"Rapid De-leveraging" = Paradox of Thrift

NPRs Planet Money reports on the record fall in consumer borrowing. Americans slashed their borrowing by $21.6 billion from June to July. They go on to state that this represents a crisis of rapid de-leveraging. But while this might be a new and fancy-sounding term, it is nothing new: this it the same thing as the paradox of thrift. Individuals that increase savings are considered to be doing a good thing, but when everyone in an economy does it at the some time it can cause a big drop in consumer demand. As consumer spending represents about 70% of the economic activity in the US economy, this can be a painful adjustment process. What this report shows is that we are still well in the process of this adjustment and thus we should not be looking for a robust recovery any time soon.

Paradox of Thrift: Update

This graph from the BEA shows the US personal savings rate since Q1 of 2000. From it you can clearly see both the sharp decline in savings rates in the US in the 2005-2008 period and the sudden and strong retrenchment. This is what we speak of when we speak of the Paradox of Thrift. But what does this look like from an historical perspective? Here is the savings rate since 1947 (but before this recent uptick).



During most of the second half of the 20th century we were saving 8 to 10 percent of our disposable income. We are still pretty far from that, but it is the recent sudden reversal that has helped fuel this recessionary cycle.

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...