Financial Literacy

The Paradox of Thrift: How a Better Savings Rate is Fueling the Recession

The Paradox of Thrift: How a Better Savings Rate is Fueling the Recession

by David Fessler, Advisory Panelist
Saturday, September 12, 2009: Issue #1091

We’ve all heard this from our parents: “Spend what’s left after saving, instead of saving what’s left after spending.”

Or perhaps this was drummed into your head: “Always save for a rainy day.”

The idea of saving didn’t just start with our parents’ generation, however. Ben Franklin was giving advice on saving way back in 1732 in Poor Richard’s Almanac: “If you would be wealthy, think of saving as well as getting. Creditors have better memories than debtors.”

As the recession of 2008 hit, Americans suddenly stopped spending, paid down their debts and started saving – some for the first time in their lives…

As a result, America’s savings rate – as a percent of disposable income – has leapt from a little over 1% to over 5% in just the last 18 months, according to the Bureau of Economic Analysis (BEA).

At first glance, things would seem to be improving. But there’s a sinister force at work here. It’s called the “paradox of thrift” – and it’s sending America to the poorhouse.

The Paradox of Thrift

So what is the “paradox of thrift” exactly?

It’s a concept that was popularized by John Maynard Keynes, a famous British economist whose ideas have had a major influence on modern economics.

It goes something like this: 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.

One can therefore draw the conclusion that an increase in savings is harmful to the overall economy. Think of it this way: If a person stops spending, he or she is affecting someone else’s income, and their ability to spend, and so on.

You could also conclude that this situation could feed on itself and things could get even worse: More savings… even less consumption… more unemployment, etc. And if nothing drastic is done, it will.

So what are the options?

America is Looking for a Global “Assist”

For a start, how about other countries picking up where we left off?

With different countries in different stages of development, it stands to reason that some are in the consumption stage and could pick up the slack where the United States left off back in 2007.

There’s just one problem: The U.S. economy is a $14 trillion-per-year juggernaut, and all the developing countries in the world put together don’t come anywhere close.

Bottom-line: The ability of developing nations to step up their spending wouldn’t adequately balance out the increased savings going on here in the United States.

So if international consumers can’t (or won’t) spend money fast enough to reverse the trend, then who will?

If you guessed Uncle Sam… bingo! Thing is, governments in other countries are in the same boat we are…

The Paradox of Thrift Demands Spending Money

The “paradox of thrift” demands that money be spent in order to reverse the current downward trend brought on by the drop-off in consumer spending and the drastic increase in individual savings.

Will it work? According to CNBC economist Steve Leesman, any time the government introduces money into the system and increases the deficit, resident and non-resident spending increases to keep pace.

This will increase the demand for products and services, so manufacturers will have to hire people in order to meet the increased demand, and that will beget even more spending, more hiring, etc.

However, this approach is highly controversial and political. And in some people’s minds, it’s just laying the groundwork for the next financial meltdown.

Stop the Ride, Please… I Feel Sick

So are we destined to keep repeating this spending cycle in order to grow as a nation?

The answer is “no.” But here’s the real problem: Foreign investors are financing the U.S. government’s massive economic stimulus spending plan.

And while foreigners are content to continue buying U.S. dollars for now, they’re tiring of Uncle Sam and his lavish spending habits – and they’re beginning to look elsewhere for places to park their cash.

The bottom line is this: The current process of deficit spending is unsustainable. The U.S. government – like the rest of us – has to begin to pay down its debt.

Sure, it’s a painful process for governments, just as it is for individuals. But in the long run, the paradox of thrift won’t be a paradox at all. Higher savings will indeed lead to greater investment and prosperity.

As another old saying goes, “Frugality is its own reward.”

Good investing,

David Fessler

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