Having mentioned the economic concept of the paradox of thrift in a post this morning, I realised there was no glossary entry on the subject, so I drafted this:
The paradox of thrift is the idea, first popularised by John Maynard Keynes, that although saving more might make sense for an individual household wanting greater financial security, if everyone in the economy tries to save more at the same time, the consequence can be a collapse in overall economic activity that leaves society worse off.
The logic is straightforward.
First, every person's spending is someone else's income.
Second, when fear, uncertainty or economic shock encourages households and businesses to cut consumption and investment, total demand in the economy falls.
Third, the resulting decline in sales forces businesses to cut production, wages and employment.
Fourth, as a result, national income falls, and the very savings people hoped to increase become harder to achieve because there is less income from which to save.
The paradox of thrift does, therefore, show that individual rational behaviour can lead to collective harm. This is the so-called fallacy of composition at work. What is wise for one household is not, when aggregated, good for society.
This insight matters profoundly for public policy. When private saving rises and demand collapses, only the government can step in to spend, sustain incomes, maintain employment, and prevent recession. Austerity in such conditions, of the sort, for example, imposed in the UK after 2010, is therefore the exact opposite of what is required. It compounds the paradox: government cuts reduce spending still further, deepening the downturn and undermining the well-being of the very households urged to “live within their means”.
In short, the paradox of thrift explains why a healthy economy requires both confidence and spending, and why governments that can create the money we need should never be afraid to use that capacity to sustain prosperity when private actors retreat.
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[…] written a glossary entry on the paradox of thrift this morning, I realised one was also required on the fallacy of composition. This […]
I feel that Keynes has provided the best interpretation of the Fable of the Bees. Adam Smith didn’t like the story because the story of thrift confuses greed (saving money) with self interest (desire to earn income). The problem that we have is that too many people don’t think like Adam Smith. We have people falling for household, spending, saving fables. We inadequately don’t think in terms of wealth of the nation. The paradox then arises because we are unable to invent the social institutions necessary to fix the issue.
Scott Santens reported yesterday that research suggests that between 10% and 33% of Christmas gifts are essentially wasted giving — clothes languish unworn, kitchen gadgets used once or not at all. The US spends a trillion dollars on Christmas gifts, so that’s hundreds of millions of dollars wasted on stuff nobody wants.
How much better it would be if the money was spent by Government on infrastructure we actually need, and will actually make lives better.
One obvious issue is that if we allow to much ‘savings’ to accumulate there may be an issue about the economy to meet those claims when demanded by the holders
If I save by spending my excess money on buying shares in a company or saving in a bank then that money will be spent on company spending on their infra structure or by spending by whoever my bank lends money to. Keynes was right to point out that government taxing/spending needs to be adjusted to keep the economy on an even keel. This is not what I think is happening at the moment (or indeed since the 1980s). Taxing/spending is directed towards benefiting people who the government thinks might vote for it.
I wish your first sentence was true. It would make life very simple. But unfortunately almost no saving funds new investment in the real economy.
When you buy shares on the stock market, almost all those shares already exist. You are not giving the company money. You are buying a second-hand asset from another saver. The company receives nothing. No new factory, no new machinery, and no innovation results. The price may go up, but that only enriches those who already own assets. It is speculation, not investment.
The same is true for the vast majority of property “investment”. Buying an existing house does not build a new one. It simply pushes up prices and creates wealth for those who already have it.
As for banks: they do not rely on your savings to make loans. They create new money when they lend. Your deposit simply becomes part of their funding base. It is not transformed into productive capital. Most bank lending in the UK goes into mortgages and financial speculation, not business investment. Again, that drives inflation of existing wealth, not creation of new wealth.
Keynes understood this. He knew that private saving is just money not being spent, and that it can drive the economy into recession unless the government steps in. Public spending is what turns idle money into useful activity. That is why austerity is always economically destructive: it withdraws spending when the economy most needs it.
And you are right: since the 1980s, government fiscal policy has been targeted not at managing the economic cycle, but at managing political interests. Parties pursue tax cuts for those who support them, and spending cuts for those who don’t. The result? Chronic under-investment in public services, insecurity for most households, and rampant asset inflation benefitting a small minority.
The truth is simple:
• Saving in financial assets rarely funds investment.
• Real investment requires either new bank lending or, best of all, government spending.
• Fiscal policy exists to serve society — not to serve political favourites.
If we want a stable, productive economy, we need a government that understands its role: not bribing voters with tax breaks, but ensuring everyone has the income, services and security that allow the whole economy to thrive.
There are rights issues with shares – Google AI : “National Grid plc: This was the largest UK online rights issue ever, announced on May 23, 2024, to raise approximately £7 billion. The fully underwritten rights issue offered 7 new shares for every 24 existing shares held, at a price of 645 pence per new share. The funds were intended to support a substantial £60 billion investment in energy network infrastructure over a five-year period.”
I’m not disagreeing with you much – I would agree that ISA, PEP and house price profits should all be taxed at some lowish rate generating government income.
As I see it, the real underlying problem of the economy is the lack of a British industrial base. A large cement plant in the NW is now owned by a German company so some of the profit from a much needed housebuilding program will flow abroad (see http://www.heidelbergmaterials.co.uk). A very successful British start-up – ARM Holdings – was sold to a Japanese company for what has turned out to be too little money.
I agree entirely with your last sentence.
An exception usually proves a rule.
And not what a small part of the investment was supposedly paid for with equity.