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.