The Paradox of Saving and Government Deficit Spending
Why is economics complicated? Among other things, because it’s full of paradoxes and different approaches that lack consensus. One such paradox is the paradox of saving. You’ve surely heard many times that saving is good, right? The entire system likes to remind people to save, arguing that it’s a smart and prudent move. Naturally, banks also promote saving because it’s one of the easiest ways for them to access new money, which they can then lend out.
Alright, we can agree that saving is generally good—for the individual. But this is where we encounter the aforementioned paradox. What if too many people start saving? Then it becomes bad for the economy, and if it’s generally bad for the economy, it will ultimately be bad for the savers themselves!
How so? Well, imagine a recession is looming because interest rates are rising (which is roughly the situation we’re in now). That means saving becomes more attractive (as banks offer higher interest on savings). But if too many people start saving their money, it will—according to theory—deepen the recession even further because consumption will drop, which inevitably leads to falling interest rates and the declining appeal of saving.
And that, in the simplest terms, is the paradox of saving—what is good for the individual can turn out to be quite bad for everyone if too many individuals do it at once.
This concept was popularized by British economist John Maynard Keynes, and it has been part of “mainstream economics” since the 1940s. However, there are numerous critics. Let’s look at their arguments.
So, the paradox of saving suggests that if many people suddenly start saving, it will weaken the economy or deepen the recession if the country is already in one. Obviously, an individual focused on saving is not focused on spending. Following that logic, demand for many products (especially non-essential ones) will drop. In such a case, producers and companies will have no choice but to reduce production, lay off workers, and implement their own “austerity measures.” Thus, we get a near-vicious cycle where consumption—and therefore buying—declines, and without it, it is believed, the economy simply cannot function.
That makes sense. But what do the critics say? They argue that this paradox has flaws or doesn’t exist at all. How? Particularly, neoclassical economists believe such a scenario won’t happen because falling demand for products will inevitably lead to falling prices, which will then encourage even the most frugal population to start buying again.
It’s hard to say who’s right. Both approaches are theoretically possible. But from a layman’s perspective, we rarely see significant price drops used to stimulate demand, do we? Moreover, some prominent examples suggest the paradox exists in practice. For instance, during the Great Recession and financial crisis of 2008, the U.S. household saving rate jumped from 2.9% to 5%, which had a concrete impact on the economy and deepened the recession. In response, the U.S. Federal Reserve (FED) decided to slash interest rates to stimulate spending.
And what did Keynes himself say, the man who popularized the paradox of saving? Was he in favor of saving or spending? Definitely spending. He advocated for lowering interest rates to reduce the amount of saving. And what if lower interest rates still don’t get people to buy (and take out loans)? In that case, Keynes (and many after him) argued that the state should engage in deficit spending.
What does that mean? Deficit spending essentially means the government spends more than it earns in a given fiscal period. The state budget slips into deficit—but that’s not necessarily a bad thing, at least from a Keynesian perspective. As mentioned earlier, if citizens can’t be convinced to spend more, then the state becomes the spender. How? In many ways—we’re all familiar with how the government uses incentives and projects to spend money or allocate it to private businesses (which can sometimes be a breeding ground for crony capitalism). Still, the state can stimulate the economy through its own spending. Of course, it would be very wise, even essential, to establish oversight and strict inspections regarding where that public money goes (because, after all, it’s money from all the country’s citizens) so it doesn’t end up in a “black hole.”
Entering into deficit spending is not a decision the state should make lightly. If the effort doesn’t result in economic stimulation, the problem will only get worse.
Keynes was convinced that the state must increase spending during a recession or depression. He believed that overall demand—including consumers, businesses, and the state—must be sufficiently high and that it is key in fighting long-term unemployment, which can make a recession even harder.
But what if the state runs up a massive deficit? Keynes believed that the government should begin repaying its debts once the spending has brought the economy back to an optimal state—when the economy begins to grow again and unemployment falls. And what if all that additional state spending causes inflation? In that case, Keynes argued, the state should raise taxes and pull that excess capital back out of the economy.
Let’s summarize this part—Keynes advocates for increased government spending during a recession to stimulate the economy, especially if the paradox of saving exacerbates the situation. Clearly, this view also has many critics, particularly from the conservative side and those who strongly oppose state intervention—for example, the Chicago School of Economics, which believes that deficit spending won’t produce the desired “psychological effect” on consumers and investors. People will know it’s only temporary and will expect high taxes and interest rates later.
As in the 19th and 20th centuries, fierce debates continue today about how to deal with inflation, recessions, and which approach is more appropriate for solving economic problems. It could be said that there’s a resurgence of Keynesian thinking today, notably through the increasingly influential Modern Monetary Theory (MMT), especially among left-of-center policymakers. MMT proponents argue that the most important thing is to control inflation, and as long as a country controls its own currency, it doesn’t need to worry about accumulating debt—because it can always print more money.
We are now in the 21st century, but the debates remain the same. What to do with inflation and the upcoming recession? Should the government start spending heavily and printing money wildly? Certainly not—that would only fuel inflation (since more money in circulation makes existing money worth even less). In fact, we can already predict the likely chronology of upcoming events—first, interest rates will rise to curb inflation, which will then trigger a recession. Then, the government may indeed have to step in to pull the economy out of the recession, which will increase the national debt. And if balance isn’t maintained—inflation returns. Sounds a bit like a vicious cycle, doesn’t it?
But again, it depends on your perspective—and it’s precisely these perspectives that we’ll explore in the next series of texts. We’ve only scratched the surface of Keynesian economics through a few current examples. A deeper dive will take us next to Chicago, then to Austria, and finally, we’ll close the circle with a look at Marxist economics.
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