Page last updated at 15:09 GMT, Monday, 24 November 2008

The paradox of thrift

By Steve Schifferes
Economics reporter, BBC News

Sale and stock liquidation signs in a shop window
Retail sales fell for a second month in a row

Should we save or should we spend?

It's gloomy out there. The economy is shrinking, property values are falling and stock markets are in the doldrums.

Many people borrowed heavily during the boom, and now are tempted to pay off debt or save more for a rainy day - something which until now has not characterised the behaviour of UK consumers.

But if this happens, will the government's plan to boost the economy through greater spending work?

Paradox of thrift

Because thrift may be a virtue for the individual, but could damage the economy as a whole, according to the economist John Maynard Keynes, writing in the midst of the Great Depression in the 1930s.

He called it the paradox of thrift. The more people saved, the more they reduced effective demand, thus further slowing the economy.

This was one reason, he pointed out, that a recession can become self-reinforcing.

Keynes also argued that, faced with slowing demand, businesses would not necessarily use the extra savings available in the economy to invest.

In the Keynesian theory, as the slump in demand cascaded through the economy, the resulting slowdown would mean that everyone had less income - ultimately reducing the absolute amount of savings, even if people increase the proportion of their income they put aside.

As unemployment grew, investment would fall, whatever the level of savings.

Government help needed

Sales signs on the High Street
The government has slashed interest rates in a bid to boost spending

But how can we persuade the reluctant consumer to spend, and the reluctant businessman to invest?

Keynes' answer was that it was only the government that could overcome the collective paradox: what was good for the individual would weaken the economy.

This is now the theory being embraced by the chancellor, who has abandoned his fiscal rules for the time being in order to pour money back into the economy.

And cuts in interest rates by the Bank of England are also designed to encourage businesses to continue to invest.

But this is not very effective, because credit markets are in deep freeze. As a result, it is even more important to inject cash into the economy - at least according to Mervyn King, the governor of the Bank of England.

Spectre of deflation

There is another reason why the government wants to give a jolt to the economy now.

It is the fear that prices will actually start to fall as the slowdown gets going.

And deflation - falling prices - would certainly reinforce the paradox of thrift.

If consumers expect prices to drop further in the future, then they have an even stronger incentive to delay their purchases until later, when they can benefit from lower prices.

Deflation, especially in asset prices like houses, can be very long-lasting and hugely damaging to the economy, as recent experience in Japan suggests.

So one reason the government may want to temporarily cut VAT now is to convince people that prices are going to go up later, thus encouraging them to spend.

Rational expectations

Will these measures work?

One reason Keynesian explanations of the economy fell out of favour in the last few decades was the rise of a new economic theory - rational expectations.

This argued that people were aware that any government borrowing would have to be paid back later. As a result they adjust their expectations accordingly, and do not spend as much as predicted.

Since this time, the government will be signalling its intentions to claw back the money it spends in future budgets, perhaps we will all save more to cover our future loss of income.

This theory may well apply to the financial markets, which are making the price of UK debt more expensive on the grounds it is likely to expand dramatically.

But the psychology of individuals may be different.

In the first place, some people may not be able save much whatever their expectations. Money that goes to pensioners surviving on the state pension, for example, may go straight into spending.

And some psychological research suggests that people do not "discount" very effectively in the long term.

So we may be under-estimating the attractiveness of spending even in the midst of a recession.

This, at least, has to be the government's hope as it embarks on its most audacious economic U-turn since Labour came to office in 1997.

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