resources aren't being made available by capital gains.)

Those two sources of capital gains-home price appreciation and rising stock prices-have now reversed and the positive wealth effect has turned into a negative wealth effect. Consumers who wish to save under current circumstances will have to do so the old fashioned way:  by consuming less than their disposable income. But, by definition, more saving means less consumption. If not offset by another category of total spending-and there is no reason to expect it to be-the reduced consumption spending will reduce total spending and cause a contraction of income and output. In other words, a significant decrease in consumption, which is warranted by individual circumstances, will cause a recession or cause a recession to be worse than it would be. Doing the right thing from the decision-makers point of view will lead to a wrong result from the community's viewpoint.

I've recently heard economists say that, if saving increases, it will reduce consumption; but they imply that the result will be just a reduced growth rate. Perhaps.  However, if saving increases on a broad scale, as it should, based on individual circumstances, the outcome could be a severe recession.

Consumers who save more will be better off if their numbers aren't too many just as the farmer is better off having a good crop in a bad crop year instead of a good crop year. A good crop in a good crop year is likely to be met with lower food prices for all that will offset the higher income resulting from a farmer's good crop.

I hope I'm wrong, but this is not just a curiosity. Consumer spending is key to a recovery from the recession. A sharp decline in consumer spending would only make the recession worse even though-individually-it is the right thing to do. We are in a pickle.

I don't want a pickle.

Comments (5)

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  1. William Locke says:

    Hi Bob,

    Excellent points, as usual. I would add one thing: for years, the US consumer has been actually spending more than their disposable income — via credit cards (which then were often moved to longer-dated payoff schedules because of re-financings, home equity lines, etc.). US consumers are also in a phase of de-levering, which means not only saving more, but also spending less to pay off credit card balances. I believe that until consumers feel better about their own balance sheets, the slowdown in spending will persist.

    Bill Locke

  2. Bob, I’m downstream in consumer spending, we sell craft supplies for people to hand make items, we are seeing an awakening of people doing this…I’ve said people are more resourceful when they have to be and they start making things, we grew well in the early 90s. I import a lot from China and the factory closings are a daily happening. I was surprised to learn that China rebates 13% back to the exporter, India does the same, maybe more. Talk about Moral Hazard! The Chinese are willing to ship goods on consignment to many USA retailers.
    Last tradeshow in China was slow,and prices dropped on many commodities.
    Deflation seems to be happening at an alarming rate.
    I enjoy your comments and I think I met you one time here in Abilene at Hardin Simmons University,
    Homer H

  3. “Second, and perhaps more important, “savings” represent loanable funds; an increase in the supply of loanable funds tends to lower interest rates and stimulate borrowing, so a decline in consumable goods with a short time horizon is offset by an increase in production in sectors with longer time horizons. For example, the demand for personal electronics might decline, but the demand for such things as real estate would be stimulated by favorable borrowing conditions.”

    I was going to write this, but Wikipedia says it better than I would have. During a recession, one can pass laws to increase long term investment and infrastructure spending, using tax breaks or government investment.

    As well, use loans and spending to help people start businesses. I actually started a business during a recession as I recall. I got a great deal on my rent at the time.

    By giving benefits to people who aren’t able to spend, with targeted tax cuts and investment, saving can be a good thing at all times. Of course, as a follower of Maimonides, moderation in most things is the wise course.

    The Paradox of Thrift seems more a problem of group versus individual behavior, which can be overcome with countervailing incentives for individuals.

  4. Stace says:

    There are a few stores that seem to want to fight the cponuos and nit pick down to you have to purchase what the picture is of on the coupon they don’t consider the wording. It may be helpful to have coupon policies with. My sister and I go on a weekly early A.M. shopping trip and we have quit going to one grocery store in Moorhead due to the issues with the couponing. We were basically told that the store was not equipped to check out people with cponuos and that daytime hours when the courtesy counter was open would be our best bet. We ended up leaving a full cart of our items. Sad thing that same item was purchased at the Fargo location with no trouble going thru the checkout line. I think it is just the attitude of the cashier at the time!!!!!! I do have to say that I’m giving a hats off to the gentleman that was working at the Fargo Hornbacher’s this morning, he was wonderful in helping us and enjoyed his job. Made the trip such a breaze and wished that all the cashiers had his attitude!!!!

  5. Namiko says:

    The US dollar is as good as the word of our lredeas. worthless in other words, based on fairy land expectations and pie in the sky economics. hundreds of millions of Americans labor under the illusion of ownership, under the rent to own (sub prime) credit scandal, huge deficits and massive trade imbalance