Paradox of Thrift
By David Henderson
Both Arnold and Bryan have weighed in on the paradox of thrift. Arnold’s response was to my mention of Bob Murphy’s refutation of Steve Fazzari. Jeff Hummel read Arnold, Bryan, and Bob Murphy and wrote me the following:
The essence of Keynesian business cycle theory can be distilled down to two simple features. The first feature is that aggregate demand (AD) fluctuates with people’s hoarding of money (called a fall in autonomous expenditures by Keynesians and a fall in money velocity by monetarists, both of which are equivalent to rise in the portfolio demand for money). People hoard more, and aggregate demand (i.e., nominal spending) falls. That is the essence of a Keynesian recession.
The second feature is some inflexibility in prices or wages that transforms the fall in AD into a rise in unemployment and a fall in output. It is just that simple. All the rest of the Keynesian apparatus attempts to bolster one or both of these two features.
The Keynesian paradox of thrift does not even deny that saving in the form of hoarding leads to more investment. It just claims that that the resulting investment takes the form of unplanned inventory increases. And because of price or wage inflexibility, that in turn leads to a fall in employment which in turn generates a fall in output. In other words, saving in the form of hoarding leads to a decline in real income in the short run, rather than a rise in real income in the long run. Hence, the paradox.
Fiscal policy works under these conditions, according to Keynesians, because people are indifferent between hoarding money and holding government securities. So the increased government deficit, rather than crowding out private investment, sucks money out of people’s hoards and re-injects it into AD. Because of the price or wage inflexibility, as AD rises, output and employment go up.
In other words, to really refute the Keynesian Paradox of Thrift, you must either argue that (a) fluctuations in hoarding (or autonomous expenditures or money velocity) are not that severe or that (b) that prices and wages are flexible enough that it doesn’t matter.