The paradox of thrift.

Hoarding cash in the bank long-term might work for you but it is not good for the economy and jobs.

Renowned economist, John Maynard Keynes, popularised this concept known as The Paradox of Thrift.

It goes like this –

“When individuals try to save more during an economic recession, this leads to a fall in the overall demand for goods and services which in turn worsens the economic recession.”

Thrift, which in buoyant times is good for the overall economy, is bad during a recession.

Keynes wrote his book, “The General Theory of the Economy”, in 1936 in which he declared that spending and investment in the economy were the keys to increasing economic growth.

He believed that jobs did not rely on the capacity of businesses to employ people, but rather on the decisions of individuals to spend and invest their money.

He also believed it was the role of central banks to reduce interest rates which in turn encourages more investment.

Does anyone recognise these principles at work in our own economy today?

Classical economics reigned supreme when Keynes wrote his book and they did not like it one little bit. Heresy, it was. Unorthodox, sacrilege, profane.

Going back to 1936. What had the world just gone through? There was a nightmare to come, around the corner, but hundreds of millions of people had been out of work for three or four years during the Great Depression while governments had preached thrift, reducing government spending and encouraging people to save at a time when fear of running out of money gripped all levels of society. Classical economics at work. Ugh!

Keynes was a breath of fresh air in 1936 and even today, it is him we should thank for the theoretical understanding that ministers of finance and central banks across the world have used to get us out of one crisis after another including the Global Financial Crisis and this latest Covid-19 crisis.

Keynesian economics

Have you heard the phrase, Keynesian economics? Sometimes used in scorn, to heap criticism on financial decisions made by governments when they borrow and spend, sometimes used in praise when governments borrow to keep people in work doing useful, productive things.

The quality of spending

A reasonable criticism of the borrow and spend approach is on the quality of their spending. It is a difficult and finely balanced decision to spend money in any circumstances and some of us are better at selecting the best purchase or investment than others. Some political parties are better at it than others.

This is not a essay on the quality of spending other than to remind ourselves that it is the quality of spending that trumps all else and where our best people and finest judgements have to be trained, both individually and as an economy.

Criticisms of Keynesian economics

The classical criticism of the Paradox of Thrift is this – when people hoard cash it is only because they cannot find any goods and services that appeal to them at the price they are being offered. By withholding purchasing goods and services consumers are forcing sellers to lower their prices until they are encouraged to buy.

There is a level of saving in the economy that is necessary for investment into technological innovation and other productivity-enhancing goods and services, but the paradox of thrift focuses on hoarding cash during a recession, not saving per se.

The paradox of thrift is talking about a change of behaviour in our community at a time when fear is griping the hearts of consumers. It is talking about a change to otherwise normal behavior, where individuals and businesses sit on cash in the bank and reduce spending and investing that would otherwise be taking place.

To what extent is fear driving the hoarding of cash in this market?

Anecdotally, the banks are awash with cash now. Also anecdotally, banks are making it more difficult to borrow by stress-testing borrower's income against higher interest rates than offered, thus affecting the availability of housing loans.

On the other hand, some retail and food businesses in tourist spots are having a very good year overall.

Keeping an eye on one’s emergency funds and continuing to pay off debt are important at all times including during this current recession but so too is the need to keep money circulating in the economy. So many families depend on it.

Keep asking great questions …