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Paradox Of Thrift Essay About Myself

. . . for public choice problems addressing long run fiscal issues.

I think that to understand the Sumner/Rawls view you have to remember that both are assuming that the economy is always operating at full employment. Rawls doesn’t specifically say anything about this, but it’s the only way to make his viewpoint make sense. Sumner writes extensively about business-cycle issues, however. One of his main themes is that a competent central bank can always guarantee full employment and that it always should guarantee full employment in part because the full employment macroeconomy of steady national GDP growth is one in which all these nifty neoclassical ideas actually work. So the way the story goes is that the people thrown out of work when you switch from consuming to saving will be reemployed in the production of capital goods. We all become thriftier, stop dining out so much and start cooking at home, and all those unemployment cashiers and waitresses get jobs building houses and manufacturing tractors. Thus society’s stock of capital goods does in fact increase through a big shift toward a higher savings rate.

I absolutely do not assume the economy is at full employment when advocating consumption taxes.  And “financial saving” is a meaningless term, so I won’t comment on that.  Saving is saving; it is defined in all the textbooks as the funds that go into investment. (You are free to have your own definition.) There are actually three errors embedded in the Roth/Yglesias critique:

1.  There is no paradox of thrift, so saving doesn’t cause higher unemployment. Oddly, the most common error on this topic is exactly the opposite; most people think high saving/CA surplus economies steal jobs from low saving economies, a view that is equally wrong.  Periods of higher than normal unemployment are caused by either NGDP shocks (bad monetary policy) or bad supply-side policies (think France/Italy/Spain.)

2.  OK, most old-style Keynesians don’t agree with me on the paradox of thrift, but today even old-style Keynesians accept the natural rate hypothesis, which says than demand doesn’t affect the long run average level of output, just the volatility. So even if higher saving did cause high unemployment, it would have no bearing on long run decisions over what sort of tax regime to implement, which affect the level of saving, not the volatility.

3.  Now let’s say I’m wrong about both the paradox of thrift and the natural rate hypothesis.  Suppose that we are permanently at the zero bound and the central bank is too conservative to push unemployment all the way down to the natural rate, but instead targets an unemployment rate that is 2% above normal.  (Put aside the question of why wages and prices don’t eventually adjust. Let’s suppose there is some sort of “hysteresis” that keeps the unemployment rate fluctuating around a trend line 2% above normal.)  In other words, I’ll take the most extreme Keynesian assumption I can think of.  What then?  Even in that case a consumption tax is optimal.  Even if we are not at full employment.  That’s because what matters is not the level of saving but rather changes in the share of GDP that is saved.  And in the long run those net out to zero.

The day we start making long run optimal tax regime decisions based on their implications for the business cycle is the day we become a banana republic.

Much better are Yglesias’s comments on the difficulty of distinguishing between consumption and investment.  Of course to some extent those problems are just as severe for an income tax (think 3 martini lunches, corporate jets, etc.)  FWIW, I’m actually pretty progressive on those questions.  I favor treating education as investment (no VAT) and business lunches and corporate jets as consumption.)  BTW, when proposing egalitarian income redistribution programs, do progressives allow the perfect to be the enemy of the good?  Obviously not, and I salute them for that attitude.

[The original version had a typo of consumption instead of investment for education]

I should comment on one of Roth’s statements:

I do agree that beliefs about what is “morally grotesque” make it impossible for economists to “embrace an aggregate economic reality of which they are fully cognizant,” which is why I ignore all progressive analysis of income inequality.

More seriously, it’s not so much that I have moralistic beliefs about how people should behave, but rather how they should be treated by the state.  I believe that people should not have to pay a higher tax rate simply because they prefer future consumption to current consumption.

PS.  For you new readers, Yglesias was stretching the truth a bit when he said I favored having the central bank “guarantee” full employment.  I favor NGDP targeting, which would (hopefully) minimize sub-optimal employment fluctuations.

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Exhibit 1. Economic growth became norm only after industrial revolution

Looking further back in history, however, we can see that economic stagnation due to a lack of borrowers was much closer to the norm for thousands of years before the industrial revolution in the 1760s. As shown in Exhibit 1, economic growth had been negligible for centuries before that. There were probably many who tried to save during this period of essentially zero growth, because human beings have always been worried about an uncertain future. Preparing for old age and the proverbial rainy day is an ingrained aspect of human nature. But if it is only human to save, the centuries-long economic stagnation prior to the industrial revolution must have been due to a lack of borrowers.

For the private sector to be borrowing money, it must have a clean balance sheet and promising investment opportunities. After all, private-sector businesses will not borrow unless they are sure they can pay back the debt with interest. But with little or no technological innovation before the industrial revolution, which was essentially a technological revolution, there were few investment projects capable of paying for themselves. Businesses also tend to minimize debt when they see no investment opportunities because the probability of facing bankruptcy is reduced drastically if the firm carries no debt. Given the dearth of investment opportunities prior to the industrial revolution, it is easy to understand why there were so few willing borrowers. Because of this absence of worthwhile investment opportunities, the more people tried to save, the more the economy shrank. The result was a permanent paradox of thrift in which people tried to save but their very actions and intentions kept the national economy in a depressed state. This state of affairs lasted for centuries in both the East and the West.

Powerful rulers sometimes borrowed the funds saved by the private sector and used them to build social infrastructure or monuments. On those occasions, the vicious cycle of the paradox of thrift was suspended because the government injected the saved funds (the initial savings of $100 in the example above) back into the income stream, generating rapid economic growth. But unless the project paid for itself – and politicians are seldom good at selecting investment projects that pay for themselves – the government would at some point get cold feet in the face of a mounting debt load and discontinue its investment. The whole economy would then fall back into the paradox of thrift and stagnate. Consequently, many of these regimes did not last as long as the monuments they created.

Countries also tried to achieve economic growth by expanding their territories, i.e., by acquiring more land, which was the key factor of production in pre-industrial agricultural societies. Indeed, people believed for centuries that territorial expansion was essential for economic growth. This drive for prosperity was the economic rationale for colonialism and imperialism. But both were basically a zero-sum proposition for the global economy as a whole and also resulted in countless wars and deaths.

Richard Koo

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