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.