The Paradox of Thrift

It has been going on for a while but with Paul Krugman’s opinion piece yesterday about the “paradox of saving” (or thrift) I wondered if I had remembered it right.

One way to look at the international situation right now is that we’re suffering from a global paradox of thrift: around the world, desired saving exceeds the amount businesses are willing to invest. And the result is a global slump that leaves everyone worse off.

[DDET Read More]

I learned about the paradox of thrift in high school and it is one of those counter-intuitive propositions that really gets you into economics. However, it has two parts. The first part is that there is some attempt by people to want to accumulate savings and so they increase their marginal propensity to save (that is, the proportion of any extra dollar of income they save rather than spend). This, in turn, reduces the circulation of money and causes a drop in aggregate income. This is the part Krugman and others have been referring to and it explains a fallacy of composition in the idea that savings is good for the individual but may not be good for society.

But it is the second part of the paradox of thrift that always intrigued me: that the attempt to increase savings would be completely fruitless and the total pool of savings would be exactly the same as before. Here are the equations (where s = marginal propensity to save, S = savings, Y = income, C = consumption and I = investment)

S = s*Y so C = (1-s)*Y as Y = C + S (on the consumer side)

Y = C + I (on the production side)

Therefore: S = I (in equilibrium). If we are in a liquidity trap the desired level of investment by firms is fixed at I. That means, that if s increases to s’, the only variable that can adjust to get S to equal I is Y.

And the narrative for this is as follows: consumers save more which drops firm demand for goods and services. They had been investing at a level based on the old expected demand and so they see inventories (a form of investment) rise in an unplanned way. They run these down by producing less and hence, income falls.

It was all a tragic failure of coordination. Consumers worry about income and so save more in a precautionary manner. Firms see the impact of that and reduce production which causes income to fall. We are all worse off and stuck in a low level equilibrium trap. (It is all in Keynes, right here).

So the Krugman story has part I of the paradox of thrift but what about part II. Are we seeing an accumulation of inventories?

By the way, how many formal models of the paradox of thrift are there in economics? I count 2. There is this unpublished paper by Chamley (from 1984) and also a paper by John Bryant in Econometrica (from 1987). Looking at each, I am not sure they fit the current situation but that is something to investigate on another day.

[/DDET]

8 thoughts on “The Paradox of Thrift”

1. Richard Green says:

Just as clarification, is it implied you learned the paradox of thrift in highschool, but that the concept was effectively untouched through some 9 years of university?

Like

2. denko says:

This paradox scratches at a fundamental (mis)understanding of modern economics; perhaps?

We currently see desperate export nations, forgoing their own consumption, to  accumulate surpluses.

These accumulated surpluses are intermediated through the international capital markets, to those nations that would consume (way) in excess of their immediate consumption need.
This is NOT adequately shown thought the national income  equilibrium equations above.

Joshua could you correct that math to show the global situation…

I dunno?

———————————————————
Do persons forgo consumption? Isn’t the phenomenon  better explained rather that persons seek to produce to their level of immediate consumption, and then seek to produce more i.e.  actively accumulate surpluses?
Isn’t this distinction relevant? Its rather a propensity to save, and not a marginal propensity to consume?
———————————————————-

btw i) From a bio-ecological perspective ‘surpluses’ are more often wasted than not – and are thus usually NOT the optimum survival technique?

A ‘surplus’ as we would commonly recognize as a surplus i.e. ‘ immediate consumption forgone’! Eg. the accumulation of honey by  bees – rather than say the accumulation of body fat by a pre-hibernation grizzly bear. Honey production demands the colony to maintain the most aggressive army insect known. This aggressive army must be an inefficiency?

Hibernation until times of plenty = natures preferred way.

btw ii) Modern civilization is grounded on those societies that perforce were obliged to save!

This was replicated along the Nile, Mesopotamia, Ganges, Yangtze river and the Mekong deltas, were successive economic experiment independently and spontaneously proved  excess production about the season of flood was crucial to stave of annual starvation.

Possibly no more pronounced than along the Nile, where seasonal production ‘out did itself’, to a point where excess production was deployed over many long millennia to produce pyramids in homage!

So powerful was the accumulation of surpluses, that successive pharaohs’ (both good and bad ones) were capable of accumulating national surplus,  plus defend the surplus (pay an army), plus  still have surplus output to build and fund  these temples .

The success of Egypt’s surplus can be gauged against the (lesser Libyans, Ethiopians, Assyrians)  economies  about Egypt that were constantly prepared to invade and pillage those surpluses, but could not create the economic wealth needed to fund a comparably large army!

—————————————————————-
The industrial age , much as the economic stumbling onto a lush delta, once again allowed for massive human surplus production.

[That’s a limited understanding of a surplus i.e. a surplus that exceeds both the cost protecting the surplus plus exceeds the cost of  a potential enemies  army. Where that potential enemies potential to fund and army = that potential enemies potential to create its own surplus]

Perhaps…

dunno4sure¿

Like

3. Richard Green says:

I was wondering the other day why the bullpen here had only two author’s whose interests mentioned macroeconomics, and none for whom it was the priority. I guess there just aren’t many left!
Or they are all in isolated post-keynesian enclaves.

Anyway, I guess it makes this paradoxyou posted earlier even stranger ( https://economics.com.au/?p=1879 ) .

Like

4. MikeM says:

Paul Krugman writing about “the paradox of saving” back in January, 1997:

“So here is an ironclad forecast: There will be more recessions in the future. Making that forecast isn’t hard. In fact, it’s childishly simple.”

From The Great Capitol Hill Baby-Sitting Co-op Crisis, http://www.pkarchive.org/theory/BabySittingCantAvoidRecessions.html

Like

5. Belittled says:

Joshua, Congratulations on seeing the latter part of the paradox of thrift. (Please tell Stutchbury.)
But you have repeated Krugman’s error about the liquidity trap. The LT happens because the demand for money is flat, not primarily because investment demand is steep. The LT arises because people think that interest rates can only go up and they wait (hold cash short) intending to lend long at the higher rate.  The LT may be part of our current woes in places where the cash rate has hit zero or nearly.
And investment is not autonomous entirely because it is interest inelastic and dominated by animal spirits. Investment is autonomous (unaffected by floes of saving) in large part because saving and investment are deemed to be disconnected. Interest rates (in Keynes) do not adjust to preserve  the equality of  planned S  and planned I at Y* (normal or trend income).

Like

6. Belittled, hmm, who taught me macro again? I must have known that stuff with more care 20 years ago.

Fair enough on investment demand. I guess it in part reflects my view is that when dealing with big disconnecting events — such as having liquidity and being in a liquidity-trap, thinking about having a model that holds in both worlds is not useful and so right now, I am in the liquidity trap mode.

Like

Comments are closed.