Keynes: The Paradox of Thrift

By James Moynan

“The long run is a misleading guide to current affairs. In the long run we are all dead” John Maynard Keynes

The paradox of thrift is an economic concept popularized by John Maynard Keynes in his controversial book the General Theory of Employment, Interest and Money published in 1936 during the latter stages of the Great Depression. Keynes went against the classical viewpoint of economics at the time, which dominated economic and political thought, for its models only applied to when the economy was in full employment and that might be (as quoted above) when we are all dead. The paradox of thrift is the theory that collective increased individual saving actually reduces overall saving in an economy.

The basic model Keynes proposes is very simplistic and makes a few assumptions, firstly there is no international trade and no government meaning that aggregate demand is made up of just consumption and investment. National Income is split between consumption and saving. However a critical assumption of the model is that investment is autonomous. This core belief of investment being constant is one of the ways Keynes separated from monetarists and the classical school of thinking and is best understood through the Keynesian simple model. The Traditional viewpoint is that income and savings are positively correlated and in turn the rate of interest adjusts so that investment follows the same trend. Hence there is a simple relationship between national income and investment called the savings identity.

Keynes however disagreed. It was his belief in the simple model that induced investment (investment depending on national income) was minimal and thus ignored. Investment he believed was determined by a number of factors such as business confidence, political climate and most importantly investor expectations of future conditions and all these conditions in the short run were constant, this means essentially that he didn’t believe that all saving were turned into investment. However he still agreed that all investment was funded from saving. Graphically the assumptions can be modeled as;

From the graph we can see the negative effects of the paradox, an increase in saving; from S0 to S1 reduces national income from Y0 to Y1, in the real world what explains this fall? It is a matter of expectations. If firms and consumers have reason to believe that an economic downturn is on its way, how would they react? Being rational economic actors they would save now in preparation for the downturn. Ironically these actions become part of the self-fulfilling prophecy of the downturn. As consumers save more in preparation for the downturn they spend less, this in turn decreases aggregate demand in the economy reducing output, classically it is assumed that this saving is turned into investment which equalizes the fall in consumption, however as businesses are predicting a downturn too they are reluctant to increase expenditure on investment and thus investment is unchanged. As aggregate demand falls, output decreases and workers are laid off they now consume and save even less (remember we assume no government- so no welfare support) compounding the situation and sending the economy into a cycle of depression as negative multiplier effects take hold. The negative multiplier then causes the paradox and total savings are less than they would have been if individual saving hadn’t increased!

Unsurprisingly the paradox has caused much debate with its notion that individuals should spend rather than save, it’s important at this point to note that the paradox is a theory rather than an economic fact. Non-Keynesians criticise the theory in three ways; firstly as demand falls in an economy so do prices and this fall in prices stimulates demand. This logic is counter criticised by Keynesians as they argue that prices are sticky downwards which draws on the point that markets can cause considerable time to clear and the price fall isn’t immediate. Secondly is that savings are treated as loanable funds (as mentioned earlier). As savings increase, the rate of interest adjusts (falls) and this encourages investment. This too is countered Keynesians who argue that not all savings are invested into banks (cash under mattress) furthermore banks who are predicting a crisis don’t want to invest and instead hoard the savings as excess reserves (just like individuals). The third and final criticism is perhaps the most prominent and criticises the assumption of a closed economy, in a globalised country funds can be transferred from struggling economies to developing economies and thus all saving is turned into investment. It is important to acknowledge at this stage that the world in 1936 was vastly different to today, Keynes writing mostly focused on Americas economy of the 1930s and the assumption of no (little) trade & government was much more realistic; tariffs, quotas, no NAFTA, 12 years of Republican rule. Also today’s highly globalised economy breeds the problem that each economy is reliant on one another. As the 2008 crisis showed, every economy was affected by the downturn and thus there was a lack of stable countries to lend to.

Overall the paradox is a fun nugget of theory that is interesting to analyse, although perhaps doesn’t hold when certain assumptions are dropped or interpreted differently. The model also fails to explain where the initial “bad” expectations stem from. Keynes however did have numerous positive effects on public policy at the time and today (which deserves an article of itself) and offered a fresh approach away from the idea that the economy would return to equilibrium but didn’t take into account of the social cost of inaction.

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