The Paradox of Thrift in the Modern Economy

Last week I introduced the central idea of this section of the blog:

If saving is not channelled to investment the value of all our savings falls.  But this fall in value is not necessarily reflected in financial markets – financial assets can be overvalued.

My only purpose in going through GDP and the saving-investment identity was to point you towards this statement and then start exploring it.

I began this exploration last week by explaining the important difference in meaning between saving and savings.  The former is a verb, the act of saving, and the latter a noun, the stock of savings.  Savings are typically “stored” in financial assets, and we determine the value of the stock of savings by adding up the value of these assets.  The second sentence of the central idea is saying that asset prices become inflated so that they do not, in fact, tell us the true value of our savings (we will explore that in more detail in a few weeks).  The first part is saying that this inflation comes when these markets do not channel acts of saving to investment.  This is what we will focus on this week.

As I pointed out last week, if saving is not channelled to to investment it will either be channelled to consumption or it will cause asset price inflation.

Intermediation of Saving to Consumption Expenditure

This post explained how an individual saving by purchasing shares in a money market mutual fund could, through a chain of financial intermediation, end up funding a personal loan to purchase a car.  The person taking out the loan is dissaving, spending more than their disposable income.  So the saving and dissaving balance each other out.  To think about this very simply, if I have managed to save money in my bank during the year and lend it to you to buy a car, my consumption expenditure on myself will be less than my income – I will save.  You will use the money borrowed off me to spend more than your income this year – you will dissave.  And the two amounts balance each other out.

In any such example, no investment has taken place, so there is no increase in national saving.  And because this intermediation keeps the money flowing through the economy there is no paradox of thrift either.

Such intermediation channels credit into specific markets, and this can have two effects.  If it increases demand that cannot be met by current supply it is likely to cause price inflation in that market.  If businesses expect this demand to be sustained, they may use the increased revenue to fund investment so that they can increase their capacity to meet demand.  So in the short-term inflation is likely, and in the long-term investment is possible but in no way guaranteed.

However, if those businesses have the capacity to meet the increased supply, inflation is less likely.  In fact, it may well be that this flow of credit to consumers is vital to stop a loss of earnings, and then a loss of jobs, in that sector.

So whether intermediation of saving to consumption expenditure is economically beneficial depends on the specific circumstances in each market.  But whatever those effects, if, as a result of intermediation to consumption, insufficient saving is intermediated to investment, this will inevitably reduce productivity in the long-run.

Now suppose that there is significant intermediation of saving into consumption expenditure across the economy, resulting in widespread inflation.  A large proportion of savings are held in assets that pay fixed returns, such as bonds.  Higher prices means you can buy less with these fixed returns – the savings lose value.  You can clearly see how the failure of markets to intermediate saving to investment could cause savings in general to lose value.

This example is purely illustrative, to highlight how the dynamic works.  This is not a significant effect in the economy currently because only a small proportion of saving is intermediated to consumption expenditure.  But hopefully this helps you see how the failure to intermediate current saving to investment can cause savings accumulated over previous years to lose value.

What is of far more significance to the economy is the asset price inflation caused by rising levels of saving.

Saving Causing Asset Price Inflation

Many pension funds offer investment plans that track a stock market index.  All contributions to one of these plans are pooled into a single pot, that buys a representative sample of shares from across that particular stock market.  The overall profit is distributed among the fund holders in proportion to the size of their contribution.  In “normal” economic times the companies will pay dividends, which can be reinvested in the pension plan increasing its value, and of course share prices will rise over time.  Some prices may fall and some companies will go bankrupt, but these losses are covered by the performance of the stock market in general.

This is how these plans work – you are investing in the stock market as a whole, rather than picking individual companies you believe will perform well.

Many pension companies offer such schemes, and every month they are looking to buy more shares with the latest pension contributions.  If the demand for shares exceeds the supply at current prices, those prices will simply rise.  The constant demand for shares will push prices up.  This is great if you happen to retire and cash in your pension towards the height of a boom.  But at some point this bubble will burst, and the prices of all shares will fall.  This can be a disaster for those retiring in the years after a crash.

Even the careful investor, who has chosen to purchase shares based on the expected performance of specific companies, will see their value wiped.  If their choices were good, their portfolios should perform better than the stock market index, but that is little comfort if you have just seen thousands wiped off your savings.

Almost no investment happens as a result of purchasing these shares (except when occasionally a company makes an issue of new shares to fund investment).  Steve Keen has described this as trading in “second-hand shares” – a wonderful phrase that captures the true nature of most stock trading.

Such dynamics play-out in all the different financial asset markets.  Increasing demand that cannot be met by current supply at current prices will simply push prices up, causing asset price inflation.  Saving is not then channelled to investment, but rather into over-inflated asset prices.  When the inevitable crash happens, the fall in asset prices wipes value off all savings.

There is a potential flaw in my argument.  If someone is buying shares, someone else is selling them – surely that person is selling because they want the money to spend in the real economy.  Doesn’t trading on financial markets simply intermediate from those who want to save to those who want to spend, avoiding the paradox of thrift?

Quite simply, no.  Much of the activity in financial markets is traders and dealers changing their portfolios – selling one type of asset in order to buy other types of assets.  When an asset is bought with new savings (an act of saving in that year), money is flowing from the real economy into the financial economy.  When an asset is sold to raise funds for real expenditure, money flows in the opposite direction.  But a considerable amount of trading is simply money circulating around financial markets, with the only seepage into the real economy occurring when traders spend their personal income (wages, commission and bonuses).

As we shall see when we look at what is happening in financial markets right now, far more money is flowing into financial markets than is flowing out.  This is causing asset price inflation, and this is how the paradox of thrift occurs in the modern economy.

I know this has been a long post, but this is a vitally important concept.  Increased individual saving doesn’t increase national saving if those savings are not channelled to investment.  Instead, it fuels asset price inflation, creating an illusion of wealth while actually slowing the economy down through lack of investment and the dynamics of the paradox of thrift (as described in this post using a very simple model).  And, of course, eventually these bubbles burst, and everyone suffers the fall-out of the ensuing crash.

Next week I will seek to lay bare this potential dynamic in an economy with greater clarity.  In about 4 weeks we will begin looking at the state of financial markets and see if there is evidence that this is what is happening.  Before getting to that point I will have to address the question of the “efficiency” of financial markets.  In saying that asset prices deviate far from their “fundamental value” I am saying that financial markets are not efficient, which might cause orthodox economists to howl in protest, so we will move on to this subject in 2 weeks.



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