The Paradox of Thrift

There is an apparent weakness within free-market economics that is often referred to by Keynesians, socialists, and the occasional Chicago-schooler as the Paradox of Thrift. The paradox is as follows: during a recession consumers naturally tighten their belts and start saving more money. Because consumers are not spending as much, producers cannot sell as much and start losing money. Because supply then goes down, prices go up, and consumers spend even less, sending the economy into a steep downward spiral.

The paradox of thrift appears convincing, but it ignores one key fact: before something can be consumed, it must be produced, and before something can be produced, it must be invested in. Before a house can be bought, someone must cut the lumber, manufacture the nails and drywall and other materials, and finally put it all together. And even before that, because that house is a large project, someone--a banker, investor, or entrepeneur--must invest a large amount of capital into it. How is that capital accumulated? By saving, plain and simple.

This is because saving, contrary to those who believe in the paradox of thrift, is not the choice to not spend. Rather, it is the choice to spend later on something that's worth that spending instead of spending now on something that's not. When consumer spending is encouraged rather than saving, money is spent on thing that are not necessarily beneficial to the economy; things that don't dramatically help productivity or increase the standard of living.

And what is the best way to encourage saving? The free market.

As noted before, people and businesses alike naturally start saving more. If the government intervenes to increase consumer demand, the process is the reverse of what is necessary for a healthy economy. People will experience a short-term economic boom because they will simply be buying more things, but because there is no supply to feed the demand, the economy will run itself into the ground in short order and wind up in a state far worse than it was in originally.

Natural, market-driven saving is the only way for an economy to get on its feet. Once saving is up, production can increase again, and consumers will be able to both buy more and save even more, continually growing the economy. Attempts to shortcut this cycle can only lead to disaster.