The paradox of thrift: does a rise in savings cause a fall in investment?

Keynesian economists argue that a rise in individuals’ savings, by reducing the amount of money that is spent on final goods and services, can in effect cause a significant fall in overall savings and investment

Published - April 30, 2024 08:30 am IST

For representative purposes.

For representative purposes. | Photo Credit: Getty Images

The paradox of savings, also known as the paradox of thrift, refers to the theory that a rise in the savings rate of individuals can surprisingly cause a fall rather than a rise in the overall savings in an economy. This is in contrast to the general belief that a rise in individuals’ savings rates will cause a rise in the overall savings in the economy. So even though savings may be good for an individual household, it is believed that it may not be good for the wider economy. The idea is part of the under-consumption theories of the business cycle which attribute economic downturns to weak consumption and high savings.

Origins of the theory

The concept was popularised by British economist John Maynard Keynes in his 1936 book The General Theory of Employment, Interest, and Money. Prior to Keynes, it was discussed by economists William T. Foster and Waddill Catchings in works such as Business without a Buyer and The Dilemma of Thrift.

Keynesian economists believe that higher savings is bad for the wider economy, and that boosting consumer spending is the way to grow an economy. They argue that savings are invested by capitalists with the ultimate aim of selling their output in the form of final goods and services to consumers. So, if consumers fail to spend enough money on the output that capitalists bring to the market to sell, it can cause losses to capitalists and discourage further investment. On the other hand, a rise in consumer demand for final goods and services is expected to encourage people to save more and invest.

So, Keynesian economists argue that a rise in individuals’ savings, by reducing the amount of money that is spent on final goods and services, can in effect cause a significant fall in overall savings and investment. In fact, many economists today believe that fluctuations in consumer spending are the primary reason behind the business cycle. They recommend that the government should take various measures, including increasing government spending, to put more money in the hands of consumers during economic downturns. Basically, in the Keynesian view of the economy, the primary challenge that fiscal and monetary authorities need to solve is how to get people to spend enough money on final goods and services to justify the costs that capitalists incur to produce these goods and services.

Criticisms of the idea

Critics of the idea argue that saving more is not bad for the economy and that a fall in consumer spending does not actually cause a fall in investment. In fact, they argue that a fall in consumer spending leads to a rise in savings and investment. This is simply because any money that people don’t spend on consumer goods or hoard under their beds has to go towards their savings, which in turn gets invested.

A rise in savings, they further note, causes an increase in entrepreneurial demand from capitalists for various factors of production. So, lower consumer demand for final goods and services gets offset by higher demand for factors of production, and hence there is no drop in aggregate demand in the economy as a result of higher savings.

Secondly, critics argue that it is not really true that a drop in consumer spending will lead to a drop in investment owing to a lack in consumer demand for the final goods and services produced by businesses. Instead, they argue, a drop in consumer spending will simply cause a change in the way capitalists allocate their savings across time. In other words, these economists note that there won’t be any adverse consequences due to lower consumer spending.

When people spend less on consumer goods and save more, they note, this will cause capitalists to invest a greater amount of available savings to satisfy consumer demand in the more distant future. So, longer-term business projects which were earlier unviable due to people’s preference to consume goods and services in the near future rather than in the distant future suddenly become viable.

Now, the greater time allowed for capitalists to bring finished products to the market is a major reason why economic output is much higher in an advanced economy, these economists point out.

Put another way, the critics argue that capitalists in a free economy will effectively reallocate higher savings in accordance with the greater preference that consumers show for goods in the distant future than in the near future.

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