Cause of Today's Economic Crises: Too Much Thrift

by: Mansoor H. Khan

In this essay I want to propose that the ultimate of cause of today's economic crises is that we have too much thrift. This view is very similar to John Maynard Keynes' Paradox of Thrift. What I want to show is that this is not a paradox at all but confusion about what saving money really means and what consequences it has. I want to explain this confusion by way of examples and not using technical economic jargon usually used by economists. But before I can go into why too much savings leads to a disaster in the modern economy, I need to clarify what I mean by savings and what money is by way of an example:

A baker produces ten loaves of bread. He consumes one loaf of bread. He barters one loaf of bread with his neighbor, the dairy farmer, for one gallon of milk. He barters three loaves of bread for one bushel of wheat with his other neighbor, the wheat farmer for wheat for next batch of loaves he will produce tomorrow. He gives one loaf of bread to the poor. He is now left with four loaves of bread. Now, he wants to be able save these loaves for his old age. So he goes to the market and sells his excess four loaves of bread for four pieces of gold. He saves the gold in his mattress. He does this because he will need loaves of bread in old age when he is physically unable to work.

Note that I am going to define pieces of gold as money for now. Because it is easier to understand. We will then expand the discussion to include fiat money. The baker saved four loaves of bread. That is his savings. Note that it is more proper to think of savings as the loaves of bread rather than the pieces of gold under his matteress. The baker is not really interested in pieces of gold but he is convinced that he can exchange them for loaves of bread when he retires. Because of this belief the pieces of gold give him psychological comfort and peace of mind that he physically owns the asset which he can exchange for loaves of bread.

Note that when he gets to his old age and goes back to the market and attempts to exchange the pieces of gold for loaves of bread he will get back loaves of bread based on the market price (in terms of pieces of gold) at the time of exchange. By acquiring pieces of gold (which is the most liquid asset in the baker's civilization) he has effectively acquired equity shares in the world economy (at least in his gold based money example economy of the baker). The market price (in terms of pieces of gold) of the loaf of bread at the future time will depend on the balance of equity shares (money) trying to purchase (bid up the price) of loaves of bread and the supply of loaves of bread at that time. Note that it is not the absolute supply of equity shares (pieces of gold) that matters what matters is the number of equity shares trying to chase (purchase) the supply of loaves of bread at that time. Another way to make the same point is this: The price of loaves of bread will not increase even if more equity shares are created and handed out unless receivers of the equity shares actually attempt to spend the newly created equity shares.

Another way our baker could have attempted to save his loaves of bread for the future is by exchanging his four pieces of gold for shares of Google (NASDAQ:GOOG) stock. This gives our baker a chance to acquire even more loaves of bread if Google makes good profits in the future. Of course, the baker is taking a risk. Google may not be able to make good profits.

Now apply this situation to all excess producers participating in the world markets (by excess producers I mean people like our baker who produce more loaves of bread than they need for current consumption but would like to consume their output in the future). As people become more and more productive there is more and more excess production (if consumption does not increase in tandem with efficiency increases) then this excess production will be directed (by capital markets) to produce more and more assets which can be exchanged ultimately for consumer goods in the future. This is how we get a boom. Bust happens when excess producers realize their assets (like dot com company shares or residential and commercial real estate holdings) will not yield as much return as they expected and may even give a negative return. Rightly, excess producers then rush to safety of the most liquid asset (cash). This causes asset prices to fall and induces managers to reduce investment spending causing unemployment. But this does not mean our ability to produce goods and services has diminished.

If investment slows down and consumption does not increase production must decrease to match the new level of investment. But what usually happens during a period of reduced investment is that consumption slows down (unemployed and those fearing unemployment spend less) reducing demand even more and reducing production even more even though our capacity to produce has not diminished during a slow down. Slow down of economic activity feeds on itself devastating the economy. In short, too much thrift devastates the economy.

On top of this productivity (output per labor hour) is continually increasing (and has rocketed upwards in the past 100 years). We will have more and more unemployment unless one of following or combination of the following occurs to a sufficient degree to stem the tide of slowdown of investment activity and improving productivity.

  1. Increase investment activity. But this won't occur unless #2 below occurs.
  2. Increase our consumption. Increase demand for goods and services.
  3. Decrease our labor hours. Work less.
  4. Do projects which will "use up" excess production.

All the stuff about too much debt (public and private) , falling asset prices and printing money is just accounting entries. We should use accounting to manage the reality around us to improve our lives and not to get confused about what is going on with the production process itself. Bad private debt should simply be liquidated. Falling asset prices does not mean that our ability to produce real goods and services is diminishing. It is in fact steadily increasing and has been for hundreds of years.

Federal debt can be paid off with newly printed money (this is akin to converting debt to equity). Inflation will only occur if receivers of the new money actually spend it and even then if we run-up against the capacity of the economy to deliver the demanded output.

Disclosure: No positions