Wednesday, February 4, 2009

Econ 101: Paradox of Thrift

You may have heard this term used recently (Paul Krugman, among others, has been talking about it), it is an old term coined by Keynes which describes a type of self-fulfilling prophecy. In a recession, we all do what is individually rational: we pull back on discretionary spending and build up savings as a buffer against the vagaries of a turbulent economy. However, taken together, all of this thrift on the part of citizens creates a drop in aggregate demand that prolongs and deepens the economic downturn. So we become thrifty to guard against bad economic times, but by doing so we actually ensure bad economic times.

But wait, you careful economists will say, becoming thrifty increases savings which should lower interest rates, increase investment and will actually help lead us out of the economic downturn. Plus, decreased demand will cause prices to fall and people will be enticed to spend again. These are both valid criticisms of the paradox of thrift though neither necessarily invalidate it - it depends on how much the aggregate demand fall is countered by the increased investment. But it is certainly true that in this particular economic crisis, low prices have not enticed consumers back in to the market very much (look at the deals you can get on cars versus car sales), and banks are still largely sitting on the money they are getting from savers and the federal government as they continue to try and shore up their balance sheets and worry about the effect the economy is having on borrowers solvency.

Another rationale for federal fiscal stimulus...

1 comment:

Jeff said...

Doesn't the Fed have the pedal to the metal right now, with little to show as a result?

You can buy cars all day long at 0% interest for 5 years, any color you want (since the lots are full), but nobody is buying.

Monetary policy is used up. (Notice how Bernanke is no longer in the news).

So the "lower interest rates" argument against the Paradox of Thrift issue seems irrelevant right now. Everyone is holding back, even those who don't have to.

The only way to keep GDP up right now would seem to be keeping govt spending (G) high, or exports (X) high. Since demand is tanking in the rest of the world, exports isn't going to solve it.

Consumer spending (C) and investment (I) are obviously tanking. Getting worse by the day.

A lot of businesses are going to continue to fail, and a lot of people are going to lose their jobs.

My personal preference is that we would at least have a health care system in place to cover people (especially children) when they lose their jobs.

Thus I'm disappointed that Obama has seemed to leave this out of his agenda at the moment.