Thursday, August 26, 2010

Are We Really Suffering from a Paradox of Thrift? Two Critics of Keynes (and Krugman)

In a blog post today, Paul Krugman claims that the U.S. economy is suffering from the "Paradox of Thrift," and we cannot hope to have a recovery until people stop saving and start spending. It is another way of saying that what might be rational for an individual is irrational for the entire economy.

Krugman writes:
In normal times, we believe that more saving, private or public, leads to more investment, because it frees up funds. But for that story to work, you have to have some channel through which higher savings increase the incentive to invest. And the way it works in practice, in good times, is that higher savings allow the Fed to cut interest rates, making capital cheaper, and hence on to investment.

But right now we’re up against the zero lower bound — yes, I’ll get the usual complaints about how long-term rates aren’t zero, but the Fed doesn’t have direct control over those rates — so this normal channel doesn’t work.

And what that means is that if people — or the government — try to save more, they only end up depressing the economy. And the weaker economy leads to lower, not higher investment. And this in turn means that attempts to save more don’t help our future prospects. On the contrary, they reduce the economy’s future growth.
In answering this latest missive, I turn to Robert Murphy (again) and Clifford Thies, both of whom are excellent economists and good writers to boot. Murphy writes:
...it will be useful to spell out exactly what happens in a market economy when consumers decide to save more of their income. The first thing to realize is that people do not decide to "spend" or not; rather, they decide whether to spend in the present versus in the future. For example, imagine that thousands of couples in a large city one day decide to skip their weekly restaurant outings in order to save up for a summer cruise. At first, it seems that this would hurt the economy. After all, local restaurants see their sales drop, and so they buy fewer items from their suppliers and lay off some workers. The suppliers and workers in turn have less income to spend, and so sales are hurt elsewhere too.

However, so long as the entrepreneurs involved in the cruise industry anticipate the eventual increase in demand for their services, they will exactly offset the above effects when they hire more workers and other items in preparation for the busy summer months. The new savings (which were previously spent on restaurants) drives down interest rates, perhaps allowing the cruise operators to borrow money and pay for an additional liner. Thus the decision to save more doesn't reduce total income or employment, once everyone adjusts to the new spending patterns. It is really no different from a scenario where thousands of people become health conscious and decide to spend their money on vegetables rather than fast food.

Now it's true, in the present circumstances of our financial panic, consumer spending has fallen because of fear, not because of a fundamental shift in the desired timing of consumption. But still, the point remains that people cut back on present consumption in order to be able to "spend money" in the future. The difference between our present situation and the cruise-liner story above is just that people right now aren't sure exactly when, and on what, they will be spending this extra savings.

Even so, the best solution is still for the government to mind its own business and let people work things out voluntarily. The uncertainty isn't phony; people really don't know what's going to happen next month. In this situation, it is entirely appropriate for humans to stop cranking out so many iPods and designer clothes, allowing a temporary build-up of the resources that go into the production of these nonessential items.

What is especially ironic in all of this is that even on his own terms, Krugman's recommendations make no sense. That is to say, even if we put aside all of the real, physical readjustments that must occur to revamp the economy in light of the unsustainable housing boom, it would still be the case that the government ought to do nothing. If the present crisis really were largely the result of irrational panic and hoarding then government activism would only make people more uncertain about the future. In particular, no one has any idea what Paulson & Bernanke will announce next regarding financial companies and mortgages. If we're trying to reassure consumers that everything is normal, why would we resurrect tools from the New Deal playbook?
Thies adds:
The paradox of thrift simply took Keynesian economics to its illogical conclusion. If governments should increase their spending during recessions, why should not households? If there were no principles of "sound finance" for public finance, from where would such principles come for family finance? Eat, drink and be merry, for in the long-run we are all dead.

The Keynesian revolution was about overthrowing the doctrines of balanced budgets and sound money, free international trade, and laissez-faire economics, and adopting instead the doctrines of deficit spending, inflation, and the managed economy. Adherence to the tried and true was to be replaced by trust in the new, self-confident generation of macroeconomists, who were not to be constrained by old-fashioned precepts, but who were to be free to do as they knew best.
Both articles are worth reading in their entirety. The point is that in a Keynesian world of homogeneous factors and "spending" (as opposed to purposeful action by consumers and producers), the "Paradox of Thrift" makes perfect sense. But, if capital and other factors are heterogeneous and the structure of production is complex and must fit the economic patterns set by consumers and producers, then the "Paradox" is not a paradox at all, but rather just another economic fallacy.

29 comments:

Anonymous said...

Anyone who believes in the paradox of thrift does not live in reality. There are millions of Americans who have no job and are on government assistance. Yet, somehow, all of them own an Iphone or a Blackberry.

Anonymous said...

Well, I'm unemployed, not on government assistance, and do not have either a Blackberry or an iPhone.

So there.

What reality are you living in?

Bob Roddis said...

The point should be that we need to be saving more in the present because we have just found ourselves much poorer than we had previously believed due to impaired economic calculation caused by money dilution. It's not Krugman's or the government's job to worry about whether we are saving too much or too little. The only real source of investment finance is from private savings. Further, spending more in the present just for the sake of spending to give "the economy" "traction" or whatever, is absurd.

The initial absurd basis of Keynesianism is the notion that a market economy stalls out without fiscal and/or monetary stimulus from The Magic State. There is no basis for that claim. They are trying to solve a problem that does not exist and their solution is the cause of the problem.

William L. Anderson said...

I'm employed, but have no BB or iPhone. However, I believe that the commenter was noting that generally speaking, our standards of living have not collapsed in this depression as they did in the 1930s. Back then, most people lived a lot closer to the edge.

Anonymous said...

Well, isn't that because we rescued the banking system from collapse, kept interest rates low, and injected nearly $1 trillion in stimulus money?

And even then - how does an "economist" jump to such conclusions from clearly anecdotal evidence? Has your home been foreclosed? Have you been to the tent city in Sacramento?

Fotsir Kovelak said...

"And the way it works in practice, in good times, is that higher savings allow the Fed to cut interest rates, making capital cheaper, and hence on to investment."

He leaves out what comes before and what comes after.

Before: Higher rates encourage savings.

After: Lower rates discourage savings.

It follows from his reasoning that with lower savings the Fed should raise interest rates. Otherwise, why wait for higher savings to cut them?

So when the Fed lowers rates during a time of high savings, it discourages savings. But as savings drop, the Fed would have to raise rates. What's the point of the Fed when the market would do this on its own?

Anonymous said...

Mr. Anderson:

"
I'm employed, but have no BB or iPhone. However, I believe that the commenter was noting that generally speaking, our standards of living have not collapsed in this depression as they did in the 1930s. Back then, most people lived a lot closer to the edge.
"

Please take a look at this quote, and ask yourself how much closer to the edge you think things should go?

"
This comment is to Mr. Whine Whine Whine. I am a 50 year old woman and have been on unemployment for two years. I worked for 30 years with no breaks in employment until I was laid off in July of 2008. I have applied for every job opening I can find with no luck. I am now waiting on a tier 5 extension. Do you know where I’m waiting? In my car. That’s right, I have lost everything and now share my ford explorer with my 2 small dogs. Not because I don’t want to work, but because I can not find work. Just remember your smart @ss comment because things have a way of coming back and biting.
"

Just because you may not see it, doesn't mean it doesn't exist.

Please also compute this: during the 1930's, unemployment was at 25 %, population was roughly 100M. Today, the official number is about 10%, but the unofficial and underemployment puts that number at 16-18%, out of a population of 310M. What does the math tell you?

Do you really think there isn't suffering out there? And any suffering that's being blunted is the result of ... wait for it ... government spending?

It's no wonder we're incapable of solving problems, when it appears we're incapable of even defining them or acknowledging they exist.

I can tell you that my family are now members of the "paradox of thrift" crowd: we will spend no money that isn't strictly necessary from now until I get employment. Multiply that by the number of unemployed or underemployed, and a picture should emerge.

AP Lerner said...

“The point should be that we need to be saving more in the present”

Wow Bob this may be the smartest thing you have posted yet.


“It's not Krugman's or the government's job to worry about whether we are saving too much”

Actually, it is the government’s job, since it’s the government that provides the surpluses to allow the private sector to save. Of course, since you do not believe in reality, and do not understand how the monetary system operates, you refuse to acknowledge this:

http://www.creditwritedowns.com/wp-content/uploads/2010/07/Pimcos_double_entry_bookkeeping.gif

Public deficits add to savings. And public surpluses, a la the Clinton, take away from savings. Historical and operational fact. No theory.

“The only real source of investment finance is from private savings”

And yet another neo-liberal / Austrian myth. And savings are not required to fund investment. Investment ADDS to savings. Savings is just the accounting record of investment. Again, futher proof you do not understand the monetary system.

“our standards of living have not collapsed in this depression as they did in the 1930s. Back then, most people lived a lot closer to the edge.”

What, Prof. Anderson acknowledging government spending kept us from the edge? Prof. Anderson acknowledging the social safety net from the New Deal is actually working Wow. Who would have thought?

“And even then - how does an "economist" jump to such conclusions from clearly anecdotal evidence? “

Because Prof. Anderson and the dreamers do not believe in anecdotal evidence. Or statistics. Or data. Or facts. I have presented ample data, facts, and evidence disproving much of what Prof. Anderson preaches. The one time he tried to address one of my charts (the post on why bond rates keep falling despite his claims of the US heading for bankruptcy) he had to enlist the help of Guido Hulsmann, and Mr. Hulsmann response was so baseless and nonsensical, it was embarrassing. I’m the firsts anonymous in this thread.

http://krugman-in-wonderland.blogspot.com/2010/06/commentary-on-current-bond-rates.html

jason h said...

Accounting troll says, "operational 'facts' overrule the laws of economics. See, the State must consume scarce resources in order to save scarce resources"

AP Lerner said...

"See, the State must consume scarce resources in order to save scarce resources"

You have it all backwards. If you paid attention to the above graph, you would see the opposite is true. Nice try.

Bob Roddis said...

APLerner:

I've ask you nicely numerous times to translate your charts into an explanation of your propositions in terms of individual human action. For example, if the government spends and goes into debt, what exactly is private person holding that you claim is "savings" and how exactly does that make this private person richer as opposed to just saving his money and finding his own entrepreneurial opportunties? I understand that when the government borrows to pay the large pension of a donut eater how that makes the donut eater richer. You schemes seem to deny the existence of scarcity. If the donut eater gets donuts from debt that the private folks have to pay, how exactly does that make the private guy richer, or help to support private investments?

If you can't answer, say so. If you just won't try, say that too.

jason h said...

Any money that the gov't spends eventually ends up deposited in a private sector account. If the gov't spends more that it recovers in taxes the money accumulates in the private sector. This is why AP says public deficits equals private savings. However, because printed money doesn't actually represent economic goods this isn't real saving. The accounting identity may hold in nominal terms, but it has nothing to do with actual goods.

Bob Roddis said...

Jason H:

Thus, the government borrows to pay donut eater's humungous pension. The now rich donut eater puts it all in his savings account at the bank. Deficit equals savings.

jason h said...

Yahtzee! And the streets will run red with blood if the productive class even thinks about cutting his pension or sacking his friends.

Anonymous said...

Well, either that, or the rich donut eater has to take his money from savings or pension, and pay the guy that makes the donuts, who then has to pay the guy who supplies his flour, sugar, and yeast, along with the transport and warehousing of said commodities, not to mention the oil he fries in, and since our guy is eating so many donuts, new donut fryers ...

Oh, and his cardiologist. Don't forget how much our previously rich and now quadruple bypass candidate will have to pay to the heath care industry to unclog his arteries ...

Then, on to his physio people, who have to be paid to get his formerly fat ass down to a manageable weight, along with all the drug companies that will be happy to put him on statins for the rest of his life ...

Yup. A lot of economic stimulus can happen from one donut eater.

But, I digress.

How is it you you guys think you can grow an economy by making everyone in it poor?

And I hope the one rich guy you have left in your limit case likes donuts.

Anonymous said...

"Yup. A lot of economic stimulus can happen from one donut eater."

Broken window fallacy. Bastiat debunked this nonsense 100+ years ago. http://www.econlib.org/library/Bastiat/basEss1.html

Anonymous said...

I take it only that you don't like donuts.

Your cardiologist would, against his economic interests, probably approve.

AP Lerner said...

Hey Bob- since your such the big brain on how the banking system works, why don't you explain for all of us why TARP, the Iraq war, the stimulus, and all other spending is not contingent on a bond issue?

Jonathan M.F. Catalán said...

It seems to me that there is too much emphasis on the role of money. What is saved are actual capital-goods, and without this savings of capital-goods there's no way an entrepreneur can invest. Investments require a previous accumulation of capital-goods.

Jonathan M.F. Catalán said...

"Wrong. The US government is a monopoly issuer of its currency which it can produce an unlimited supply of. The limitation to this production is inflation, as I have said at least a dozen times."

I think the scarcity that poster was talking about was scarcity of economic goods, not of money per sé.

jason h said...

Hey AP, we understand how the monetary system works. I summarized your point above.

Unfortunately, the definition of private savings is rubbish. Perhaps you could explain how increasing the balance of an account on a spreadsheet is equivalent to scarce goods being set aside today for consumption in the future. That is REAL savings.

AP Lerner said...

Real savings?

Ugh, one more time. When the public sector runs a deficit, and assuming the external balance remains negative, the private sector runs a surplus. See the graph i have posted 100 times. It's up to the private sector to do what it wants with this financial equity. If they want to invest, save, paydown debt, etc. it's up to them. This is not about scarce resources and factors of production...the same tired punchline you guys keep dropping. If the public sector maintains a balanced budget, or cuts the deficit, your
factors of production and/or your ability to save now and consume later is reduced. It's called double entry accounting and if it does not hold anymore the laws of mathematics haves changed

If you are so up to speed on the monetary system, then maybe you can explain why spending initiatives are bit contingent in a bond auction. And maybe you can explain why China does not have a line item veto on spending

Bob Roddis said...

This is not about scarce resources and factors of production...the same tired punchline you guys keep dropping. If the public sector maintains a balanced budget, or cuts the deficit, your factors of production and/or your ability to save now and consume later is reduced.

Economics is ALWAYS about scarce resources. I've determined that "Chartalist" is derived from an old term in Zimbabwe meaning "we got charts but we got no theory".

This endless display of Chartilian obscurantism is pointless and boring.

Jonathan M.F. Catalán said...

We're just as tired of "you guys do not understand the present monetary system", "look at my graphs", and "it is just accounting", as you are of our emphasis on scarcity.

What I find amusing is the lack of a causal explanation for all of this, and instead the torrent of accusations that serve as the alternative form of argumentation.

It's hard to take the argument seriously.

bravo said...

Look you guys, reality doesnt exist until you pie chart it, and you cant pie chart finite resources fulfilling infinite wants and needs. Jeez why do you guys keep bringing up the fact that theres only so many resources to go around and just face reality, i.e. my pretty pretty charts.

AP Lerner said...

'Ignorance is Bliss'

that should be the slogan for this blog, and so called Austrian economists in genera.

Hey Bob - I'm still waiting on the answer to my quesion: how come big spending initiatives like TARP, the Iraq invasion, the stimulus etc. are not done on the condition of a completed bond auction? Tic, toc, tic, toc...

jason h said...

I can take this one. The treasury simply credits accounts, and adds a debit to their own, eventually, the debits are accounted for in a bond auction where the Federal Reserve is happy to buy up as many bonds as necessary to keep interest rates low.

AP Lerner said...

Partial credit. The Fed is not allowed, by law, to participate in treasury auctions. So when you say "the debits are accounted for in a bond auction where the Federal Reserve is happy to buy up as many bonds as necessary" you are 100% incorrect. This gets back to the operational facts that so many on this blog, including Prof. Anderson, refuse to bother to understand.

And of course, what you are saying is the Fed buys bonds to lower interest rates which is correct and inline with their everyday open market operations. But in Prof. Andersons world this makes no sense since the Fed buying bonds is highly inflationary. Of course, it’s not (just changes the composition of reserves), but the folks on this blog want you to believe that since that’s what their neo liberal ideology says is true, despite all the empirical evidence that says otherwise. Of course, everything that is written about monetary policy by Prof. Anderson is 100% wrong and clouded by ideology, so no surprise he does not bother to understand how the monetary system in the US operates.

However, you did just prove one of my primary points. You have correctly shown the US government is never revenue constrained. The US government, unlike a household, spends first, manages reserves second. No constrains on revenue. You have been doing your homework on MMT. Congratulations.

jason h said...

Well if the Fed can't directly purchase U.S. bonds how can you say the U.S. gov't issues it's own currency? Could it be that the Fed eventually prints the money to get a hold of t-bills, and banks buy bonds at auction knowing they are immediately going to sell to Fed. You keeping nit-picking semantics over substance.

Now that we've established that Austrians actually do understand the monetary system, care to stop dragging out your tired old arguments, and explain how the gov't can print a factory or the steel and electricity to run said factory. Or how expanding the monetary base is not inflationary? Does your empirical evidence include the CPI which conveniently leaves out energy and food, the same CPI that is measured differently every few decades when the numbers don't match the inflation targets?