What is... | October 21, 2011

What is the paradox of thrift?

When someone is worried about the outlook for their finances, it is perfectly rational for them to cut spending. But if everyone did this at once it could cause problems.

Such a sharp drop in the purchasing of goods and services could, in turn, lead an economic downturn. Businesses could cut jobs fuelling a vicious circle that actually leaves households with a lower level of savings. Economists call this the “paradox of thrift”. The concept was popularised by the famous economist John Maynard Keynes in his General Theory in the 1930s. More recently, British politician Vince Cable described the paradox of thrift as “people being individually wise but collectively foolish”.

What goes around, comes around
The paradox of thrift again rose to prominence as countries tried to recover from the latest global financial crisis. Financial Times columnist and Undercover Economist author Tim Harford explains how the paradox of thrift is “the idea that when we all try to pay off our debts, in fact we end up more indebted than ever”. He writes that the theory says damage to economic growth could be so great that incomes fall faster than spending, “and borrowing increases”. Academic Max Corden writes in a 2011 paper that the paradox becomes more complex at an international level when people in some countries tend to save a lot – while people in others tend to go into debt.

One man’s thrift…
As many people tightened spending during the 2008 – 2009 global financial crisis, discussion turned to whether the paradox of thrift would becoming reality in some countries. For individuals, it can be difficult to determine how they might be affected and what they can do about it. Personal circumstances will vary, but, in general, the best course of action could well be to make financial decisions based on their own circumstances. But that can be harder than it first appears. People’s decisions can be influenced by how they see others behaving. They can be influenced by “herd behaviour” and peer effects.

A jury of your peers
Peer pressure can influence spending and saving. Research shows the decisions of neighbours and workmates can sway the choices of others. Peer effects can even lead to perverse results. Dutch researchers found that if someone won a brand new car in a lottery, their neighbours were more likely to buy a similar new model, even though they did not have a windfall. With saving and the paradox of thrift, it might be that if others are cutting back, you are more likely to follow suit rather than stand out as someone doing well in bad times.

Be your own person
It can pay for individuals to be aware of the paradox of thrift and also wise to herd behaviour and peer pressure. Assess your personal circumstances before deciding whether to spend or save. If the price of an item that someone has hankered after for years falls suddenly it may make sense to go against the flow and use some savings to grab a bargain. On the other hand if your outlook is uncertain, it may make sense to reduce spending and save for a rainy day. Ultimately it is rational for people to cut their spending if they are pessimistic about the outlook and are worried by uncertainty. By looking at their own circumstances rather than following the crowd should ensure individuals do not make a bad situation worse.


Phil Thornton
Phil Thornton

Lead consultant at Clariti Economics

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