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Economics is Full of Paradoxes

By December 1, 2015 No Comments

Economics is full of paradoxes. A paradox is a statement that contradicts itself or defies common sense. Most of the anomalies found in economics are named after the economists that first identified them. Examples include the Edgeworth Paradox, Leontief Paradox, or the Solow Computer Paradox.

Following the financial crisis of 2008 and 2009 economists started paying more attention to what is known as the Paradox of Thrift. This apparently bad outcome in the economy was first attributed to John Maynard Keynes by Paul Samuelson in Samuelson’s widely used economics textbook published in 1948.

The Paradox of Thrift says while saving more of current income may be good for the individual, it is bad for society as a whole.

Keynes believed recessions and periods of slow economic growth like the US has experienced over the past seven years cause households to save too much of their income. When everyone in a society is saving more, the effect is a large drop in demand, which in turn leads to low output and high unemployment. With a greater risk of losing work, households then save even more, leading to a downward cycle in the economy.

Keynes’ antidote for the problem is active fiscal and monetary policies that discourage savings. The idea is if we give people more money and keep interest rates low they will spend more and save less.

Perhaps not surprisingly, Keynes has many followers in government who have tried both fiscal policy and monetary policy with a vengeance. Federal government expenditures have increased 23 percent since 2008.[i] The Federal Reserve has facilitated a 46 percent increase in the money stock over the same period.[ii]

These Keynesian responses to a financial crisis and weak economy have been ineffective. Why? Keynes’ Paradox of Thrift doesn’t fit the current situation.

A key reason why Keynesian economic policy is wrong is due to the multiple ways households can save more of their income. Keynes expected households to hoard cash and other valuables, but today households are not holding onto their cash, they are using it to pay down debt.

A more precise theory for the current situation is Irving Fisher’s debt deflation. Fisher published his theory about the same time as Keynes, but the work received much less recognition.

Fisher predicted that when households start paying off debt in response to some crisis, assets will most often be sold at distressed levels (think housing foreclosure sales), and the velocity of money, or the frequency of its use, will decline.

The situation today more closely matches Fisher’s predictions over those of Keynes. Since the financial crisis household debt as a percent of income is down 17 percent and the velocity of money has dropped by a quarter.[iii]

Unfortunately, many politicians and monetary policy makers still see a problem here. Like the paradox of thrift, they see the lower debt level as good for the individual household but bad for society. Lower debt use and slower turnover of money leads to a reduction in demand for goods and services, thereby producing unemployment and a recession.

Like Keynes, Fisher said these negative consequences for society can only be counteracted by inflation. That is, their theories propose the economy will only stabilize or get back to growing if policymakers somehow get prices to rise.

The US Federal Reserve has been unable to produce this supposedly needed inflation. Overall prices have risen 10 percent since 2008, according to the Federal Reserve’s preferred measure of inflation, and the value of the dollar has risen. The Fed has flooded the market with dollars, but the dollar’s price is not falling. The US dollar has gained 19 percent in value relative to other major currencies like the Yen and Euro since 2008.iii

Fiscal policy did little, if nothing, to lift the economy out of the recession and despite all its efforts, the Federal Reserve has been unable to produce inflation. Like a coaching staff that finds themselves losing at halftime, politicians and the Fed should throw out this playbook.

Today’s fiscal and monetary policy is simply overburdening the economy with taxes.

Government spending needs to decline to reduce the tax burden more government debt has on future generations. The Fed needs to stop fighting world capital markets with the hope it will produce inflation. Inflation is a tax on our savings that just ends up hurting us in the long run.

Stop trying to fight a paradox that is not.  

Peter R. Crabb, Ph.D.Peter R. Crabb, Ph.D.
Professor of Finance and Economics
Department of Business and Economics
School of Business, Northwest Nazarene University
[email protected]

Dr. Crabb holds a Ph.D. in Economics from the University of Oregon and an MBA in Finance from the University of Colorado. His research in economics and finance is published in the Journal of Business, the Journal of Microfinance, and the International Review of Economics and Finance, among others. Dr. Crabb lives with his wife, Ann, and their four children in Canyon County, Idaho.

Dr. Crabb’s regular Financial Economics column is published by the Idaho Statesman.Previous work experience includes international trade, banking, and investments.