Countering the Paradox of Thrift

So I was listening to NPR as usual and they were interviewing this guy, I think he was some kind of Democrat politician, who was talking about the bailout plan. He said that government spending is more effective in stimulating the economy than tax cuts since parts of those tax cuts would be saved.

The biggest problem that I have with Democrat politicians (and actually most politicians in general) is that they ignore the basic fact that savings is what drives the economy. If you looked at the savings rate for countries, there is a direct parallel between the savings rate and the growth rate. People in Thailand, Singapore, South Korea, and post-reform PRC had really high savings rate  of around 30-40% and they experienced very high growth rates. Then you looked over at sub-Saharan Africa and their savings rate was somewhere around 15% and they all had very low growth rates.

The argument that was made by Keynes is that when people save money, they’re not spending. When people are not spending, revenue for firms go down. When revenue goes down, firms hire less people, which leads to less jobs, and less income for the people. As a result, when people save money, they  actually hurt themselves because their income decreases. Thus the term ‘Paradox of Thrift’ was coined.

Note: This is not just a liberal term. Bush, right after 9/11, told people to go shopping based on the idea that savings is bad. Even when Republican politicians propose tax cuts, they do so not to promote savings, but to promote higher consumption.

So what happens when people save money? Do they just stick it under their mattress and forget about it? Probably not, except in the case of Japan in the 90s when people were ‘hoarding’ (not saving) money due to poor confidence in t he banking system.

Instead, savings goes into financial institutions, bonds, financial assets, and stuff like that, but for simplicity sake, lets just look at banks. People put money in the banks. What happens to that money? Do banks really just sit on all that cash and not lend it out as a bunch of people were saying before? Well, during the time when people were saying there was a ‘credit crunch’, interest rates were actually decreasing, which means that banks were trying to loan money out. If a bunch of people were demanding credit and were unable to get it, the interest rate should have increased. Which it didn’t (and just to dispose of another myth, while the Federal Reserve can influence the interest rate by printing or destroying money, it doesn’t exert control over it).

So people put money into banks. The banks do not just sit on it since the way that banks make money is by loaning it out. If people are pulling out of the stock market (which is why it tanked so much in the past few months), then they have to put it somewhere. Lets assume that they’re putting it into their savings account just for continuity sake. Now the banks are overflowing with money and they want to loan it out. Who do they loan it out to? Well obviously to people that they think would be able to pay it back. Now this is not always the case, which is what led to a few bank collapses, but the majority of the banks in America are still solvent, which means that most of the loans made were good.

So who borrows money? Well, sometimes its by people who want to buy a new yacht, but usually, its businesses that want to invest so that they can increase production and efficiency in the future. Higher investments means higher productivity. On the micro level, this can be seen as an outward shift in supply, which leads to lower prices and higher quantity. Multiply that supply-demand chart by 300 million and you got increased production due to higher capital to labor level and as a result are able to reach a higher income level (Solow growth model). Everybody is richer, everyone has more, and everyone is materially better off. Now those people who are seeking spiritual enlightenment are left wanting, but everyone else should be happier.

At least this is what the people who say that the Paradox of Thrift is all screwed up. Next time, I’ll counter the argument that the Paradox of Thrift is totally wrong and that spending AND saving can both lead to growth.