Where We Should Be Investing: The Paradox of Thrift

by: Steve Waldman July 31, 2008    

Steve Waldman

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Over the weekend, Paul McCulley offered a thought-provoking piece (hat-tip to Justin Fox, Brad DeLong), which starts with a discussion of the "paradox of thrift":

For those of you who might not recall, the paradox of thrift posits that if we all individually cut our spending in an attempt to increase individual savings, then our collective savings will paradoxically fall because one person’s spending is another’s income – the fountain from which savings flow.

There's a hidden assumption in the "paradox of thrift" that really ought to get teased out more often. It is true that one person's spending is another person's income. But it does not follow that an increase in saving translates to a decrease in aggregate income. There are two kinds of spending, consumption and investment. Laying a subway line adds to somebody's income as surely as buying a Ferrari does. Ordinarily, nearly all savings are actually spent on investment goods, and there is no "paradox of thrift". What is "saved" is really spent on current production of future capacity, and there are plenty of paychecks to go around. There is no "fallacy of composition": individually and in aggregate, today's thrift lays the groundwork for tomorrow's abundant consumption.

 

However, for this to work out, two things must be true: Today's savings must be invested in projects that will actually generate future wealth, and savers must believe they will retain a stake in the increased wealth commensurate with the size and wisdom of their investments. We have a financial system in order to make these facts true. If the investment industry is capable of finding or initiating projects likely to satisfy future wants, and if financial claims are predictable and stable stores of value, we need not trouble ourselves over the paradox of thrift. The issue only arises when the financial system breaks down. When investors lose faith in the quality of available investments or their ability to collect the proceeds (in real terms), they pull out savers' Plan B: precautionary storage. They buy gold, or oil, or art, or whatever, and they keep it, generating scarcity rents for those who can offer perceived value stores, but very little in the way of general income and employment. Precautionary storage, not thrift itself, is the villain of the tale.

The vulgar Keynesian prescription is to encourage consumption, when a dynamic of precautionary storage takes hold. And in extremis that might be a good idea, because if all everyone does is hoard, it's hard to figure what to invest in, except maybe storage tanks. But it's much better to develop a financial system that actually performs, that identifies fruitful projects and allocates claims fairly. Storage eats wealth, while productive enterprise creates it. People know this. No one "invests" in gold or oil when a financial system is working. They do so when it is broken. Like now.

Encouraging people to go shopping in order to help the economy is not "second best" policy. It's a desperate last resort. We're not at a point where there's so little economic activity that we can't foresee future wants. We're at a point where people are beginning to shift from investment to storage because of a well-deserved loss of confidence in the financial system. Encouraging consumption now is nihilistic. It feeds into a vibe (I feel it personally, do you?) that saving is so uncertain and money so volatile that one might as well spend, 'cuz who knows what tomorrow might bring. The right way to sustain aggregate demand and maintain current income is to figure out what we should be investing in — not stocks, bonds, or CDOs, but factories, windmills, or schools — and then to put current resources to work. Our financial system is failing spectacularly because it erred grievously. It built homes and roads and sewers that oughtn't have been built, it "invested" in vacations and plasma televisions, and it paid itself handsomely for doing so. That's not a problem we can spend our way out of. To fix the financial system we have to change it, not rally to its support. We will know we've put things right when thrift is something we can celebrate, when we save because we are excited about what we are creating rather than frightened by what we might lose.

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This article has 18 comments:

  •  
    Jul 31 08:41 AM
    Thank you for the well-stated truths !
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  •  
    Jul 31 09:53 AM
    I read a lot, learn a lot, but rarely comment. You have stated the real truth to this chaotic mess, and it becomes more clear for me.

    I am suddenly responsible for family finances without the benefit of any previous experience, other than a personal checking account. What a time to pick up the baton!
    Thank you for your insight.
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  •  
    Jul 31 10:10 AM
    This is the best article I have ever read here and one of the best anywhere not written by Bonner. Thank you for having a clue.
    Reply | Link to Comment
  •  
    Jul 31 10:18 AM
    A pretty good commentary that is logical. Most "investments,&quo... so to speak yet remain in the secondary market - a thoughtful bet on future income derived from an earnings premium noted today. Productivity generated by such investments is of course debatable - and as noted by accon1031 - the handoff of the baton has boomeranged back. Invest in one's self, payoff unecessary debt (an absolute rate of return), and recognize that if one merely offloads responsibility to another device, the responsibility yet remains - a personal observation regarding the absurdity of the delay in FASB rule implementation relative to balance sheet accountability.
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  •  
    Jul 31 10:32 AM
    This is an excellent article and emphasizes the current real estate price situation in a straight forward realistic way. Many people wonder how the bubble happened in the first place. You can read about it in my blog TheInvestmentSpa.blogs....
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  •  
    Jul 31 10:34 AM
    Great article and great discussion topic. Thanks.
    Reply | Link to Comment
  •  
    Jul 31 10:57 AM
    Wow, thanks for that breath of fresh air. A great explanation of how investing in unproductive assets has put us behind the 8 ball.

    Now we just need to figure out how to convince financiers and government to stop plowing our savings and taxes into ventures that produce only short-term gains and long-term liabilities.

    Perhaps a follow-up article would be warranted?
    Reply | Link to Comment
  •  
    Jul 31 11:47 AM
    Gen X,Y and hopefully not Z have all grown up in the 'consumption' mode. The whole financial system has over glorified the likes of hedge funds (who in their cleverness think that they can actually neutralise market - look at the massive failures) and shorters. Do these activities actually build - or are they just wealth transfer mechanisms which operate in a zero sum environment. What happened to investing the traditional way - hardwork, vision, perseverance, values that are enduring. Now, shorting is known as investing....

    Certainly agree that the precursor to wealth education and wealth planning is 'delayed gratification'. The whole financial system has very foolishly built on the believe that leverage can create value - yes, leverage can create value - only if real underlying value is created. And really, I think too many heas in the finance arena are way overpaid.
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  •  
    Jul 31 12:03 PM
    "Abundant consumption" can not be the goal of any sustainable economy. Consumption means consumption of resources like oil, metals, fish, soil etc. Many of the problems our economy is suffering from today have their origin in the fact that the US is running out of important natural resources, most spectacularly oil, but also many important metals are becoming scarce.

    It took nature hundred of millions of years to create the oil in the ground. Mindless consumption has burned more than half of that oil. If we ignore oil imports, the remaining oil reserves in the US would not suffice to run the US economy for more than 5 years. Depletion of natural resources can not be compensated by more investment. People invest into oil and metals simply because they start to realize that these, although nonrenewable, are being wasted by the "consumption economy".
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  •  
    Jul 31 12:05 PM
    Great article, thank you for your views, it points to the corruption and mistakes made since the 80's on deregulation. Once banking became a private club run by a rather narrow set of views provided by the Ivy league schools of entitlement investing in real industries became a thing of the past. CDO and other packaged securities are the same as "three card monty". That banking fees have become a greater part of the GDP than traditional banking gains from productive loans shows how far we have drifted from any sustainable path.
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  •  
    Jul 31 12:06 PM
    Hehehe, there is investing beyond mere accounting... I only know where you should not invest. The likes of Starbucks or the airlines. No vision, preoccupied only with cutting costs, facilitating the weakening of their business. This while their business contracts due to management griped by corporate inertia, in "save thy ass mode", instead of seeking ways to make money.
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  •  
    Jul 31 12:10 PM
    dude, you got bearfund and buyitcheap giving the thumbs up, great work
    Reply | Link to Comment
  •  
    Jul 31 09:19 PM
    I do not compliment this article.

    The marketplace directed the spending over the past several years into excess housing stock. Sure, maybe we "should have" been building bridges and improving our schools but are you recommending the creation of a tax/regulatory system that would have discouraged the houses and produced these "better" outputs? How about a little good old fashioned central planning eh. commissar? Been tried before. Doesn't work.

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  •  
    Aug 01 07:11 AM
    Loans from fractional reserve banks are inherently "liar's loans", the lie being, the bank is loaning money that it really doesn't have. The result is the active discouragement of thrift: I have to throw my money at something that hopefully will go up in a lot in price in order to hold onto the buying power of my money, trading the certainty of being screwed for the chance to possibly avoid being screwed at some future time. I am not a gold bug, but debt-money leaks out value like a bucket with a hole in the bottom leaks out water. This is just going to keep happening until the basic cause gets fixed.

    First of all, WE NEED OUR OWN DEBT-FREE CURRENCY, backed by all of the real estate owned by the United States (which is, in fact, all of the real estate within the national boundaries, and really more than that including other nations whose continued claim to existence depends on U.S. defense of that claim; case-in-point, Kuwait, 1991), we should distribute that new currency in monthly equi-dollar amounts to all legal residents (amounts due minors to be held in trust accounts). Also, we need bankers to be held financially responsible for any loss of depositors' money (if they want to gamble with fractional reserves, it's the bank owners who should pay, not taxpayers, and if you lose your own money by depositing it in a fractional reserve bank, again, it's YOU who should pay, not taxpayers. How can we ever expect things to get right with a system based on socializing losses?

    Next, we should REPLACE ALL FEDERAL NON-CONSUMPTION TAXES with a one-half percent(+/-) Tobin-type tax on ALL outgoing electronic transactions (avoidable by using cash for all transactions, and, since avoidable, the tax will be arguably being paid voluntarily) in order to:

    1. Pay off the national debt,

    2. Repair the damage that the U.S. government has done to persons and the free market by favoritism (reparations for having "Constitutionaliz... slavery might be considered) and excessive regulation (e.g., we need about 4 times as many doctors and healthcare professionals as we currently have in order to have enough competition extant to get medical costs back to the realm of affordability, and we would have had them had there been a free market in medical education), and

    3. Extract and destroy excess currency as required to avoid inflation.

    No other form of Federal non-consumption tax would be allowed (this tax could go to zero when it has done its job if there is no inflation in the system).

    The monthly equi-dollar distribution amounts should be of sufficient quantity (assuming $1000, that's $24,000 Federal tax-free per couple, plus whatever wages and other income they bring in) to be considered sufficient replacement for all forms of corporate, farm and personal welfare, including subsidies, welfare, tax incentives, Social Security (to be phased out), Medicare, the Federal Minimum Wage law, and ALL OTHER forms of Federal financial redistribution schemes; there won't be any need for separate Federal retirement accounts since there won't be any income or investment taxes.

    For those who like their political solutions morally justified, the monthly equi-dollar distribution amounts can be considered "justified compensation" for the denial of free access to all the property that the government has privatized.
    With everybody getting the same monthly amount, and everybody paying the same percentage increase of fiat money, there is no redistribution nor inherent injustice in the plan.

    Please direct any comments or questions to me at U4Prez.com, username=alajac
    Reply | Link to Comment
  •  
    Aug 01 05:11 PM
    Alan,, he has a point. The fed government should put up the land they own as collateral for a sound dollar. If they go too much in debt they have to sell the land to pay off the debt. They (the government) is just like the banks, they payout money to buy our votes and actually are printing it to devalue the almighty dollar. Investors go figure. As for Bill Gates, his company is sitting by 45 billion dollars and watching it depreciate by about 8% per year and that is stupid.
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  •  
    Aug 01 10:03 PM
    only gold
    Reply | Link to Comment
  •  
    Aug 02 05:08 AM
    Thank you for a particularly eloquent springboard piece from McCulley's essay. I had already read his article when I stumbled onto your post. It is spartanly simple and elegant, particularly so in that we have all around an increasing "tragedy of the commons" in almost all things vital to us. I could not agree with you more. The siren songs of the goldbugs and their opposite, the entitlement & consumption dupes, have all along made little sense to me. I enjoyed your post as much as any I have seen here.
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  •  
    Sep 12 12:21 AM
    messy, what part of `Debt-Free` wasn`t clear? And a government is the ACTUAL owner of ALL the land within its borders (and quite a lot of it sometimes outside those borders). A government allocates its land in some fashion (in the US we usually use `market auction of right to exclusiveand perpetual use`, other governments have used other methods), attempting to sustain its own longevity. The government never has to sell its land to pay its debts. It can just print up more of its own currency, creating a de facto tax on all current holders of that currency. It runs into trouble when it allows the use of private currency in place of public currency, as the wealth generated by the use of that currency winds up in private (banking) hands rather than contributing to the welfare and longevity of the government and its people. And then they want us to tax ourselves to cover their paper losses? bs.
    Reply | Link to Comment
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