The Paradox Of Thrift

There is a lot of misunderstanding about the causes of recessions and what to do about them.  In particular, Keynes developed a theory that explained why it is difficult to escape from a deep recession.  His explanation is poorly understood.  It has been characterized by his critics as an excuse for governments to run deficits.  Classical economists believed that price adjustments would enable market economies to recover from recession.  One of the price adjustments was the interest rate mechanism.  The amount of loanable funds would increase if consumers or businesses cut back on spending and saved more of their income.  Keynes developed the paradox of thrift to explain why the supply of loanable funds would not increase when individual agents decide to spend less and save more.  Consequently, interest rates would not fall far enough to encourage more spending.  An economy in recession would not recover from recession through the interest rate mechanism.

The paradox of thrift is not easy to grasp because many people believe that savings are a virtue and that debt should be avoided.  In doing so they commit the fallacy of composition.  They believe that what is good for the individual is good for the society as a whole.  This article does a good job of explaining the paradox of thrift and the fallacy of composition.