Matt Yglesias offers a clear, non-technical explanation. I would add a few points:
1. If wages are relatively flexible in the downwards direction, it is easier to avoid the downward spiral from falling aggregate demand. There is an odd tension (though not contradiction) between the view that a stimulus is necessary and the Progressive view that workers don't have much bargaining power and that bargaining power really matters.
2. Savings are especially likely to fail to translate into investment when the banking system is messed up. That applies today, but Keynes was not sufficiently aware of the importance of this condition.
3. Prior to the collapse, savings out of income in this country were approximately zero. So the notion of "people ending up saving less" has to mean a rising ratio of debt to gdp. That's OK for the argument, but now it gets complicated.
For instance, instead of "saving more" the core action under consideration might be to pay down some debt instead of spending money on consumption. But what does the creditor do with those funds? Are dollars sent to creditors "low velocity dollars" rather than "high velocity dollars"? Maybe, but of course they don't have to be. If the citizenry is paying back to creditors who engage in active lending (or for that matter rapid consumption), and make new loans rapidly, things can be OK. If the citizenry is paying money back to zombie banks, maybe those banks just sit on the cash. (How much of the money is going to zombie banks?)
A lot of claims about the paradox of thrift depend on having a good handle on which micro-sectors of the economy breed high vs. low velocities of money. We don't always have such information. The whole notion of how money can get trapped in "low velocity circuit," beyond simple observations about first-round effects (the poor spend a higher percentage of their incomes than the rich), is receiving insufficient attention.
The "Treasury view" that you can treat monetary velocity as constant is wrong. But there's a lot about monetary velocity which we don't understand, or at least which we have not yet applied to the current problems at hand.
Krugman’s saying that there’s a paradox of thrift going on, Yglesias naturally picks up on it, and now it’s being discussed here. That’s all well and good, but I think it’s a big assumption, regardless of what the BEA says. (How do they gather their data?)
From here:
http://www.techcrunch.com/2009/01/30/the-economy-according-to-mint/
Mint, for those of you that don’t know, is like an online version of Quicken or Money. They track over 900,000 consumers’ finances. As a result, they are able to do some interesting trends analysis over time in a way that (I’m fairly sure) the BEA is unable to replicate. Here’s their word on consumer savings:
“But what the data, the hard facts, mean for you – if you run a consumer business – is that your customers are spending $400 less each month than they were a year ago, have burned through half of their savings, and on average have taken on an additional $5k in debt.”
Where’s the paradox of thrift that I keep hearing about? (Unless I’m missing something obvious.)
A deflationary spiral happens when something is a bottleneck, but we do not understand it. We get continual demonetization until the only thing people spend on is the bottle necked item. At that point we say, “Aha”
FDR is a great example. No one could figure out what the problem is until FDR noticed people migrating on roads. He said “Aha” we likely have a transportation bottle neck.
I’m still confused. Even if there is a “paradox of thrift,” and I’m not convinced there is, shouldn’t we look at what is causing people to want to save more? Blindly spurring demand seems reckless to me if you don’t take into account what came before.
Another Keynes question. When he mentioned the problems with “savings,” how much emphasis was he putting on the hoarding of metals? I am under the impression that hoarding gold or silver was much more common back when he wrote the general theory than now. It is the only type of “savings” I can think of that has no probable upside for anyone else.
Isaac,
“shouldn’t we look at what is causing people to want to save more? Blindly spurring demand seems reckless to me if you don’t take into account what came before.”
No, the problem with this cycle is that it’s self-sustaining. When aggregate demand falls, businesses lay off workers, which further decreases aggregate demand. So at this point, the original cause is not so important.
The root problem, that saving does not equal investment, is rather important and needs to be fixed. But while that’s being fixed, money needs to be spurred to keep dislocation from getting too bad.
“When he mentioned the problems with “savings,” how much emphasis was he putting on the hoarding of metals? I am under the impression that hoarding gold or silver was much more common back when he wrote the general theory than now. It is the only type of “savings” I can think of that has no probable upside for anyone else.”
Hoarding was uncontroversially considered a bad thing. But the entire point of this crisis, is that all “savings” don’t really produce any investment spending right now.
Reconfiguring mortgage instruments has received too little consideration. There are options that can be explored and developed between the mortgagee and the mortgagor. The quickest and arguably the most effective actions need to impact both the homeowner and the creditor. What’s the downside in the approach discussed at this link?
http://culture-economy-and-politics.blogspot.com/2008/10/approach-that-helps-homeowners-causes.html
David Shor,
The decision to lay off workers depends on expectations of future earnings (or lack thereof). Businesses make decisions based on current demand and expected future demand. One business laying off workers only causes another business to do the same if that business believes the dip in demand will continue or worsen. If the government comes in and stimulates spending, businesses will expect more earnings now and less earnings later. It isn’t clear to me that an increase in spending will cause a positive feedback loop unless its expected to be permanent, e.g. if the cause of the problem is not removed.
To me this observation also seems elementary: if businessmen think the sky of the economy is falling, they’ll make bad decisions that may cause the sky of the economy to fall. Alright, so why not just try to convince businessmen that the sky isn’t falling, and the downturn is very temporary*? Isn’t that a lot cheaper and easier than a huge stimulus package?
* I haven’t encountered any businessmen who really believe the sky is falling in the long term. All of them I’ve met, including myself, have adjusted their short-term plans for the recession, but aren’t planning for a long-term (e.g., 2+ years) downturn.
Grant,
I must not have been clear. When a business lays someone off due to a decrease in demand, this laid-off employee stops spending money. This causes demand to fall further, which causes businesses to lay off more people, which causes further drops in demand…
And I don’t really think the “expectations” game is very relevant here. Most businesses don’t have large enough cash reserves for much future planning to be possible(and it’s not like the capital markets are going so great either). Instead, the instantaneous “Nobody is buying doughnuts anymore, let’s lay off a worker” is more prevalent.
If the government steps in to employ that unemployed person, then he still keeps spending money, and the cycle is stopped, giving the economy breathing room to adjust to the original dislocation without ruinous spillover.
Just a short comment to Rian, the 1st poster:
Extrapolating from Mint’s data might be far-fetched. I’m not sure how representative their customers are of the “general public”. They might be more prone to taking on debt cos they have jobs that are not under threat. Or they might be very aware of the paradox of thrift (cos they’re econs-savvy MR readers) and are trying their best not to make it happen
Here is a short, accessible paper on the paradox of thrift(I don’t remember where I found it).
http://artsci.wustl.edu/~fazz/saving.pdf
The “paradox” exists because the theory is wrong.
I find Cowen’s privos a bit peculiar.
1. It is flexibility of all prices (including wages) that might solve the problem of “excess” savings. Sufficiently increased wealth from a sufficiently high real money base will result in sufficently high consumption or investemnt to maintain real speding, realy output, and employment. Sadly, falling prices generally make things worse on the way.
2. Money received, spent, or saved is already “in the bank.” While saving may result in an increase in the demand for bank deposits, it isn’t clear how it will generate an increase in deposits into banks. It is true, of course, that banks accumulating reserves (demanding more base money) generates problems.
3. Income not spent on consumption bur rather on paying down debts is saving. What those receiving the debt repayments do is really nothing different than asking what is done with the funds saved.
I think that if you want to think about shifts between households, that high and low money demand makes much more sense than high and low velocity.
how do theorists categorize inflexible demand for money per household? this has certainly changed in the past few years with higher debt to income ratios? (since people borrowed based on too-optimistic income assumptions.)
I realize this was just a watered-down version for the lay person, but one major hitch in the standard expositions of the paradox of thrift is that it seems to rely on nominal magnitudes. E.g. this piece as well as others tell us that the attempt by everyone to save more cannot succeed, because of declining income. But this occurs amidst falling prices. (Even if wages are sticky, prices of goods and services aren’t.)
So we don’t know from Yglesias’ exposition whether it’s true that real savings dropped. For sure, the real value of cash balances has increased (unless you make an argument about declining M1 due to fractional reserve banking).
Grant, excellent points.
David Shor, if what you say was true, wouldn’t the economy (any economy) collapse the moment any firm laid-off workers or went out of business? Great logic, but that can’t possibly be the case.
If a firm lowers or stops production, it reduces supply into that industry or market, putting upward pressure on prices in those markets, shifting income from consumers to producers, but a downward spiral is not precipatated. The problem is confined to the laid-off workers.
The paradox of thrift is usually explaned without reference to an autonomous decline in aggregate demand, so called. Usually it’s just “what’s good for Matt (more savings) is bad for the economy, if everyone decides to lower their time preference and save more,” or some such rendering.
What believers in this story omit is the real adjustments in the economy–prices, interest rates, supply and demand for money, as well as markets for commodities, labor, and capital–and the inconvenient fact that markets, including the labor market, end up clearing. There are no involuntarily unemployed laborers. Not even the fattest economist alive.
Of course, he posits a recession scenario, which leads to more uncertainty and therefore more saving, at least by income recipients. However, this only occurs as a result of the market working off the excesses and malinvestments caused by Fed-induced credit expansion. There is no explanation of the cluster of entrepreneurial error. Did entrepreneurs wake up one morning and take stupid pills en masse and then start piling up losses, leading to layoffs and less demand for capital goods and financial capital?
As for his last point, that fiscal policy has to ride to the rescue, Steve Forbes pointed out in his essay, “How Capitalism Will Save Us” (Forbes, Nov. 10), in 2003 an ounce of gold could buy 12 barrels of oil; whereas today it will buy 11, even though the nominal price of oil is over twice what it was then. Most of the rise was in dollar inflation. So here we have a generally ignored point about government spending, namely that its spending has to be paid for either in future taxes or inflation. Either way, people will be poorer, so fiscal policy is not a free lunch.
There are many other problems with fiscal policy, which have been pointed out by Tyler and others at various blogs.
Bottom line: in a free market, there is no paradox of thrift.
“The “Treasury view” that you can treat monetary velocity as constant is wrong. ”
At or near equilibrium the velocity of money is approximately constant, within the normal measurement error of the economy. This much should be accepted.
If you keep the same equilibrium structure and execute temporal shifts from the future to and back from the present, then over the integration period of the temporal shift, money velocity can be considered constant. This is Ricardo Equivalence. Most economists recognize this, and mathematically it is equivalent to complex variable accounting.
If the equilibrium structure is disturbed or changing by some shock, then you are screwed until you figure out what the shock was all about.
The key to understanding this “Keynesian” process is to realize that we all think we are running under the old system; the effects of the new system are disguised. The system changed because of some unexpected shock.
The shift between equilibrium systems would cause velocity to rise in the old system and drop under the new system.
We finally accept the new system when we decide to quit working around bottle necks and simply adopt the new system.
“But building a new financial sector is going time, and the government should step in for the meantime to keep everything humming.”
And how is a financial sector built? With investments… How is money from the government different than money from the private sector? I suppose the government can pump “more” money into the system at any given time, but I would think that inflationary pressures would make that, at best, a temporary fix. I have zero faith in the congress, treasury, etc. being able to figure out what parts of the financial sector should be saved. Even if there was perfect knowledge and pure intentions, the political process makes a hash out of all of those attempts.
So, if the financial system needs to be rebuilt, what, other than investments, will it need? What is the difference between private sector and government money in that rebuilding process and why would anyone think that the government will do a good job of rebuilding it? If it is investment that is needed to rebuild the financial sector (and I think it is), what does that do to the so called paradox of thrift? I’m not trying to be argumentative, but I am really confused, none of this makes any sense to me. There seems to be an assumption that the government can print money at will with no downside behind all of this. How else can this bailout and rebuilding business be implemented?
Two helpful posts from Yglesias and Mr. Cowen, and a lively and thought provoking commentary. This is what a good blog should look like.
1. So…is the Fed’s soaking up of large amounts of dubious instruments an effort to stop the 21st century version of Gresham’s law: bad debt instruments drive the good out of circulation — so the Fed (and any future ‘bad bank) is taking bad debt instrument out of circulation as a countermeasure?
2. David and Isaac arguing about business expectations vs. business reserves makes me wonder (and I guess it’s obvious): did the move towards ‘optimizing’ all sorts of industrial processes (just-in-time inventories for the factory, just-enough-cash for the accounting arm) make the industrial system far more fragile and prone to creating extreme volatility of labor demand and demonstrating extreme volatility of company survival. Did too much competition and too much efficiency doom us to a much more destructive depression?
Did too much competition and too much efficiency doom us to a much more destructive depression?
No, more competition and efficiency softened the impact of the Fed’s crimes. One of the reasons why that 70s show was such a horror story was that the economy was far more regulated than it is now–especially finance and transportation.
The (partial) deregulation of the banks since then (the 1980 monetary decontrol act, and the partial repeal of Glass Steagall) also made the current mess less bad than it would have been, contrary to leftwing pundits and blogeratti.
Somebody please explain how shifting time preference is bad for the economy. Yes, the shift itself causes dislocation and some suffering. But a permanent shift towards higher savings rates would mean permanently lower long term rates, making it less risky to take on truly grand scale projects, the kind that can stably employ people for long periods. Greater savings is only bad for the economy if you like your progress to come from the government down and not from the grass-roots up.
I thought (some) banks weren’t lending because they aren’t sure where their assets will be marked next week, month, or year and so they don’t know how much reserve capital they’ll need.
The quickest way out of this mess is to let bondholders participate in some of the pain of closing or restructuring impossibly overleveraged banks instead of stealing trillions from the taxpayers.
Kaleberg,
Only lunatics would invest now? I’m sorry, I know a lot of people who are investing (including myself) who are not lunatics. Not every sector of the economy is shrinking, and there are sectors which do well during recessions. Aside from that, there are some great deals on stocks out there, because everything is so cheap. People do invest for 10 or 20 years in the future, its called investing for one’s kids, their schooling, or retirement. Even an investment expected to mature in 3 or 4 years will likely outlast the recession, which really isn’t a very long time.
Trying to encourage less savings when the savings rate is zero should be called an “illiquidity trap”.
You “save” to get out of your underwater debts.
If we were talking about nations instead of consumers and firms, we would be talking about a drop in the level of trade. One of the best ways to boost international trade is to lower tariffs and domestic subsidies not big government purchases from foreign producers. It’s unclear why people believe that the stimulus strategy will work domestically. If you want people to trade more, lower the cost of doing so. You can’t cut costs permanently by giving consumers a short-term loan now at the expense of severe indebtedness in the future. That’s just the run-up-the-credit-card strategy, which has landed so many individuals in trouble, writ large.
Comments on this entry are closed.