Paradox of thrift: Why a high savings rate is bad for the economy?


Let me ask you three questions.

  • Question 1: Do you have high savings?
  • Question 2: Do you save at the expense of putting off critical purchases?
  • Question 3: Do you think that is good for the economy?

Well if the answer to the questions is yes, yes and yes, then you might find this piece very interesting.

High savings rate-001

In the 1940’s John Maynard Keynes pulled the world attention to a theory that had been around since biblical times. The theory states that

“The paradox is, narrowly speaking, that total savings may fall even when individual savings attempt to rise, and, broadly speaking, that increase in savings may be harmful to an economy.”

The first reference to this theory came from the The Fable of the Bees: or, Private Vices, Publick Benefits (1714) by Bernard Mandeville, the title itself hinting at the paradox, and Keynes citing the passage:

As this prudent economy, which some people call Saving, is in private families the most certain method to increase an estate, so some imagine that, whether a country be barren or fruitful, the same method if generally pursued (which they think practicable) will have the same effect upon a whole nation, and that, for example, the English might be much richer than they are, if they would be as frugal as some of their neighbors. This, I think, is an error. (Source: Wikipedia)

Now how is that possible one might wonder? But to Keynesian economists the answer is very simple. In an ideal scenario total income would be equal to total expenses and the savings would match the investments. So in other words total savings would equal investments.

This equation holds everything in balance with all other factors being normal.

Total Income: Total expenses = Total Investments: Total Savings

In other words If the savings is increased then the equilibrium shifts against investments at a lower value, which finally affects the total income leading to a weakening of the economy.

So that is the theoretical logic, let me try to explain with an example.

In the 70’s and 80’s, Japan was at the forefront of world economy winning the war. From electronics to Automobiles the Japanese brands could do no wrong. Soon Japanese brands like Toyota and Sony were household names across the world. Japanese management practices were being copied and there were many best sellers on the rise of Japan. Hollywood also made some very funny anti-Japanese movies.

But then in 1990’s the Japanese juggernaut stalled. Sales and exports declined and Japanese economy went into recession, a recession that lasted almost a decade. The reason for the recession was that Japanese being very cautious on the economy curtailed spending. As the exports were falling, the Japanese consumers increased the saving rate, to brace themselves for the tight days ahead. This led to lesser spending in the local economy and further loss of business for the local Japanese establishments. So now not only the exporters were facing loss of sales but also the local businesses were losing business. This led to further recession something that lasted for more than a decade.

India faced a similar challenge during the peak of the 2008 recession. Luckily for us domestic demand picked up at the right time and bailed India out of the jaws of the recession.

Are savings good? The answer is yes, but as excess of anything is bad, the same holds true for savings.

It is best to view expenditure as investments and invest in local businesses as that would drive the economy and help sustain growth.

  1. Anonymous says

    This article is completely misses the point.
    The problem we have is because we DO NOT have free money. There is something called CENTRAL BANK that dictates interest rates and money supply.
    With interest rates and money supply un-dictated, the free market would find its interest rate. When there is more saving it would push interest rates down for financial institutions, which would discourage savings and encourages people to take more risk (well justified since the economy would have the capital to sustain any possible losses). In contrast, when savings diminishes, interests rate would rise to encourage people to save.

    If we had free money there won't be such thing as "too much savings", since the free market would balance itself from time to time.

    SAVINGS ARE ESSENTIAL FOR THE SURVIVAL AND GROWTH OF AN ECONOMY! Let say just for you as an individual, if you want to take on a project (say you want to open a business or some sort), you will need your savings to fund your project. For an economy as a whole, the same applies. SOMEONE must save and have capital for ANOTHER to borrow.

    In today's world, we have this monster called CENTRAL BANK that continuously PRINT MONEY to fund borrowing, which is extremely unhealthy for the economy, as it will continuously drives prices up until your money does not worth the paper it's not printed on.

    The problem is Japan is also in Central Banking, not in its saving rate. The Japanese people continuously, diligently save only for the Japanese government to bailout its buddy zombie banks (sounds familiar?). The whole reason the Japanese people did not get strike by both inflation and depression (which is what Amerika is experiencing), but actually a deflationary depressions is because of all the savings. IF the Japanese government did not bailout the zombie banks and let the economy tank, and allow the private capables to take over the incapables, they would have long got out of their lost decades.

  2. Dr Vikram says

    Hi Altaf

    That is a difficult one to answer, it depends how you classify expenditure? Would you call investment in a gym membership as an expenditure? If yes then yes it is difficult to have a 70% expense. According to theory the ratio is income:expense= investment:savings.

    Hope that helps..

  3. Altaf Rahman says

    Dr. Vikram,
    I dont want to argue your theory of 30% savings (well!! I agree that its proposed and time tested by enlightened people)
    I am just curious to know how it works in the below mentioned cases.
    1) A person with a family of 4 (couple and 2 kids) earns about lets say 50K in a Tier 2 or 3 city. As per your theory I can understand that he should save max 15K and the rest 35K is spent on house rent, car emi, kid’s schooling, medical expenses, visits to relatives marriages (with a gift envelops etc) and many other expenses which Indians identify themselves with.
    2) A successful businessman in his early 30s who inherited his family business which is getting him somewhere around a crore (10 mil. rs) per anum. Do you really mean to say that he should spend about 70 lakhs (7 mil. rs)? I can at the most assume that, that person in case 2 may buy a car, change furniture in home, etc. Also once you buy a car, that takes care of next 5 yrs. Next year what you will do with your 70% spending?

    What I feel is that once your income reaches the levels of your expenses, you are no more borrowing. Once income crosses your expense, you grow surplus.As the income increases, the savings grows exponentially. Becasue the person can not suddenly aquire new expenditure to be in the 70% spending limits.

    Just my two paisa :)

  4. Dr Vikram says

    Hi Faiz

    I agree as the Indian government is not providing citizens with a social security net, it is important to save. But I thinks a 30 % saving rate is good anything above that can create a overall depression of the local economy. Now again this is a theory that can be proven mathematically not just some guesswork. But your point is taken and savings rate is critical.

  5. Faiz Uddin says

    Why Indians save has a lot to with the economic climate of our country. Government policies in India offer no protection, fall back in case of lay offs during recessionary periods. Secondly, the Government has no significant healthcare policy. To make matters worse, the Government taxes healthcare just the way it would a normal business. As diligent tax paying citizens, we do not enjoy the benefits of social welfare. Lastly, with a combination of public and private corruption and a sustained gloomy global economic environment warrants a healthy saving in wake of downturns and lay offs. This is akin to prehistoric man – during uncertain climatic changes, winters, the hunter would ensure a sufficient supply of food is stored away to tide over uncertain times. Can't blame or reverse hundereds and thousands of years of genetic wiring…

  6. Faiz Uddin says

    Why Indians save has a lot to with the economic climate of our country. Government policies in India offer no protection, fall back in case of lay offs during recessionary periods. Secondly, the Government has no significant healthcare policy. To make matters worse, the Government taxes healthcare just the way it would a normal business. As diligent tax paying citizens, we do not enjoy the benefits of social welfare. Lastly, with a combination of public and private corruption and a sustained gloomy global economic environment warrants a healthy saving in wake of downturns and lay offs. This is akin to prehistoric man – during uncertain climatic changes, winters, the hunter would ensure a sufficient supply of food is stored away to tide over uncertain times. Can't blame or reverse hundereds and thousands of years of genetic wiring…

  7. Dr Vikram says

    Hi Altaf

    I love your comments, and look forward to them. I just thought you should know the back ground. Looking forward to more of your comments on my articles.



  8. Altaf Rahman says

    Dr. Vikram,
    I always read all your articles with keen interest and hold you in high regard. Your articles on Marketing are in general knowledgeable for Marketing students.
    I always try to put my view in the form of comment in all your articles.
    I being a layman in terms of marketing am thinking a more orthodox way.
    Please do not consider my comment as a expert statement. I just put forward my point thats all.
    I am not a man to contest what is said by Mr. Keynes (in fact I am such a layman that I never heard of him before). I am sure his principles worked fo rmany countries.
    What made me comment like above is the title of the article which immediately made me react that way. Even now I am wondering how More savings is bad :)
    But it gives me a pleasure to put up my comment and interact with esteemed people like you through the media of
    Cheers :)

  9. Dr Vikram says

    Hi Altaf

    You have surely brought out some very important facts. I agree that boycotting American junk is very good for the Indian local businesses, but I am sure our desi Samosas and Vadas are equally unhealthy as a doctor I can certify that.

    I think the Indian government has led the way by rejecting American war aircraft I think the rest of the country can do the same, in all products.

  10. Dr Vikram says

    Hi Altaf

    The theory was put forward by John Maynard Keynes, an English economist in the 1930’s. His theories were put to use by many governments during the great depression to pull them out of trouble. He is not American if that was your concern on culture.
    More on him can be found here

    This economic theory can be proven using mathematics, a very basic formula is what I have used in the article, more advanced calculations are available.

    But on a emotional level I agree with your argument and it is probably right. You are also correct on the other macro economic findings.

  11. Altaf Rahman says

    Now coming to why the Japanese model failed, let me explain it this way.
    When a nation saves very high, that gets converted to industrial growth. But the trick for Japan in 70 remained that their consumers remained outside Japan.
    What I am saying is that Japs saved, put up industries with saved money, and they sold to outside Japan. This helped them grow. It encouraged more savings.
    Now what happened in 90s has nothing to with Japs savings. They remained intact but with stiff compitition from Taiwan and Korea, their consumers had more choice and exports suffered / their profits from exports suffered. So from the assets Japs created, the return was less than before.
    Recession also played its part but its not the main part.

    The reason why I am stressing this subject is now that the US has fully exploited its citizens of their money (by encouraging them to spend more regardless of their income) now it has turned its eyes on other nations.

    It wants to promote its products in other countries and asks those govts to allow their people to stop worrying about their savings and spend on US products.

    The very first products that US want to push into any country that opens up to Open market is KFC, Pizza Hut, Pepsi, Coke, Mc Donalds and an army of other junk foods. Everybody knows that Junk food is bad for health. But what people can do when their own govts allow US to push the products to India and stupid public figures like Akshay Kumar promotes them?
    Then the next phase comes. US creates tension between two neighboring countries and sells its war machinary to both for its own “Industrial growth”.
    At the same time it discourages other nations to push their products in its own country. The “Anti dumping duties” on forign products once the price of them becomes less than local products is one of the measures taken “in the interest of the nation” They discourage Indian Software industry by levying taxes on companies dealing with Indian IT cos, denying or increasing fee for visas etc is another form of “protecting intersts of US”
    If the other countries do the same thing, it is portrayed as lacking good spirit, against global economy etc.

    The final target is ” Promote US products in other countries” while discourage forign products (only if you can not do with out). They keep swearing at cheap Chinese products destroying US factories but can not put a ban on them coz they cant live without cheap chines products.

    Just my another two paisa :)

  12. Altaf Rahman says

    I generally dont agree with “High savings is bad for economy”.
    I want to go in this subject step by step.
    Phase 1 :
    We as individuals will all agree that we have incomes, we have expenditure and the difference is savings. Some people have less income and more expense and they remain poor. Some people have more income and less expense and they get richer. There are other kind of people who have less income and more expense but they borrow not only to survive but to live lavish lives and still grow in stature, power, like the US government.
    Our goals are :
    Increase our earnings (what ever the case of you being a salaried employee or a businessman or public official)
    Control expenditure (by following the concept of spend on what you need and not on what you want)
    The effect of both the above excersize is increase in savings.

    Phase 2 :
    Now that you saved, your next goal is to protect your saving / increase the asset value of your saving / continue to convert your savings to assets.

    Phase 3 :
    Now as individuals keep increasing the savings, now its the turn of the government to put the savings to productive / constructive use. Most governments have soverign funds like the Singapore, Japan, Taiwan govts, Gulf Arab govts etc, who invest their surplus in other countries. Some gulf Arab countries even plan to grow their investments so large that even after the oil is gone, they plan to maintain their standard of living on the returns on these investments.

    Now coming to the argument of “More savings is bad”, I feel that this theory is put forward by a new nation, without culture, without traditoin, without time tested meathods of living. Nobody gets prizes for guessing who it might be.
    The then Fed Chief Greenspan put forward the theory that even though peoiple dont have purchasing power, give them loans, so that they can buy and by buying, they are helping the industrial growth and the growth of the nation. So US as a nation grow on borrowings to fire their industrial growth.
    They borrow today with the promise of returning the money in next 10 or 20 years (meaning next generation). What they are doing is they borrow from outside US with the promise that their kids (the next generation) will pay back. This is going on for generations. Now if US stop this monkey business and start repaying, it takes their next 20 generations to repay what their forefathers have borrowed.
    They become so used to borrow that they feel that savings is something from out of the world thing. Its very bad.
    Borrowing in itself is not bad if you want to feed your kids not bad if you want to borrow to take your kid to a hospital or to school.
    But it is bad to borrow to change your car every year, to shop for indulgence, to travel, to pay for scams by govt officals etc.

    Just my two paisa :)

  13. Dr Vikram says

    Well said and well put. Optimization is the key. Investing in local brands and local businesses is the key to a sustainable economy.

  14. Stock tips intraday says

    The short answer is, if you squander what you save, you will end up with very little. A country that has an extremely high capital accumulation rate, but extremely inefficient use of capital, will not grow any quicker (or more sustainably) than a country with a relatively low savings rate but extremely efficient use of the capital it does save (or attracts from others, given its productive returns). It’s worth noting that Japan, another country with an extremely high savings rate, also encountered this problem. The precise dynamics may be different, but persistent surplus imbalances can be just as harmful to an economy as persistent deficit imbalances. Subsidizing overproduction and subsidizing overconsumption are both economically wasteful.

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