What is the Paradox of Thrift?

Also known as the paradox of savings, the paradox of thrift is an economic theory that suggests that personal savings are the net, during a Recession, on the Economy.

This theory is based on the presumptions that prices are not clear or that producers may Fail to adjust to the altering conditions in contrast to the classical microeconomics’ expectations. In general, John Maynard Keynes – a British Economist popularized this paradox of thrift.

Explaining the Paradox of Thrift

As per the Keynesian theory, the adequate response to an economic recession is spending more, taking risks more and saving less. Keynesians have a belief that a recessed economy doesn’t produce at its full capacity as some of the production factors, such as Capital, labour, and Land, remain unemployed.

Also, Keynesians argue that spending, or consumption, drives Economic Growth. Therefore, though it is sensible for households and individuals to decrease consumption during the recession, this will be a wrong recommendation for a larger economy.

A tieback in aggregate consumer spending may compel businesses to produce lesser, further extending the recession. This disconnection between the group and individuals’ rationality is the foundation of the savings paradox.

The very first conceptual description of the paradox of thrift could have been mentioned in The Fable of the Bees, published in 1714 by Bernard Mandeville. In the book, the author pointed out that increased spending and not the savings could be the key to prosperity. Keynes also credited Mandeville for this concept in The General Theory of Employment, Interest and Money that was published back in 1936.

The Paradox of Thrift Example

Let’s understand this concept with a better example. Suppose a person, known as X, owns a computers’ parts producing factory. The factory is one of the biggest in terms of its employment. Now, X is planning to expand the capacity of production by integrating more machines and hiring more workers.

Unfortunately, X’s country goes into recession, and he tries to return to saving more. He starts by laying off more workers and discontinuing operations during the night. This resulted in unemployed factory workers to save more and decrease their demands.

Thus, these unemployed factory workers started adding more to the overall spending on social benefits, and the economy starts weakening.