The Paradox of Thrift

NBP Gold.  Photo by covilha.Two years ago (in those economic halcyon days before the so-called “Great Recession”), I wrote a short article entitled Is Not Spending Money Bad for the Economy? In it, I largely concluded (by my own logic) that not spending money – in other words, saving it – isn’t necessarily bad for the economy at at all.

Of course, this article was written against the backdrop of the economic conditions of the time. We were at the peak of six years of economic growth, with only the faintest hints of the economic onslaught about to occur. We, as Americans, also had a negative savings rate at the time – we were actually spending more than we earned as a whole (which meant that there were a whole lot of individuals spending far more than they earned).

Today, we live in a different world. Saving has certainly rebounded – many estimates show that the savings rate is now somewhere around 5%. The economy has certainly slowed as well, and countless trillions have been lost in a 50% dip in the stock market.

So, now’s the time to revisit that question: is saving money instead of actively spending it bad for the economy? Again, I come to the same conclusion – no – but this time, there’s a bit more food for thought on the vine.

The Paradox of Thrift

The whole idea that saving money is bad for the economy comes from the economist John Maynard Keynes, who referred to it as the “paradox of thrift.” (“Paradox of thrift” and John Maynard Keynes is one of those things you can bust out at a party to seem quite smart.) He believed that if everyone saved more money during times of recession, then demand for goods will fall. If demand for goods falls, then economic growth will stall, causing all sorts of additional economic problems (lost jobs, failed businesses, etc.).

It makes some sense on the surface. If everyone stopped spending money tomorrow, the economy would indeed fall apart. There are two big factors that keep this from happening.

First, when demand falls, prices fall.
When prices fall, people are more likely to spend money. That’s why sales always work – and thus businesses regularly have sales. If demand falls across the board, then businesses will lower their prices to get more customers.

Savings Accounts Contribute to the Economy

The second factor – and this is the big one – that makes the “paradox of thrift” fail is that putting money in savings accounts does not remove it from the economy. When you put money in a savings account, it becomes money that the bank can then lend out to businesses. Thus, when more people save, the banks have more resources to pump out to businesses, and when the businesses have more resources, they employ more people, innovate new products, and find new ways to sell.

This is a simple example of why the economy cycles back and forth between economic growth and recession. Right now, we’re in a recession and we’re putting our money away in various savings accounts and investments. That money is then being loaned out to businesses of all kinds who are taking advantage of the very low interest rates available. This means that businesses will soon begin hiring people – reducing unemployment and getting more money out there in the hands of consumers. With more people involved in steady work, more money will be spent and the economy begins to grow. Eventually, people stop saving as much – times are good. The banks then slowly close the taps since they don’t have as many resources for lending. Businesses feel the pinch and begin laying off workers – and we’re back to a recession again.

By saving, you’re actually doing your economic duty, just as you would be if you were buying things. A healthy economy needs plenty of both.

Hoarding Doesn’t Help the Economy

This, obviously, doesn’t include the guy with hundreds of dollars in his mattress or in his safe, or the guy who buys gold coins and buries them in his back yard. That type of saving (I view it as hoarding) does not help the economy at all, as it locks up money in a place where it’s not constantly being cycled back and forth between workers and employers, between businesses and customers.

If you’re concerned about whether or not saving money will help the economy, be aware that it will, but only if you actually invest it in a business (by buying stocks), in a community (by buying bonds), or in a bank where it can be distributed through business and personal loans.

That way, you can not only build a safety net for yourself, but you can also do your part in making sure the economy functions like a well-oiled machine.

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