Everyone knows we are in the midst of a financial crisis. Our investment portfolios are down, unemployment is over 7%, and the headlines are filled with doom and gloom. I have spoken to many clients who are living in absolute fear and panic. Some have lost their jobs, some have taken pay cuts, and others are cinching their belts and pinching their pennies just in case. It is a very rational response, but is it the best response?
John Maynard Keynes was one of the most influential macro-economists of the 20th century. An advocate for government intervention as a means of managing the economy, many of the principals he pioneered are guiding the US government's attempts to lessen the severity our situation.
Of fascination to me is a principal he called "the paradox of thrift". Here is how it works. Let's say you have a white collar job with a large financial institution. You decide that with the declining markets and the financial uncertainty we now face, that you should avoid unnecessary spending and increase your savings. You eat more meals and home instead of dining out. You stop buying new clothes to replace your still good, but not the latest fashion, wardrobe. You decide your spring break will be a good opportunity to spend family time renting DVD's and playing board games rather than going to the beach. As a result, since everyone is thinking like you do, the local restaurant sees a drop in income and eventually closes. The textile factory and the airlines lay off workers. All three businesses were clients of your firm. Now their business is down. Soon your boss calls a meeting and tells you the "good news". She was required to cut 20% from the budget. Instead of eliminating positions she has decided that everyone needs to take a 20% pay cut. You thought you were being wise and frugal, but ultimately your income dropped by more than you saved by cutting your spending. Now things are tighter than they were at the beginning of the cycle. You need to cut spending even more. The economy has entered a downward spiral.
So what should you do? I am not advocating ridiculous spending, but instead look at this as an opportunity for the right kind of spending. Is there a home improvement project you would like to do? If you find a contractor who is slower than normal, maybe they would be willing to do the job at a slight discount. Simply put, the economy depends on us to spend some of our money. If we don't, in the long run we may only be hurting ourselves.
I fear that many of the lost jobs and wage reductions have not occurred out of need, but rather out of fear. I suspect that in some cases businesses are using the economic environment as a justification to cut budgets. Just in case. Unfortunately when everyone responds with the same prudence, it becomes a self fulfilling prophecy.
That is why Keynesian economists call for increased government spending in times like this. In theory, the government's spending can replace the diminished spending of both business and consumers to break the chain caused by the paradox of thrift and provide a base from which the economy can grow again. Once the fear has subsided and normal spending increases, the economy should grow on its own.
I wish I studied more economics as an undergraduate, but I never thought I would ever witness this kind of macroeconomic theory in play out in real life. Soon we will discover how smart Keynes really was.
What others are saying:
- Are you making the recession worse?
- Obama's shout-out to John Maynard Keynes
- John Maynard Keynes: The Abridged Version
- What J.M. Keynes Should Have Said
- Bad news, and the paradox of thrift
- Is Saving Bad? The Paradox of Thrift Says Yes
John Maynard Keynes image from Wikipedia under free license
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