Paradox of thrift: What we think protects us, hurts the economy even more

The first conceptual description of the Paradox of Thrift may have been written in Bernard Mandeville’s “The Fable of the Bees” (1714). Mandeville argued for increased expenditure as the key to prosperity, rather than savings. Keynes credited Mandeville for the concept in his book “The General Theory of Employment, Interest, and Money” (1936).

The paradox of thrift was popularized by John Maynard Keynes. This paradox states that savings can be harmful when an economy is going through a recession. This is because increased savings lead to a fall in aggregate demand which then reduces economic growth. Such a situation is harmful as investments give lower returns than they usually do.

This is considered to be a paradox due to the contrasting implications of savings to households and the economy. To a household, savings are a protective shield whereas to an economy they can be detrimental. It is generally the case that for households, consumption should be kept minimal and savings should be maximized as money saved today can lead to increased income for the future. However, the chain reaction that consumption patterns can have not been taken into account i.e. multiplier effect on the economy as a whole.

Keynes pointed out that as people’s tendency to save increased, they ended up saving less or the same amount as before. If all of the households in the economy increase their proportions of savings then the value of these savings will not increase. It will either decline or remain the same. When households save more, unplanned inventories increase which results in an increase in unemployment and fall in production. This effect is harmful to the economy during a recession as it plunges the economy further into a recession rather than helping it out of it.

Keynesians argue that increased spending or consumption drives economic growth. So when people tend to save more it harms the economy. This disconnect between the individual and group rationality is what forms the basis of the paradox of thrift.

This effect was observed during the economic recession on 2007. This increase was largely driven by uncertainty about future employment, efforts to reduce debt, and wide fluctuations in stock and housing prices. A simple example of this would be: Let's assume I want a new phone, so I start saving an extra Rs.100 each month that I would otherwise spend going out to eat. By choosing not to spend that Rs.100, I deny the wait staff at my favourite restaurants some work hours and tips (i.e., some portion of their income). As a result, these workers also have to reduce their consumption because they are earning less. If society (as opposed to an individual as in our example) follows this saving pattern, this snowball (or Keynesian multiplier) effect could ultimately lead to decreased consumer spending and lower income for everyone. Consequently, Keynes argued, output would decrease and, therefore, limit economic growth/recovery until, I bought my new phone with the money that I've saved.

In the US during the Great recession it was observed that there was an increase in the number of adult children (25 to 29 years of age) living with their parents. According to the Census Bureau's "Families and Living Arrangements" dataset, the percentage of 25- to 29-year-olds living with their parents increased from 14% in 2005 to 19% in 2011. This arrangement allows them to save money on rent/mortgages, utilities, cable, and furniture. However, because the addition of just one new household contributes an estimated $145,000 to the economy when one factors in multiplier effect, the rise in the number of adult children living with their parents deprived the economy of billions of dollars per year. This potentially slowed down the housing market, retail, and construction and manufacturing industries.

Therefore, the paradox of thrift is something which has been observed in real life and keeping in mind that the global economy is going into a recession, it is an effect which can be observed currently too.