Paradox of thrift — a Keynesian fallacy

Gerard Jackson
BrookesNews.Com
Wednesday 25 June 2003

The paradox of thrift is one of the oldest and gravest fallacies in economics. Unlike tariffs, fortunately, it cannot acquire a constituency and can therefore be dealt with without political rancour. Simply stated the fallacy declares that increased savings reduces the demand for consumer goods which reduces output and investment while raising unemployment.

Yet some financial and economic commentators still mindlessly peddle this nonsense. A more subtle version of the fallacy claims that it is only in times of depression that increased thrift is detrimental because it reduces consumption. This too is nonsense. Thrift means savings and savings are just another form of spending.

In its crudest form, the sum of individual savings reduced the total amount of spending, leading to a fall in consumption which in turn reduces the demand for labour. In times of depression it is argued that increased savings will worsen the situation by lowering demand further. It inescapably follows from this that attempts by individuals to cater to their future needs, i.e., retirement, by saving may benefit them personally but at the expense of harming the economy.

Keynesians call this particular action the fallacy of composition. Though such a fallacy itself is very real it does not apply to saving. It is true that a sudden increase in savings or the demand to hold money would disrupt the economy and cause unemployment. But this would only be temporary until the economy adjusted to the new situation. There would be absolutely no need for lasting unemployment (Franco Modigliani's Liquidity Preference and the Theory of Interest and Money, W. H. Hutt, The Significance of Price Flexibility).

Keynesians assume that (a) saving and investing are different actions carried out by different people with no or few links between them, and (b) that investment is basically a function of demand. Therefore an increase in consumer demand will lead to an increase in investment. Two things need to be noted: (1) it does not matter a jot if the people who save are not the people who do the investing; (2) savings are investments.

What struck me about this nonsense when I was first introduced to it was not that it flew in the face of common sense (a great deal of science does that anyway) but that it defied historical experience. The second thing that struck me was that it is not increased savings that Keynesians are talking about but a sudden increase in the demand to hold money. Two entirely different things.

The effect of increasing savings is to signal to producers through interest rates that an increased amount of present goods (savings) were now available to be transformed into future goods (producer goods). This has the effect of increasing investment in more roundabout stages of production that will raise the productivity of labour. In short, to save is to divert expenditure from consumption goods (present goods) to investment (producer goods) which will in the future expand the output of consumer goods. This is what the classical economists meant when they said that to save is to spend. The total effect is to lengthen and make more productive a country's capital structure.

Saving is what fuelled the Industrial Revolution and what really fuelled the 'Asian miracle'. It is no accident that these Asian success stories had high growth rates when one considers their high savings ratios. Growth means capital accumulation and you cannot accumulate capital without savings, i.e., forgoing consumption.

It follows from the paradox-of-thrift concept that the Asian countries high saving rates should have severely depressed their economies while low-saving countries like Australia should have had booming economies and zilch unemployment. This Keynesian nonsense was demolished in 1929 by Frederich von Hayek (a prominent member of the Austrian School of economics) when he effectively disposed of Foster and Catchings' underconsumption theory (see Profits, Interest and Investment).

The Austrian School also demonstrates why depressed economies need more savings and not less. Monetary booms create malinvestments that eventually reveal themselves in the form of idle capital and labour. This happens because inflation misdirects investment causing over-investment in some stages of production at the expense of investment in other stages production. Increased savings would help salvage some of these investments and stimulate the demand for more capital goods. The 'Austrians' always stress that depressions are adjustment periods: increased savings would accelerate the adjustment process.

Keynesians basically assume that what matters is current demand for consumer goods. Reduce that and you reduce economic activity, even driving the economy into recession. That is why all of our economic commentators constantly parrot on about consumer demand.

They have not grasped that in an advanced economy consumer demand is only a small fraction of total economic spending. Moreover, consumer spending does not, and cannot, drive investment. On the contrary, diverting more expenditure to consumption would have the effect of shortening the capital structure thus lowering living standards (Hayek, Prices and Production and Profits, Interest and Investment). It amounts to a policy of hollowing out the economy.

Gerard Jackson is Brookes' Economics Editor