FoC (5) - Thrift

The paradox of thrift is an example of a wrong application of the fallacy of composition. Many economists claim that personal thrift harms the economy during a recession. If households stop spending, the reduction in aggregate demand slows the economy further. Some people lose their jobs and everyone is worse off. The solution is government spending. Keynesian economists urge governments to increase spending to compensate for household thrift. However, government spending is often wasteful, so this solution does long term harm to the economy.

The same economists suggest that governments should implement policies that will encourage household spending and discourage saving. The problem with this approach is that there can be no investment in capital goods without savings, so policies that discourage savings eventually reduce investment, which harms the economy in the long term.

The fallacy of composition should really be applied during the boom that precedes the recession. The real problem is not the “paradox of thrift”, but the “predicament of debt”. However, there is no “predicament of debt” in economic theory, because economists are not interested in the real problem. Most prefer a theory that justifies government intervention in the economy, because interventionist governments need more economists to advise them.

The reason that households need to slash spending during a recession is that they have overspent during the prior good times. When central banks reduce interest rates to strengthen the economy, households take advantage of cheap interest rates to buy goods on hire purchase and credit cards. They increase their mortgages and buy houses to take advantage of the increase in house prices. This is the predicament of debt. Massive increases in personal debt allow people to improve their lifestyle, but this is bad for the economy, because speculative bubbles and reduced investment in productive assets eventually produces a recession.

This is the real fallacy of composition. Increasing debt may be good for businesses and households, but it bad for an economy. Therefore instead of taking action to counteract thrift during recessions, governments should avoid policies that encourage excessive spending and debt during the good times that precede and cause the recession. Thrift is only harmful during a recession, if there has been a lack of thrift during the good times.

The complete series on the Fallacy of Composition is here.