The Non-Paradox of Inactivity

The Paradox of Thrift states:

If everyone tries to save more money during times of recession, then aggregate demand will fall and will in turn lower total savings in the population because of the decrease in consumption and economic growth. The paradox is, narrowly speaking, that total savings may fall even when individual savings attempt to rise, and, broadly speaking, that increase in savings may be harmful to an economy.

It is in many ways a microcosm of Keynesian economics — mostly right, but in a few details spectacularly and outlandishly wrong

(A small detour: In many cases, these few details matter — big time. Austrian economics, of course, is the inverse of this — mostly wrong, but in a few details spectacularly and outlandishly right. I remain unsure as to which set of ideas gives more insight; although I am deeply impressed by some insights of Austrian economics, I generally think the only sensible economic outlook is to scavenge for whatever explanations fit the facts.)

If many people in the economy cease economic activity and hoard their capital, of course the economy will slow down — both in nominal (GDP) and generally also in real terms. Satisfying supply and demand requires a constant and continuous flow of productivity, and goods, and services and money.

Of course there is no paradox there: lowered economic activity is almost always deleterious (the exception being the rare cases when a type of economic activity is itself deleterious to the health of the economy.)

But here is where the paradox of thrift really falls down: saving is not necessarily the same thing as hoarding. Hoarding is saving without investment. And there’s a good chunk of evidence to suggest that more saving with investment is correlated with stronger economic health.

From Lawrence Kotlikoff:

Facts reinforce the idea that spending is no cure-all for what ails America. Most countries experiencing full employment and rapid growth do so while saving at very high rates. China is growing like crazy with a saving rate of more than 30 percent. Japan also saved at very high rates when it was booming. Since then, both rates have plummeted.

The U.S. has also done better when saving was high. In the 1950s and 1960s, saving averaged 14 percent of national income, which grew at 4.4 percent a year in real terms. In the 1990s and 2000s, saving averaged 5.1 percent and national income increased only 2.4 percent.

The connection between saving and growth runs through domestic investment. Countries that save invest not only by building inventory for tomorrow; they also invest in physical capital that makes workers more productive.

U.S. saving is highly correlated with domestic investment; when we save, we primarily invest here at home in starting businesses, buying equipment, and building factories.

In reality, Keynes (and his antecedents) identified an important economic eventuality — a slowdown resulting from hoarding. However, associating this with saving — and subsequently tilting policy toward consumption — is really a misidentification. Societies need investment to grow, and investment requires saving.

30 thoughts on “The Non-Paradox of Inactivity

  1. I enjoy reading your blog; today you really hit the nail on the head of the common economic flaw (not just paradox of thrift) of preoccupation with aggregate demand. Saving is the deference of consumption today for the potential benefit of creating capital for tomorrow. That capital can be allocated to create an investment return.Keynesianism makes no distinction between productive spend and consumptive spend. We have all been exhorted to be good “consumers”; that phrase always struck me as odd as a child even then. I suggest to you that “the rare cases when a type of economic activity is itself deleterious to the health of the economy” is a lot less rare than you imagine! A bit more save and spend on productive capital and less spend on plasma TV’s/cars/junk would be a far better allocation of resources; the fact that a large portion of society “consume” on credit just compounds the allocation error.

    • Thanks, Rob.

      I suggest to you that “the rare cases when a type of economic activity is itself deleterious to the health of the economy” is a lot less rare than you imagine! A bit more save and spend on productive capital and less spend on plasma TV’s/cars/junk would be a far better allocation of resources; the fact that a large portion of society “consume” on credit just compounds the allocation error.

      I do think you’re using too broad a brush here, because a lot of “junk” spending funds basic research, many types of employment, etc. Not ideal, but not all bad. By “rare cases” I am basically referring to wars of aggression that destroy infrastructure, jobs, people, environments, etc.

      Although, you are quite correct, these are not very rare.

  2. Your blog posts are fascinating, but maybe the Keynesians outsmarted you this time. The TBTF (or TFTB, too f**ked to bail) Banks – after receiving money from the savers – don’t lend them out to the businesses for investment. Instead they hoard the savings in Fed Excess Reserve accounts with risk-free 0.25% interest. How wonderful…..

    • If I can explain away a key tenet of the “Keynesian” worldview — that consumption should take precedence over savings — how have the “Keynesians” outsmarted me?

      (Quick diversion: it may surprise many of you to know that I take pleasure at calling myself a Keynesian from time to time. Keynes’ aims in economics were very much the same as mine — world peace, individual liberty, capitalism and a functional society. I split from Keynes on two things — his excessive faith in central planning, and his excessive faith in modernism)

      The IOER charade ( you are hinting to here is absolutely an example of the “non-paradox of inactivity”. They are not using their funds for economic activity, and nor are they investing them therefore aggregate demand and real economic activity are lowered.

      Of course, the real culprit is the Fed. By bailing out the TFTB banks and saving a broken system the Fed guaranteed five or more years of slow painful deleveraging in the shadow banking sector. This deleveraging is the real reason confidence is low and they are not lending the excess reserves.

      • I referred to “Keynesian” as the combination of large-government, deficit-spending and military-war-spending advocates (most of the established politicians and economists, Paul Krugman being the extreme case). In other words, the military-pseudo-Keynesians who claim themselves to have inherited Keynes’ economic ideas. They constantly try to brainwash us into the idea that saving is sinful and consumption is holy. Sorry if it was an offense to you and other heirs of Keynes’ true ideas.

        In fact, I was trying to say that nowadays “saving” doesn’t go into productive investments and instead is wasted in Fed excess reserved or Wall Street derivative binges. IOER and the repeal on Glass-Steagall act are two of the stupidest economic policies in, uh, last two or three decades.

        • Speaking of people I would put in that category, I had a throwdown with Brad DeLong on Twitter a couple of days ago about Ron Paul’s foreign policy. Very revealing. He was saying Obama is “the lesser of two evils” and charged that Paul’s foreign policy followed in the 40s would have allowed Hitler to construct and maintain a huge empire.

          I pointed out that Roosevelt DID follow Paul’s foreign policy — the U.S. didn’t enter the war ’til Pearl Harbor, and even then it was a well-defined war declared by Congress…

      • I have to say that the Keynesian small print disturbs me greatly. His remarks (hearty endorsement) of the “euthanasia of the rentier” in his opus magnus have profound relevance today and serve to underline his fallacy – that abundant capital cannot exist in a finitely resourced world; at least not without destroying the value of that capital. I wouldn’t call that capitalist! Why save to create capital when govt can just magic it into existence (and dish out to it’s mates). Keynesian policy (in action at least) is fundamentally dishonest but loved by govt – it typifies and enables almost all that is wrong with modern govt.

        • By capitalism, I am referring to his preference for a largely self-organising system (even with some central planning of money supply, counter-cyclical macro policy) as opposed to the totally planned worlds of communism and fascism in his time.

          Of course there are great problems with Keynesian capitalism (such as dishing out newly printed money to insiders, etc), but if this were the 1930s I would take Keynesian capitalism ahead of Mussolini and Hitler’s corporatism, or Stalinism. Central planning of the money supply is problematic, but nothing like those other systems!

          And I will say that today’s Western economies today have more in common with Mussolini’s system than Keynes’.

      • “it may surprise many of you to know that I take pleasure at calling myself a Keynesian from time to time. Keynes’ aims in economics were very much the same as mine — world peace, individual liberty, capitalism and a functional society”

        Now I don’t think the Austrians or other serious economists would aim for world war, totalitarianism, communism and a dysfunctional society (joking :P). But of course, there’s a world of difference between what one intends and what one actually achieves. But seriously now, I’m surprised (or confused) you’re saying that the Austrians are mostly wrong while the (neo-)Keynesians are mostly right. A post clarifying your views on these 2 doctrines would be helpful.

        • Well the school of economics I really oppose is monetarism, and (unlike most economists) I would put most modern day “Keynesians” – particularly Paul Krugman, Brad DeLong, Scott Sumner, Greg Mankiw, Christy Romer, etc — into that category. Keynes recognised monetary policy is useless in a liquidity trap. All these Keynesians advocate for more monetary easing. By that standard, they are monetarists. Of course, many of them favour fiscal policy, too. But the key here is that they favour fiscal policy for ciculatory (monetary) reasons (Ben Bernanke is the prime example there).

          There are few real Keynesians left — Joe Stiglitz (sometimes), Ken Rogoff. Real Keynesians recognise that the point of fiscal policy is to fix structural and societal problems. Now, I don’t guarantee that it will, but if there is going to be any government response to economic problems it needs to address more than just “raising aggregate demand”. It needs to address the shape and structure of the economy.

          Now my main problem with Austrian economics is its metholodogy of rationalism. That doesn’t mean I favour the mathematical modelling of Keynesian economics either (it is merely another and more sophisticated form of rationalism — as you know, my economics is mostly empirical historical analysis), but certainly the notion of a “praxeology” based on axioms leaves a bitter taste in my mouth. In my world, to make an assertion you need evidence; real world evidence — not reasoning (Austrian economics) or maths (Keynesian-Monetarist economics).

          I don’t know if you ever read this but I wrote it to refute both Keynesian and Austrian economics on epistemological grounds. They both have serious problems.

        • That’s informative. However, maybe the Austrian school can be redeemed if you understand it like this: maybe they reject JUST drawing overarching conclusions from lab studies BUT they do not dismiss lab studies as a means of understanding how humans’ minds work. I mean, even their axioms must come from somewhere – I don’t believe an Austrian would be such an idiot to claim he was born with these axioms in his mind.

        • From Wikipedia:

          Whereas mainstream economists generally use mathematical models and statistical methods to model and test economic behavior, Austrian economists argue that current mathematical models and statistics are a flawed, unreliable, and insufficient means of analyzing and testing economic theory.

          So far so good. Mathematical models today are at best very, very rough sources of information, and can be seriously misleading. We all remember how Bernanke believed the sub-prime crisis was “contained”. Continuing:

          Instead, they advocate deriving economic theory logically from basic principles of human action, a study called praxeology.

          This, of course, stems from von Mises’ (correct) observation that human thought and decision-making is (essentially) unmodellable. I agree with that.

          The problem is that “praxeology” is so loosely defined, and so Austrian economists disagree on exactly what axioms should be used, and where they should be derived from.

          One writer on the von Mises Institute’s forum summed up his interpretation as follows:

          “Humans act, their decisions are based on subjective values, and uncertainty exists.”

          That is extremely hard to disagree with. But Austrians surely invoke other assumptions (von Mises and Rothbard list different axioms, etc). Having read a lot about (for instance) Austrian interpretations of deflation it is obvious that Austrians assume far more than that which is listed above. Ultimately “axioms” seem to mean “whatever is common sense”, and this can vary greatly from person to person (ironically, the reality of subjective values is of course one of the grounds Austrians use to criticise “rational expectations” and mainstream econ).

        • OK, I understand your doubts. So probably there are a lot of differences of opinion in the Austrian school. But so it is in the Keynesian school. Ultimately I still lean towards the Austrians especially if understood as defined by me above. A “negative” definition that is vague still looks like a sounder base to build upon than the “affirmative” stance of the Keynesians.

        • You have probably read this already:

          – understanding Austrian economics pretty much as I understand it. And that is, not as a specific way of doing economics, but pretty much as the only way of doing economics. You may say that there are people within or outside the Austrian community who have different views, but certainly, the Keynesian approach cannot be understood in a way that would fit the way of doing economics described in the above article (and I don’t think there’s another way of doing economics).


          “The Austrians don’t disagree with that price and quantity vector. But they want to talk about all the activity, a lot of which is what we call entrepreneurship – people adjusting the price, arbitrage opportunities and so on. Eventually you get to that vector, but your focus isn’t on the vector, it’s on all the stuff that goes on before it’s discovered.”

  3. There is no such thing as “hoarding” in economic terms. If I refrain from consumption and save some money there will be some consequences. My cash balance is getting higher and I can later buy something expensive or have some reserve, obviously. Demand is lower, let’s say 1 TV set is not getting bought and production eventually is lowered consistently with lowered demand. Actual resources are freed and now available and their price lowered. It obviously is much more clouded with millions of people and 1 less TV demanded and a little bit of resources freed will not make a visible change in production structure, but the principle stands.

    On the other hand if I “save” by say depositing the money in the bank it is not really saving at all. (Well, more accurately it would be somewhere between an outright investment and actual saving.) Bank lends the money to someone else (lets ignore fractional reserve here) who spends it. No real resources are freed. Demand for TV sets is lower, production of them is also lowered, but the person who got credit from the bank is spending with the same purchasing power, dragging demand up for something else. Resources were shifted, but not freed. In situation where there is no saving at all economy would have to go at full capacity. Not a bit of free space would be left. All the resources we can muster put to all the production possible to get as much consumption as sustainable. Is it bad, or rather very good? I’d say that optimally it should go close to this 100% of capacity. After all the purpose of entire economy is eventual consumption. If we needed no goods and no services we’d produce nothing. However we don’t control the situation so good as to go for a closed system. There’s a lot of risks and fragility (your current pony actually). Gap between maximum capacity and actual consumption could smooth transitions. With some resources free – their price will be lowered. Let’s say there are some bricks left. They will be at hand when savers eventually decide what they want for their money, or in case of any emergencies arising. This is not true if this “saving” is just covert investment, where the bricks are used up to some other purpose. In this case it’s just the transfer between “savers” and their debtors and it will go the other way around when paying back begins.

    While investment is hailed from every corner, I’d say that saving (or what you call hoarding) is also useful. It is quite unexpected for total saving to ever reach very high levels, as human life is finite and we pretty much know what we want. However not consuming and not investing is not just an error it has it’s own value. It leaves resources – actual physical “bricks” free. They can be bought on the cheap and used to build up production that will eventually fulfill stalled consumption. Also if there’s a new idea out, or dramatic shift you don’t have to tear down “walls” of other production branches to get the bricks you need, as some of them are ready but not yet used up.

    • Yes, ordinary people saving money in a bank is not hoarding, because the bank reuses the money for investment (lending). The only way ordinary people can truly “hoard” is by hiding money under their mattresses.

      However, the excess reserves situation — an act of bankers and finance — is absolutely an example of hoarding, as opposed to the personal example you’re talking about.

      You correctly note a couple of benefits:

      Actual resources are freed and now available and their price lowered.

      Usually, falling prices will self-correct as cheaper goods and services bring money and activity back to the market.

      The risk is that this will cause a runaway chain of inactivity as confidence plummets, and the real economy stagnates. This is, more or less, what happened in the 1930s.

      The stagnation of the real economy (closed shops, closed factories, wasted resources, unemployment, underemployment, etc) is problematic.

      Investment becomes fraught with difficulty, because long-term stagnation means investors may never see a return as many businesses fail. Eventually the economy will bottom and new demand will make investments more worthwhile

      In terms of consumption and production, “demand” may return, but the market may be gone altogether. Of course, that opens a hole to be filled, and eventually it will be.

      As Keynes put it:

      The long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is past the ocean is flat again.

      Of course, policy makers have taken this as a justification for throwing slush money at their friends, saving broken systems, the abolition of deflation, mass central planning, etc, all of which are really misinterpretations of Keynes.

      So while the inactivity the paradox of thrift points to is problematic, I don’t think it always merits government intervention, which very often can have more negative consequences than positive ones (zombification). That doesn’t mean we can say that demand-side recessions will immediately self-correct, though.

  4. Interesting discussion. The claim that people save up (or hoard), and do not spend, increasing the effects of lower aggregate demand and lower economic growth is a bad thing? If people are saving it means their current needs are being met and they are largely content which is surely a good thing?

    We do not have to be consumers as rob has said.

    If in this situation the savers are also contemplating starting other businesses either singly or in partnerships (and some are doing it) and they are also giving charity to the needy….where is the problem?

    • If people are saving it means their current needs are being met and they are largely content which is surely a good thing?

      When the monied hoard money it very often means that another section of society — the poor, and debtors — are not getting the money they need repay their debts, and sometimes even to pay for food and shelter.

  5. I think Aziz and others ought to read a online essay named The Abolition of Work

    It starts:
    “No one should ever work.

    Work is the source of nearly all the misery in the world. Almost any evil you’d care to name comes from working or from living in a world designed for work. In order to stop suffering, we have to stop working.”

    Anyway it is a good read in times when working and consuming have become the modern religion of man, with few unbelievers and this has largely come about because of the financiers and their practices covered and justified by the words of priestly economists.

    • Your anarchist article is interesting. I probably have a similar ambition to Bill Black — but under the current technological paradigm it is far from possible. If we can progress society to a stage where most houses produce enough of their own energy (solar, wind, etc) food (greenhouses, etc) and goods (3-D printing, molecular assembly, etc) then yes, there would be much less need to work. But we’re nowhere near there yet.

      For now, capitalism suffices because it is self-organising rather than centrally planned.

  6. In Australia we have a high savings rate. We are not as materialistic as the USA, Yet! People are busy paying down their home loan, and this is impacting the economy. Paradox of Thrift is alive and kicking!

    150 years ago, if people saved, they invested in a cottage industry (e.g. Bought a sewing machine, sold clothes). Now if they save, they earn no interest, yet spend that money on junk down the track. Banks are not lending, just ploughing that saved capital into bonds, most likely paid for by governments printing money.

    The biggest problem the world faces is the throw away short term gratification culture. Any money saved from the past is wasted on unnecessary items that detract from new age technology investment.

    For example. How many mops, brooms, household goods, cars, clothes, trinkets, cigarettes, alcohol do we consume? It is not basic need (Food clothing shelter).

    Has anyone calculated the cost of these throw away items over a lifetime. How many people have restored their deceased relative’s car, or occupied their home when they passed away, or used their garden tools. The energy and resources are used up thrown away, to be replaced by items that look fresher.

    Economics theory does not work in the real world, because people are not rational. A 50 year old car with a $5000 overhauled engine, get you from A to B(admittedly with more ooks) than a $50,000 car. Sure the new car may use less fuel, but it take a long time for payback, and the antique car, can be rejuvinated again. People buy a new car as a fashion statement. This was the lesson learned by Ford, who made rational cheap cars (Model T but lost out to Chevrolet, because of their emphasis on short production runs and style.

  7. But how do you know that that statement is incorrect? The economy may be in a state where a marginal increase in the savings rate can have a higher marginal destruction effect which will in turn lead to a pressure to decrease savings. I’m not necessarily saying the US economy is now in that state.

    Ultimately though what’s more important is that it seems to me that you believe the current state of the economy is sustainable and good – and hence it needs to be supported by govt. interventions – i.e. you see no benefits for “creative destruction”. True, the destruction may be so great that it should be avoided; but perhaps we should wonder whether we ended up in such a situation (where letting everything just sort itself out would be catastrophic) just because of decades of pursuing the same Keynesian policies of smoothing the business cycle.

  8. This is a good critique, but falls short of noticing something spectacularly idiotic about the Keynesian religion: this fear of hoarding as if it were the active destruction of wealth and well-being. As with most Keynesian idiocies, this one can be easily exploded with the simple question of “And then what?”

    So let’s assume a mass epidemic of anti-Keynesianism breaks out in a country and people start hoarding their money away under their mattresses. “And then what?” And then, eventually, they will have to take them out of the mattresses and spend them on things. Nobody hoards for the sake of hoarding. People hoard to transfer consumption from today to the future. In fact, not only will people who hoard today spend tomorrow, but also, people who hoarded yesterday will unhoard and spend today.

    Once we remove the Keynesian dogmas and start thinking like adults, we find that this process of hoarding is nothing but individuals making inter-temporal decisions about spending. It is in fact no different than making inter-spacial decisions about spending: when I decide not to buy a shirt from Polo but buy it from Boss, the same thing is essentially happening. This isn’t scary or crazy and we need not fear it. It is natural. When I decide to take my money away from Polo to Boss, that gives the market a signal for Boss to make more and Polo to make less. That is good, and that is how market economies work. Similarly, when I decide to ‘hoard’ my money away from coke and hookers today, and instead put them under my mattress so I can buy a car next year, this sends a signal to the market to produce less coke and hookers, freeing up resources for making more cars for me next year.

    Keynesians’ dumb obsession with aggregates is what makes this appear like it’s in any way bad. When a financial crisis happens (thanks to Keynesian monetary policy in the first place, it must be added) and a lot of people decide to cut down on coke and hookers in order to be able to have money left over for the coming years of Keynesian dystopia, they are doing something good for themselves and their society. This is the first step towards economic recovery: people spend less, save more, work harder, and delay the enjoyment of the fruits of their labor. Once this processes is allowed to proceed for a while, it results in long-run economic growth and prosperity. If Keynesian nerd-retards with a printing press decide to forestall it in order to save Aggregate Demand, the result will be unsustainable booms and large crashes, which will then beget even more Keynesian nerd-retards trying to save Aggregate Demand.

    Obviously, all Keyensian thinking is based on contempt for the future and short-termism, which explains the spectacular long-run successes of this ideology. This same myopia means that Keynesians have no understanding of time. They are incapable of understanding that people make these ‘hoarding’ decision every second of their existence when they decide not to buy something. Did you not just blow all your life-savings on coke and hookers? Why are you hoarding? Public policy must step in and save our dear Aggregate Demand.

    Finally, I genuinely do not understand how people who are aware of just how idiotic the Keynesian religion is will still feel compelled to write something complimentary about how Keynesian economics is “mostly right”. What is mostly right? How? Keynesian aggregates analysis is utterly scientifically bunk, making the entire discipline absurd–it’s not right, it’s not even wrong, it’s downright absurd in the truest sense of the word. It is absurd to expect aggregates’ analysis to yield anything but endless academic papers that nobody reads and tenure jobs. The conclusions of Keynesianism are worthless, and its predictions are impeccably wrong.

    • I am really talking about methodology. Any academic or nonacademic analysis begins and ends with methodology. Austrian economists’ methodologies, or at least the ones described by Mises & Rothbard as a “praxeology” are pseudo-scientific. Starting with a set of axioms and reasoning (without reference to evidence) to get to conclusions is completely at odds with how I work. Keynesian methods — looking at evidence, and constructing models to explain the evidence is closer, but I do not like the over-reliance on arbitrary mathematics. “Keynesians” have been guilty of an incredible variety of bad science too, mostly variations of putting models ahead of reality. Keynes himself was scathing about these nerds (and sceptical of mathematics — most of the “Keynesian” models, e.g. IS/LM actually come from Hicks) and so I don’t think this trend can be attributed solely to Keynesians (certainly Monetarists are also guilty) — it’s a problem with nerds in general.

      My own approach is pure empiricism. I reject all dogma, and only look to evidence when I want to construct an argument. I am happy to be proven wrong if better evidence emerges. Ultimately, I believe this is the most scientific approach. So when I say “mostly correct” but “spectacularly and outlandishly wrong in the details”, it is very much the case that the devil is in the details, and Keynesian economics has of course led to many spectacular absurdities and central planning disasters. The inverse is true for Austrians — I do not favour their methods, but they very often end up correctly recognising important economic trends, and for that they should be commended.

      As for “what happens next”, well I agree that deflation and slowdowns are generally self-correcting, and that Keynes’ obsession with aggregates is rather neurotic. In fact, the modern neurosis I describe in my post on the Abolition of Deflation has had some very strong negative effects — namely, an excessive buildup of debt, malinvestment and capital misallocation that has not been allowed to clear.

      But getting back to my breakdown of the paradox of thrift, I still think there is a real danger (demonstrated by the 1930s) that runaway loss of confidence can lead a breakdown in the real economy. Simply, prices may fall to a point where markets aren’t there anymore. Now that can be conceptualised as a “breakdown of aggregate demand” (just as much less severe episodes of hoarding can be). But really the problem is when there is a breakdown in the real economy.

    • @saifedean: I enjoyed your post. I agree on most parts.

      Except Coke and Hookers. What if someone gave up their car and put away their money for the future consumption on coke and hookers?

      1. Would Oil prices be lower.

      2. Governments see this as a reason to invest in public transport.

      3. Would there be massive price inflation in coke and Hookers, because of the lack of supply?

  9. Pingback: Breaking the Camel’s Back « azizonomics

Leave a Reply to robin Cancel reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s