Monday, March 23, 2009

The Paradox of Thrift

This is the last post for awhile on why we need spending, so let's look at the clearest possible case: a village of three people who trade only with each other.

If some hold back on their spending, they all suffer. Why?

Suppose they each buy $5 of goods from the others, spending and earning $10. Peter bakes bread, Paul grows grapes, and Mary cooks casseroles, and everyone buys - and sells - two items each month.

This works fine until Peter begins to worry about the future and wants to save. He decides he can do without Paul's grapes for now, so he buys nothing more than the $5 casserole from Mary.

Paul now has just $5 to spend, since only Mary bought his grapes. Paul must cut back on his own spending as a result, and once he buys one loaf of bread from Peter - and nothing from Mary, since he has no more money - all trade is finished.

How much money does Peter now have to save?

Nothing. Zero. Zip. No one has more money in this situation, yet everyone has less to enjoy. How can that be?

This is what economist John Maynard Keynes called "the paradox of thrift." When people move too drastically to save, they can all end up saving less than if they were less thrifty. The problem results from a sluggish economy when everyone pulls back at once from their spending.

What can be done to get this village economy moving again?

Someone has to have confidence that things are improving, enough to promise purchases from both other merchants. Then the whole chain can begin moving again at full capacity. 

Saving isn't inherently evil. But if people leap too quickly to increase their saving habits, they can end up with less on the table and in the bank.

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