Pay off $500 of your Visa bill and you may put someone out of work for a week.
That is the downside of the Federal Reserve’s announcement this week that U.S. households paid down their consumer debt by $21.6 billion in July — the sixth straight month of dropping consumer debt and the largest absolute decline ever recorded.
A higher savings rate and lower consumer debt levels are good news for the long run. But in the short run, such thrift will slow economic growth and keep unemployment rates higher for longer than if consumers spent more and saved less. This is what economists call “the paradox of thrift.”
History buffs will recognize the reference to paying off a credit card bill as an update of an observation John Maynard Keynes made in a January 1931 BBC radio talk, when he said, “The best guess I can make is that whenever you save 5 shillings you put a man out of work for a day.” This was 15 months after the New York stock market crash had touched off a worldwide Depression and unemployment was painfully high in the United Kingdom, which, unlike the United States, had not enjoyed a 1920s boom.
Keynes explained how depressed consumer spending hurt business sales and hence employment, creating a vicious circle of poverty and suffering. He urged British housewives to “sally out tomorrow early into the streets and go to the wonderful sales which are everywhere advertised. …”
Keynes’ diagnosis was fundamentally right. What seemed prudent for any individual household — to cut back spending in the face of a sick economy — was harmful for the economy as a whole. Economic activity and employment could return to normal levels only when overall spending in the economy returned to normal levels.
We still teach this paradox to every introductory economics student: that sound saving decisions by individuals can be harmful to the economy as a whole. It is as true in 2009 as it was 80 years ago. Higher savings in itself improves the balance sheets of individual households, but the nationwide effect is to lower the incomes of tens of millions of households and thus, indirectly, hurt those same balance sheets.
Keynes’ eventual prescription was for government to spur spending both by households and businesses through a combination of lower taxes, greater government spending and a more plentiful money supply that drove down interest rates. That prescription is just what all the industrialized nations of the world are doing right now.
But the U.S. situation is different from 1930s Britain in an important respect. The Depression in Britain was not preceded by an orgy of consumption financed by increasing household, business and government debt or by large borrowing from other countries. Instead, all three sectors had contributed to a positive savings rate, and the United Kingdom was a net lender internationally, as it long had been.
Keynes sought to return his nation’s economy to a sustainable equilibrium that had prevailed before the Depression. But the United States economy in 2003-07 was not a sustainable equilibrium. High levels of household consumption depended on increasing consumer debt just as growth of the financial sector hung on greater and greater leveraging and large federal deficits depended on borrowing abroad. None of this could continue over the long run.
So yes, increased household savings, like that of the past six months, does slow growth and keep unemployment high in the short run. But there is no alternative to it in the long run. That is why, regardless of when pundits declare the recession officially over, the return to prosperity and full employment will be long and painful.
© 2009 Edward Lotterman
Chanarambie Consulting, Inc.