Friday, January 09, 2009

“Rising Water Worsens Flooding”

I was reading the Wall Street Journal Wednesday and happened upon a poorly written general interest story which I promptly blew off until I saw that it was the second most read online article of the day. In “Hard-Hit Families Finally Start Saving, Aggravating Nation's Economic Woes” author Kelly Evans attempts to make the case that the sudden contraction in consumer spending is somehow making the recession worse.

Usually, frugality is good for individuals and for the economy. Savings serve as a reservoir of capital that can be used to finance investment, which helps raise a nation's standard of living. But in a recession, increased saving -- or its flip side, decreased spending -- can exacerbate the economy's woes. It's what economists call the "paradox of thrift."

The premise of this article is flawed. It implies that the shift in savings rates are somehow independent of the recessionary condition itself. To imply that the economy is made worse by saving leads one to the question “worse compared to what?” A contraction in spending is what happens during the initial stages of a recession. It is the recession! To imply that it worsens the recession is like implying that rising water worsens flooding.

This sort of thinking is at the heart of the reasoning of those economists who think that we must try to stimulate the economy by spending. Implying that something that is a natural part of any recession is worsening it gives credence to the idea that one could spend their way out of a recession. Ultimately, if the public won’t spend, then they must be “stimulated” to spend by allowing the government to spend their money for them. This is a failure to understand a basic law of economics, Say’s Law, which says that supply constitutes demand. One way to consider this is that it is ultimately capital (i.e. money) put to productive use in the hands of capitalists, which causes costs to drop and buying power to increase stimulating consumer demand.

We have seen capital destruction in the last few years, and with it, a natural contraction in the resulting demand. In order to quickly recover then, one would want to accumulate that capital, and put it to productive use. In other words, the best thing one can do when faced with destruction of personal capital is to reaccumulate it, i.e. to save!

Note the funny logic implied as well. This crisis was supposedly caused by a glut of consumer credit, a binge of spending, a lack of savings. But now, the solution to exiting the crisis is to spend. Don’t believe it. The best thing for the public to do today is to save. Yes that will cause a contraction of demand for a time, but the capital saved and ultimately deployed will mean that demand will again begin to increase naturally.


Burgess Laughlin said...

The same article is analyzed here, at the weblog of Mish Shedlok, Global Economic Trend Analysis.

I have only just begun reading Shedlock's writings. Apparently he is an "Austrian" economist. I welcome an evaluation from anyone more familiar with his work. Have his analyses and predictions been accurate in the past?

Tenure said...

I don't know if you read Medworth, but he offers a very good analogy for why Keynesian economics are to blame, and why they can't help get us out now (it follows on from the popular conception that the recession is like the 'hangover' after a night of excessive 'binge drinking').

Kendall J said...

Burgess, Shedlok's position is pretty standard for the Austrian School. I have another article from the Mises institute which discusses the same phenomena in industry which goes by the concept of "deleveraging."

I'm not sure I'd look at it as a particular economist, but rather as an abstract issue the division of which forms two broad schools of thought. That is, this particular concrete issue (the so-called "paradox of thrift") is a result of mistakes at very broad abstractional levels. So you'll find a large group of economists who follow one particular school and a large one that follow another more Keynsian line of thought.

I think the idea however, is very concretizable as is most of economics. It concists of formulating the proper examples that highlight the errors in one or another school of thought.

To that end, if you have the inclination, you might consider collecting several economics blogs to get various thoughts from a particular school. You'll start to see themes appear. Some of my favorite economics blogs include: Marginal Revolution, Carpe Diem, naked capitalism, Cafe Hayek, EconLog, Newmark's Door, Greg Mankiw, RealClearMarkets, Truth on the Market, Medworth, Division of Labor.