Wednesday, October 5, 2011

The Key Is the Paradox of Thrift

My austerity program is ruining our economy. Thumbs up!
The choice of austerity to cure our economic ills is so starkly wrong at a time when we have low interest rates, nearing zero, combined with low lending rates (either no one qualifies or no one wants to borrow) that hearing UK prime minister David Cameron recommending "households -- all of us -- paying off credit card and store card debts" makes you think that we are indeed ruled by idiots.

His prescription was so conspicuously wrong that he was forced to rewrite the speech within hours of a draft being circulated. "That's why households are paying down their credit card and store card bills," Cameron will now say. Big whoop. He changes it to a fait accompli instead of a recommendation.

John Maynard Keynes
The contrast between Keynesians and Austrians is perhaps no more apparent than in the way this most basic formulation works. Keynes, known for having popularized the concept of the paradox of thrift, maintained that if everyone tries to save more money during times of recession, then aggregate demand will fall and will in turn lower total savings in the population because of the decrease in consumption and economic growth. The Austrian School and Friedrich Hayek countered that what mattered was the consumption-investment ratio and, since prices will fall during a slump, the consumption-investment ratio will remain the same.

I have trouble with this in several ways. If paying down debt lowers consumption, then the economy will in fact slow because of decreased aggregate demand, leading to increased unemployment, leading to even lower demand. The result will be a labor class unable to either consume or pay down debt, let alone increase savings. If indeed the lower demand, matched by lower output, leads to lower prices, even outright deflation, then debt begins to be in real terms more expensive to pay off. This is the very definition of a vicious circle. Even if a citizen was able to remain employed without a pay cut and managed to put some amount into savings, the lower interest rates would reduce the value of savings. Lower value of savings + falling prices = a reason to spend, not save.

If you go into debt during a deflationary cycle, your subsequent debt will be easier to pay off during an inflationary cycle.

Friedrich Hayek
Hayek and the Austrians, known in this country as the Freshwater School of Economics (don't ask right now), suggest that when consumption slows, making interest rates decline, cheaper borrowing will lead to increased borrowing and spending, which increases demand, ending a slump. Lower prices because of the slump also stimulate demand.

Sticky prices come into play here. Prices aren't fixed in anything resembling a rational or efficient way, with prices for goods remaining high when the underlying commodity prices fall. Gas prices rising fast when oil prices rise but gas prices falling more slowly when oil prices fall are good examples of price stickiness, especially to the detriment of consumers.

My experience in the last 10 years as a teacher tells me that wages, though often thought to be as sticky as prices, have stopped being so. Raises are fewer and farther in between, and the real culprit has been benefits, with the cost of health care -- and employee contributions thereto -- rising rapidly. Over time, my wages haven't kept up with prices. And I've watched my savings and investments remain flat or worse.

I get confused easily by all this, but to summarize:
  • Recommending austerity during a time of flagging demand invites further shrinking of economies, leading to a downward spiral.
  • Recommending the paying down of debt when debt is cheap is counterproductive.
  • Recommending increasing savings at a time of rock-bottom interest rates seems also counter-productive.
  • Encouraging practices that lead to decreased demand will lead to lower consumption and higher unemployment, leading to more of the same.
  • Asking individuals to follow prescriptions for austerity might make marginal sense, depending on the circumstances. Asking whole nations to do it during ravaging economic times is the height of insanity.
Final verdict: the paradox of thrift says saving money now will make you poorer. Don't do it. The one thing George W. Bush got right was telling people to go out and spend after 9/11. It stopped the post-attack economic swoon in its tracks. Too bad he followed his own advice with a spending and borrowing binge of his own, while drastically reducing revenues. Uh, thumbs up!

I love wars, but I hate paying for them! (Let's not, and say we did.)

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