The paradox of thrift and demand deficiency

Posted by: Matt Nolan on: November 12, 2008

• In: International economics | Macroeconomics | New Zealand Economics | US economics
• 1 Comment

The paradox of thrift is one of the key lessons taught to macroeconomics students during their first undergraduate year.

Fundamentally it states that if everyone in society decides to save more right now, then it reduces consumption, with reduces economic activity and thereby incomes – and as a result it may actually decrease aggregate savings, and it will definitely reduce economic activity.

It is still widely applied, with recent Nobel prize winner Paul Krugman appealing to it in order to explain why the US needs to jump on in and get consumers spending again.

Of course this does not mean the theory is necessarily right. The paradox of thrift does not have a supply side – as long as prices and quantities can adjust to an economic shock this paradox, and the suggestion of government intervention in the face of it, does not hold water. For government intervention to be a possible solution we need a MARKET FAILURE, a market failure that causes a special macro-economic situation called “demand deficiency”. (Note: This is effectively the difference between Say and Keynes).

Now, demand is deficient only when prices and quantities cannot respond in the face of a sudden negative change in economic conditions – this is the key, if we don’t identify where the problem is our solution will be average at best. In the labour market the price is “sticky” and as a result we can experience a “demand deficiency” and excess unemployment. This market failure then leads to costs for other industries – effectively the “cost of production” is higher than it would be if the labour market cleared and so output and thereby aggregate income will fall.

I don’t know what is going on in the US – I know their income growth is weak, but is the labour market still “over-priced” given the change to the fundamental value of assets?  If so there could be some role for government involvement. However, if real wages are adjusting optimally any government intervention will merely add unnecessary noise – even if the change in consumption is SHARPLY downwards, this could still be a optimal response to new information by consumers (especially given the debt levels of US consumers and the increasing risk surrounding said debt!).

As a result, it all comes down to whether we think changes in the labour market represent just the fundamental change in economic conditions, or whether they also include some self-reinforcing demand deficient element.