During economic recessions and downturns, people tend to spend less and save more. The thinking is that a larger personal savings account provides insulation against future job loss and lower earnings in the stock market. But the paradox of savings says this may not always be true.
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The Paradox of Savings
Outside of a college economics course or an occasional mention in academics, the paradox of thrift, also known as the paradox of savings, doesn’t get discussed much. In the most basic sense, this economic theory postulates that personal savings are, contrary to popular belief, a drag on the economy during periods of recession.
“This theory relies on the assumption that prices do not clear or that producers fail to adjust to changing conditions, contrary to the expectations of classical microeconomics,” Investopedia explains.
Popularized by British economist John Maynard Keynes, the paradox of thrift suggests that the proper response to an economic recession is actually more spending and risk-taking (and less savings). The belief is that a recessed economy will not be able to produce at full capacity unless there’s consumption and stock market to drive economic growth.
The problem is that there seems to be a disconnect between individual and group rationality. In theory, the economy would be able to pull out of a recession if everyone banded together to spend. However, individuals don’t always operate with the collective in mind and are more likely to save and hoard on a case-by-case basis. As a result, recessions drag on until other elements are able to successfully move it forward.
But the paradox of thrift isn’t a perfect theory. Unless people are saving money by tossing cash into a shoebox, their savings are contributing to the economy.
“When you put money in a savings account, it becomes money that the bank can then lend out to businesses,” personal finance expert Trent Hamm suggests. “Thus, when more people save, the banks have more resources to pump out to businesses, and when the businesses have more resources, they employ more people, innovate new products, and find new ways to sell.”
