Saturday, 7 February 2009

Paradox of Thrift

Paul Krugman points out that the personal savings rate is rising rapidly, as people try to cut their debt levels. He says this is a variant on Keynes's "paradox of thrift". Keynes argued that if everyone wants to save more (as a fraction of their income), for whatever reason, the net effect is that aggregate income falls (as people spend less) until it reaches a new equilibrium level at a sufficiently low level that savings have been brought back down to their original level (so that S=I again, investment having stayed constant in the basic Keynesian model). So all the individual attempts to save more get cancelled out. Krugman here says that a similar logic applies because people feel too indebted; they try to save more to pay back debt, income falls as in the above argument, and they end up even more indebted:

Yesterday’s report on consumer incomes, spending, and saving showed a sharp rise in the personal savings rate; it also showed a decline in nominal personal incomes, the third in a row, reflecting the weakening economy.
I don’t know who else has made this point, but it’s quite clear that we’re in serious paradox of thrift territory here. Or perhaps more accurately, we’re in a paradox of debt.
Consumers are pulling back because they’ve realized that they’re too far in debt. The economy is shrinking in large part because consumers are pulling back. And the result, almost surely, is to leave household balance sheets worse than ever. I can’t do this accurately until the Federal Reserve’s flow of funds data have been updated, but almost without question the ratio of household debt to personal income has been rising, not falling, as consumers try to save more.
Damnification in action.

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