A succinct explanation of the paradox of thrift (savings):
“The paradox of thrift (or paradox of saving) is a paradox of economics, popularized by John Maynard Keynes, though it had been stated as early as 1714 in The Fable of the Bees, and similar sentiments date to antiquity. The paradox states that if everyone tries to save more money during times of recession, then aggregate demand will fall and will in turn lower total savings in the population because of the decrease in consumption and economic growth. The paradox is, narrowly speaking, that total savings may fall even when individual savings attempt to rise, and, broadly speaking, that increase in savings may be harmful to an economy.
The paradox of thrift is a central component of Keynesian economics, and has formed part of mainstream economics since the late 1940s, though it is criticized on a number of grounds.”
Professor Ebeling clearly points out the flaws in the reasoning behind this so called paradox in his excellent work, “Monetary Central Planning and the State“. In Chapter 8, he describes how savings and consumption can both increase in a growing economy:
“In an economy experiencing increases in real income, decisions by income-earners to save a larger proportion of their income need not require an absolute decrease in consumption. Suppose income-earners’ time preferences were such that they normally saved 25% of their income. Out of an income of, say, $1,000, they would be saving $250. If their preference for saving were to rise to, say, 30%, with a given income of $1,000, their consumption would have to decrease from $750 to $700 to increase their savings from $250 to $300. However, if income-earners were to have an increase in their real income to, suppose, $1,100 and their savings preference were to increase to that 30%, then they would now save $330 out of their higher income. But consumption would also rise to $770. This is the reason why savings can increase for new capital formation and investments in even longer periods of production without any absolute sacrifice of consumption in a growing economy. Consumption increases with the higher real income, albeit less than it could have if income-earners had not chosen to save a greater percent of their income.”
While this is not in dispute by other schools of economic thought, it is the spring board for Ebeling’s critique of the paradox of thrift. He notes:
“But if there were a decline in the demand for consumer goods and an increase in savings, what would be the incentive for producers to invest in more capital and productive capacity? This was a criticism leveled against Böhm-Bawerk at the turn of the century by an economist named L.G. Bostedo. He argued that since it is market demand that is the stimulus for manufacturers to produce and bring goods to the market, a decision by income-earners to save more and consume less destroys the very incentive for undertaking new capital projects that greater savings is supposed to facilitate. Bostedo concluded that greater savings, rather than being an engine for increased investment, served to retard investment and capital formation.
In 1901, in an article entitled “The Function of Savings,” Böhm-Bawerk replied to this criticism. “There is lacking from one of his premises a single but very important word,” Böhm-Bawerk pointed out. “Mr. Bostedo assumes . . . that savings signifies necessarily a curtailment in the demand for consumption goods.” But, Böhm-Bawerk continued,
“Here he has omitted the little word ‘present.’ The man who saves curtails his demand for present goods but by no means his desire for pleasure-affording goods generally. . . . For the principle motive of those who save is precisely to provide for their own futures or for the futures of their heirs. This means nothing else than that they wish to secure and make certain their command over the means to the satisfaction of their future needs, that is over consumption goods in a future time. In other words, those who save curtail their demand for consumption goods in the present merely to increase proportionally their demand for consumption goods in the future.””
Note the emphasis on time. This is one of the key insights of the Austrian school of economics, especially with regards to the capital structure. It is also an instructive lesson regarding the necessity of moving beyond first order thinking. As Bastiat noted, “Between a good and a bad economist this constitutes the whole difference – the one takes account of the visible effect; the other takes account both of the effects which are seen, and also of those which it is necessary to foresee.” Thus, a failure to treat time as an important aspect of economic thinking leads the unwary economist down a road paved with fallacies.