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.