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Debunking The Paradox of Thrift: Why Consumer Spending Won’t Save Our Economy
by Mark Skousen, Contributing Editor
Wednesday, September 23, 2009: Issue #1100
“America’s saving rate has leaped ahead – and it’s sending America to the poorhouse.” – David Fessler
An Investment U column attacking the virtue of thrift – surely not?
Yet there it was – an article from David Fessler on September 12, entitled, “The Paradox of Thrift: How a Better Savings Rate is Fueling the Recession.”
David Fessler is a friend and smart investment analyst, so I was surprised that he fell for one of the biggest myths in economics today – the so-called “paradox of thrift” that Keynesian economists spout all the time.
Here’s the problem with the theory, plus a few stocks that are front-and-center of the opposite argument…
The Keynesian Way
Let’s start with the facts, as David correctly noted. During the “Great Recession,” Americans have suddenly reduced their spending, paid down their debts and started saving. As David says: “America’s savings rate – as a percentage of disposable income – has leapt from a little over 1% to over 5% in just the last 18 months.”
So far, so good. But then David suddenly warns that this positive advance in personal finance is somehow a negative “sinister” force that will plunge America into some kind of economic disaster.
David states: “When consumers stop spending and start saving, the overall demand for products and services drops and unemployment rises. In turn, this causes the overall nationwide savings rate to drop because of the decrease in consumption and the slower economic growth that ensues.”
How so? This follows the belief behind “paradox of thrift,”- the theory invented by British economist John Maynard Keynes.
So what can save us from the paradox of thrift?
If individuals and businesses won’t spend in a recession, it’s up to foreigners to “pick up the slack” by spending more, or (and here’s the plug for big government) the federal government runs deficits and stimulates the economy.
However, it’s simply not true that when consumers start saving and stop spending, overall demand for products and services decline and unemployment rises. Here’s why…
The Problem With the Paradox of Thrift
Aggregate demand is a function of current and future consumer spending. Businesses make investing and hiring decisions based not solely on current consumer patterns, but what consumers will want to buy in the future, months or years from now.
Firms use the increased savings to invest in new capital goods, technology, research and development and to replace old equipment.
Take automobile companies, for example. Car sales are way down for the automakers. So why then would Toyota announce a new $1 billion marketing campaign? Because the firm’s executives think they can sell more cars in the future.
In other words, the increase in savings isn’t wasted. Businesses can generally invest those savings productively (through intermediaries, such as commercial banks, insurance companies, new stock issues and other institutions) because interest rates have declined as savings increase.
Moreover, business cycle data support my thesis, too…
Debunking The Paradox of Thrift: Why Say’s Law Beats Keynes’s Law
During a recession, businesses are the first to hire and invest more money, long before consumers start buying again. Why? Because they can use their retained earnings and loans to produce products that consumers will demand over the next few years.
As CNBC’s Larry Kudlow states: “Though not one in a thousand recognizes it, it’s business, not consumers, that is the heart of the economy. When business produce profitably, they create income-producing jobs and then consumers spend. Profitable firms also purchase new equipment because they need to modernize and update all their tools, structures, and software.”
Look at the leading economic indicators in the G8 countries (issued by the Conference Board), and you’ll see that almost all of them are business indicators in early-stage production: new manufacturing orders, corporate profits, capital goods, building permits, average weekly manufacturing hours, stock prices, etc.
In short, it’s Say’s Law (”supply creates demand”) that drives the economy, not Keynes Law (”Demand creates supply”).
The question is: Where can you invest to take advantage of this?
Here Are Three Ways to Take Advantage of Say’s Law
If we’re talking about early-stage production, the technology sector offers some of the best investment opportunities. That’s because it invests heavily in advance of the business cycle in R&D, marketing, etc.
- Conservative investors should consider Intel (Nasdaq: INTC) – the world’s largest maker of integrated circuits for computers.
- If you want to speculate a bit, you could look at SanDisk (Nasdaq: SNDK), which makes flash storage card products.
- And for broader exposure to the tech sector, go for the iShares Dow Jones US Technology (NYSE: IYW) ETF, which is up 26% this year.
I’ve repeatedly exposed the paradox of thrift fallacy in my books. For more of what I mean see, “What Drives the Economy and Stocks: Consumer Spending or Business Investment?” in Chapter 33 of my new book, EconoPower: How a New Generation of Economists is Transforming the World.
On a personal financial level, cutting back on wasteful expenditures, getting out of debt, saving and investing more is obviously beneficial. In the short run, businesses and individuals who cut costs and build up cash are in a better position to profit from the turnaround in the economy when it comes.
And note that even though consumer spending is still declining, the stock market has rallied sharply. Those who reduced their spending and saved money took full advantage. If you wait for consumer spending to turn around before investing, you’ll miss out on the big rally.
Good investing,
Mark
Editor’s Note: Because Mark’s column was in response to Dave Fessler’s original “Paradox of Thrift” article on spending and saving, we thought we’d get Dave’s counterpoint. It’s always interesting when our experts go head-to-head!
Here’s Dave’s reply…
Mark Skousen is a good friend and one of the smartest economists I know. I’m not surprised that he and I differ on this issue. But with all due respect, I didn’t “fall” for anything. I’m simply pointing out what’s actually happening.
Here are three things that can’t be argued:
Reality Check #1: Consumers have stopped spending and are saving at record rates.
Reality Check #2: 70% of U.S. GDP is from consumer spending.
Reality Check #3: Overall unemployment is still rising, not falling.
Mark suggests that business is going to be the primary genesis of an economic recovery. In other words, as businesses start spending and rehiring, consumers will then start spending again.
That may indeed happen eventually. But I don’t believe it will happen fast enough to effect immediate change. It’s going to take a very, very long time for it to affect the consumer’s mindset and their real ability to spend – especially in an environment where unemployment is still increasing.
Time will tell. Frankly, I’d love to be wrong and have Mark tell me, “I told you so.” And for the record, I’m not suggesting that Americans should stop saving and start spending like thirsty sailors on shore leave. That’s what got us into this mess in the first place.
- The Paradox of Thrift: How a Better Savings Rate is Fueling the Recession
- We’re Squeezing the “Recovery” for Every Penny
- Energy & Infrastructure: The Cure For Our Economy
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23 Responses to “Debunking The Paradox of Thrift: Why Consumer Spending Won’t Save Our Economy”
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September 23rd, 2009 at 6:34 am
“Earth to Mark” you are a little late to the party!
I don’t know how old you are, but Supply Side Economics (your Supply Drives Demand) has been tried and failed a generation ago.
Your theory is one that sales neophytes fall for on a Micro Economic scale, that products sell themselves. They never have and never will.
Google “Ronald Reagan”
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September 23rd, 2009 at 6:51 am
Do you people have it backwards!
My car will disintegrate before I buy another.
My refrigerator will die before I buy another.
My dryer will stop working before I buy another.
My income is basically government checks augmented by savings. I may die before the government checks get reduced but at these rates of deficit spending, probably not.
I have not yet panicked but I am afraid, very afraid. I can honestly say that I will never
consume again, I only spend for NEED. I am 68 years old.
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September 23rd, 2009 at 8:19 am
Would someone show me calculations that indicate consumer spending is 70% of GPD. 70% is way too high for me to believe.
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September 23rd, 2009 at 8:23 am
Supply Side is an a league with Freudian Analysis: discredited and passed by.
The example of Toyota spending $1 billion on advertising may be seen as a defense of their turf and not entirely a blind faith in aggregated, wished-for, future events.
It seems odd that saving has the stigma of not using one’s money wisely. I am not sure saving money is the dark stalking horse of today: I believe banks not lending is a far worse problem. Stuffing bubbles of cash into mattresses is not an issue today; we put it in banks. The problem is banks not lending.
The arguments of a paradox of savings seem vacuous and I smell sterile academics.
As a mere mortal I cannot grasp how investment follows the act of saving which then is transformed by the God of Free Enterprise via a miracle into capital formation. Get behind me, Supply Side.
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September 23rd, 2009 at 8:58 am
David,
To follow up our debate, you are right that consumer spending represents 70% of GDP, but remember, GDP is FINAL output only. If you measure spending at all stages of production, consumer spending represents only about 30% of the US economy.
I like to use Seattle as my best example. What transformed Seattle from a small lazy town in Northwest US into a vibrant city? Not consumer spending. It was first Boeing and its entrepreneurial enterprises in building great jumbo jets, and later Microsoft, which generated the information technology revolution. Only AFTER those businesses flourished did you see consumers become big spenders and create a great metropolitan city.
I encourage you to read my many books on this subject, including “Economic Logic,” my free-market textbook; and “EconoPower: How a New Generation of Economists is Transforming the World.”
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September 23rd, 2009 at 9:29 am
I think I’m gonna have to go with David on this one. While the stimulus on a local economy by big business is certainly irrefutable, we are talking about a recession here. Good points made by both sides the here and now is unemployment is driving the views and attitudes of consumers and business is certainly driving this category. Common sense economics will win out here. Business will notventure out or materialize without the market or demamnd set about by consumers and without that consumer spending there is no demand.
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Richard Ferry Reply:
September 29th, 2009 at 7:21 am
I think a major issue now is demand vs debt. Many consumers are afraid to spend and cannot afford to borrow. Everone (people,business,and government) bought into the concept that growth will pay for debt. Debt was how you got ahead. The powers that be will inflate the economy untill some people have equity again. If your smart enough to get ahead the government will reward you with high taxes at every level.
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September 23rd, 2009 at 10:00 am
Both gentlemen have some very valid arguments here. Mark and the supply-siders are correct that the capital of increased savings will be put to use during a recession to increase future capacity, and in that sense, business will be the primary driver of recovery, well before consumers open their pocketbooks again.
But sorry, Mark, you missed the mark by a mile on one very important point: consumers ARE the ultimate driver which fuels the economy; No matter what a businesses primary market, its ultimate market is the individual consumer. A parts manufacturer may produce nuts & bolts only for sale to an automotive company like GM. But GM will buy those nuts & bolts to put into a car, which they will sell to whom? An individual consumer. In the end, ALL production is consumed by an individual, therefore Keynes’ theory does bear out: demand drives supply, not the other way around. Winner by deduction: Dave.
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September 23rd, 2009 at 11:17 am
Can someone please explain how Consumer Spending (i.e. consumption) comprises a key part of our Gross Domestic Product (i.e. production)? It seems to me that the act of purchasing a Chinese flat screen TV from Walmart adds nothing of value in the way of American-made goods or services. True, retailers provide a “service” by buying products from others and reselling them but their profits are merely a shift of wealth from one group of American consumers to another (i.e. Walmart’s owners and its employees). Only when American retailers sell to foreign consumers can we say that they’ve truly added to our GDP because, in so doing, they’ve brought cash into our economy. And herein lies the heart of our economic problem: our horrendous negative balance of trade has been bleeding America dry for decades. We’ve lost too many jobs to low-cost foreign competition, hocked our homes in an effort to maintain our lifestyles, and are doing nothing to reverse the damage.
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September 23rd, 2009 at 11:18 am
How wonderful when you provide intelligent repectful discourse from two great minds who disagree. Good value.
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September 23rd, 2009 at 12:00 pm
Dave it is.
While it might not be good for investors, the world needs to be consuming less. What if we returned to a debt free economy? How much would/could houses cost if there were no loans? Or cars? Or university tuition? We wouldn’t be building giant homes to be filled with truckloads of cheap, imported furniture. We might be living more sustainably. We also wouldn’t be lining the pockets of the financial manipulation industry.
I agree with the ideas of David Korten: that the global economy is so corrupt and powerful that we need to build a parallel economy that is earth and community centered. Supply side builds giant coal-fired plants for central, elite control. Demand side builds solar and wind distributed generation for personal control.
i know which world I’d rather live, and invest, in.
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September 23rd, 2009 at 12:10 pm
Love the collegial “point – counterpoint” discussion. A refreshing change from the course and shrill discourse seen and heard so often these days.
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September 23rd, 2009 at 2:40 pm
I never understood why savings and consumption was viewed as separate – arbitrary in my view. Savings is still part of the demand equation as financial services are required by the consumer. The savings don’t just disappear and have no value to the economy. A return is generated even in a savings account (small) and the bank/credit union needs to invest the money to generate a return. So it ends up in all kinds of financial instruments generating income and demand. And eventually it gets spent. I believe the economy gets stronger when consumers save and spent their own/earned money rather then spending someone else’s money (debt).
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September 23rd, 2009 at 2:45 pm
You ‘experts’ ought to know that money invested (saved) is seeking a payback in about 3 to 5 years, which amounts to an economic multiplier effect of about 15% to 30%. That means a dollar saved turns into $2 over 3 to 5 years.
A dollar spent, on the other hand, moves through the economy from retail to wholesale to trucker to manufacturer and so forth, with a multiplier impact of about 300% or more per year. That is, a dollar spent generates three dollars or more per annum.
Think of water in a river where a waterwheel turns a mill every mile or so along the stream. The same water performs work at every point, each being a new transaction. Water saved behind dam has its purposes, but the work is not done till much later, if at all.
If money is wanted to do its work now, then spending is the way to do it, provided it is not sent away immediately to China! That may be the largest fly in the American ointment – the fact that taxpayer-funded outsourcing has proceeded so far along the path.
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September 23rd, 2009 at 3:16 pm
I don’t understand Mark’s conflicting words: Profitable businesses will produce more so the economy will thrive. How do they become profitable if people (or businesses) aren’t buying but saving??
It seems a simple case of the cart before the horse. And — there are so many more variables involved, not the least of which are politics and world events.
While it certainly influences price, demand does not create supply.
And to answer the previous comment that buying at Walmart doesn’t help the economy, I think Mr. Lefcourt missed the benefit of Walmart’s positive effect on our economy and keeping its employees working,
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Ants Viirlaid Reply:
September 23rd, 2009 at 3:34 pm
“Buying at Walmart” is not a total negative, I agree.
But I also agree with the first sentiment. Namely if we only consume other nations’ production — even though some part of our own retail sector thrives for a while as a result — how long can we keep it up? It’s not sustainable on its own.
In the long run we can only consume the equivalent of what we produce. Trade has to be balanced over the long run, otherwise we are just “Selling America’s wealth” as Warren Buffett might say. In other words. Squanderville is just liquidating its capital
http://www.freerepublic.com/focus/news/1053684/posts
So while it may help Walmart and its employees, if our Economic System is so heavily skewed to pure consumption, with so little production to finance that consumption, we are ’skrewed’.
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September 23rd, 2009 at 3:18 pm
Yes, I agree, a very good and civil discussion.
Dave’s comment that “That’s what got us into this mess in the first place” says a lot.
Over the last half century, as one contributor wrote, we have become overly-dependent on Debt.
This was not by accident.
The FED is most egregiously responsible as a Central Bank for over-promoting the use of Debt especially at the consumer level.
This practice has caused the overloading of end-consumption at the expense of other economic activities.
Why did The FED keep interest rates so low so as to discourage saving but to encourage consumption and borrowing in general terms over many, many decades?
Because The FED in some respects agrees with the concept that the majority of economic activity is driven by consumer consumption. Therefore The FED thought it was Doing Good.
In other words, The FED also most likely believes in The Savings Paradox (once it arrives) but apparently has a great deal of difficulty in understanding that it CREATES the conditions for The Savings Paradox to arise in the first place — a.k.a. The Paradox of Thrift.
In Ben Bernanke’s view, consumers should EVEN NOW be discouraged from saving and instead be encouraged to take on more Debt — even to the extent that The FED would destroy the value of savings to force people to get rid of their dollars in some (uesless) kind of consumption activity.
Please see Dr. Ben Bernanke’s infamous Helicopter Speech at http://www.federalreserve.gov/BOARDDOCS/SPEECHES/2002/20021121/default.htm
Today we have arrived at a point as though we were all on a huge ship that has taken on water which has all sloshed to one side of the ship’s hold. That is what our consumption binge has done.
We are imbalanced. Financial Koyaanisqatsi has arrived.
It is the Rebalancing that we have to go through now, regardless of any Paradox of Saving that we might face. The water has to be either pumped out or at the very least the ship has to be righted so that the water is not predominantly on one side or the other of the Economic System we are in.
There is no magical way out of this requirement. We MUST save and reduce our debts. That is what a depression is. As Ted Turner said, the piper must be paid.
The FED needs to acknowledge this need and not work against its resolution. Otherwise our difficulties will be deeper and more drawn out. It would also help if The FED could acknowledge its central role in creating these difficulties in the first place.
As to the debate between Dave and Mark, I think that both shine a light on the topic and on the current economic catastrophe, but just from different perspectives. So I agree with the others above — both contributions are most useful in generating further discussion.
As one contributor wrote, if businesses cannot see any reasonable investment to make, based on expected future demand (and thus some reasonable ROI), then they won’t make those investments.
That, I fear, is the state that The FED’s great experiment in Money-Manipulation (MoneyPulation) over the last several decades has delivered us into.
Invest now? I fear not. In fact, I think this tragedy is only STARTING to unfold. Give it some time before we can all cry Hallelujah, we are out of the Woods!
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September 23rd, 2009 at 5:41 pm
Both Mark and Dave are one-half right which also make them one-half wrong. Consumer savings generate demand for goods which stimulsates the producers. Also producers need to “produce” and will do so to maintain a viable business. Advertising and reduced prices of necessity will generate the demand from the consumers. Ever hear of the argument about which came first–The chicken or the egg?
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September 23rd, 2009 at 6:32 pm
I love a good debate… The real problem is that this time I think things truly are different. Previous recessions didn’t start out with the consumer up to his eyeballs in debt. That why Mark’s thesis that supply will drive demand falls apart THIS time.
Demand only comes if the consumer has something to spend to drive it. Now eventually his “stuff” will wear out, and he’ll need to buy new. But it isn’t going to happen in the next 6 months. It may take a year or more. He’s hunkering down, fixing things instead of buying new.
The painting business is booming. My sister-in-law is a house painter. She can’t keep up with the demand, and brought on a partner. When I asked her about this, she said everyone is fixing up instead of moving. Just one example.
A friend of mine is a VP at DHL. Nearly 80% of the “stuff” sold at retail – other than food – passes through warehouses of his customers. This month these warehouses should be filling up in anticipation of selling into the holiday season. Most of them are empty. DHL just had a huge layoff. None of the retailers are importing anything close to what they brought in last year.
So I know what happened before, but I think this time it’s different. We’re in uncharted waters, I believe.
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September 23rd, 2009 at 6:38 pm
Both gentlemen put forward compelling arguments and in my view both are not wrong.
I think you should get a third point of view,I believe both arguments are correct but neither one by it self would solve the countries problems.
Kind Regards Zen.
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September 24th, 2009 at 7:34 am
I will have to agree with Dave. Supply has never nor will it ever drive demand. As an owner of a retail establishment suffering from a drop in sales due to consumer thrift I can assure you I have plenty of inventory available for sale. I will not replace the inventory unless I sell that which is currently in stock. Simple supply and demand issues control my decisions of what inventory to buy and how I should invest in my business. I will never follow the losing philosophy of “If you build it they will buy it”. It did not work in Russia and it sure won’t work here in the Socialist States of America.
With regards to consumer spending being 70% of the economy that is also true. We have sent almost all of our manufacturing jobs overseas. Manufacturing used to be a much bigger piece of the domestic economy than it is now. We became a very rich nation because of manufacturing.
We started becoming poorer when we closed down our factories and sent our jobs overseas due to “cheap” energy and labor. Manufacturing jobs generally pay better than customer service jobs so we went from being nation that used to lend to others to a nation that now is the biggest debtor in this planets history. We have now given that wealth and production ability to the Chinese. They are now the lender and we are the debtor. We put the chains of slavery upon ourselves.
Unless government overspending is stopped ALL of the money saved by consumer thrift will be squandered by the politicians in Washington buying votes and pandering to the special interests.
As a nation we are in very big trouble and realistically I see no way of ever getting out of it. We have already put this nation into debt to a level that cannot be sustained. Our debt is to the point where we have a very tough time paying just the interest (at rates of less than 1%). Should interest rates rise as I expect them too the future looks even worse.
Paying off the principle? What a joke. Everyone knows it will NEVER happen. This is why the U.S. dollar is headed for the scrap heap. The Asian’s are buying fewer dollar denominated paper assets while at the same time buying up TANGIBLE assets such as commodities. Even if we sent every single penny we earned to the pirates in Washington we could not do it. Rising interest rates and inflation will be the next thing to destroy this nations already critical budget deficit. God help us.
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September 24th, 2009 at 2:55 pm
As a earlier comment said ” interesting debate about chicken and the egg”. The economy is a complex dynamic system that is heavily influenced by confidence of the consumer(also workers and management) and business ( also consumers). I am increasingly of the belief that traditional economic theory often fails us when we need it most, because it gives no weight to psychological factors. It seems to me that sudden changes in ” crowd psychology” result in “black swan” events. I don’t know we have a model that will accurately explain the impact of a sudden increase in savings in US society, but given that we have been there in the past; I am not convinced it will be bad for the economy; you can bet that it will be different.
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September 26th, 2009 at 3:48 pm
Once again Fessler shows he does not know what he is talking about. If he says “buy,” I avoid or sell immediately. Any success he has is pure luck!
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