Understanding the Paradox of Thrift

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When the economy goes into a recession, one of the first reactions consumers have is to spend less and save more. It’s only natural to want to look out for yourself and make sure that you have enough savings to get through the difficult times that may lie ahead. However, some economists argue that an abrubt increase in consumer savings during a recession can actually deepen the recession.

John Maynard Keynes called this problem of saving during a recession the Paradox of Thrift.

[VIDEO] Understanding the Paradox of Thrift

The Paradox of Thrift

The Paradox of Thrift states that if consumers follow their natural inclination to reduce their spending and increase their savings during a recession, they are actually causing the recession to be deeper and their own economic situation to be worse. In other words, decreasing consumption and increasing savings during a recession is like pouring gasoline on a fire.

Proponents of the Paradox of Thrift would argue that if consumers want to improve their economic situation, they should continue to spend during a recession to help get the economy back on its feet and then start to increase their savings once the economy is up and rolling again. Locking your money up in a bank or other savings account only exacerbates the problem.

Of course, opponents of the Paradox of Thrift would argue that individual investors need to look out for themselves during a recession and make sure that they are okay financially, and that it was consumption and overspending that got the economy into trouble in the first place. They would also argue that putting your money into a bank is the best thing for you and for the economy because banks aren’t designed to just sit on your money. They are designed to lend your money out and put it to work. So eventually the money consumers are saving will end up in the hands of businesses and other consumers in the form of loans—which will stimulate the economy.

That’s Why They Call It a Paradox

Ultimately, you have to decide what is best for you. You may decide to spend more during the recession, or you may decide to save more. However, if the majority of consumers decide to tighten their purse strings during the recession, the economy will eventually recover, but it may have to take a longer, bumpier road.