- 'Paradox of thrift; is a concept that if individuals decide to increase their private saving rates, it can lead to a fall in general consumption and lower output.
- Therefore, although it might make sense for an individual to save more, a rapid rise in national private savings can harm economic activity and be damaging to the overall economy.
- In a recession, we often see this 'paradox of thrift'. Faced with prospect of recession and unemployment, people take the reasonable step to increase their personal saving and cut back on spending. However, this fall in consumer spending leads to a decrease in aggregate demand and therefore lower economic growth.
Paradox of Thrift in 1930sIn the great depression of the 1930s, GDP fell, unemployment rose and the UK experienced a long period of deflation. In response to this disastrous economic situation, mainstream economists were at a loss as how to respond. Such a lengthy period of disequilibrium didn’t sit well with Classical theory which expected markets to operate smoothly and efficiently.
One policy the National government did approve was the cutting of unemployment benefits. The rationale was that in times of a depression the govt should set an example by reducing its debt. This example actually inspired members of the public to send in their savings in the hope that it would help the economy.
By reducing benefits they further reduced consumer spending and AD. This made areas of high unemployment even more impoverished. When people saved rather than spent their money it just made the recession worse.
J.M. Keynes argued that this 'paradox of thrift' was pushing the economy into a prolonged recession. He argued that in response to higher private saving, the government should borrow from the private sector and inject money into the economy.
This government borrowing wouldn't cause crowding out because the private sector were not investing, but just saving.
In the UK and US Keynes was largely ignored until after the war and as a consequence the UK economy experienced high levels of unemployment for the remainder of the decade.