The THRIFT paradox

Continuing from the last blog about public debt, some economists have been arguing that the government should get out of the way and let the market heal itself. They warn that massive government "stimulus" packages only divert resources away from the private sector, thus delaying recovery.

Although its a wise thought (more so because I believe in it), some schools believe that the government must borrow and spend many hundreds of billions of dollars in order to close the "output gap." Such thoughts are very common amongst the Keynesian economists.

While listening to a podcast in which Russ Roberts interviewed the eloquent Keynesian professor Steve Fazzari, I came up with a very interesting idea - "The paradox of thrift" as they call it. This is what this blog is going to be about and not really the economic debate on government spending.

To understand the idea, lets imagine a family that decides to save more, in the hopes of providing for a future vacation or the kids' college expenses. To that end, the family cuts back on how often it eats out at a local restaurant. At first, it might seem that the total saving of the community would rise, but the paradox of thrift argues -

The decision by such families in the neighborhood to not eat out as often forces a reduction in income—indeed destroys the income of the restaurant. Now how does the restaurant adjust to this? One way they might adjust to it is to keep doing things the same way they used to. So the workers continue to get paid, they continue to consume, the income of the restaurant is lower but the spending of the restaurant and its employees stays the same. hat means that the saving of the restaurant group has to go down. So yes, the family that decides to eat at home rather than eating out is saving more, but—by exactly the same amount—the restaurant owner and its employees are saving less. So the initial reaction to lower consumption and higher saving by one group in the economy is less income and therefore less saving by another group in the economy. So they just cancel out.

Another alternative the restaurant owner has is to cut on his spending by firing people and producing less food. What does that eventually lead to? Bankruptcy....

This example should give a good idea about the underlying philosophy. I tried coming up with a counter argument. Don't really know if its that convincing. To understand it, we need to point out the fallacy in the underlying assumption. The system we considered starts at a point of time and stops before the cycle completes. Moreover the sample considered is biased. Lets try and explain that using the earlier example.

First of all, the example assumes that once the family spends less, the restaurant owner straight away goes into bankruptcy. There is a possibility (a very high one at that) that the restaurant owner saves money by cutting on his expenditure a little bit, produces only as much is required and eventually survives the recession to have the whole economy saved enough money for the time when it revives. When we extend the sample, maybe a few restaurants go out of business, but eventually everyone will have saved enough money and the recession would have passed.
Moreover, th sample assumes that everyone in the economy behaves the same way instead of some families spending and some being thrifty. The sample bias is clearly visible.

All said and done, each argument has its merits. If i were to decide, I truely believe in the paradox that a thrift in recession presents. So guys, spend and live your life. Thats the only way we are ever going to get out of recession.