The paradox of thrift

Now, some folks have wondered why I consider personal savings going up as a problem. The answer is simple: by reducing consumption, this adds deflationary pressure to prices, which in turn makes people unemployed, which in turn causes consumption to decline even further. More importantly, by reducing the number of people that banks can lend money to (since businesses seeing reduced demand will not borrow and people who are increasing their savings will not borrow), it increases the effective reserve ratio and thereby decreases the money supply due to the fractional reserve multiplier effect basically operating in reverse to de-multiply. As I pointed out previously, if the ratio of reserves to loans rises from 10% to 15%, this is effectively a 33% decrease in the money supply -- which adds even more deflationary pressure to the economy.

This is called the Paradox of Thrift. The paradox of thrift can be explained simply: What is beneficial on a personal microeconomic level (keeping your consumption level down and savings level high so that you can more easily cope with changes in economic conditions), can be disasterous on a macroeconomic scale, resulting in a lower standard of living for everybody as consumption, wages and prices decrease yet debts stay the same (thus debt inflation, the primary characteristic of deflationary spirals).

Now, does this mean that you should immediately go out and spend down your savings? No. You have to make personal decisions based upon what is best for you. But it does mean that, if millions of other Americans are making this same personal decision to decrease consumption and increase savings, that there needs to be significant government intervention to a) re-inflate the money supply (by, for example, borrowing these excess reserves in order to build infrastructure projects), and b) increase consumption (by, for example, consuming goods from the economy in order to build infrastructure projects). Otherwise there is a significant risk of entering a deflationary spiral, and said deflationary spiral, sans government intervention, ends up with a typical Latin American solution -- most people chronically un-or-under-employed living in utter squalor and poverty, and a few wealthy people owning all the wealth of the nation. Which is nice if you're one of the few wealthy people, but not particularly good for America, since under-employed or un-employed people living in utter squalor and poverty are not contributing much to the economy.

So any time you see Rethuglicans saying "Obama's recovery plan is extravagant and spendthrift", recall what the end result of following their advice is: Mexico North, with most Americans under-employed or un-employed living in cardboard boxes in utter squalor and poverty. While their advice makes superficial sense because it works on the micro-economic (i.e. personal) level, on a macro-economic level their advice is pure disaster. America is currently in the process of de-leveraging -- reducing debt and increasing savings -- and while that can be a good thing in the long term, in the short term it requires significant government intervention to avoid going into a deflationary spiral, a deflationary spiral which Republican oligarchs have wet dreams about -- but which would be a nightmare for the rest of us.

-- Badtux the Economics Penguin

Postscript: Great minds think alike, I see. Paul Krugman wrote an article on this today too. Go read his. He doesn't go into as much detail as I do, but at least he proves I'm not full of penguin poop! (Note: I wrote this hours before I saw his posting on the same subject, he posted at 11:12 AM EST but I didn't read his blog until 10:15 PM tonight. Though I had seen his Damnification post and had it in mind).