Ever since John Maynard Keynes popularized the Paradox of Thrift, economists, central bankers and politicians have labored under the misapprehension that high levels of savings are bad for the economy and inhibit growth. The Paradox of Thrift:
- Increased savings means there are less buyers for goods produced, so the nation as a whole will tend to produce less.
- If an individual saves they increase their wealth;
- But if an entire nation saves, this causes a shortfall in consumption; and
- The shortfall in consumption will cause national income to fall.
Keynes was correct in his observation that high level of savings caused a shortfall in national income, but we need to remember that he was writing in the 1930s — in the middle of the Great Depression. His General Theory was published in 1936. What Keynes observed was an anomaly caused by the financial crisis. Falling asset prices threatened the solvency of both individuals and corporations, forcing them to increase their level of savings and — most importantly — use their savings to repay debt.
Not only will national income fall when savings are used to repay debt, but it falls rapidly. The shortfall between saving and new investment (or spending and income) may be small but, like a punctured car tire, the result is disastrous. At each point in the supply chain the leakage is repeated: A receives an income of $1.00 and use 5 cents to repay debt, only spending $0.95. B will receive $0.95 from A, where previously they received $1.00, and will use 5% to repay debt, only spending $0.9025. C will only receive $0.9025 from B but still uses 5% to repay debt, only spending $0.857……… The pattern continues until incomes shrink to the point that parties are forced to consume all of their income and can no longer afford to repay debt. The impact on national income — as evident from the 1930s — can be devastating.
Keynes pointed out that government can break the cycle and make up the shortfall, by spending more than it collects by way of taxes — so that the aggregate level of spending is unchanged. But fiscal stimulus is fraught with dangers, not least of which is the massive public debt hangover faced by the US, Japan and many European economies. I will cover these dangers in more depth in a later post.
Under normal conditions, however, the paradox of thrift does not apply:
- If an individual saves they will increase their wealth;
- If the entire nation saves, there is no effect on national income provided savings are channeled through the financial system into new capital investment.
- All that then happens is less consumer goods are produced but more capital goods — spending as a whole does not fall.
- Production, as a result, will also not fall.
National income is, in fact, likely to rise. New capital investment will boost productivity and accelerate growth.
Consider the simple example of a farmer who saves and buys a tractor. His overall spending is unaffected. He merely consumes less and spends the proceeds on something else — in this case a tractor. The income of the store that supplies him with consumer goods will decrease, but the income of the dealer that sells him the tractor will rise; the net effect on national income is so far zero. But the farmer now produces more food with his new tractor; so his income — and the national income — increases.
This misconception that the paradox of thrift applies in normal markets has done immense harm to the economy and eroded the savings of the middle-class and retirees. For three generations, central bankers attacked savers by artificially reducing interest rates — in the belief that lower savings would boost demand and stimulate the economy. Low interest rates simply forced savers to assume more risk, in order to earn a return on their investment, and encouraged speculation. The traditional work hard and save ethic that is the backbone of the capitalist system has been supplanted by the consume, borrow and speculate profligacy that got us into such a mess. High levels of public and private debt, inflation, volatile investment returns and rising income inequality are all consequences of the low-interest policy pursued by the Fed. Today’s giant casino is a far cry from the cautious, prudent investment outlook of our grandparents’ generation.
I will conclude by reminding you that savings channeled into new capital investment actually boost growth.
- Savings are only harmful when used to repay debt or for other non-productive purposes.
- Low interest rates encourage speculation and the formation of bubbles;
- Bubbles cause financial crises; and
- Financial crises force consumers to repay debt.
….the never-ending circle of life.
“Savings are only harmful when used to repay debt or other non-productive purposes”
so how was the play, mrs lincoln?
I get the “mrs lincoln” but cannot see the connection.
The big problem in this is the debt in the first place. Debt is harmful when it is used to drive consumption rather than investment. That is true no matter who does the borrowing, The public or the government.
Most public companies know this and eventually if they don’t they go broke, Banks seem to be a special case as do very large companies (Like GM in the US). if any company is ‘too big to fail’ it should be broken up
Individuals and families will eventually go bust the same way (If you are using a credit card to pay your food, fags, booze and electricity bills you are well on your way there.
Governments never seem to know this. They have bred a huge class of welfare sucking zombies who they need to keep sweet to get re-elected so they print more money (once again robbing savers) or borrow and keep spending on even more unproductive crap (Robbing the unborn). They can do this for a very long time until they become Greece
Great piece of fundamental analysis. – from a technical commentator too.
As a retired banker I well rember the introduction of consumer debt (credit cards) into this country. Inflation took off, with the burst of purchasing power, but nobody seems to realise that after the first flush, people using credit cards actually purchase less. About 20% less goes into the consumer economy due to the interest syphoned off to bankers. Especially if the debt is used to purchase depreciating liabilities (consumer toys) rather than appreciating (or productive) assets. The end result is that after the credit card limits are reached, levels of consumer spending have to fall. The reverse applies after a cycle of repaying debt. People (and countries) will reach a critical mass of self-sufficency, even affluence, and can spend more freely than the indebted entity. –
I use fundamental (macro) and technical (micro). I started as a fundamental analyst but my approach evolved to include both.
The problem is that we have had the party (consumption funded by rapidly increasing debt levels) and now have to suffer the hangover when the debt is repaid. The only way to ease the pain is to ramp up investment so that overall (public + private) debt is constant, but we end up with assets to offset the debt.
“savings channeled into new capital investment actually boost growth.”
The problem during the Depression and in other downturns (the present being probably the 2nd worst) is that business does not invest if it sees no prospect of a return. That is why govt spending is needed to fill the gap at those times. The main problem has been that govts were spending in the good times when they should have been neutral or saving, so when their spending is needed, taxes are down and they are running on empty.
This does not debunk Keynes. Read Steve Keene’s Debunking Economics for an explanation of how Keynes has been described incorrectly and this incorrect description is then debunked.
The best examples of Keynes are comparing Germany and US during the 1930s. After the economic novice Adolf Hitler took control in 1933 he started spending and by 1937 had turned Germany around from economic disaster and hyperinflation to a strongly growing economy. The US grew when the govt spent money and slowed when it stopped because business did not have confidence to invest. In 1937 a “responsible” attempt to reduce the deficit put the US into another depression. The Tea Party is trying to do the same again in the US. In the 1930s the US was only saved when it began spending on the war effort.
Some rather moralistic comments have been made about spending having to be productive. What is productive about making weapons that will blow up or be blown up? Yet the effect was to set the US up to be the world’s strongest economy for the rest of the century, with the resources to give Europe the money to rebuild after the war. These were the equivalents of paying people to make widgets to be dropped down an empty mineshaft, so please give up on the “productive” moralising.
Sometimes the mechanisms that make economies work stall and govts have to kickstart them and keep priming them until they start working properly. And do not expect govts to be capable of spending wisely. Nice if they can, but what works is that someone gets paid and they spend that money, and people start paying taxes and the govt spends it and someone gets paid……… Noone really understands how economies work, but if you can get money moving fast enough, somehow they do.
The effect of WWII was that the US was the last power standing; it had most of the remaining capital (factories and labor). So, it gave away fiat money on the condition everyone agreed to use that money to buy things from the US.
This had nothing to do with Keynes. WWII was the world-wide equivalent of hitting the economic reset button. And the empire it created worked until the inevitable excesses of the Federal Reserve acting as the world’s banker overtook the system. That’s where we are now.
It’s time to hit the reset button again, which means trashing the derivatives pyramid that is the basis of our current financial system. The sooner, the better. And while we’re at it, let’s trash the bankers and politicians that created these excesses. Not for revenge, but to leave a message for posterity.
Colin: This piece was worth the price of my yearly subscription to your servcie. Thank you.
Thank you for the feedback. Where it started to go wrong was with Kennedy in the 1960s. Excessive money creation undermined the gold standard. Nixon was forced to take the US off the gold standard in 1973.
I believe we need strong fiscal stimulus to put the economy back on its feet. This must be long-term (10 to 20 years) and must focus on infrastructure investment that creates real assets that generate a market related return on investment. The return on assets can be used to repay the debt. Public debt should not be repaid out of future taxes (which would harm growth) but with of returns from investment. How do you fund this infrastructure spending?
Ultimately the wealth of a society is predicated on the capability of individual citizens, and how efficiently their efforts are organised to produce the goods and services that the society needs. Education, rule of law, stable and transparent government all contribute to achieving this. There are parallels with debt, which in essence is “rent on money”.
If debt is put to productive use which enables an outcome with an ongoing payback well above the “rent”, great; lets take on more and put it to work. In that scenario, paying down debt does not make much sense. However, if the debt is used to fund purely consumptive activities with no ongoing ROI, the debt is simply an operating cost which should be critically assessed in terms of real value delivered in the prevailing financial context.
Now those who are licensed to issue debt have created a self referential industry of packaging and approval of new debt which is completely disconnected from any feedback mechanism where the productivity or sustainability of debt created can govern the system. The genie has been let out of the bottle and it’s now a free for all.
At the same time, we can also push the same argument to the other end. The capital investment induced productivity rise can also lead to the price reduction for the wheat of the same farmer. The net income may remain the same, unless, he can export the surplus wheat outside of his trading radius. Increasing capital investment to produce the same product will lead to price reduction, as shown by the price of computer chips. We need to increase capital investment to produce innovative products, and this is the challenge.
I said it was a simple example. An increase in total wheat production would lower the price of wheat and increase wheat consumption. Does that increase GDP? We may consume more wheat but less of something else, but if total output increases then yes it should. We can improve output by introducing existing goods at lower costs — that is another form of innovation.
Colin,
Keynes thesis is still valid today. In your example you mentioned the farmer buying the tractor. This is investment not consumption. Your example confuses consumption and investing so naturally you would come up with an erroneous conclusion.
Many graduate students have trouble with “The General Theory” so it is not surprising that even those in finance and politics make a mess of it.
The term saving in economics has a totally different meaning than is commonly used. It is extremely easy to trip yourself up on this definition. I would suggest either studying for the first time or reviewing the definition of the variables in the macro-model.
If you read Keynes carefully you will find that Keynes advocated governments running surpluses in times of rapid economic growth so that they could stimulate business during slow business growth. The Theory is not to be used to justify a perpetual deficit. This was something the Clinton Administration understood and the Bush Administration did not understand.
Once again, I suggest studying your basic macro economics prior to diving into Keynes. Also, note that the investing model that Keynes describes in the general theory is not the American model of investing.
Hope this helps.
C Walter
I think you missed the point:
I’m happy to debate these definitions with you. Keynes’ model has bothered me for close on 30 years. There always seemed to be something missing. Richard Koo supplied the missing piece (S and I do not match when debt is being repaid).
Regards, Colin
Today, w/ mechanization of farming pretty well complete in the first world and land agricultural land utilization pretty well maxed out , the farmer doesn’t buy a new tractor to grow more food but to operate more efficiently.
I said it was a simple example. Today it may be a GPS navigation system for an unmanned tractor or an automated dairy with no human intervention. I saw a system on TV where the cows milk themselves — no more herding — which increased milk output by about 40 percent.
Thanks for the article Colin, and for the interesting comments. I like that observation, that the word “productive” has become a moral value. Adding one thing: If one is “breaking even”, week to week, year to year, one is in debt. At the very least one is living of their principle, even if that “principle” be their (his or her) body, which they must use–consume, that is, however slowly–to continue working, whether white or blue collar. “Capitalism” is engendered by excess–excess resources of all sorts.
The problem was/is excessive debt creation. Now Europe and the US are attempting to solve the problem by creating more debt.
I see the whole thing as being REALLY simple…..so perhaps I’m wrong! 🙂
All credit vs saving does is to move consumption (and hence production) from the present (with credit) to ‘down the road’ (with saving). The only people (other than bankers) who, temporarily, benefitted from credit were those manufacturers and retailers who lived during the period of INTRODUCTION of credit, because it increased the consumption over THAT time. So for a few years, until stabilisation occurred, manufacturing and retailing benefitted. Once things reach equilibrium, however, credit doesn’t help consumers, as people can only sustainably consume what they can afford to buy, at any time, on their income…..with or without credit.
If, from now on, it was decided not to have credit and people had to save for what they wanted there would be a few years where there would, obviously, be less consumption but there would be no difference in consumption once it stabilised. The main difference, as someone else wrote, is that the person who doesn’t save (in order to buy the item a few years hence) and buys it now, pays interest to the bankers. Bankers are the ONLY people (although others have now climbed onto the lucrative credit interest bandwagon) who benefit ONCE equilibrium is reached as they are effectively able to take money from the consumers (ad infintitum) in the form of interest….it’s another ‘tax’ on the consumer, effectively….but one the government coffers don’t get except via VAT and corporation tax.
If credit was stopped now, in favour of saving for things, there would be a period of a few years where it would be very painful for manufacturing and retailing and the folk working therein (just the opposite of what happened when credit was introduced….the golden years for them). However, at the end of those years, consumption would be just the same….and no one would have credit interest to pay. The only losers would be those who charge interest to those who can’t wait; ie the bankers et al. They would lose all this steady annual income from charging interest.
Talking about interest reminds me of something which I only recently learned, even though I’m at the fairly ripe old age of 66. This was that Jews, like Muslims, (and Christians too; pre middle ages) regard charging interest on a transaction as a sin (Usury). In fact the Jews and Arabs have similar words for it, apparently. However, the point that I was surprised with is that Jews ARE allowed to charge interest to gentiles (non Jews) !!!! Hmmmmmm….. I don’t know if that goes for Muslims too. Christians were also against usury until after the middle ages. A fascinating history which I’ve just had to look up:-
http://en.wikipedia.org/wiki/Loans_and_interest_in_Judaism
You are right in saying that repaying debt would create hardship. The biggest challenge we face is how to deflate the massive debt bubble without injuring anyone.
Thanks Colin, very well articulated – not an easy thing to do when explaining money. Personally I’ve never understood the dogma that saving is bad, so I never followed it. My approach in its simplest form is this: The bank pays me interest so I’ll lend them my savings. My savings get loaned to people who want to buy a house. To repay the bank, those people have to work. That work creates prosperity (assuming it’s not a parasitic job) and the economy improves. More jobs get created for people who’ll then bank their savings and keep the machine turning. It’s not a perpetual motion machine (especially for a retiree not earning), but for working people, and provided the borrowed amounts can be repaid in a lifetime, it’s pretty close. But the machine can’t cope with leaks in the system – middle men and parasites who ride the machine without peddling. Then if banks are allowed to gamble instead of invest in productivity, the machine crashes altogether, and no one trusts it anymore.
Banks don’t loan money to housing mortgage for a long time. They initiate the loan, front the funds and then package it to sell to investors (insurance companies, FNMA, etc.). They then service the loan and take the money and use it again to initiate another loan. The simple, albeit wrong, understanding of how the mortgage market works is one of the problems we have – ignorance of how economics works and the mistaken belief that it is simple to understand and solve. Mr. Aquino’s lack of information is a basis for his belief in how something should be attended to.
If government would do the right thing that would work (like the Chinese have) we would be ahead of the game. But government (ie politicians) want to be re-elected so they pander to the misinformed such as Mr. Acquino.
Thanks Steve Bell, it just goes to show how out of date I am, and why I don’t trust the system anymore. With all those middle men (read: percentage parasites) in the organism, no wonder it’s sick. Thanks for setting me straight. Cheers.
“”provided savings are channeled through the financial system into new capital investment.””
It is the people who did this surely did a rooen job. Even though your thesis is right the financial system oversight is questionable. this does not mean QE 1,23 etc are right either.
I agree they did a rotten job. This has nothing to do with QE.
Central banks, e.g.the Fed, create new money to support banks whose balances are suffering because they have made bad decisions, probably as a consequence of their part in the cycle you described. A fraction of the electronic money however also finds its way into the real money accounts of senior staff since that is the way their algorithms work. Other people do not have recourse to this convenient way of resolving debt and accumulating wealth by position alone. Whether the participants realize it or not, that in a nutshell is what is driving the current broad based social unrest.
If it is good enough for money to be created for banks, at what point is it wrong to create money for other purposes? The rural road system in NSW is in a shocking condition-the same probably applies to the rest of Australia. Because it is out of sight to the cities where most people live, it is out of mind. Why can’t money be created electronically to massively improve the rural road infrastructure? After rural roads, why can’t money be simply created to address other glaring national infrastructure needs?
At least there would be better sense of sharing in the money keystrokes – more so than pouring it into banks. I guess what I am suggesting is that the banking system is a purveyor of privilege if you are in one camp, and an insurmountable obstacle if you are in another.
I agree with your comment.We are now @ the other end of this cycle .People are frustrated with the present spending spree, result ,riots & demonstration. Had savings been encouraged the bubble would not have happened.What we have to watch now is the pendulum swing in the other direction.
Correct if the capital investment is in fact made into a sector which materially increases the wealth of the nation generally at all levels and if there is demand for that investment.
In Australia at present it could be argued that most of this investment is being channeled into the resources sector,whilst much of the balance is waiting for a home into other decreasingly productive sectors.
It has yet to be established that the resources boom is of major benefit except to one side of the economy,hence the two speed economy.
A lot of other savings surely are lying idle in banks waiting for demand from the non resources sector and until the demand in both areas are balanced and expanding, it seems difficult to accept your argument for the Australian situation.
Also-
“provided savings are channeled through the financial system into new capital investment.”
Aren’t we forgetting that this new capital investment will not be required except for stimulatory purposes,if there is no consumer demand, by and large.
Consumers create most of the national economic activity, surely.
Its all like a dog chasing its tail
“Aren’t we forgetting that this new capital investment will not be required except for stimulatory purposes,if there is no consumer demand…”
I agree that you would not want to invest in sectors where there is existing over-capaicity. But think of new automated container-handling facilities at a port, a new toll road or bridge, or a national broadband network (we won’t go into the actual merits of the current NBN scheme).
All of these would be used because they either save costs or improve outcomes (e.g. a shorter trip, a faster download, etc.).
G’day Colin,
Appreciate the new platform…well done.
Regarding your opening comment…my question is WHY?
If what you have stated regarding people saving is true, and I believe it is so, then why do policy makers “persist” in this self distructive process?
The only reason I can come up with (!?) is that to bring in a cashless arrangement where “everyone” is expected to “fall in to line” is to Crash the money system!
Fincerely yours,
Bruce
WHY? Because it is a stealth tax and they do not have to account to voters for it. It also suits a socialist agenda where everyone is dependent on the state.
The overall economy doesn’t work like a mirror of personal or even company finances where it’s obvious you can’t “spend” your own way out of debt. I don’t think you’ve debunked Keynes, because you’ve assumed saving will be spent on something productive like useful investment and at present that’s not the case. It’s being hoarded, not invested, as a reasonable fear based response to the limp wristed politicians we seem to have in most ‘developed’ countries at present. Taking down the Glass-Steagle act which prevented US ordinary banks from indulging in speculative investment banking practices and allowing a 33 to 1 leverage of depositors money was probably the key trigger for the GFC. The Goldman Sachs types still rule the roost and therefore it can all happen again.
“I don’t think you’ve debunked Keynes, because you’ve assumed saving will be spent on something productive like useful investment…..”
You may have missed the point. Under normal circumstances, savings will be channeled into new capital investment. During a banking crisis/balance-sheet-recession, savings will instead be used to repay debt.
Or are you referring to the fact that some savings will be used to fund consumption? That of course would have a net effect of zero.
when you repay debt it is loaned out again as soon as possible by the lenders.
Therefore no difference to the economy would be caused
I beg to differ. If clients are repaying debt, banks will seek to find new borrowers under normal market conditions. But during a banking crisis they are scared to lend because of falling asset prices. They will either buy Treasuries, leave the money on deposit with the Fed as excess reserves ($1.6T in the US) or simply shrink their own liabilities by offering lower rates on deposits.
Here is something else to think about. The erosion of wages and under-employment. Both of which have a huge impact on the ability to save OR spend.
Pulling back a bit, I see the bigger picture pointing towards the recent events ( i.e. the GFC ) as indicating the start of a transfer of economic ascendency from the west to east.
Perhaps the only effect that you are missing is the different multiplier effects through the economy. Not to say that all capital investments have a lower multiplier. For example, construction has a multiplier of 2.4 compared to retail of 2.0. Your point seems valid, so the destination of the spending may be more important than whether it is savings > capital or directly retail. It does stand to reason, in the longer term, saving must be better because considered investments (unlike speculative bubbles) should generate a return for further investment (ie, compounding growth).
I would expect capital goods to have a greater multiplier effect than consumption goods. I seem to recall that India built steel mills because that had the greatest multiplier, but ran into problems with steel quality. It always sounds good in theory…..
I agree. People spending more than they make and not saving ALWAYS eventually causes a burst bubble when the people are so far in debt that they can’t get any more credit. Like now. If people can make loan payments plus interest, they should be able to make these same payments to their savings to save up for what they want. They only probable exception is saving for a house. Most people can’t save for a house.
The easy way to solve this crisis, which will never happen because it would require impossible amounts of cooperation, is to “reset all debts and give tax breakes to the lenders in proportion to the amount of money they stand to lose, and give part ownership of assets where debts are unpaid etc”. This is kind of what would happen if there was a Third World War as no country is going to pay back debts owed to a country they are at war with. Food for thought.
As I said above, time to hit the RESET button — time to reboot the system.
But very few are willing to even talk about this now. Which means there’s a lot of pain yet to be inflicted on the victims.
The key is: how to save the banks? A 10% write-down on loans would wipe out the entire banking system. 10% inflation would probably achieve the same ends, but with far less pain.
10% inflation will do the trick? There are bogus derivatives valued in the HUNDREDS of TRILLIONS (no one has any idea exactly how many) on the books of the world’s financial institutions. And they’re all counterparties to each other.
The banks don’t get saved. New ones get created, with (relatively speaking) real assets, probably based on gold. Commercial and casino banks are once again seperated. The commercials cannot gamble, and the casinos must eat their own cooking.
Hundreds of Trillions makes a good headline, but most of these are inter-bank and net off against each other. Still, there is no denying it is a big figure. If one bank cannot meet its commitments the creditor bank will become the new owner. More too-big-to-fail…..
Indeed, Colin, many offsets. But don’t these derivatives, and the swaps that supposedly protect them, make up what passes for assets these days? isn’t this why the bank emporers are so afraid of another (liquidity) crisis? They know they’re in a roomful of naked bankers.
And, we haven’t even started talking about sovereign debt, which is also in the tens of trillions, if not hundreds, counting all entitlements. Some haven’t even been recognized yet. Here in the states, we have private and public pension obligations that have only been winked at, to date.
How is inflation going to cover all of rhis, not to mention the continued deficit spending, which I don’t believe will change until the events that force a reset stop it?
Phil, Further QE appears inevitable. It looks like even the ECB may be forced to join the party. The question is not will there be QE, but how much?
Agreed. But can they suppress the commmodities, especially XAU and XAG?
More cans down the road, making the inevitable more painful. Obama and Congress are holding their collective breath, hoping this gets them past elections in a year and a week from now. Looks like Merkel may already be finished.
Thanks for the lively discussion.
If we want a stable future we need to shrink the amount of debt in the system. By raising capital reserve requirements (9% is just a start). But that would lead to a Fisherian debt deflation spiral similar to the 1930s. Inflation would lift asset prices but also the amount of debt. There are no easy solutions here.
Why is it that ‘the authorities’ do not seem to understand what they are doing and the effects their policies impose on us.
Maybe a subscription to the Colin Twiggs ‘school’ would help them.
Debt is never a problem if it can be managed. Governments should not underwrite the capitalist system. Short sharp pain
caused by defaults would be better than this death by a thousand printing presses.