Very clear and insightful as always! I'll point to this article when people ask me 'What's happening exactly?'

This is an elegant essay, that clarifies for me much of the confusion I have about the social value of spending versus saving. If we look at the available investment options as a whole, we see capital investments -- railroads, factories, schools -- as both continuing current incomes and increasing future incomes. But much of today's investment goes to lend money to people for current consumption -- car loans and credit cards -- and for home loans. A home loan has aspects of a current consumption loan, and also has aspects of investment in "storage". It doesn't seem to me, though, too much like a capital investment. If loans to buy new houses allows more *needed* housing to be built, that will increase future incomes somewhat like capital investment, but the emphasis must be on the *needed* and the price being paid.

So, if I put my money in my local thrift, which lends it out to home buyers, is my money truly *invested* in the economy in a way which creates value?

Another excellent piece, Steve.

What about applying the same reasoning in the context of government response? In the 1930s, the government engaged in massive "economic stimulus"... By hiring people to build roads, bridges, hydroelectric plants, etc.

How quaint and old-fashioned that looks today! The modern approach is so much simpler: Just send everybody a $600 check so they can buy more crap. Oh, and create hundreds of billions in explicit and implicit subsidies to prop up the prices of purely financial. like houses and MBSes.

Can't wait to see how that'll work out.

This is a thought-provoking article, thank you !

Basic economic theory posits that lower marginal rates (A) will spur investment, (B) generating economic growth.

Part (A) worked marvelously over the past several years as lower rates on capital resulted in an investment boom.

Part (B) failed miserably, as the investment boom was into speculative real estate and related instruments, with no productive value for continued growth. We may as well have been buying tulip-bulbs.

The lost opportunity form all that misallocated capital is immense. If even half of the 'investment' in real-estate items had been into economically productive assets (increased capacity for providing real products and services), we might today be in a sustainable period of expansion.

I would be interested to know what thoughts anyone has regarding policy prescriptions to limit the chance of another such failure ?

Alessandro — I don't think that the problem is the attitude of savers as much as the reality they face. I think risk-averse potential savers view face sharply negative real returns after you take a haircut for forward-looking uncertainty in the financial system. But as you say, the alphabet soup doesn't address this issue at all unless it reduces the risk in real terms faced by potential investors. To the degree that people view all the loans and bailouts etc as impacting currency stability, opening the door for future "malinvestment", or simply being unjust and potentially repeatable, they don't reduce the uncertainty faced by those who could put their resources into distant future claims.

Alex R — Excellent points. The boundary between consumption and investment is always blurry, and a lot of our current mess is that we were very good at rebranding as investment what should really have been tallied as consumption. Housing is a case-in-point: Building very large houses doesn't enable future production anymore than building comfortable but modes homes does, the cost difference should be treated as consumption, but it's treated as investment. Overpaying for an appreciated home is neither consumption nor investment, it's just a transfer, but if the transferee views the wealth as a windfall and consume rather than invests the "free money", at the ends of the chain we end up with "investors" holding mortgages that in aggregate fund consumption. The difference between granite countertops and a plasma TV is very subtle to me, but all that "home improvement" was considered investment.

JKH — "The US doesn't save enough to finance the investment it has." This is right, according to normative data, but see the comment above. We don't need "more" investment, we need better investment. Much of what is accounted for as investment is in aggregate better viewed as consumption. So far, the US has had no trouble funding its spending, whichever cubbyhole we stick that spending into. Nevertheless, I don't think present levels of "investment" are a useful baseline. Spending could fall dramatically, including the consumer credit and housing expensitures that get turned into securities, without harming the level of real investment in the US. It's quality of investment, not quantity, that is really the issue. Domestic savings is low in part because domestic investors know the product is crap (while foreign central banks don't care, they are motivated by concerns other than return or US economic development).

We disagree as a matter of definition about where the financial system stops and starts. I think a good financial system is tightly coupled to "outside" economic decisions, and to the degree that an inside/outside boundary arises, that is a symptom of failure. The purpose of the financial system is to guide and incentivize real investment. I think your perspective is more mainstream than mine, and guides a lot of policy, wherein a "Wall Street / Main Street" distinction is commonly made, and the only linkage is "contagion" from crises on Wall Street. Therefore "saving" Wall Street can only help Main Street. But I think that's wrong. Wall Street and Main Street are the same street except over the very short term, and Wall Street can damage Main Street even while the financial sector is booming. As a matter of fact, it just did.

Your point about the paradox of thrift and first derivatives is well taken — no financial system will be perfect, and a sudden shift in propensity to save may temporarily be hard to absorb productively. But in this situation, I'm not sure that consumption is a better choice than precautionary storage. Bidding commodity prices up conserves real capital until it can be productively used, while spending risks squandering it. But as you say, this suggests short-term fall in aggregate income. I think we're getting to the Krugman/Rogoff debate now. There might not be a normative answer, it might be a question of values, tolerating recession in this circumstance enhances future growth but exacts a present cost, and those alternatives have to be weighed. But it obviously depends on magnitudes, a fast recession that to prevent large future costs would surely be worthwhile, and so would spending to avoid a terrible recession at a very low future cost. There are legitimate tradeoffs here, and people can disagree. What troubles me about the "paradox of thrift" reasoning is that people often forget the tradeoff, and assume evading current underutilization is always good.

Still, the key point is that an effective financial system minimizes the trade-off. Perhaps I'm utopian, but I think it's quite doable, to come up with a financial system that creates worthwhile projects to match an increased preference for future rather than present consumption. (And I mean a financial system broadly, which might include state components, institutions that enable entrepreneurship, etc.)

Steve -

My unhappy inference is that non-market "mechanisms" (i.e., the dreaded "central planning," at least in the sense of activist tax policy) will be required to counter falling C and I intermediate term.

When I say "new New Deal" I mean don't let the government run the project, but use competitive bid contracts, and hope the process doesn't get too corrupt....

A cleaner first step might be a revenue-neutral progressive change in personal income tax rates to fund a targeted investment tax credit. This would be especially attractive to folks in partnerships and S-corps and would force some of their precautionary saving directly into investment. One can only hope the money is spent domestically, I suppose. The beauty of bridges and tunnels is that the people working on them have to be here.

A fine post.

May I mention another factor -- the rather high cost of not saving?

There's an advantage to being able to buy large items when a good price crops up, pay bills reliably, and cover unexpected or refundable costs (a health emergency, a car rental, a business trip your company will reimburse you for). With American savings at or below zero, I am sure they are incurring large interest costs, or other non-monetary costs, in addressing the lumpy contingencies of life. The costs of coping with these contingencies is a waste of resources which could be better deployed elsewhere.

Those costs, I suppose, mostly show up as either profits to banks and credit card companies, or increased pressures on families and friends, leading to real social and health costs of the contingencies which could only be tracked by the most fine-grained analysis.

Noni

For my part, I assume most people talk their book, whether it's a financial commentator with a personal or professional portfolio, or a writer doing a road show, or a blogger channelling in real time a yet unwritten comprehensive world view. I also assume they are not self-defeating and that their book aligns with their talk. I look for quality in both the talk and the book, and try not to let my assessment of quality be too biased by its philosophical alignment, although this is hard. McCulley seems to me to be a cogent analyst of the Fed, interest rates, and related economics. He understands particularly well the actual plumbing and detailed effect of Fed balance sheet operations. The quality of the analytical insight is rare, notwithstanding whatever one's attitude might be toward “Keynesianism”. Conversely, stealth conveyance of one's book alone can curdle in an unseemly way with personal agenda.

I'm not too concerned about the precise explanation of the paradox of thrift. The conversion of foregone consumption to longer duration inventory investment is what ensures the persistence of the identity of saving and investment on a continuous basis. I agree that McCulley's summarization of the paradox of thrift is somewhat sloppy. But whether he flubbed it or just skipped a bunch of steps, it is very far from the main point of his essay. Extending the notion to financial leverage is the far more interesting and relevant idea here.

P.S. This is one of the very best economic blogs. Not only is the writing unusually penetrating and thought-provoking, but as importantly, it is seamless in its high quality as between the original post and feedback on comments. Thanks for the continuous investment. :)

And I look forward to your upcoming scheduled guest blogger appearance on naked capitalism. Are you prepared for a likely spike in traffic here as a result?

JKH - your point is well taken. I should clarify: what I find particularly repulsive is the lobbying for taxpayer/Fed money in the guise of analysis, sometimes accompanied by outright fear mongering. Some of the PIMCO pieces have provided reasonable analysis even while talking their book.

It occurred to me before reading Steve's post that McCulley's piece started with a lobbying purpose with the analysis (possibly deliberately) tailored accordingly.

It's not a crime. It's just that it grows tiresome and in my view should be discouraged.

If you have a broken and badly functioning financial system, you want the pilots and the controllers to attempt the controlled crash landing of a rather large vehicle. You don't want them to immediately eject and abandon stations for the redesign meeting, while the existing system proceeds to cartwheel into the corn field of the real economy.

Not sure I get the logic of the piece on the "Paradox of thrift". If people buy "gold, or oil, or art, or whatever", don't the people who sold them that "gold, or oil, or art" earn income which they can then spend/invest? Exactly where does the pipe spring a leak? Again, I remember reading somewhere that, historically, consumption is fairly stable during a recession, but investment falls off. Which seems to imply that businesses are holding back investment even as households are consuming away. Still don't know where the leak is..

nextinline:

"Not sure I get the logic of the piece on the "Paradox of thrift". If people buy "gold, or oil, or art, or whatever", don't the people who sold them that "gold, or oil, or art" earn income which they can then spend/invest?"

I have an indirect comment without relating directly it to the Paradox of Thrift.

It depends on whether the gold, oil, or art is newly produced and considered part of current GDP (the way it is actually measured, or conceptually revised if one wishes), or something produced earlier. (Oil tends to be "new" in this sense).

If newly produced and part of current GDP, we can assume both the producer and the buyer have earned income. The buyer has purchased the producer's output with his income. Somebody else will purchase the buyer's output with their income. The producer will purchase something else or save with their income. The current output and income markets will clear.

On the other hand, if the gold, oil, or art is "old", it has essentially become an aged asset rather than a new product output. In this case, the transaction is essentially independent of current GDP and the income and purchasing power associated with current GDP. In accounting terms, it is a balance sheet transaction but not an income transaction (at least on a net basis). Two assets are being exchanged – money and the other. And if the money is actually or selectively associated with the income result of current GDP, the transaction effectively only transfers the ownership of that income result and its purchasing power from buyer to seller. But it doesn't match up current income with current output, which must be done before everything in current GDP gets cleared.

Again, this interpretation has little to do with the technical definition of GDP and whether one agrees or disagrees with it. The point is that one must draw a demarcation line somewhere between new and old when discussing issues of economic output and income.

The logical implications of distinguishing between a concept of new and old are the source of a lot of confusion in economic analysis, in my opinion.

The “old” piece is sometimes called the asset economy. Stephen Roach of Morgan Stanley (formerly chief economist; now head of Asia) has written great things about the deleterious impact of inflation in the US asset economy. A good part of the housing crisis has impacted GDP negatively (output in the form of new housing), but an even greater portion has brought down values and wealth in the asset economy (existing housing). And a corresponding amount of the mortgage and financial problem is related to prior asset inflation rather than GDP inflation per se.

Stephen Roach has received enormous criticism over the years for being a bad forecaster in terms of timing. But he has been brilliant at seeing the nature of the train wreck at the end of the tunnel and writing about it.

JKH — Great minds think alike (and sometimes even fools like me get it right!). Looks like we were simultaneously writing almost exactly the same thing.

Thanks also for the kind words. I love your airplane analogy above. An important point, and a nice analogy to think things through with. We want as gentle a crash landing as possible on the one hand, but we don't want the bastards running the airline to stick us back on the same broken plane for our next trip, pointing out mildly that sure, there was a bit of turbulence but we did manage to get through it, didn't we?

Nels — I'm broadly optimistic, in that I don't think economies are like individual industries, destined to mature and then slow. Humans are too good at manuafcturing and appreciating novelty for that.

But I think you're right on in discussing the tension between central planning and allegedly decentralized markets, and we also need to think about the structure and quality of each, not just set them up as iconic extremes. The market part of our system has a good deal of power politics and central planning, and the government part, while very deeply flawed, has different blindspots than our market institutions, and shouldn't be ideologically illegitimized. Our institutions on both sides of the public/private divide are very deeply flawed, and the best approach to fixing things is not to set up some Olympian Objectivist struggle between capital and the state, but improve the decision quality of both sets of institutions and define some equilibrium where each "checks and balances" the other. Much easier said than done, sure, but so is getting out of bed, and we do sometimes manage it.

Steve - re. the airplane analogy, I recall a post of yours from a while back in which you wrote that central banks are dangerous. I think it was in the context either of the BS bailout or the Fed loosening the collateral standards.

The impression I got was that you did not approve.

I am wondering whether you have reconsidered and now consider the powers that be as reasonably piloting a plane in trouble, notwithstanding the obvious risks of crashing into a heavily populated area in the process of trying to land (to expand the analogy, though I do think it has its limitations.)

Although we'll probably never know, it seems to me that aggressive management of the crisis without bailing out so many bad or reckless actors stood an equal or better chance of working, and still does.

If the steps taken so far continue at every turn, I don't see how we can avoid a "full faith and credit" crisis, which would obviously be worse.

To your point about being put back on the same plane, with the current approach I don't see how that can be avoided if we get lucky and the airline crows that it was just some turbulence and they had it under control all the time.

This is probably a failure of imagination on my part, but it seems to me that if strong medicine is ever called for, the sooner the better. I don't see how we can get lucky forever.

I would appreciate whatever insight you can offer.

good analysis...the problem is the real savers need a real unit of account in order to invest in something real and worthwhile...

hence gold, which is imperfect, but don't let the good be the enemy of the perfect...

«Brad Delong, Larry Summers, Bob Rubin and their like from the growth at any cost club defended Greenspan's serial bubble blowing because it was their belief that the eventual collapse could be ameliorated and the growth resulting from the bubble would be greater than the contraction after the collapse. In essence a net gain and ultimately we're all better off.»

The Greenspan/Bernanke/Delong/Summers/Rubin/... side is the side of people who know very well that the USA are running two very expensive, unpopular wars (and a half), and the good times must roll, regardless, both to keep the home front happy and not thinking about those wars, and to finance those wars with cheap debt.

Just like most people forget that financial capital is highly mobile, and loose money in the USA can well result in jobs, investment and inflation booms elsewhere, most people forget that the USA are at war, and the government is running a war economy, and an internal propaganda war. The various wars that the USA government are waging are the first in the history of the world entirely financed with tax cuts after all.

As long as people can see the prices of the assets they own go up, they will think "F*ck you, I am fully vested" and not worry a bit about the war -- why worry, be happy? This is elementary management of home front morale.

In effect a very large mass of the USA electorate (most of which are asset owners) have been turned into war speculators.

BSG — I still don't approve. My bottom line is that those piloting the crash landing need to be very publically and non-repudiably admitting that they are in fact piloting through a crash landing. What bothers me about the present strategy, which I do on balance oppose, is not that it is trying to limit "collateral damage" and harm to the real economy, but that it is trying to retain the financial system status quo as much as possible, by acting as covertly as possible and minimizing and perception of discontinuity. As you suggest, banks could be nationalized rather than bailed out, cooperation by organizations could be compelled with sticks rather than with carrots (financial organization principals could be put in civil or criminal jeopardy for failing to minimize disruption during transitions the terms of which they may not approve). I am not at all happy that on balance, the financial community has been net rewarded for its idiocy this decade, rather than net punished, and that most individuals who participated in the boom, should circumstances repeat, would be better off doing exactly what they did for a while (perhaps retiring a bit sooner) than doing anything different. We can't undo people's past salaries and bonuses, but we can make them not worth the hazard in retrospect on a risk adjusted basis. That requires creating hazard, which we have shirked from doing.

All of this does nothing to invalidate JKH's point that we do have to get this plane down to the ground with most of the passengers unharmed. My main bottom line is that it had better be clear when we stumble off that the contraption was badly put together by people who profited from cutting corners, and we'd better do something about that before we fly again (and we must always fly again).

Blissex — I'm sympathetic to some of your points, and think it especially important to consider the international dimensions of things. In the context of this discussion, I think the international dimension is complicated. We had kind of an antiparadox of thrift, where supposed investment was really devoted to present consumption, including a very great deal of foreign investment. It's not obvious why squandered foreign investment would result in an apparent capital deepening within the countries whose capital was squandered, and a capital "shallowing" in the capital recipient who did the squandering, but I think you're right that something like that happened. But we'd have to talk about more than just quantities of "C" and "I" to get at why, we'd have to look at the qualitative dimension of those quantities, what is being invested where, and why, to see why it may have been in the interest (from a national power and industrial development perspective) for some nations to let their capital be squandered, and why an overabundance of capital in the United States failed to translate into a sustainable capital deepening, but were devoted to consumption or overinvestment is sectors that predictable would be required to shrink when the flow of foreign capital ceased. I do think that's what went on, but we can't understand that in terms of quantities of consumption and investment, in an accounting sense the US had an investment boom, it's just that much of that "investment" really belongs in Zanon's "bubble" term.

Zanon — I love your discussion, and agree with nearly all of what you have to say. It is a common error among economists to assume that whatever it is you aren't studying will take care of itself. If you are not investigating market efficiency, you assume markets are efficient, which provides for well-defined behavior so you can make sense of whatever you are investigating. If you are not investigating bubbles or misallocations of capital, you presume that a scalar variable I is sufficient to describe investment, because despite the variety of possible ways real diverse stuff might be used as capital, there is only one "optimal" mix for any quantity, and efficient markets would certainly find it, so the quantity is the only free parameter. Of course that's total bullshit, but it does simplify the modeling. As you say, at the very least, we need to include a quantity for misallocation or waste, but once you allow for that, how do you quantify it? Sensible people knew it was "a lot" in the recent past, but if you're an economist, how do you justify an estimate of "40% wasted" before any losses are tallied? For modeling purposes, zero was always the most defensible number. Given the large quantity of "investment", with zero waste and presuming modest to normal returns, things looked just peachy. Until they didn't. Sometimes the most defensible model is dead wrong. Quite often in fact.

I like your point about deleveraging. Ironically, if "investment" had actually been investment and it had simply failed, the "deleveraging" would be easier, because we would have lost an expected increase in consumption before we'd hit current consumption. When we have leveraged present consumption, deleveraging hurts, because it means a diminishment of our existing lifestyle. As you say, our difficulties in managing deleveraging says something not so nice about how forward-looking our use of "capital" has actually been.

McCulley's article might be an easy read, but it seems like rubbish to me. I cannot believe, for example, that the Fed would call the vicious circle dynamics he describes as a "negative feedback loop".

I can appreciate that some cushioning of the fall in asset prices may be desirable, although its aim should be to reduce the gradient not the size of the fall. But the primary role of the authorities in this should be to organise it. First, do not stand in the way of any shareholder wipeouts. If a failing institution is too big to fail, forcibly nationalise it, break it up, and sell the bits. Second, unless there is evidence of predatory lending, do not spend taxpayers money to help defaulting mortgage borrowers to stay in their houses - give them an adjustment grant to move into good rented accommodation, and give a marginal homeless person a grant to help them take over the house. Third, to the extent that taxpayers' money is required, raise taxes as close as possible to those responsible for this mess. We hear about windfall taxes on oil companies, so why not a levvy a windfall wealth tax on anyone working in the finance industry whose tax returns showed that they earned more than, say $10mn over the last five years?

I never really understood the paradox of thrift, because I was not convinced that prices would not adjust to break it, but if anyone knows of a convincing explanation, please tell. However, it seems clear to me that the USA has a capital shortage. Given its ageing population, America was probably not saving enough even given the unrealistic expectations of return on investment that had been made until a year ago. But now that these expectations have been falsified, it seems to me that some serious investment is in order. Output will rise as the capital stock grows, but not consumption, as much output will have to be ploughed back into increasing the capital stock further and much output will have to be exported to pay foreign creditors, so it will feel like a recession anyway.

3:11 p.m. rude late comer:

Apparently our host thought McCulley's piece was worthwhile enough to be "thought-provoking". He developed an impressive post from that starting point. And many here appreciated the quality of the lengthy discussion that resulted.

Would you appreciate somebody advertising the work on your own blog as "rubbish"? Be more careful with your words and your manners. You need a little more of a following to be quite so pretentious. And in the interim, why would any one bother to explain the paradox of thrift to you?

Steve,

I dont think were going to see the bottom or a return to financial health until serious punishment are reforms are undertaken. The good news is the chances get higher after november.

shrek

4:49 p.m.:

Here's the Wiki article on it. It actually makes a reference to you in it, and categorizes you according to your own misunderstanding, which in a lovely way is the opposite of what you contend above the article. See the sentence beginning "One who does not know ..."

It basically says everything you deny about it, but since you're bent on inventing your own definition, do it, and then put it up on Wiki. Enlighten the world with some supra Wiki intelligence and sophistication! And then advertise like crazy!

Paradox of thrift

From Wikipedia, the free encyclopedia

The paradox of thrift (or Paradox of Saving) is a paradox of economics propounded by John Maynard Keynes. The paradox states that if everyone saves more money during times of recession, then aggregate demand will fall and will in turn lower total savings in the population. One can argue that if everyone saves, then there is a decrease in consumption which leads to a fall in aggregate demand and thus leads to a fall in economic growth.

The simplified form of the argument is that, in equilibrium, total income (and thus demand) must equal total output, and that total investment must equal total saving. Assuming that saving rises faster as a function of income than the relationship between investment and output, an increase in the marginal propensity to save, all other things being equal, will move the equilibrium point at which income equals output and investment equals savings to lower values.

In this form it is a prisoner's dilemma as saving is beneficial to each individual but on a whole it can be harmful. This is a "paradox" because it runs contrary to common intuition. One who does not know about the paradox of thrift would fall into the fallacy of composition. This fallacy arises when one infers that something is true of an economy from the fact that it is true of an individual. Although exercising thrift might be good for an individual, by enabling that individual to save for a "rainy day", it might not be good for the economy as a whole.

This paradox can be explained by analyzing increased savings in an economy. If a population saves more money (that is the marginal propensity to save increases across all income levels), then total revenues for companies will decline. This decrease in economic growth means fewer raises and perhaps downsizing. Eventually the population's total savings have remained the same or even declined because of lower incomes and a weaker economy. This paradox is based on the proposition, put forth in Keynesian economics, that many economic downturns are demand based.

6:36 a.m.:

For starters, saving has nothing to do with borrowing per se. This is its own type of fallacy. For example, businesses save and invest without borrowing.

Second, if you choose not to spend, the item on the shelf inadvertantly becomes a protracted inventory investment for business. Businesses retrench their full production and investment processes as a result. Excess saving leads to contraction.

a

Allow me to try to convince you:

One of the counterparts to saving I mentioned was to "buy some kind of investment item". As you say, inventories count as investment. Of course, a firm does not purchase inventory from itself, but it must pay its production costs for that inventory, and if it chooses not to sell the inventory, it must raise the money to pay its costs somewhere else. The firm must either run down its own savings or borrow, in which case someone else in the economy must save.

If I just stop spending my income, what happens to it? If my income is paid into a bank deposit, then the bank will accumulate some asset - ie lend to someone. If I retain my income in banknotes, I have chosen to hold more of a marketable loan to the central bank / government. Banknotes are just bearer debt securities.

a

I would be sorry to agree to disagree. As someone who took a career in science as far as a PhD, this is something I find frustrating about economics. In a science, the two sides would refine the point of their disagreement in an attempt to identify a key proposition, test it either by experiment or logic, resolve the disagreement and move on.

If you take as your starting point a situation in which the inventory has been produced, and the initial act is that of the consumer to retrench, then the consequence of them not spending (saving) is that the firm does not receive income it had expected to receive. Initially, this shock forces the firm to either save less than it would have done, or borrow to fund its unsold inventory (negative saving in either case), so there is no net saving. Thereafter, it is not clear what happens to output, unemployment etc, because this depends on, first, the effect of the shock on interest rates, second, the response of the firm to that change in interest rates (ie is it happy to hold higher inventory or does it cut production to work off inventory), third, the effect of any production cuts on product prices, wages etc, then the response of the economy to those changes, and so on. And even if output does fall, this is not necessarily undesirable or wasteful, as, assuming that the markets are clearing, this is consistent with the modified preferences of consumers. Ultimately, it comes down to the debate between real business cycle theorists and new-Keynesians about whether markets are clearing, and as far as I know, that debate continues.

The practical point of all this is, is the amount of saving that the US (and UK for that matter) has been doing reasonable? My guess is that there has been too much borrowing based on unreasonable expectations about returns. If so, in the absence of clear evidence that markets are not clearing, I would err on the side of allowing saving to rise as the return mistake is recognised, rather than, for example, attempting to forestall adjustment by debt financed government spending.

Sorry for my sloppy use of the word "saving". I meant to say that the reduction in consumption was matched by an increase in investment, so that aggregate demand was unaffected (at the first round). Like I say, I am prepared to be convinced, but I cannot see any way of saving that reduces aggregate demand at the first round. There has to be an outlet for saved resources somewhere, either in investment or in someone else willing to purchase your present resources (for their own investment or present consumption) in return for a promise of future repayment.

a

Hopefully, we now have a meeting of minds on the effect of the initial retraction of consumption (although it is worth noting that my argument is based on markets clearing and resources not being wasted - eg involuntary unemployment - which Keynes effectively disputed). The resources saved by cutting consumption initially reside in inventory investment.

So now it is necessary to consider how the firm responds - which I referred to as the second round, which is less clear. Perhaps you will find my conclusion challenging! There are links between our discussion and that on the following thread, especially the comment from JKH, who I know from other discussions is a smart guy. As JKH says, for the system as a whole, inside (ie financial, IOU etc) saving nets out. Any saving must be outside saving, meaning real investment. In our case, in the first round the saving has gone into inventory, held by firms. Ultimately, however, trading based on prices including interest rates, should allocate the desired outside saving (investment) to the best place (eg according to return and risk).

After round 1, the firm has higher inventory and a smaller bank balance than it expected. Consumers, who started the process, have a larger bank balance. It seems likely that consumers' saving initiative has led to lower interest rates. So the firm has to decide whether it is worthwhile carrying higher inventory at lower interest rates. As I said before, it is conceivable that they do in which case round 1 is sustainable, but unlikely, especially if their inventory is perishable. The firm is therefore likely to try to reduce its inventory by a combination of lowering its output prices and cutting production. Round 3 is the consumers' response to changed prices and changed labour demand. And then the firm responds to those, and so on.

Where the new equilibrium ends up after the shock to consumer preferences is difficult to say. It depends on how prices change and how participants in the economy respond to those prices. But I ask you to make one leap of faith. That is that consumers' preference for increased saving ends up with an increase in investment, with the increase having a positive return. Essentially, assume that the economy is able to adjust to find some productive use for the increased outside saving.

So far, this has been a story about flows. However, while depreciation does mean that investment flows do not just accumulate ever more capital stock, an increased flow of investment will produce a higher capital stock (ie the bucket may have a hole, but pouring in water faster will increase the level of water in the bucket). Now, if resources are not being wasted, and the capital stock is higher, the output of the economy will be HIGHER when more is saved. In short, assuming that resources are not being wasted, thrift does indeed lead to higher output - in that sense, there is no paradox of thrift.

Where there is something like a paradox of thift, however, is that saving more leads to lower consumption. More than the increase in output from the larger capital stock is required to maintain the capital stock itself. Y is bigger, but C is smaller because I is bigger.

For sure, it is not unequivocal how the shock to consumer preferences will play out. For example, don't forget that the firm is cutting its price to reduce its inventory, so its revenue, and its ability to finance investment, might be increased depending on whether the price or volume effect dominated. Also, the idea that consumers would continue to attempt to save a desired proportion of their income as their income fell seems unrealistic to me.

Ideally, economic policymakers would make some kind of cost benefit analysis of whether mitigating pain by braking adjustment was worth the cost of delaying reaching a more efficient equilibrium outcome (assuming that equilibrium is more efficient of course). Even if the economic model that they would use to make this judgement is imperfect, at least it would be objective. Sadly, I suspect that policymakers respond more to the near term, for which they expect to be held responsible!

Given the uncertainties, I think we have taken our discussion about as far as we can. Or is there more to say?

OK, you've found a loophole, thrift as savings can be reinvested. But thrift in the context of a credit crisis means "savings" in an environment where lending freezes up. Fear is rampant, and lending standards are tightened. Less money is available to be put to work because financial institutions are seeking to raise their capital as an act of "battening down the hatches" for the oncoming financial storm. Thus, savings end up in accounts with little or no investment income because it can't be lent out. Cosequently savers are not rewarded and entrepreneurs have no access to the fear-frozen funds.

Maybe McCulley needs to rewrite this as the "Paradox of Fear-induced Thrift". The classic example of fear-induced thrift is putting your money under your mattress.

Oh, Thanks! Really interesting. Big ups!