Earn What You Spend

The paradox of thrift is a phrase that, having traded economics classes for philosophy as an undergrad, I just recently learned.  But it is the exact explanation for the downward cycle of consumer spending we are in. 

Last week, Paul Krugman wrote an excellent article outlining much of what we have been discussing here in the past few posts: consumer spending is falling, right at a time when the country needs it to stay stable. Krugman notes that it looks like we are about to see a “a very big change in consumer behavior. And it couldn’t have come at a worse time.”  

Think back to the graph of GDP with and without consumer spending in the last post - consumer spending, comprising two-thirds of our economy, has been a critical element in helping us avoid a recession for the past few years.   But it has been financed through debt that eventually has to be repaid. 

Krugman continues:

It’s true that American consumers have long been living beyond their means. In the mid-1980s Americans saved about 10 percent of their income. Lately, however, the savings rate has generally been below 2 percent — sometimes it has even been negative — and consumer debt has risen to 98 percent of G.D.P., twice its level a quarter-century ago…

Sooner or later, then, consumers were going to have to pull in their belts. But the timing of the new sobriety is deeply unfortunate…

The point is that if consumers cut their spending, and nothing else takes the place of that spending, the economy will slide into a recession, reducing everyone’s income.

So we’re back to what we’ve talked about before — an unfortunate cycle in which consumers, having lived beyond their means, pull back their spending.  This leads to a reduction in GDP, which takes us back full circle. 

It’s the Paradox of Thrift:

The point is that if consumers cut their spending, and nothing else takes the place of that spending, the economy will slide into a recession, reducing everyone’s income.

We’ve spent more than we’ve earned, and need to pull back our spending habits.  But here is the catch: doing what we need to do has real-world, negative consequences!  

Krugman advocates a fiscal stimulus, but one that “would take the form of actual government spending rather than rebate checks that consumers probably wouldn’t spend.”  It’s a way to help break this cycle. 

Tyler Cowen disagrees, noting that he is “more inclined to think that consumers need to cut their spending now.  It is widely understood that consumers have been living beyond their means.”  

We are undergoing a massive adjustment right now, one that needs to take place.  The intersection of economic theory and reality usually surrounds the price we pay for such adjustments.  Will they be easy?  Painful?  The paradox of thrift shows that with the appropriate fiscal policy response, sometimes consumer spending can adjust to a new level painlessly.

But sometimes these adjustments aren’t very pretty, especially when we’re undoing decades of living beyond our means.