The paradox of thrift is an economic principle that states that households in an attempt to save more end up contracting national income and not saving at all. When individuals save more, they do so with the intention to increase their consumption probabilities in the future. However, if society saves more, it has the tendency to reduce future consumption and welfare.
Classical economists argued that saving was a virtue and that more saving leads to lower interest rates, more investment and faster growth without taking into account other factors underlying this mechanism. Under-consumption was a major economic drawback in French economies during the 16th and 17th centuries and Bartholomew Laffemas, a neo-classical mercantilist, published The Treasures and Riches to put the state in splendor in 1598, in which he advocated for higher consumer expenditure to boost production because the miser caused the poor to die in distress. This principle is of much essence in the Ghanaian economy today with the presence of huge fiscal incentives in the form of tax cuts. Relatively, there is now less pressure on company profits, personal incomes, dividends among others. The onus now lies in the hands of individuals and firms to spend MORE to boost production in the domestic economy. Contracting household expenditure and investment expenditure from firms in the presence of tax cuts slows economic growth.
You may have heard several times on the radio, television and other mediums about the importance of saving to an individual and a nation. By saving, the general idea is that we are able to put some money down today in order to better our economic conditions tomorrow. But then, is that all there is about saving? Does saving more today necessarily mean we will be better off tomorrow? The answer is of course a big NO and the paradox of thrift explains why.
The paradox of thrift arises because higher aggregate saving leads to lower aggregate demand. Lower aggregate demand in effect is a disincentive to production and investment, in that, it leads to a fall in prices as aggregate supply exceeds aggregate demand. Firms cut down on their supply of goods and services, leading to lower wages and higher unemployment as workers are laid off.
Hence, the adverse MULTIPLIER effect of lower consumption and increased saving are lower wages and higher unemployment which further leads to another cycle of lower aggregate household incomes, lower purchasing power and consumption – households become worse off. This phenomenon is what is termed as the paradox of thrift. By increasing savings today in order to benefit in the future we end up losing our jobs and going home with lower wages.
Household consumption is the most important component of National Income. Hence, any undue volatility in household expenditure has the tendency to adversely affect National income. The paradox of thrift does not only affect economies but individuals as well. A foreknowledge of this principle will enable us maximize our economic welfare as individuals. I have had several experiences with this economic principle way back in school. During school days on campus KNUST, several attempts to save money for one or two things ended me not saving at all and more miserable than I could imaging. Usually when I receive money from the house I will try to squeeze my expenditure in order to save by trying to consume relatively “cheaper” diets. I will prefer to eat kenkey and fish or Gob33 (Gari & beans) which cost me around GHS3 than to eat either indomie or fried rice which cost GHC6 to GHC7 in the hope of saving. The later diets were more favorable to my health than the former ones and what happened to me most of the time when I chose to eat relatively cheaper diets was that I almost always ended up vomiting and having a running stomach the following day. I would miss lectures for a couple of days and ultimately end up spending my ‘saved’ money and even more on drugs – running me down at serious deficits.
Upon having this experience for several times I advised myself and stopped thinking about saving for anything. Have you had a similar experience before? Have you ever preferred a “cheaper” transport to a more expensive one in the hope of being frugal only to be delayed several hours? That was the paradox of thrift at work.
What we need to do as individuals is to be able to distinguish between saving and investment. I’m not an advocate of savings at all. Savings is simply putting money down today for future use (consumption). Saving does not attract any significant interest margins, as such, it follows the usual ‘hand-to-mouth’ cycle that traps many in poverty. I would rather invest than to save. In that, the former implies putting your money into productive ventures so as to earn extra income (interest, dividend etc.).
There is a popular mantra that says individuals should save 5% to 10% of their monthly incomes. In this era of hyperinflation, you can put your 10% income in a money box or a savings account only for its real value to be wiped out by inflation. Think about this, would you put GHC10 (10% of your income) in a savings account only for it to be wiped out by inflation or you will INVEST that into your head by buying a productive book to read and grow? Furthermore, would you save GHC 100 only to spend it on food when you go broke four weeks later or you will use it to attend an international wealth creation seminar happening today?
The best investment you can make is that which is in yourself. What we should be concerned about as individuals is creating a consistent income flow and not a stagnant income “barrel”. Have you seen how firms and corporations operate? Do they take their profits and hide them somewhere for tomorrow? No, they are always re-investing their profits into the business so they can grow bigger. Choose to re-invest your extra income in productive ventures and grow bigger from today!
Author: E.O. Essien is an Economics graduate from KNUST and currently at the Associate Level studying as a Chartered Financial Economics with the Association of Certified Chartered Economics(ACCE). EMAIL:email@example.com (0240080104).