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.

Shouldn't We Be Saving?

Let's start with a great graphic:

This is a hugely informative piece for comparing consumer spending during past economic crises. The 'Peak' line intersects with '1' in the middle, so anything to the left is before the worst of the recession, and anything toward the bottom reflects less spending. That sagging red line shows our current decline.

Now it's clear: recessions deepen until spending picks up.

That makes sense. What employer wants to hire more workers without more customers?

Once answer to that question could be 'the government,' when suggesting that federal money be used to build more bridges, upgrade the electrical grid, and improve schools. All those will indeed create jobs and ease the recession.

But if we want more jobs in the private sector, we need consumer demand, and as long as it keeps falling, we're going to lose more jobs. 

Don't take those jobs lightly. One reader responded to the above graphic by saying, 

'So what if it gets worse? Standard of living is all relative, anyway. You don’t mind not having as long as your neighbor can’t have it, either. Find other things to enjoy in life besides more stuff.'

But we're not just talking about the amount of 'stuff' you have. We're following people's ability to earn a living. Before we start telling others how they ought to handle their money and values, let's reverse the loss of millions of jobs.

Maybe you think people shouldn't be buying junk, but while they refuse to buy anywhere, America will continue to lack jobs.

So do you have to run out and spend? No, do what you see fit: no one knows your needs better than you do. But don't feel guilty for spending when you do, and above all, join me for a cheer when that red line starts to rise.