The "paradox of thrift" holds that if everyone attempts to save more at the same time, the total amount of savings will actually decrease. Because in saving more, we spend less. That means the national income falls because as "one family spends less, other families earn less and respond by cutting their own consumption." Thus the more we save, the poorer we get.
But, in the final analysis, there is another paradox–the paradox of optimism–that we should be more concerned about as we navigate our way through the economic thicket.
The Post Partisan
After 9/11, George Bush infamously told us all to relax and spend as much money as possible. While Barack Obama was fond of mocking Bush’s one-dimensional directive on the campaign trail, even Obama knows that Bush’s statement was based on at least one kernel of wisdom–that ours is a consumer-driven economy and that, without that fundamental drive, it all breaks down.
Spending and borrowing at the grass roots level is what enables not only Wall Street to prosper, but the entire global economic network. It’s not how much you make that determines your contribution to the economy, but how much you spend. When consumer spending significantly subsides, economies grind to a halt.
That’s why the plummeting unemployment numbers are so frightening. Because if people aren’t working, they’re not going to spend. The meltdown has already taken 3.6 million American jobs. But on a global scale, that number could reach 50 million by the end of 2009. That means that people are spending a lot less. To the extent we have any money to spare, the tendency these days is to stash and save it.
According to the "paradox of thrift," however, saving our money only worsens the situation. The paradox holds that if everyone attempts to save more at the same time, the total amount of savings will actually decrease. Because in saving more, we spend less. That means the national income falls because as "one family spends less, other families earn less and respond by cutting their own consumption." Thus the more we save, the poorer we get.
Still, it’s hard not to acknowledge that it is the failure to save that got us into this economic quagmire. Since the rise of Ronald Reagan, Americans have been borrowing more and more, and saving less and less. The Hoover Institution reports that annual saving rate hovered close to 10 percent between 1970 and the mid-1980s. But it began a steady decline during the 1990s. Between 1999 and 2004, the savings rate averaged around 2 percent. In an ominous sign, in 2005, for the first time since the Great Depression, Americans’ personal savings rate dipped into negative territory at minus 0.5 percent, meaning that Americans not only spent all of their after-tax income in 2005 but had to dip into previous savings or increase borrowing. The savings rate had been negative for an entire year only twice before — in 1932 and 1933 — when the country was coping with the Great Depression, including massive corporate failures and job losses. In contrast to those gloomy years, however, in 2005 the Dow was humming at around 11,000. That was a huge red flag.
Meanwhile, Americans have been borrowing at astronomical levels. Credit card, automobile, mortgage, and other forms of personal debt stood 8 trillion in 2000. Today it’s more than 14 trillion! On the housing end, with depressed housing prices and no savings, the result, according to one study, will be 5,000 foreclosures a day. Government was our debtor role model. When President Bush began his first term the national debt was $5.7 trillion. Today it’s $10.6 trillion, and climbing.
As MSNBC reported in January of 2006,
One major reason that consumers felt confident in spending all of their disposable incomes and dipping into savings last year was that a booming housing market made them feel more wealthy. As their home prices surged at double-digit rates, that created what economists call a "wealth effect" that supported greater spending.
Time Magazine put together a rogue gallery of 25 people (including the likes of Dick Fuld and Bill Clinton) in an article entitled "25 people to blame for the economic mess we’re in." But, in the final analysis, it’s not so much people who are to blame. Rather, it was one simple belief that turned out be wrong: that, despite all the historical evidence to the contrary, real estate values would continue to rise.
Many people peddled that belief. Some more than others. Like David Lereah, the former chief economist for the National Association of Realtors (NAR). During the housing boom, Lereah, 55, was one of the most visible and vocal servers of the Koolaid. In 2005, when home prices were hitting record highs, Lereah was jet-setting around the country making television appearances, flying first class and staying in luxury resorts. He tirelessly promoted his Panglossian book "Are you missing the real estate boom?" and continued to make optimistic statements even when it was all but a certainty that the market was going to crumble. In January 2007, for example, Lereah famously stated, "It appears we have established a bottom." Bloggers nicknamed him "Baghdad Dave" after Iraqi information minister, Mohammed al-Sahaf or "Baghdad Bob," who was well-known for his pro-Iraq press conferences when the U.S. first invaded Iraq. Lereah now says he was encouraged by the NAR execs to issue rosy forecasts but then was left holding the bag when things turned sour. But even Lereah admits, "I never thought it would be as bad as this."
Few did. With Indymac’s shares sinking, and with Wall Street betting big on the company’s downfall, CEO Michael Perry told the world "I am here to tell you that I believe we have turned a corner and that our business is improving." A few months later, the government seized the failing bank. As Bank of America navigated through dire straits, CEO Ken Lewis insisted in Spring 2008 that his company would maintain its cash dividend payments. To those who were saying that BofA had to cut dividends in order to stay afloat in hard times, Lewis said "We’ve reminded them that the market over the short term is not always right." Ultimately, Lewis cut the dividend by half on October 6 saying that these "were the most difficult times for financial institutions that I have experienced in my 39 yeas of banking." And, of course, there’s Lehman CEO Dick Fuld who, as Lehman teetered on the brink and with the help of virgin CFO Erin Callan’s pretty fronts, continued to paint a rosy picture of the company far beyond the point of no return. And the list goes on.
Now, however, the cold reality of a sustained economic downturn is finally settling in. Real estate is falling. But so many other things–clothing, food, rents– seem to be rising uncontrollably as businesses try to make ends meet.
While commentators often cite to the "paradox of thrift" and the need for spending, the truth is that the paradox applies only when economic conditions are bad and when there is no other effective stimulus to spend. Because when the economy is operating near or at full employment, there is a rise in investment, which offsets any decrease in consumption from people saving some of their money. Saving, under these circumstances, can actually boost productivity, spurring faster national income growth in the long term. In other words, the paradox of thrift only applies in the short-term.
Lack of consumer spending is therefore not the problem per se. It’s the lack of confidence, and of optimism. In the end, perhaps that is the paradox to which we all should be devoting more time and thought–the paradox of optimism. Because just as brimming optimism has enabled this country to be the greatest on earth, it also has the potential to sow the seeds of our demise.
The Post Partisan