http://web-xp2a-pws.ntrs.com/content//media/attachment/data/econ_research/0902/document/ec022309.pdfMainstream economists and the mainstream media continue to embrace John Maynard Keynes’ notion of the “paradox of thrift.” While most economists subscribe to the view that the pace of long-run economic growth is a function of productivity and thrift (saving), short-run growth can be retarded by too much thrift. According to this view, if households in the aggregate decide to cut back on their current spending, i.e., save more, aggregate economic demand will be negatively affected. Hence, the paradox of thrift. A little later in this commentary, I will try to dispel the notion that thrift retards growth in aggregate demand in the short run.
But before getting into this aspect of economic myth-busting, I want to call your attention to a February 19th WSJ opinion article by a member of the paper’s editorial staff, Daniel Henninger, entitled “Obama’s ‘Hair of the Dog’ Stimulus.” Henninger essentially buys into the paradox-of-thrift argument. He cites the “Making Work Pay” element of the new fiscal stimulus plan as a way of giving a tax rebate to households with a lower probability that the tax reduction will be saved. Again, according to Henninger, an increase in saving would mute the stimulative effects of the new fiscal program.
Is Henninger actually endorsing an economic plan that does not include reductions in marginal tax rates? Not to worry. He falls into line with The Journal’s monolithic editorial view that any stimulus plan devoid of marginal tax rate reductions is bound to fail in igniting aggregate demand because American households have rediscovered the virtue of thrift. To buttress his case, Mr. Henninger cites an authority on the subject of women’s marginal propensity to consume/save, Anna Wintour, the editor of Vogue. Ms. Wintour’s sampling, scientific, no doubt, suggests that ladies of leisure will be cutting back on their current spending. (To be complete, perhaps Mr. Henninger should have consulted Playboy’s octogenarian playboy, Hugh Hefner, as to what we men will be doing with our extra eight dollars a paycheck.) Moreover, Mr. Henninger says that President Obama has met the enemy of household spending and it is the president himself. You see, President Obama has an “austere persona” that evidently promotes household austerity! I found it paradoxical that anyone on the editorial board of The Journal would embrace anything Keynesian such as the paradox of thrift. Hence the title of this commentary, “Paradox Squared.”
Let’s get economically objective. Thrift or saving does not necessarily mute aggregate demand in the short run or the long run. As any economist of the Austrian school will tell you, saving simply implies one economic agent cutting back on its current spending and transferring its spending power to another economic entity. For example, suppose a household decides to cut back on its current spending in order to purchase an about-to-be issued corporate bond. The household is transferring its purchasing power to the corporation. Presumably, the corporation does not intend to simply sit on the proceeds of its bond sale. Rather, the corporation likely borrowed funds in order to spend now on some capital equipment or R&D. So, the act of increasing its saving on the part of the household does not lead to a reduction in aggregate spending in the economy, just a redistribution of spending.
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http://blogs.reuters.com/rolfe-winkler/2009/02/23/kasriel-debunks-the-paradox-of-thrift/Mainstream economists and the mainstream media continue to embrace John Maynard Keynes’ notion of the “paradox of thrift.” While most economists subscribe to the view that the pace of long-run economic growth is a function of productivity and thrift (saving), short-run growth can be retarded by too much thrift. According to this view, if households in the aggregate decide to cut back on their current spending, i.e., save more, aggregate economic demand will be negatively affected. Hence, the paradox of thrift…I will try to dispel the notion that thrift retards growth in aggregate demand in the short run.
Before getting to the meat of Kasriel’s argument, it’s worth noting a recent NYT article in which the thrifty were blamed for Japan’s economic malaise: “As recession-wary Americans adapt to a new frugality, Japan offers a peek at how thrift can take lasting hold of a consumer society, to disastrous effect.” The economic consensus is that too little consumer spending causes a downward spiral for the economy. Thrift might as well be a four-letter word. Personally I think this is nonsense, and I’ve tried to explain why on the blog. Kasriel does too. (emphasis his)
Thrift or saving does not necessarily mute aggregate demand in the short run or the long run. As any economist of the Austrian school will tell you, saving simply implies one economic agent cutting back on its current spending and transferring its spending power to another economic entity. For example, suppose a household decides to cut back on its current spending in order to purchase an about-to-be issued corporate bond. The household is transferring its purchasing power to the corporation. Presumably, the corporation does not intend to simply sit on the proceeds of its bond sale. Rather, the corporation likely borrowed funds in order to spend now on some capital equipment or R&D. So, the act of increasing its saving on the part of the household does not lead to a reduction in aggregate spending in the economy, just a redistribution of spending.
There is, however, a special case in which an increase in thrift will result in a fall in aggregate spending. This is the case of “hoarding” money – currency and bank deposits. Hoarding in this sense is the term classical economists used to describe what hip-hop economists refer to as an increase in the demand for money to hold, or a decrease in the velocity of money. If more and more households wish to curtail their current spending and increase their money balances, this will lead to a decline in aggregate spending in the short run if the supply of money is not increased commensurate with the increased demand for it to hold. The supply of money is created by the new lending actions of banks in cooperation with the central bank, the Fed in the U.S. case. An increased demand for money to hold does not automatically elicit an increase in the supply of money. Let’s say that an employee of XYZ Company decides to save a larger portion of her paycheck in the form of increased money balances. On payday, XYZ transfers into the employee’s bank account the employee’s salary. So, XYZ’s bank account is debited by the same amount that the employee’s bank account is credited. No new money is created in this process. All that has happened is that the ownership of money has changed. No net new bank credit is created in this process. Although the employee’s bank has gained some additional reserves in the process that would enable it to create some new credit, XYZ’s bank has lost reserves, requiring it to extinguish credit, all else the same. Aggregate spending does decrease because the employee cuts back on her spending in order to increase her money balances.
So, the paradox of thrift, which mainstream economists…so readily embrace, is only paradoxical in the special case in which the public’s demand for money to hold increases. How do these economists…know ahead of time that tax rebates will be accompanied by an increased demand for money to hold on the part of households? Even if the demand for money to hold does increase, I can make an argument that the supply of money available to be held is likely to increase. The Treasury is going to issue securities to finance its new spending and tax rebate programs. If, which is likely, banks and the Fed purchase a large quantity of these Treasury securities, then the supply of money will increase. An increased demand for money to hold matched by an increased supply will not lead to a decrease in aggregate spending.
Kasriel goes on to debunk another myth—”that the U.S. economy cannot grow rapidly unless there is a high level of consumer spending.” He has a nifty chart the demonstrates why…
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