# Paradox of Thrift: How Savings Can Affect Economic Growth

![Paradox of Thrift: An economic theory that personal savings are a net drag on the economy during a recession.](https://www.investopedia.com/thmb/8ajmXVmGI3A4qcfzAIoRx63eAd0=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/paradox-of-thrift.asp-final-a9fea24edf0e4c3f8f7ff25c576f52d9.png)

*— Investopedia / Julie Bang*

## What Is the Paradox of Thrift?

The paradox of thrift, introduced by John Maynard Keynes, suggests that while saving is typically wise for individuals, it can negatively impact the economy during a [recession](https://www.investopedia.com/terms/r/recession.asp). This theory explains that individual savings reduce total spending, leading to decreased production, employment, and further economic downturn. Understanding this contradiction helps clarify why increased savings during a downturn may exacerbate the situation instead of improving it.  

### Key Takeaways

*   The paradox of thrift argues that increased personal savings during a recession can harm overall economic growth by reducing spending.
*   John Maynard Keynes popularized this economic theory, suggesting that lowering interest rates could boost spending.
*   Critics point out that the theory neglects Say's law and the role of capital goods, as well as potential inflation or deflation effects.
*   Historical examples of the paradox are seen during the Great Recession and the 2008 financial crisis, where increased savings led to reduced economic demand.
*   The paradox suggests that while individual savings are prudent, they can contribute to a broader economic downturn if widespread.

## How the Paradox of Thrift Affects Economic Growth

The proper response to an economic recession is more spending, more risk-taking, and fewer savings, according to [Keynesian theory](https://www.investopedia.com/terms/k/keynesianeconomics.asp). Keynesians believe that a recessed economy doesn't produce at full capacity because some of its factors of production such as land, labor, and capital are unemployed.

Keynesians also argue that consumption or spending drives economic growth. It's the wrong prescription for the larger economy even though it makes sense for individuals and households to reduce consumption during tough times.

> **Fast Fact**
>
> A pullback in aggregate consumer spending might force businesses to produce even less, deepening the recession. This disconnect between individual and group rationality is the basis of the savings paradox.

During the [Great Recession](https://www.investopedia.com/terms/g/great-recession.asp) following the [2008 financial crisis](https://www.investopedia.com/articles/economics/09/financial-crisis-review.asp), the average American household's savings rate rose from 2.9% to 5%. The [Federal Reserve](https://www.investopedia.com/terms/f/federalreservesystem.asp) cut interest rates to encourage spending in the economy.

Bernard Mandeville may have first described the paradox of thrift in his 1714 work, "The Fable of the Bees." Mandeville argued for increased expenditure rather than savings as the key to prosperity. Keynes credited Mandeville for the concept in his book "The General Theory of Employment, Interest, and Money" in 1936.

## The Circular Flow Model and Its Role in the Paradox of Thrift

Keynes helped revive the [circular flow model](https://www.investopedia.com/terms/circular-flow-of-income.asp) of the economy. This theory states that an increase in current spending drives future spending. Current spending results in more income for current producers that rationally deploy their new income, sometimes expanding business and hiring new workers. These new workers earn new income that can then be spent.

Keynes advocated for lower interest rates to reduce savings and increase spending. If low interest rates didn't spur borrowing and spending, Keynes suggested government deficit spending to fill the gap.

## Criticisms and Limitations of the Paradox of Thrift

The circular flow model overlooks [Say's law](https://www.investopedia.com/terms/s/says-law.asp), which asserts that goods need to be produced before being exchanged. Capital machinery boosts production levels and requires more savings and investment. The model is applicable only in a system without capital goods.

The theory also ignores the potential for [inflation](https://www.investopedia.com/terms/i/inflation.asp) or [deflation](https://www.investopedia.com/terms/d/deflation.asp). Future production and employment will remain unchanged if higher current spending causes future prices to rise concordantly. If thrift during a recession lowers future prices, production and employment might not decline as Keynes predicted.

> **Important**
>
> The paradox of thrift ignores the potential for saved income to be lent out by banks. Interest rates tend to fall and banks make additional loans when some individuals increase their savings.

 Keynes countered these objections, arguing that Say's law was incorrect and that prices are too rigid to adjust quickly. Economists still debate the concept of sticky prices. Many believe Keynes misrepresented Say's law in his argument.

## Examples Illustrating the Paradox of Thrift

Ivan owns a factory that produces parts for computers. The factory is among town XYZ's biggest employers. They've been planning to expand their production capacity by installing more machines and hiring new workers.

But a recession strikes and Ivan reverts to savings mode. The factory [lays off](https://www.investopedia.com/terms/l/layoff.asp) workers and discontinues operating the machines at night. Unemployed factory workers who don't have income to spend also begin saving, reducing [demand](https://www.investopedia.com/terms/d/demand.asp) for goods produced by Ivan's factory. The unemployed factory workers also add to the town's overall spending on social benefits and its economy becomes weak.

A real-world example of the savings paradox involves 25- to 29-year-olds moving in with their parents during the Great Recession. Their percentage rose from 14% in 2005 to 19% in 2011. The move helped families save money on rent and other expenses but it caused estimated damages to the economy of as much as $25 billion per year.

## What Was the Savings Rate During the COVID-19 Pandemic?

The personal savings rate increased to almost 30% in 2020. U.S. households held about $2.3 trillion in savings in that year. Those figures began plunging by the end of 2021.

## Who Is Credited With Say's Law?

Say's Law is attributed to John Baptiste Say, a French economist. “It is worthwhile to remark that a product is no sooner created than it, from that instant, affords a market for other products to the full extent of its own value," said Say in 1803.

## What Is a Recession?

A recession is said by some to occur when an economy has suffered two consecutive quarters of falling gross domestic product (GDP). But this isn't an official definition because there are no quantifiable terms of a recession on record.

The National Bureau of Economic Research puts it this way: A recession is “a significant decline in economic activity that is spread across the economy and that lasts more than a few months."

## The Bottom Line

The paradox of thrift, popularized by economist John Maynard Keynes, suggests that while personal savings are prudent for individuals, they can harm the broader economy during a recession by reducing overall spending.

Keynesian theory advocates lowering interest rates to encourage spending as a remedy. Critics point out that it overlooks inflation and other economic dynamics, such as Say's law and capital investment needs. Understanding both the theory and its limitations helps individuals navigate economic challenges while aligning savings with personal financial goals.

> **Article Sources**
>
> 1.  Britannica Money. "[The Paradox of Thrift: Understanding Economic Behavior in Recessions](https://www.britannica.com/money/paradox-of-thrift)."
>     
> 2.  Economic Research Federal Reserve Bank of St. Louis. "[Wait, Is Savings Good or Bad? The Paradox of Thrift](https://research.stlouisfed.org/publications/page1-econ/2012/05/01/wait-is-saving-good-or-bad-the-paradox-of-thrift/)."
>     
> 3.  Board of Governors of the Federal Reserve System. "[Excess Savings During the COVID-19 Pandemic](https://www.federalreserve.gov/econres/notes/feds-notes/excess-savings-during-the-covid-19-pandemic-20221021.html)."
>     
> 4.  Economicshelp.org. "[Say's Law](https://www.economicshelp.org/blog/glossary/says-law/)."
>     
> 5.  The White House. "[How Do Economists Determine Whether the Economy Is in a Recession?](https://www.whitehouse.gov/cea/written-materials/2022/07/21/how-do-economists-determine-whether-the-economy-is-in-a-recession/)"