paradox-of-thrift

What Is The Paradox of Thrift? The Paradox of Thrift In A Nutshell

Business / By / October 15, 2023

The paradox of thrift was popularised by British economist John Maynard Keynes and is a central component of Keynesian economics. Proponents of Keynesian economics believe the proper response to a recession is more spending, more risk-taking, and less saving. They also believe that spending, otherwise known as consumption, drives economic growth. The paradox of thrift, therefore, is an economic theory arguing that personal savings are a net drag on the economy during a recession.

AspectExplanation
1. Concept Overview– The Paradox of Thrift is an economic concept that highlights a counterintuitive situation where increased savings at the individual level can lead to reduced overall savings and decreased economic output at the macroeconomic level. It challenges the notion that personal thriftiness is always beneficial for the economy.
2. Key Idea– The core idea is that when people collectively increase their savings by reducing consumption, it can lead to a decrease in aggregate demand, which, in turn, may result in decreased production, lower income, and potential economic downturns. This seemingly prudent behavior can have unintended negative consequences.
3. Saving vs. Spending– The paradox underscores the tension between saving (putting money aside for the future) and spending (immediate consumption). While saving is essential for individual financial security, excessive saving in the economy as a whole can reduce spending, which drives economic growth.
4. Aggregate Demand– A critical component of the paradox is the role of aggregate demand, which represents the total demand for goods and services in an economy. When households collectively save more and spend less, it reduces aggregate demand, affecting businesses, employment, and economic growth.
5. Business Impact– Decreased spending and lower demand can lead to reduced business activity, including production cuts, layoffs, and reduced investments. Businesses respond to weaker demand by producing fewer goods and services, which can exacerbate economic slowdowns.
6. Unemployment– A consequence of the Paradox of Thrift can be increased unemployment. When businesses reduce production due to lower demand, they may lay off workers, contributing to rising unemployment rates. This can create a negative feedback loop, as unemployed individuals often reduce their spending further.
7. Government Role– To mitigate the adverse effects of the Paradox of Thrift, governments can intervene through fiscal policies. They may increase government spending, cut taxes, or implement stimulus measures to boost aggregate demand and counteract the economic slowdown caused by excessive thriftiness.
8. Timing and Balance– The paradox highlights the importance of timing and balance in economic decision-making. While saving is crucial for long-term financial security, overemphasis on saving during economic downturns can exacerbate the downturn, necessitating a delicate balance between thriftiness and spending.
9. Historical Examples– Historical examples of the Paradox of Thrift include the Great Depression in the 1930s, where increased personal saving contributed to a prolonged economic slump. Additionally, it is observed in times of economic uncertainty when individuals and businesses become more cautious.
10. Economic Policy– Understanding the Paradox of Thrift informs economic policy decisions. It highlights the need for counter-cyclical policies that stimulate demand during economic downturns and encourage saving during periods of economic growth and stability. Policies must adapt to the prevailing economic conditions.
11. Individual vs. Macro– The paradox underscores the distinction between individual behavior and macroeconomic outcomes. While personal thriftiness is generally a prudent financial strategy, the aggregate impact of widespread thriftiness can lead to economic challenges, highlighting the complexity of economic systems.

Understanding the paradox of thrift

When consumers choose to save their money over spending it in a recession, this harms the businesses that sell goods and services. The business experiences fewer sales and a decrease in productivity and cannot sustain as many employees as a result. When some of these employees lose their jobs, they have less disposable income to spend and the recession may deepen.

This disconnect between individual and group rationality is the basis of the paradox of thrift. Consumers reduce their consumption and attempt to increase their savings during a recession because it makes sense for them to do so. But it does not make sense for the broader economy since consumer savings are removed from the circular flow of income. This means they cannot contribute to an increase in consumption and demand.

The paradox of thrift and the circular flow model

circular-flow-of-income
The circular flow of income model was first introduced by French-Irish economist Richard Cantillon in the 18th century. Cantillon’s initial model was relatively primitive and was progressively expanded upon by Karl Marx and John Maynard Keynes, among others. The circular flow of income is a model that illustrates how money, goods, and services move between sectors in an economic system.

The paradox of thrift can be explained by the circular flow model which demonstrates how money moves through society. In general terms, money flows from producers to workers as wages and then from workers to producers as payment for a product or service. 

The circular flow model starts with the household sector and consumer spending. To boost this spending, Keynes said banks needed to lower interest rates to make saving money in a bank account less attractive. If this strategy was ineffective, the government could use deficit spending to take on debt and use its power to stimulate demand in the economy.

Criticisms of the paradox of thrift

The paradox of thrift has been criticized by neo-classical economists. 

These economists believe that a consumer saving their money sends a signal to the market that they do not want to consume any goods or services at current prices. To counteract this scenario, producers can lower their prices or change the goods and services being produced. In essence, the lack of consumption forces the market to optimize and does not, as Keynes suggested, reduce future output.

To a lesser extent, the paradox of thrift also ignores the ability of a bank to lend out consumer savings to other consumers or companies to stimulate demand. Neoclassical theorists also suggest that consumer savings are essential to growth and technological innovation, with a capital threshold reached before such innovation can raise the total output of an economy.

Lastly, the paradox of thrift ignores Say’s Law of Markets, a classical economic theory that states that goods must be produced before they can be exchanged. In other words, the source of demand in an economy is due to the production and sale of goods for money and not from money (spending) itself.

Key takeaways:

  • The paradox of thrift is an economic theory arguing that personal savings are a net drag on the economy during a recession.
  • The paradox of thrift is based on a disconnect between individual and group rationality. Consumers reduce their consumption and attempt to increase their savings during a recession, but this removes money from the circular flow of income and exacerbates the problem in the broader economy.
  • The paradox of thrift has attracted criticism from neo-classical economists who suggest that markets will self-correct when faced with low consumer demand. The paradox of thrift also ignores the ability of banks to lend out consumer savings to stimulate demand in the economy.

Key Highlights

  • Definition and Keynesian Economics:
    • The Paradox of Thrift was introduced by economist John Maynard Keynes and is a central concept in Keynesian economics.
    • Keynesians advocate for increased spending, risk-taking, and reduced saving as responses to recessions. They view consumption as a driver of economic growth.
  • Explanation of the Paradox:
    • During a recession, individuals tend to save more and spend less, which harms businesses and reduces overall economic activity.
    • Reduced consumer spending leads to decreased sales, lower productivity, and potential job losses in businesses, worsening the recession.
  • Discrepancy in Individual and Group Rationality:
    • The Paradox of Thrift arises from the contradiction between individual rational behavior (saving in times of uncertainty) and its detrimental impact on the broader economy.
    • Individual saving leads to money being withdrawn from the circular flow of income, reducing consumption and demand.
  • Connection to the Circular Flow Model:
    • The circular flow of income model illustrates how money moves between sectors in an economy.
    • Money flows from producers to workers as wages, and then from workers back to producers as payment for goods or services.
    • The paradox of thrift disrupts this flow by reducing the money available for consumption and demand.
  • Solutions Proposed by Keynes:
    • Keynes suggested that banks could lower interest rates to discourage saving and encourage spending.
    • If this strategy failed, the government could use deficit spending to stimulate demand and counter the effects of reduced consumption.
  • Critiques from Neo-Classical Economists:
    • Neo-classical economists criticize the paradox, asserting that reduced consumer demand can lead to market adjustments.
    • Producers can respond to lower demand by adjusting prices or changing goods and services offered, thus self-correcting the market.
    • The ability of banks to lend consumer savings to stimulate demand is also overlooked by the paradox.
  • Importance of Consumer Savings:
    • Neo-classical economists argue that consumer savings play a crucial role in growth and innovation.
    • Savings can be lent out by banks to other consumers or companies, contributing to overall demand and economic activity.
  • Say’s Law of Markets:
    • The paradox of thrift does not account for Say’s Law, which asserts that demand is derived from the production and exchange of goods, not just from spending money.
  • Key Takeaways:
    • The Paradox of Thrift states that increased personal savings during a recession can negatively impact the economy by reducing consumption and demand.
    • This paradox highlights the conflict between individual rationality and its broader economic implications.
    • Critics from the neo-classical perspective emphasize market self-correction and the role of consumer savings in growth and innovation.

Read Next: Circular Flow Model.

Connected Economic Concepts

Market Economy

market-economy
The idea of a market economy first came from classical economists, including David Ricardo, Jean-Baptiste Say, and Adam Smith. All three of these economists were advocates for a free market. They argued that the “invisible hand” of market incentives and profit motives were more efficient in guiding economic decisions to prosperity than strict government planning.

Positive and Normative Economics

positive-and-normative-economics
Positive economics is concerned with describing and explaining economic phenomena; it is based on facts and empirical evidence. Normative economics, on the other hand, is concerned with making judgments about what “should be” done. It contains value judgments and recommendations about how the economy should be.

Inflation

how-does-inflation-affect-the-economy
When there is an increased price of goods and services over a long period, it is called inflation. In these times, currency shows less potential to buy products and services. Thus, general prices of goods and services increase. Consequently, decreases in the purchasing power of currency is called inflation. 

Asymmetric Information

asymmetric-information
Asymmetric information as a concept has probably existed for thousands of years, but it became mainstream in 2001 after Michael Spence, George Akerlof, and Joseph Stiglitz won the Nobel Prize in Economics for their work on information asymmetry in capital markets. Asymmetric information, otherwise known as information asymmetry, occurs when one party in a business transaction has access to more information than the other party.

Autarky

autarky
Autarky comes from the Greek words autos (self)and arkein (to suffice) and in essence, describes a general state of self-sufficiency. However, the term is most commonly used to describe the economic system of a nation that can operate without support from the economic systems of other nations. Autarky, therefore, is an economic system characterized by self-sufficiency and limited trade with international partners.

Demand-Side Economics

demand-side-economics
Demand side economics refers to a belief that economic growth and full employment are driven by the demand for products and services.

Supply-Side Economics

supply-side-economics
Supply side economics is a macroeconomic theory that posits that production or supply is the main driver of economic growth.

Creative Destruction

creative-destruction
Creative destruction was first described by Austrian economist Joseph Schumpeter in 1942, who suggested that capital was never stationary and constantly evolving. To describe this process, Schumpeter defined creative destruction as the “process of industrial mutation that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one.” Therefore, creative destruction is the replacing of long-standing practices or procedures with more innovative, disruptive practices in capitalist markets.

Happiness Economics

happiness-economics
Happiness economics seeks to relate economic decisions to wider measures of individual welfare than traditional measures which focus on income and wealth. Happiness economics, therefore, is the formal study of the relationship between individual satisfaction, employment, and wealth.

Oligopsony

oligopsony
An oligopsony is a market form characterized by the presence of only a small number of buyers. These buyers have market power and can lower the price of a good or service because of a lack of competition. In other words, the seller loses its bargaining power because it is unable to find a buyer outside of the oligopsony that is willing to pay a better price.

Animal Spirits

animal-spirits
The term “animal spirits” is derived from the Latin spiritus animalis, loosely translated as “the breath that awakens the human mind”. As far back as 300 B.C., animal spirits were used to explain psychological phenomena such as hysterias and manias. Animal spirits also appeared in literature where they exemplified qualities such as exuberance, gaiety, and courage.  Thus, the term “animal spirits” is used to describe how people arrive at financial decisions during periods of economic stress or uncertainty.

State Capitalism

state-capitalism
State capitalism is an economic system where business and commercial activity is controlled by the state through state-owned enterprises. In a state capitalist environment, the government is the principal actor. It takes an active role in the formation, regulation, and subsidization of businesses to divert capital to state-appointed bureaucrats. In effect, the government uses capital to further its political ambitions or strengthen its leverage on the international stage.

Boom And Bust Cycle

boom-and-bust-cycle
The boom and bust cycle describes the alternating periods of economic growth and decline common in many capitalist economies. The boom and bust cycle is a phrase used to describe the fluctuations in an economy in which there is persistent expansion and contraction. Expansion is associated with prosperity, while the contraction is associated with either a recession or a depression.

Paradox of Thrift

paradox-of-thrift
The paradox of thrift was popularised by British economist John Maynard Keynes and is a central component of Keynesian economics. Proponents of Keynesian economics believe the proper response to a recession is more spending, more risk-taking, and less saving. They also believe that spending, otherwise known as consumption, drives economic growth. The paradox of thrift, therefore, is an economic theory arguing that personal savings are a net drag on the economy during a recession.

Circular Flow Model

circular-flow-model
In simplistic terms, the circular flow model describes the mutually beneficial exchange of money between the two most vital parts of an economy: households, firms and how money moves between them. The circular flow model describes money as it moves through various aspects of society in a cyclical process.

Trade Deficit

trade-deficit
Trade deficits occur when a country’s imports outweigh its exports over a specific period. Experts also refer to this as a negative balance of trade. Most of the time, trade balances are calculated based on a variety of different categories.

Market Types

market-types
A market type is a way a given group of consumers and producers interact, based on the context determined by the readiness of consumers to understand the product, the complexity of the product; how big is the existing market and how much it can potentially expand in the future.

Rational Choice Theory

rational-choice-theory
Rational choice theory states that an individual uses rational calculations to make rational choices that are most in line with their personal preferences. Rational choice theory refers to a set of guidelines that explain economic and social behavior. The theory has two underlying assumptions, which are completeness (individuals have access to a set of alternatives among they can equally choose) and transitivity.

Conflict Theory

conflict-theory
Conflict theory argues that due to competition for limited resources, society is in a perpetual state of conflict.

Peer-to-Peer Economy

peer-to-peer-economy
The peer-to-peer (P2P) economy is one where buyers and sellers interact directly without the need for an intermediary third party or other business. The peer-to-peer economy is a business model where two individuals buy and sell products and services directly. In a peer-to-peer company, the seller has the ability to create the product or offer the service themselves.

Knowledge-Economy

knowledge-economy
The term “knowledge economy” was first coined in the 1960s by Peter Drucker. The management consultant used the term to describe a shift from traditional economies, where there was a reliance on unskilled labor and primary production, to economies reliant on service industries and jobs requiring more thinking and data analysis. The knowledge economy is a system of consumption and production based on knowledge-intensive activities that contribute to scientific and technical innovation.

Command Economy

command-economy
In a command economy, the government controls the economy through various commands, laws, and national goals which are used to coordinate complex social and economic systems. In other words, a social or political hierarchy determines what is produced, how it is produced, and how it is distributed. Therefore, the command economy is one in which the government controls all major aspects of the economy and economic production.

Labor Unions

labor-unions
How do you protect your rights as a worker? Who is there to help defend you against unfair and unjust work conditions? Both of these questions have an answer, and it’s a solution that many are familiar with. The answer is a labor union. From construction to teaching, there are labor unions out there for just about any field of work.

Bottom of The Pyramid

bottom-of-the-pyramid
The bottom of the pyramid is a term describing the largest and poorest global socio-economic group. Franklin D. Roosevelt first used the bottom of the pyramid (BOP) in a 1932 public address during the Great Depression. Roosevelt noted that – when talking about the ‘forgotten man:’ “these unhappy times call for the building of plans that rest upon the forgotten, the unorganized but the indispensable units of economic power.. that build from the bottom up and not from the top down, that put their faith once more in the forgotten man at the bottom of the economic pyramid.”

Glocalization

glocalization
Glocalization is a portmanteau of the words “globalization” and “localization.” It is a concept that describes a globally developed and distributed product or service that is also adjusted to be suitable for sale in the local market. With the rise of the digital economy, brands now can go global by building a local footprint.

Market Fragmentation

market-fragmentation
Market fragmentation is most commonly seen in growing markets, which fragment and break away from the parent market to become self-sustaining markets with different products and services. Market fragmentation is a concept suggesting that all markets are diverse and fragment into distinct customer groups over time.

L-Shaped Recovery

l-shaped-recovery
The L-shaped recovery refers to an economy that declines steeply and then flatlines with weak or no growth. On a graph plotting GDP against time, this precipitous fall combined with a long period of stagnation looks like the letter “L”. The L-shaped recovery is sometimes called an L-shaped recession because the economy does not return to trend line growth.  The L-shaped recovery, therefore, is a recession shape used by economists to describe different types of recessions and their subsequent recoveries. In an L-shaped recovery, the economy is characterized by a severe recession with high unemployment and near-zero economic growth.

Comparative Advantage

comparative-advantage
Comparative advantage was first described by political economist David Ricardo in his book Principles of Political Economy and Taxation. Ricardo used his theory to argue against Great Britain’s protectionist laws which restricted the import of wheat from 1815 to 1846.  Comparative advantage occurs when a country can produce a good or service for a lower opportunity cost than another country.

Easterlin Paradox

easterlin-paradox
The Easterlin paradox was first described by then professor of economics at the University of Pennsylvania Richard Easterlin. In the 1970s, Easterlin found that despite the American economy experiencing growth over the previous few decades, the average level of happiness seen in American citizens remained the same. He called this the Easterlin paradox, where income and happiness correlate with each other until a certain point is reached after at least ten years or so. After this point, income and happiness levels are not significantly related. The Easterlin paradox states that happiness is positively correlated with income, but only to a certain extent.

Economies of Scale

economies-of-scale
In Economics, Economies of Scale is a theory for which, as companies grow, they gain cost advantages. More precisely, companies manage to benefit from these cost advantages as they grow, due to increased efficiency in production. Thus, as companies scale and increase production, a subsequent decrease in the costs associated with it will help the organization scale further.

Diseconomies of Scale

diseconomies-of-scale
In Economics, a Diseconomy of Scale happens when a company has grown so large that its costs per unit will start to increase. Thus, losing the benefits of scale. That can happen due to several factors arising as a company scales. From coordination issues to management inefficiencies and lack of proper communication flows.

Economies of Scope

economies-of-scope
An economy of scope means that the production of one good reduces the cost of producing some other related good. This means the unit cost to produce a product will decline as the variety of manufactured products increases. Importantly, the manufactured products must be related in some way.

Price Sensitivity

price-sensitivity
Price sensitivity can be explained using the price elasticity of demand, a concept in economics that measures the variation in product demand as the price of the product itself varies. In consumer behavior, price sensitivity describes and measures fluctuations in product demand as the price of that product changes.

Network Effects

negative-network-effects
In a negative network effect as the network grows in usage or scale, the value of the platform might shrink. In platform business models network effects help the platform become more valuable for the next user joining. In negative network effects (congestion or pollution) reduce the value of the platform for the next user joining. 

Negative Network Effects

negative-network-effects
In a negative network effect as the network grows in usage or scale, the value of the platform might shrink. In platform business models network effects help the platform become more valuable for the next user joining. In negative network effects (congestion or pollution) reduce the value of the platform for the next user joining. 

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Gennaro is the creator of FourWeekMBA, which reached about four million business people, comprising C-level executives, investors, analysts, product managers, and aspiring digital entrepreneurs in 2022 alone | He is also Director of Sales for a high-tech scaleup in the AI Industry | In 2012, Gennaro earned an International MBA with emphasis on Corporate Finance and Business Strategy.
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