From Seekingalpha.com - "Where We Should Be Investing: The Paradox of Thrift

Post by Steve Waldman
July 31, 2008
http://seekingalpha.com/article/88220-where-we-should-be-investing-the-paradox-of-thrift

Over the weekend, Paul McCulley offered a thought-provoking piece (hat-tip to Justin Fox, Brad DeLong), which starts with a discussion of the "paradox of thrift":

For those of you who might not recall, the paradox of thrift posits that if we all individually cut our spending in an attempt to increase individual savings, then our collective savings will paradoxically fall because one person’s spending is another’s income – the fountain from which savings flow.

There's a hidden assumption in the "paradox of thrift" that really ought to get teased out more often. It is true that one person's spending is another person's income. But it does not follow that an increase in saving translates to a decrease in aggregate income. There are two kinds of spending, consumption and investment. Laying a subway line adds to somebody's income as surely as buying a Ferrari does. Ordinarily, nearly all savings are actually spent on investment goods, and there is no "paradox of thrift". What is "saved" is really spent on current production of future capacity, and there are plenty of paychecks to go around. There is no "fallacy of composition": individually and in aggregate, today's thrift lays the groundwork for tomorrow's abundant consumption.

However, for this to work out, two things must be true: Today's savings must be invested in projects that will actually generate future wealth, and savers must believe they will retain a stake in the increased wealth commensurate with the size and wisdom of their investments. We have a financial system in order to make these facts true. If the investment industry is capable of finding or initiating projects likely to satisfy future wants, and if financial claims are predictable and stable stores of value, we need not trouble ourselves over the paradox of thrift. The issue only arises when the financial system breaks down. When investors lose faith in the quality of available investments or their ability to collect the proceeds (in real terms), they pull out savers' Plan B: precautionary storage. They buy gold, or oil, or art, or whatever, and they keep it, generating scarcity rents for those who can offer perceived value stores, but very little in the way of general income and employment. Precautionary storage, not thrift itself, is the villain of the tale.

The vulgar Keynesian prescription is to encourage consumption, when a dynamic of precautionary storage takes hold. And in extremis that might be a good idea, because if all everyone does is hoard, it's hard to figure what to invest in, except maybe storage tanks. But it's much better to develop a financial system that actually performs, that identifies fruitful projects and allocates claims fairly. Storage eats wealth, while productive enterprise creates it. People know this. No one "invests" in gold or oil when a financial system is working. They do so when it is broken. Like now.

Encouraging people to go shopping in order to help the economy is not "second best" policy. It's a desperate last resort. We're not at a point where there's so little economic activity that we can't foresee future wants. We're at a point where people are beginning to shift from investment to storage because of a well-deserved loss of confidence in the financial system. Encouraging consumption now is nihilistic. It feeds into a vibe (I feel it personally, do you?) that saving is so uncertain and money so volatile that one might as well spend, 'cuz who knows what tomorrow might bring. The right way to sustain aggregate demand and maintain current income is to figure out what we should be investing in — not stocks, bonds, or CDOs, but factories, windmills, or schools — and then to put current resources to work. Our financial system is failing spectacularly because it erred grievously. It built homes and roads and sewers that oughtn't have been built, it "invested" in vacations and plasma televisions, and it paid itself handsomely for doing so. That's not a problem we can spend our way out of. To fix the financial system we have to change it, not rally to its support. We will know we've put things right when thrift is something we can celebrate, when we save because we are excited about what we are creating rather than frightened by what we might lose.