Paradox of Thrift

If we are not at the beginning of GDII, and I certainly hope not, then we may still be facing a very long recovery period.  As stated in today’s WSJ, in an article discussing strategies being taken at home:

…families hope their new found frugality will see them through the economic downturn. But this same thriftiness, embraced by families across the U.S., is also a major reason the downturn may not soon end. Americans, fresh off a decades long buying spree, are finally saving more and spending less — just as the economy needs their dollars the most.

Usually, frugality is good for individuals and for the economy. Savings serve as a reservoir of capital that can be used to finance investment, which helps raise a nation’s standard of living. But in a recession, increased saving — or its flip side, decreased spending — can exacerbate the economy’s woes. It’s what economists call the “paradox of thrift.”

This is goes back to Krugman’s point: if families cannot stimulate the economy via spending, if tax cuts will not (the Bush rebate stimulus last June did nothing to stimulate spending, it increased saving), if loosened monetary policy will not lead to increased lending, then we need governmental spending, and quickly.  The WSJ article continues,

As savings increase, economists say, spending is likely to contract further. They expect gross domestic product to decline at an annualized rate of at least 5% in the fourth quarter, the biggest drop in a quarter-century.

“The idea that the American family will quickly spend us out of this recession is a fantasy. It won’t happen,” said Elizabeth Warren, a professor of law at Harvard University who last month was named chair of the Congressional oversight panel tasked with overseeing the distribution of the government’s Troubled Asset Relief Program funds.

Along with prolonging the recovery, this increased savings will add to deflationary pressures which, as discussed in prior posts, also prolong recovery, creating a vicious cycle that are extremely difficult to break.  Japan still has not recovered from it’s initial deflationary period in the early 1990s.

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