What is the Paradox of Thrift?
MA, Management Science (University College London)
Date Published: 06.08.2024,
Last Updated: 15.08.2024
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Definition and origins
Save or spend? This is a question that most individuals are faced with in their day-to-day lives. The truth is that there is no wrong or right answer to this question. An individual’s decision in this regard is truly dependent on many factors, such as their perceived uncertainty for the future, whether they're risk takers, or the overall state of the global economy. However, according to the paradox of thrift, there is a single and obvious right answer: Individuals should not save, but instead spend in order to foster economic growth.
Essentially, the paradox of thrift illustrates that if a large group of people decides to save more, it might not lead to a rise in national savings. Instead, falling consumption could cause the economy to fall into a recession, leading to a decrease in incomes and, consequently, a reduction in savings.
Before delving into the rationale behind the paradox of thrift, let us first understand what exactly is meant by ‘thrift’: the main character in the paradox at hand. In Thrift and Its Paradoxes, ‘thrift’ is defined as follows:
We start by taking thrift to be the careful management of resources to ensure a person or household has enough to sustain it. It is therefore oriented toward a future, typically involving minimizing expenditure and wastefulness. But thrift is also freighted with a multitude of linked characteristics—hard work, self-discipline, sobriety, rational forethought, restraint, the desire and capacity to save and accumulate—that are often used singly as synonyms for thrift. (“Introduction,” Catherine Alexander and Daniel Sosna, 2022)
Edited by Catherine Alexander and Daniel Sosna
We start by taking thrift to be the careful management of resources to ensure a person or household has enough to sustain it. It is therefore oriented toward a future, typically involving minimizing expenditure and wastefulness. But thrift is also freighted with a multitude of linked characteristics—hard work, self-discipline, sobriety, rational forethought, restraint, the desire and capacity to save and accumulate—that are often used singly as synonyms for thrift. (“Introduction,” Catherine Alexander and Daniel Sosna, 2022)
Essentially, the term ‘thrift’ is a more comprehensive synonym for saving. It refers to the careful rationing of resources – typically money – to ensure an individual’s future is sustainable and prosperous. Cognizant of this, Alexander and Sosna follow with a definition of the paradox:
The paradox of thrift suggests that an increase in individuals' savings serves to reduce overall demand, output, and hence, eventually, the wealth of the national economy. (2022)
This paradox was popularized by John Maynard Keynes, the father of macroeconomics, in his well-known book The General Theory of Employment, Interest and Money (Keynes, 1936). However, it was Dutch philosopher and political economist Bernard Mandeville who first articulated the paradox in a rather original way in his book The Fable of the Bees (1725). In this book, he wrote a poem titled “The Grumbling of the Bees” to explain the paradox, where he describes a community of individuals who forsake luxurious living to start saving:
The great art to make a nation happy, and what we call flourishing, consists in giving everybody an opportunity of being employed; which to compass, let a Government’s first care be to promote as great a variety of Manufactures, Arts and Handicrafts as human wit can invent; and the second to encourage Agriculture and Fishery in all their branches, that the whole Earth may be forced to exert itself as well as Man. It is from this Policy and not from the trifling regulations of Lavishness and Frugality that the greatness and felicity of Nations must be expected; for let the value of Gold and Silver rise or fall, the enjoyment of all Societies will ever depend upon the Fruits of the Earth and the Labour of the People; both which joined together are a more certain, a more inexhaustible and a more real Treasure than the Gold of Brazil or the Silver of Potosi. (Manderville, 1936, [2018])
Bernard Mandeville
The great art to make a nation happy, and what we call flourishing, consists in giving everybody an opportunity of being employed; which to compass, let a Government’s first care be to promote as great a variety of Manufactures, Arts and Handicrafts as human wit can invent; and the second to encourage Agriculture and Fishery in all their branches, that the whole Earth may be forced to exert itself as well as Man. It is from this Policy and not from the trifling regulations of Lavishness and Frugality that the greatness and felicity of Nations must be expected; for let the value of Gold and Silver rise or fall, the enjoyment of all Societies will ever depend upon the Fruits of the Earth and the Labour of the People; both which joined together are a more certain, a more inexhaustible and a more real Treasure than the Gold of Brazil or the Silver of Potosi. (Manderville, 1936, [2018])
In economic literature, this passage is regarded as the birthplace of the paradox of thrift. So why is it a paradox? It is a paradox because, in the long run, an individual’s total savings may decrease despite their initial intent to increase them if their actions trigger an economic downturn. As influential economist Paul Samuelson stated, “It is a paradox [thrift] because in kindergarten we are all taught that thrift is always a good thing” (quoted in Thrift, David Blankenhorn, 2011).
The workings of the paradox of thrift
An inevitable question that arises from reading the above is how one is supposed to know whether saving will paradoxically lead to a long-term decrease in one’s savings. In other words, how can I know whether saving will trap both myself and the economy in the paradox of thrift?
To solve that question, we must return to macroeconomic principles, revisiting the Aggregate Demand-Aggregate Supply model (AD-AS model). As a recap, the AD-AS model defines the equilibrium level of output (or GDP) in an economy. That is, the monetary value of goods and services produced in an economy over a given time period. In the context of the paradox of thrift, output or GDP are the variables that interest us to answer our question, because changes in GDP reflect the performance and wealth of an economy, which ultimately impact an individual’s ability to save. As stated in Principles of Macroeconomics 2e,
[...] aggregate demand [in Keynesian Analysis] is the sum of four components: consumption expenditure, investment expenditure, government spending, and spending on net exports (exports minus imports.). (Steven A. Greenlaw, Timothy Taylor, and David Shapiro, 2017)
Steven A. Greenlaw, Timothy Taylor, and David Shapiro
[...] aggregate demand [in Keynesian Analysis] is the sum of four components: consumption expenditure, investment expenditure, government spending, and spending on net exports (exports minus imports.). (Steven A. Greenlaw, Timothy Taylor, and David Shapiro, 2017)
On the other hand, aggregate supply is the total supply of goods and services produced domestically in an economy over a certain period of time. When combined, aggregate demand and aggregate supply are graphically represented as the AD-AS model to show the equilibrium output (Y*) and price level in an economy (P*), as shown in Figure 1. (For a deeper understanding of how the AD-AS model works, including the shapes of the curves and how equilibrium is determined, you can read our study guide “What is the AD-AS Model?”)
What truly interests us here is the aggregate demand curve, where savings or ‘thrift’ plays a role. Say that individuals lose confidence in the future of the economy because of a specific economic shock, such as a sudden increase in unemployment, a significant drop in stock market values, or a major geopolitical event. It is likely that individuals will be tempted to start saving to prepare for the potential negative consequences of such a shock. Therefore, consumption in the AD curve decreases, and with it, there is a downward shift in the AD curve (Figure 2).
In the short run, equilibrium output decreases from Y* to Y2, at a lower output level. While this proves that saving can indeed lead to a decrease in the output of the economy, we are yet to find out whether this will decrease an individual's savings in the long run and prove the paradox of thrift.
The book Macroeconomics for Dummies addresses this question, expanding on the AD-AS model explanation just introduced:
Let’s label the savings rate before the drop in confidence as s1 and the higher savings rate after the drop as s2. Since real GDP was initially at Y*, total national savings was then s1Y*. Then came the rise in the savings rate to s2. It lowered aggregate demand and real GDP to Y2. Hence, total savings after the shock is s2Y2. It follows that the rise in the savings rate will cause total savings to fall if s1Y* > s2Y2, that is, if s2 < s1(Y*/Y2). If, for example, the savings rate increases from 18 percent to 20 percent, while real GDP falls from $18 trillion to $16 trillion, total savings would drop from $3.24 trillion to $3.20 trillion. Yes, people are saving at a higher rate, but real GDP is the base to which that savings rate is applied. The higher savings has induced a recession that has so lowered that real GDP base that total savings declines even though everyone is trying to save more. (Dan Richards, Manzur Rashid, and Peter Antonioni, 2016)
Dan Richards, Manzur Rashid, and Peter Antonioni
Let’s label the savings rate before the drop in confidence as s1 and the higher savings rate after the drop as s2. Since real GDP was initially at Y*, total national savings was then s1Y*. Then came the rise in the savings rate to s2. It lowered aggregate demand and real GDP to Y2. Hence, total savings after the shock is s2Y2. It follows that the rise in the savings rate will cause total savings to fall if s1Y* > s2Y2, that is, if s2 < s1(Y*/Y2). If, for example, the savings rate increases from 18 percent to 20 percent, while real GDP falls from $18 trillion to $16 trillion, total savings would drop from $3.24 trillion to $3.20 trillion. Yes, people are saving at a higher rate, but real GDP is the base to which that savings rate is applied. The higher savings has induced a recession that has so lowered that real GDP base that total savings declines even though everyone is trying to save more. (Dan Richards, Manzur Rashid, and Peter Antonioni, 2016)
To recap, we can use the AD-AS model to not only determine the equilibrium output and price levels in an economy, but to dictate whether an increase in savings will lead to a decrease in savings in the long run.
There are other, more sophisticated, models which can be used to explain the paradox of thrift, including the Harrod-Domar model (see Alain de Janvry and Elisabeth Sadoulet's Development Economics, 2021) and the Investment-Savings model (you can read our study guide on the IS-lM model to find out more). These models are more rigorous given they are more forward-looking than the AD-AS model, and take into account a wider range of variables such as investment and interest rates to answer the question at hand. You can find interesting articles that expand on these concepts in the External Sources section of this article.
Real-life examples of the paradox of thrift
The paradox of thrift became especially relevant during the Great Depression in the 1930s. As individuals and businesses attempted to save more in response to economic uncertainty, overall consumption continued decreasing. This reduction in aggregate demand led to lower production, higher unemployment, and further declines in income, which in turn reduced overall savings. The initial intent to save more was only exacerbating the recession and prolonging the economic downturn of the Great Depression. In 2020, the Centre for Economic Policy Research (CEPR) published an article which proved that indeed, the paradox of thrift had become a reality during the Great Depression. In the article, there is a truly enlightening chart, clearly illustrating the negative correlation between savings and output during the Great Depression, broken down by various European countries and the United States.
The Great Depression was not the only instance where we can observe the paradox of thrift. Nearly 80 years after the Great Depression, in 2007, the Great Recession came about, sparked by a crisis in the housing market. The research conducted by E. Katarina Vermann from The Federal Bank of St. Louis shows how as savings increased between 2008 and 2009, GDP significantly dipped in the U.S.
Solutions to the paradox
So what is the solution to the paradox of thrift? In Intermediate Macroeconomics, one finds that Keynes, who played a major role in the development of the paradox of thrift, was an advocate of encouraging government spending (instead of saving), to address this paradox and revamp economic growth:
His monumental work, The General Theory of Employment, Interest, and Money, appeared in 1936. This book worked out a new framework to provide remedies for economies caught up in the global depression of the 1930s. His model did not explain the origins of the Great Depression but did argue that market economies had a general tendency to experience persistently low aggregate output and persistently high unemployment rates. He argued that these poor aggregate outcomes could be improved by active fiscal policy – specifically, increases in government expenditure and cuts in taxes in response to a recession. (Robert Barro, Angus Chu and Guido Cozzi, 2017)
Robert Barro, Angus Chu, and Guido Cozzi
His monumental work, The General Theory of Employment, Interest, and Money, appeared in 1936. This book worked out a new framework to provide remedies for economies caught up in the global depression of the 1930s. His model did not explain the origins of the Great Depression but did argue that market economies had a general tendency to experience persistently low aggregate output and persistently high unemployment rates. He argued that these poor aggregate outcomes could be improved by active fiscal policy – specifically, increases in government expenditure and cuts in taxes in response to a recession. (Robert Barro, Angus Chu and Guido Cozzi, 2017)
This is typically referred to as an expansionary fiscal policy, where the objective is to stimulate economies and bring them back to life by increasing government spending, cutting taxes, or both, to boost aggregate demand and drive economic growth.
Policies and initiatives to anticipate and avoid the paradox of thrift have become increasingly inventive over time. For example, during and after the COVID-19 pandemic, the effects of the paradox of thrift were creeping in, as explained in this article by the Central European Bank. In response, the UK implemented the Eat Out to Help Out scheme to financially support businesses in the hospitality sector and stimulate employment. This policy measure encouraged individuals to spend rather than save by offering meals at a 50% discount from Monday to Wednesday in August 2020. Overall, the scheme cost the UK government £840 million and covered 160 million meals during the month (BBC, 2023). Although opinions and evidence about the scheme's effectiveness are mixed (LSE, 2021), restaurant reservations from Monday to Wednesday increased by more than half in August 2020 compared to the previous August. Moreover, the Office for National Statistics (ONS) reported higher spending in restaurants on those days, suggesting the scheme successfully encouraged consumer spending (ONS, 2020).
Criticisms of the paradox of thrift
By this point, you might have several questions about the workings of the paradox of thrift. For example, what if you were saving to invest in a machine that aims to improve your productivity in the long run and will bring overall wealth to the nation? Or, what about other variables that affect aggregate demand, such as exports, imports, or investment? What role do these elements play? These are the same questions that influential economists have asked themselves throughout history, sparking interesting discussions, criticisms, and further developments in economic theory.
There are three main criticisms that arise when we look at the paradox of thrift which are explained in the book Economics Paradoxes (Bryson Bolin, 2014). Firstly, as previously mentioned, aggregate demand decreases as a result of increased saving which triggers a decrease in consumption. In this scenario, not only does the equilibrium output decrease (from Y* to Y2) but so does the price level of the economy (from P* to P2). Arguably, in the short run, these lower prices could incentivize individuals to reverse their saving intentions and spend more, given that the general price level is lower. If this happens, the conditions for the paradox of thrift — an increase in savings and a decrease in economic growth — do not necessarily hold.
The second criticism concerns the role played by a critical variable – investment. This is summarized by Bolin:
[...] savings represent loanable funds. These funds represent an increase in potential lending and investing by borrowers of the said savings. Among other things, this represents an increase in the supply of such loanable funds that will lower interest rates and stimulate borrowing. So a decline in consumer spending is offset by an increase in institutional (such as banks) lending and subsequent spending. This criticism is especially significant because the extreme degree of saving, that would obviously connect saving to hard times, is rare. The aforesaid "saving for a rainy day" is never considered paradoxical. Frantic saving, in the face of a feared recession, on the other hand, may be viewed as the situation that obviously attaches the word paradox to thrift. (2014)
Bryson Bolin
[...] savings represent loanable funds. These funds represent an increase in potential lending and investing by borrowers of the said savings. Among other things, this represents an increase in the supply of such loanable funds that will lower interest rates and stimulate borrowing. So a decline in consumer spending is offset by an increase in institutional (such as banks) lending and subsequent spending. This criticism is especially significant because the extreme degree of saving, that would obviously connect saving to hard times, is rare. The aforesaid "saving for a rainy day" is never considered paradoxical. Frantic saving, in the face of a feared recession, on the other hand, may be viewed as the situation that obviously attaches the word paradox to thrift. (2014)
In essence, savings are typically stored in banks, meaning they are loanable funds. Therefore, this means that companies will have more money available to borrow in times of high savings, and output will not necessarily decrease. Austrian economist Friedrick Von Hayek felt particularly strongly about this criticism, publishing “The ‘Paradox’ of Saving” (1929) where he explained his concerns with the paradox.
Lastly, the paradox assumes we have no international trade, and all transactions happen in a nation’s economy:
[... ]the paradox assumes a closed economy in which savings are not invested abroad (to fund exports of local production abroad). If participants in the closed economy are producing an ever greater amount than is being consumed, leading to increased savings, this can be offset by trading partners consuming a greater amount relative to their own production. (Bolin, 2014)
This is not a realistic assumption, given that we live in an increasingly globalized world, where international trade is a key player in any nation’s economy. Bolin explains that any economic growth losses made in a country due to increased savings can be potentially compensated by the volume of international trade in a country; a variable which the Paradox of Thrift fails to account for.
Closing thoughts
All in all, the paradox of thrift argues that while an individual's initial intent might be to increase their savings, if this intention is compounded across a community, economic growth and wealth will decrease, leading to paradoxically lower long-term savings for these individuals. This paradox can be explained like most economic questions: with economic models. More specifically, the AD-AS model serves as a good foundation for understanding the key economic levers involved in the paradox of thrift and their impact on the economy. More sophisticated models, such as the Harrod-Domar model, take a deeper look into some variables that might condition this paradox over time.
We have seen this paradox come to life in several situations, including the Great Depression in the 1930s and the Great Recession of 2007, which, according to Keynes, could be addressed by reversing the root cause and stimulating spending. While the Paradox of Thrift has proven to be a reality in several situations throughout economic history, there are several questions about its workings and validity. Most criticisms focus on the paradox’s failure to account for the plethora of variables influencing daily economic life. Understanding the Paradox of Thrift reminds us that individual actions can have compounded effects on the community around us, highlighting the delicate balance that needs to be struck between saving and spending essential for overall economic stability and growth.
Further reading on Perlego
Charles Crowson Fifty Economic Fallacies Exposed (2014) by Geoffrey E. Wood
Hayek vs Keynes: A Battle of Ideas (2017) by Thomas Hoerber
Whatever Happened to Thrift? Why Americans Don't Save and What to Do about It (2008) by Ronald T. Wilcox
External resources
Pettinger, T. (2018) Would an Increase in Savings Help the Economy? Economics Help. Available at: https://www.economicshelp.org/blog/7102/economics/would-an-increase-in-savings-help-the-economy/.
Singh, J. (2024) Concept of Paradox of Thrift (With Diagram). Economics Discussion. Available at: https://www.economicsdiscussion.net/income/concept-of-paradox-of-thrift-with-diagram-micro-economics/713
What is the paradox of thrift in simple terms?
Are there any real-life examples of the paradox of thrift in action?
What are some of the main criticisms of the paradox of thrift?
Bibliography
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Barro, R., Chu, A., and Cozzi, G. (2017) Intermediate Macroeconomics. Cengage Learning EMEA. Available at: https://www.perlego.com/book/2754592
Blankenhorn, D. (2011) Thrift: A Cyclopedia. Templeton Press. Available at: https://www.perlego.com/book/2740981
Bolin, B. (2014) Economics Paradoxes. White Word Publications. Available at: https://www.perlego.com/book/1241255
Cuffe, R. (2023) Eat Out to Help Out: What was the impact of the scheme? BBC News. Available at: https://www.bbc.co.uk/news/uk-67658106
de Janvry, A. and Sadoulet, E. (2021) Development Economics: Theory and Practice. Routledge. Available at:
https://www.perlego.com/book/2529794/development-economics-theory-and-practice
Eat Out to Help Out Scheme Had a Limited Effect on the UK's Restaurants and Cafes (2021) London School of Economics and Political Science. Available at: https://www.lse.ac.uk/News/Latest-news-from-LSE/2021/b-Feb-21/Eat-Out-to-Help-Out-scheme-had-a-limited-effect-on-the-UK%27s-restaurants-and-cafes#:~:text=The%20government's%20%E2%80%9CEat%20Out%20to,for%20Economic%20Performance%20(CEP)
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Keane, K. (2020) Impacts of Eat Out to Help Out on Consumer Prices: August 2020. Office of National Statistics. Available at: https://www.ons.gov.uk/economy/inflationandpriceindices/articles/priceseconomicanalysisquarterly/october2020#:~:text=Overview%20of%20Eat%20Out%20to%20Help%20Out,-As%20part%20of&text=Under%20the%20scheme%2C%20participating%20restaurants,50%25%20paid%20by%20the%20government.
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Richards, D., Rashid, M., and Antonioni, P. (2016) Macroeconomics For Dummies. For Dummies. Available at: https://www.perlego.com/book/998876
Vermann, E. K. (2012) Wait, Is Saving Good or Bad? The Paradox of Thrift. Federal Reserve Bank of St. Louis. Available at: https://www.stlouisfed.org/education/page-one-economics-classroom-edition/wait-is-saving-good-or-bad-the-paradox-of-thrift
MA, Management Science (University College London)
Inés Luque has a Masters degree in Management Science from University College London. During high school, she developed a strong interest in Economics, leading her to win the national Economics prize in her country of nationality, Spain. Her expertise is in the areas of microeconomics, game theory and design of incentives. Inés is passionate about the publishing industry and is currently working in the consulting department of the Financial Times in London.