Financial Literacy

Debunking The Paradox of Thrift: Why Consumer Spending Won’t Save Our Economy

Debunking The Paradox of Thrift: Why Consumer Spending Won’t Save Our Economy

by Mark Skousen, Contributing Editor
Wednesday, September 23, 2009: Issue #1100

“America’s saving rate has leaped ahead – and it’s sending America to the poorhouse.” – David Fessler

An Investment U column attacking the virtue of thrift – surely not?

Yet there it was – an article from David Fessler on September 12, entitled, “The Paradox of Thrift: How a Better Savings Rate is Fueling the Recession.”

David Fessler is a friend and smart investment analyst, so I was surprised that he fell for one of the biggest myths in economics today – the so-called “paradox of thrift” that Keynesian economists spout all the time.

Here’s the problem with the theory, plus a few stocks that are front-and-center of the opposite argument…

The Keynesian Way

Let’s start with the facts, as David correctly noted. During the “Great Recession,” Americans have suddenly reduced their spending, paid down their debts and started saving. As David says: “America’s savings rate – as a percentage of disposable income – has leapt from a little over 1% to over 5% in just the last 18 months.”

So far, so good. But then David suddenly warns that this positive advance in personal finance is somehow a negative “sinister” force that will plunge America into some kind of economic disaster.

David states: “When consumers stop spending and start saving, the overall demand for products and services drops and unemployment rises. In turn, this causes the overall nationwide savings rate to drop because of the decrease in consumption and the slower economic growth that ensues.”

How so? This follows the belief behind “paradox of thrift,”- the theory invented by British economist John Maynard Keynes.

So what can save us from the paradox of thrift?

If individuals and businesses won’t spend in a recession, it’s up to foreigners to “pick up the slack” by spending more, or (and here’s the plug for big government) the federal government runs deficits and stimulates the economy.

However, it’s simply not true that when consumers start saving and stop spending, overall demand for products and services decline and unemployment rises. Here’s why…

The Problem With the Paradox of Thrift

Aggregate demand is a function of current and future consumer spending. Businesses make investing and hiring decisions based not solely on current consumer patterns, but what consumers will want to buy in the future, months or years from now.

Firms use the increased savings to invest in new capital goods, technology, research and development and to replace old equipment.

Take automobile companies, for example. Car sales are way down for the automakers. So why then would Toyota announce a new $1 billion marketing campaign? Because the firm’s executives think they can sell more cars in the future.

In other words, the increase in savings isn’t wasted. Businesses can generally invest those savings productively (through intermediaries, such as commercial banks, insurance companies, new stock issues and other institutions) because interest rates have declined as savings increase.

Moreover, business cycle data support my thesis, too…

Debunking The Paradox of Thrift: Why Say’s Law Beats Keynes’s Law

During a recession, businesses are the first to hire and invest more money, long before consumers start buying again. Why? Because they can use their retained earnings and loans to produce products that consumers will demand over the next few years.

As CNBC’s Larry Kudlow states: “Though not one in a thousand recognizes it, it’s business, not consumers, that is the heart of the economy. When business produce profitably, they create income-producing jobs and then consumers spend. Profitable firms also purchase new equipment because they need to modernize and update all their tools, structures, and software.”

Look at the leading economic indicators in the G8 countries (issued by the Conference Board), and you’ll see that almost all of them are business indicators in early-stage production: new manufacturing orders, corporate profits, capital goods, building permits, average weekly manufacturing hours, stock prices, etc.

In short, it’s Say’s Law (“supply creates demand”) that drives the economy, not Keynes Law (“Demand creates supply”).

The question is: Where can you invest to take advantage of this?

Here Are Three Ways to Take Advantage of Say’s Law

If we’re talking about early-stage production, the technology sector offers some of the best investment opportunities. That’s because it invests heavily in advance of the business cycle in R&D, marketing, etc.

  • Conservative investors should consider Intel (Nasdaq: INTC) – the world’s largest maker of integrated circuits for computers.
  • If you want to speculate a bit, you could look at SanDisk (Nasdaq: SNDK), which makes flash storage card products.
  • And for broader exposure to the tech sector, go for the iShares Dow Jones US Technology (NYSE: IYW) ETF, which is up 26% this year.

I’ve repeatedly exposed the paradox of thrift fallacy in my books. For more of what I mean see, “What Drives the Economy and Stocks: Consumer Spending or Business Investment?” in Chapter 33 of my new book, EconoPower: How a New Generation of Economists is Transforming the World.

On a personal financial level, cutting back on wasteful expenditures, getting out of debt, saving and investing more is obviously beneficial. In the short run, businesses and individuals who cut costs and build up cash are in a better position to profit from the turnaround in the economy when it comes.

And note that even though consumer spending is still declining, the stock market has rallied sharply. Those who reduced their spending and saved money took full advantage. If you wait for consumer spending to turn around before investing, you’ll miss out on the big rally.

Good investing,

Dr. Mark Skousen

Editor’s Note: Because Mark’s column was in response to Dave Fessler’s original “Paradox of Thrift” article on spending and saving, we thought we’d get Dave’s counterpoint. It’s always interesting when our experts go head-to-head!

Here’s Dave’s reply…

Mark Skousen is a good friend and one of the smartest economists I know. I’m not surprised that he and I differ on this issue. But with all due respect, I didn’t “fall” for anything. I’m simply pointing out what’s actually happening.

Here are three things that can’t be argued:

Reality Check #1: Consumers have stopped spending and are saving at record rates.

Reality Check #2: 70% of U.S. GDP is from consumer spending.

Reality Check #3: Overall unemployment is still rising, not falling.

Mark suggests that business is going to be the primary genesis of an economic recovery. In other words, as businesses start spending and rehiring, consumers will then start spending again.

That may indeed happen eventually. But I don’t believe it will happen fast enough to effect immediate change. It’s going to take a very, very long time for it to affect the consumer’s mindset and their real ability to spend – especially in an environment where unemployment is still increasing.

Time will tell. Frankly, I’d love to be wrong and have Mark tell me, “I told you so.” And for the record, I’m not suggesting that Americans should stop saving and start spending like thirsty sailors on shore leave. That’s what got us into this mess in the first place.

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