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9.9 Keynes’s Paradox of Thrift Revisited

It is instructive to compare the Austrians’ treatment of increased saving and

consequent market adjustments with Keynes’s treatment of these issues. There

are two important differences. First, pre-empting any extended analysis of

changes in saving preferences was Keynes’s judgement that such changes are

unlikely to occur. Second, any increase in thriftiness, should such a preference

change actually occur, would in his reckoning have perverse consequences

for the economy.

Saving, in Keynes’s theory, is a residual. It’s what’s left over after people

do their consumption spending, which itself is dependent only (or predominantly)

upon incomes. In the Keynesian framework, the rate of interest has no

effect (or only a negligible effect) on saving behaviour. Hence an extended

analysis of a change in saving preferences was largely uncalled for. Keynes’s

analysis of the interest rate is carried out in terms of the supply and demand

for money (that is, cash balances) and not in terms of the supply and demand

for loanable funds. And to the extent that Keynes did deal with loanable

funds – or, more pointedly, investment funds – his focus was on the other side

of the loanable funds market. The demand for investment funds, in his view,

is subject to dramatic shifts owing to the uncertainties inherent in investment

decisions. A comparison of Keynesian and Austrian theories of the business

cycles, the Keynesian theory featuring a collapse in investment demand, will

be the subject of section 9.11.

Keynes’s judgement that saving behaviour is not subject to change was

accompanied by some degree of relief that this was the case. He argued that

an increase in saving would send the economy into recession. This is Keynes’s

celebrated ‘paradox of thrift’. If people try to save more out of a given

income, they will find themselves saving no more than before but saving that

unchanged amount out of a reduced income. That is, in their effort to increase

their saving rate, S/Y, by increasing the numerator of that ratio, they set a

market process in motion that increases the saving rate by reducing the ratio’s

denominator. What is the essence of this market process that produces results

so different from those envisioned by the Austrians? In summary terms, the

Austrian story about derived demand and time discount becomes, in Keynesian

translation, a story about derived demand alone.

The market adjustments envisioned by Keynes can be revealingly depicted

as an alternative sequence to the one shown in Figure 9.8. In Figure 9.9 the

same initial conditions of full employment are assumed. But in the spirit of

Keynes, the loanable funds market is drawn with relatively inelastic saving

and investment schedules. The initial saving schedule is labelled S(Y0) to

indicate that people are saving out of an initial level of income of Y0. As in the

Austrian story, we show an increase in thriftiness by a rightward shift of the

Figure 9.9 A saving-induced recession

S, I

ieq

Interest

rate

Investment

C

Stages of production I

S (Y0)

S = I

=S (Y1)

S(Y0)

supply of loanable funds – from S(Y0) to S(Y0). And, as before, there is

downward pressure on the interest rate. But in the Keynesian story, the

market process that might otherwise restore an equilibrium relationship between

saving and investment is cut short by a dominating income effect.

More saving means less consumption spending. And less consumption spending

means lower incomes for those who sell these consumer goods. It also

means reduced demand for the inputs with which to produce the consumables,

that is, a reduced demand in factor markets, generally.

The economy spirals downward as spending and incomes fall in multiple

rounds. With reduced incomes, saving is also reduced. As the process plays

itself out, the saving schedule shifts leftward from S(Y0) to S(Y1), where Y1 <

Y0. The negative income effect fully offsets the positive increased-thrift effect.

Both saving and investment are the same as before the preference change. But

with reduced consumer spending and no change – and certainly no increase –

The Austrian school 503

in investment spending, the economy has fallen inside the production possibilities

frontier. (In Figure 9.9 the upward-sloping line that intersects the frontier

suggests that the level of consumption in the thrift-depressed economy is lower

than it would have been had intertemporal coordination somehow been achieved

without the lapse from full employment. The parameters of this upward-sloping

‘demand constraint’ will be identified in section 9.11.)

The Hayekian triangle changes in size but not in shape. Note that even if

Keynes were to allow for the allocation of resources within the capital structure

to be achieved by changes in the interest rate, no thrift-induced reallocation

would take place – since (abstracting from possible changes in liquidity

preferences, which would only compound the perversities) the interest rate

does not change.

To isolate the consequences of increased thriftiness, it is assumed that

investment spending does not change at all. But, of course, if the recessionary

conditions dampen profit expectations in the business community, investment

spending will actually fall, exacerbating the problems caused by the increased

thriftiness.

The paradoxical – and perverse – consequences of an increase in thriftiness

are seen by Keynes as the unavoidable outcome of the market process.

In his own words, ‘Every such attempt to save more by reducing consumption

will so affect incomes that the attempt necessarily defeats itself’ (Keynes,

1936, p. 84). The economy simply cannot move along its production possibilities

frontier, and savers who push in that direction will cause the economy

to sink into recession. Keynes’s paradox of thrift stands as a summary denial

that a market economy has the capability of achieving and maintaining an

intertemporal equilibrium in the face of changing saving preferences. Relative

change in resource allocations within the capital structure are no part of

the story. Again, the wholesale neglect of all such structural changes is what

Hayek (1931) had in mind when he remarked that ‘Mr. Keynes’s aggregates

conceal the most fundamental mechanisms of change’.