The Paradox of Thrift - Case Study Example

The Paradox of Thrift In John Maynard Keynes's 1936 groundbreaking book d The General Theory of Employment, Interest, and Money Keynes parted ways with the classical view of economics and investment by putting forward the Paradox of Thrift (cited in Chamley 1984, p.1,2). Until that point in time it was the widely held belief that savings resulted in increased investment in the capital structure and would stimulate the economy. Keynes broke ranks with the paradox and challenged the traditional view by postulating that savings would remove demand from the system, result in less production, and stimulate unemployment. He contended that "...lack of spending was likely to be a chronic problem in an industrialised economy" and reduce output (cited in Schenk). In other words, the level of investment determines the level of saving and not the other way around (Michl 2002, p.43). The point has been argued for the next 70 years and both theories have at times fallen in and out of favour. Thomas Palley of the AFL-CIO wrote in a 1996 paper that, "The view that saving causes investment is widely identified with classical macroeconomics, while the view that investment causes saving is widely identified with Keynesian macroeconomics. However, deeper inspection reveals that both theoretical perspectives are capable of producing bidirectional causality, and this limits the usefulness of theory for resolving this crucial matter" (p.5). Supply side economics has run headlong into the demand side theories and have resulted in numerous, and yet valid, academic arguments on both sides. According to theory, "...saving can never be different from intended investment, in equilibrium" (McCain 2007). The Paradox of Thrift is one explanation, though not the only one, of how savings can influence an economy's production and increase the unemployment rate. Supply side economics maintains that the marginal tax rate, the rate at which the next dollar earned is taxed, directly influences people's propensity to work, save, and invest (Gwartney 2002). By reducing the marginal tax rate investors are stimulated to invest in a business that may be too risky under a higher tax rate. Lower tax rates may spur people to work harder or longer hours and save their money. Indeed, the tax rate has often been used by governments to stimulate investment. According to Gwartney (2002), "Of eighty-six countries with a personal income tax, fifty-five reduced their top marginal tax rate during the 1985-90 period, while only two (Luxembourg and Lebanon) increased their top rate. Countries that substantially reduced their top marginal tax rates include Australia, Brazil, France, Italy, Japan, New Zealand, Sweden, and the United Kingdom". Many critics saw these deep tax cuts as a bonanza for the rich and argued that the increased tax revenues during this period were simply the result of an in increase in demand. However, during this period of tax cuts in the United States, "...the income tax revenue collected from the top 10 percent of earners rose from $150.6 billion in 1981 to $199.8 billion in 1988, an increase of 32.7 percent" (Gwartney 2002). It can be inferred that a lower rate and increased revenue were the result of a massive increase in wealth for the top 10% that came from capital investment. It would seem that supply side economics had proven itself once and for all. Demand side theorists continued to point to the Paradox of Thrift and its effect on consumption and production. Advocates of demand side economics contend that, "...a decrease in spending leads to a decrease in employment, which leads to a further decrease in spending, which leads to a further decrease in employment, which leads to a yet further decrease in spending, and so on" (Thies, 1997). Some economists contend that corporate cost cutting is a path to a 'corporate paradox of thrift' which could lead to massive layoffs and firings' (Shostik 2002). Individual savings decreases spending for the consumer class and so any increase in savings decreases consumption and increases unemployment. The paradox is that while personal savings is a benefit to personal wealth it may not be good for overall economic health. Due to the fallacy of composition when everyone saves it can have a long-term negative effect on the economy (Cottrell & Lawlor 1995, p.197). This puts forward the theory that the economy is only demand driven. Increased investment can do little or nothing to spur decreasing demand. The less being spent, the less production that will result. The Paradox of Thrift is not so much a paradox as it is an economic philosophy. Supply siders advocate massive tax reduction for the capital class, which results in increased investment and stimulates the economy. The paradox supports placing more money into the hands of the consumer class which will boost consumption. One viewpoint is that the middle class is more likely to buy durable goods, automobiles, and household accessories than the wealthy. There is some logical sense to this aspect of the economy. The wealthy are not likely to divert their increased wealth into areas that are already satisfied. However, the middle and lower classes may well immediately spend any increase in income on consumer goods. The top 10% that experience an increase in income might not buy goods that spur the manufacturing sector as they already have that need met. The top 10% are more likely to use the money for future purchases or as an investment. The only real result in consumption comes from an increase in demand by the middle and lower classes. (Figure 1) The diagram indicates that supply will move to meet demand. The high demand ( the dotted Demand line) indicates a higher output as indicated by Q2. The lower demand (solid Demand line) results in a decrease in production as indicated by Q1. Supply, demand, and production will always reach an equilibrium. Lower demand equates to lower employment. While it is true that an economy needs a source of investment capital it is hardly necessary in an economy where demand is already outstripping the supply of goods and services. However, the global economic situation and trade agreements have made it more necessary to look for demand outside a country's own borders. The Paradox of Thrift is a simplistic model that does not include global capital and international demand. Emerging Asian economies have relied on exports and government intervention into the direct credit market to limit a country's ability to expend its own savings. According to Hubbard (2005), "Asian economies consider the strategy a reach for safety to maintain economic growth through rising exports, while accumulating international reserves as a precaution in the event of a financial crisis. But such policies sacrifice long-term growth". As Makin (2000), says of Japan's recent recovery, "If a nation restricts consumption in order to run a balance-of-payments surplus and accumulate gold, the shortage of demand depresses output, prices, and employment". Herein lies the paradox. While Asian economies may be flourishing and saving at a high rate, Hubbard (2005) argues that, "Essentially, relatively poor citizens of China and other emerging Asian economies are lending funds to the more affluent U.S., where lower interest rates can facilitate a property boom. [T]his outcome may be sensible, but like Keynes's paradox of thrift, it is unsustainable". This reiterates the long-term effects of massive tax cuts for the wealthiest citizens as noted by Gwartney (2002), when he proposes that any real effect of tax rates and fiscal policy must be considered in the long run. The policies of global economics are just beginning to bear results. The unsustainability is demonstrated by the cascading effect of the economic system as it reaches the limits of savings and consumption. Predicted future demand, based on present consumption, will affect inventory levels by reducing or increasing them to the desired level. When employment levels fall, the prediction of future consumption also falls. This results in an additional cutback in production to alleviate the pressure on inventory levels. The cutback results in more unemployment and a reduction in consumption and savings. The Paradox of Thrift is an indicator that there is a safe level, and a safe method, of saving sustainability. The fact that there is a paradox is clear. No well respected economist would recommend that no one save for their future. Still, unbridled saving can strangulate an economy, dry up demand, and raise unemployment. No country can adequately limit an individual's propensity to save. However, fiscal policy may be able to influence how the money is saved. The importance of analysing the paradox is to gain a better insight into the types of saving a nation should pursue. Increased taxation for the purposes of government financed pension programs places the money where it may be spent with a promise of a future debt. This diverts any private savings into the consumer economy. This type of savings program would seem to nullify the paradox and not reduce the rate of employment. This assumes that the government will base future pensions on a promise to pay. If the investment money is garnered into a secure account, it will be no different than private savings and employment will be negatively impacted. The Paradox of Thrift is based on the fallacy of composition that says what is good for one person in the economy is good for the economy as a whole. This simple model holds up, but there is a more complicated equation. While in the simplest model, savings will decrease employment, savings in a government promissory account may result in adequate savings with no impact on employment. In addition, the effect of the national budget on the economy must be considered as well as the effect of the economy on the budget (Berglund & Vernengo 2006, p.153). The only way to solve the paradox is through stable economies and stable governments. Government intervention to reduce the rate of change toward equilibrium, such as manipulating interest rates, can sometimes be helpful. The effects of global participation in trade groups have made it even more necessary to define the cause and effect relationship between saving and investment. The ideal equilibrium will be reached only through stability and long term planning. The paradox, just like tax cuts, are a short-term explanation to a problem that has been debated for most of a century. References Berglund, PG & Vernengo, M 2006, The means to prosperity: Fiscal policy reconsidered, Routledge, Abingdon OX. Chamley, C 1984, 'A general equilibrium expression of the paradox of thrift', Cowles Foundation Discussion Paper No. 700, Yale University, New Haven, Connecticut, pp. 1-41. Cottrell, A & Lawlor, M 1995, New perspectives on Keynes, Duke University Press, London Gwartney, J 2002, Supply Side Economics, viewed 24 July 2007, < http://www.econlib.org/LIBRARY/Enc/SupplySideEconomics.html>. Hubbard, G 2005, 'A paradox of interest', The Wall Street Journal'. 23 June. Makin, J 2000, 'Japan battles the paradox of thrift', American Enterprise Institute for Public Policy Research, 1 July, viewed 23 July 2007, < http://www.aei.org/publications/pubID.11715/pub_detail.asp> McCain, R 2007, Consumption and Saving Again, viewed 23 July 2007, < http://william-king.www.drexel.edu/top/Prin/txt/flux/save1a.html> Michl, T 2002, Macroeconomic theory a short course, M.E. Sharp, Armonk NY. Palley, T 1996, 'The savings-investment nexus: Why it matters and how it works', CEPA Working Paper Series II, Center for Economic Policy Analysis, New York, NY, pp.1-28. Schenk, R n.d. The Paradox of Thrift, viewed 23 July 2007, < http://www.ingrimayne.com/econ/Keynes/Paradox.html>. Shostak, F 2002, The Campaign Against Cost Cutting, viewed 23 July 2007, < http://www.mises.org/story/1045>. Thies, C 1997, 'The paradox of thrift: RIP', The CATO Journal, vol.16 no.1, viewed 23 July 2007, < http://www.lib.flinders.edu.au/resources/sub/healthsci/referencing/electronic.html#ejs>. 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