Why You May Need to Spend if You Want to Save

By Abubakar Sadiq Ilyasu

Saving is often encouraged as a prudent way of preparing for future uncertainties. However, economies are driven by demand, a lesson the world had to learn the hard way after the calamitous effects of recessions caused by demand shocks, especially the Great Depression.

From one person’s perspective, saving seems like a harmless and judicious thing to do. But imagine a situation where a considerable number of people in the country are of a similar mindset and collectively have a very high propensity to save with a corresponding low propensity to consume. This fall in demand caused by lower consumption is heightened by the fact that a dollar change in aggregate demand will have a bigger impact on the economy than a dollar’s worth because of the flow of income from one person to another (Multiplier Effect). The end result is lower revenue for businesses, unemployment, and eventually, an economic crisis that forces them to spend whatever they have saved up, and in times of recession, this provident practice only makes things worse. By trying to save more, they end up saving less, a paradox known in economics as “The Paradox of Thrift”.

The paradox of thrift is a classic example of the Fallacy of Composition; the false belief that because something holds true for a part, it must hold true for the whole. For example, if one student in a classroom is blonde, all the other students must be blonde. Just because saving is good from one person’s point of view, the same view held by the collective can have catastrophic repercussions. The closely related Paradox of Deleveraging asserts that when people try to lower their debts by saving more, they end up garnering more debt as this similarly causes a fall in aggregate demand and eventually an economic downturn or even recession.

The paradox of thrift, like most economic concepts, is a polarizing topic. Some have described the paradox as a destructive misconception. They explain that unless people save their money at home, bank savings are reinjected into the economy as investment and this will make up for the loss in aggregate demand. They also stipulate that the globalization of economies means that lower domestic demand is countered by the exportation of local produce to other countries.

Others argue for the presence of a paradox of thrift, especially in the wake of the 2008 global recession and earlier financial crises in China, Germany, and Japan, which they attribute to the paradox. They explained that these financial crises were preceded by increased personal savings in these countries.

Indeed, throughout time, recessions have been associated with higher savings. In the period leading up to the Great Recession, there was a trend of more young adults in their mid to late twenties resorting to living with their parents in an effort to save money otherwise spent on other necessities like rent and utilities. Ultimately, the crash of the real estate sector bubble played a crucial role in the recession. Also, during the recession, personal savings skyrocketed from 2.9 percent to 5.0 percent due to uncertainty, but this evidently only served to make matters worse. These events have strengthened the case for the existence of the paradox of thrift.

It is always interesting to examine how our personal financial decisions affect the macroeconomic landscape. In a time like this when the global economy seems to be heading towards a steep recession, decisions we ordinarily think of as sagacious may be sending us further down the rabbit hole. If we are to go by the principles of the paradox of thrift, the austere financial decisions we’ve been making to help us navigate these difficult times will only worsen our situation.

Nevertheless, while these practices may be detrimental to the economy, it is not fair to place the burden of reviving an economy or attribute its woes solely on the common man. It is always the government’s responsibility to lead the charge by stimulating demand through expansionary fiscal and monetary policies during these times. History has shown that recessions have only festered when governments remain dormant in the midst of economic turmoil.

Abubakar Sadiq Ilyasu, 08055668874.