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The Paradox of Thrift or The Down Side of Saving

After extolling the virtues of saving (http://blog.wienerfinancial.com), it would be useful to point out why our government feels it necessary to deal with the detrimental aspects of thrift.

It is common wisdom that our current situation has arisen in no small part from our boundless spending with little thought to saving for the future.  Now that fear has struck, we are responding rationally by lowering our expenditures and shoring up our reserves.



The problem, however, is that "what is rational at the individual citizen or firm level, notably to increase savings ... becomes irrational at the community level," according to Paul McCulley, of PIMCO fame.

Why?  Because on the national level our aggregate consumption drives our income.  In other words, if people save more and buy less, then less is produced by businesses. In turn, lower production means less income paid to employees.  So if we all save at once, our incomes will decline.

McCulley points out that the federal government seeks to fill the gap by maintaining spending to keep up our level of income.  This solution has its  drawbacks -- increased federal debt and the risk of future inflation.  Yet the alternative, a depression mixed with deflation, was deemed to be far worse.  Deflation is particularly difficult to reverse once the downward cycle takes hold.

We all have differing views on the adequacy and reasonableness of the steps being taken to resolve the economic crisis.  We should not fail, however, to realize the complexity of the problems and the inter-relationship between the proposed solutions and their consequences.

Words of Wisdom

 

In recent decades running a business or a household with a conservative balance-sheet has been a bit like being the only person in an opium den not to inhale.
-- The Economist