What is the Paradox of Thrift?

The paradox of thrift is an economic theory posited by John Maynard Keynes, a noted 20th century economist. According to Keynes, when people start to save money instead of spending it in response to growing concerns about a recession, they can actually make the recession worse, while the overall rate of savings remains the same. This argument is often used to promote consumer spending in periods of economic uncertainty, and it has led numerous governments to spend heavily during recessions in an attempt to prevent these events from growing worse.

The logic behind the paradox of thrift is this: when Person A puts money in the bank instead of spending it, that money fails to end up in the cash register of Business B. Business B, in turn, is forced to lay off workers because fewer people are spending at its establishment. These laid off workers have no spending money, therefore causing other businesses to falter because they start to experience a decline in customers, and over time, the recession grows ever-deeper, with people hanging on to as much money as they can instead of spending it.

When the paradox of thrift comes into effect, the overall savings rate across a society remains the same, because while wealthier members of society may be able to put large amounts of money into savings, people in the lower classes have no savings because they have no jobs. When savings is averaged across the whole population, the low and high savings rates at opposite ends of the class spectrum effectively cancel each other out.

People refer to this theory as a “paradox” because it is a case in which a seemingly beneficial behavior is actually detrimental. While individuals do, in fact, benefit from choosing to save money instead of spending it, society as a whole experiences economic problems when large numbers of people start to save, according to the paradox of thrift. This theory is also believed to hold true for consumers who pay down debt instead of spending money or putting it in savings.

Numerous criticisms have been leveled against the paradox of thrift, a reminder that this principle in economics is a theory, not a stated fact. Some people have argued that when demand falls, prices fall, and this triggers a rise in demand again, so the paradox of thrift is not nearly as damaging as has been suggested because demand rarely falls below a certain level. Others have said that money in savings represents loanable funds, which means that by putting money in the bank, someone can benefit his or her community by making funds available to people who need to borrow them.