A refutation attempt on the paradox of thrift

Economics Economics Questions
1

It’s not perfect. I put this on another forum hoping that it would gather some eyes. It just doesn’t seem solid enough to me. What do you think?

Keynesians want people to spend all of their money. So, you can either spend or invest. And your investment will act as savings.

So this means that there would be no loans. But this just isn’t right, companies take out loans. Why? They want to invest in future production off of perceived future gains. They increase productive capacity sooner spurred on by this profit motive.

But what happens when no one is saving money? Well, you don’t exactly loan money. There is nothing to lend. So if you’re not lending money, then you aren’t increasing production as soon as you can. Increases in production beget other increases in production (because production creates its own demand, and demand can entice expansions in production).

So in the end, you’re basically cutting production over time. But Keynesians have a way around this: a central bank system.

But what does this mean? The bank gives out loans of newly printed money. This means inflation. So while you are waiting for future gains in production, you are paying people with this newly devalued money. It’s really like they got a cut in wages. So, I guess there is no way around this issue of getting capital investment only via deferred present consumption.

But here’s the problem, people themselves aren’t deciding how their time preferences, the central bank is. The cut in real wages that they get is proportional to the amount that the central bank is printing in new bills. So what happens if they are printing more than people would be willing to save? First of all, you have inflation, prices rise, and those investments may not pay off. People then realize that they have less than they thought. How will they react? They will spend like people who are making lower wages previously, by buying less. The price system forces them too. Investments don’t pay off and you get a lot of bankruptcies and failures.

A general overproduction is a bad thing, right? Business failures after making all of these investments are bad things too, right?

This is why the typical response of the populace to a downturn is what we should have. We need more savings so that we can base loans on savings so that we don’t overproduce, by the mechanism I explained before. Also, businesses need to fail. The wages that people thought they had are actually lower, which means that a correction needs to occur. You need mobility for a good correction that will result in efficiency. Measures such as unemployment benefits and welfare impede mobility which prevents a good efficiency.

I guess I should add a little more detail about why this overproduction is possible. Afterall, production is supposed to create its own demand, right? Well, to an extent. Only desirable production creates its own demand. When companies are expanding, do they take into account this response to a decline in real wages? Remember, this cut in wages is really across the board. So demand drops across the board. So the demand that investors were expecting may never come.

Basically, the increased production may not be that desirable, which means that Say’s Law may not really be applicable here.

Sorry about the multiple posts, but I just realized that the last post almost sounded like deflationary spiral. Well, you have to allow for some complication. Remember that not all companies were taking out these loans, and that not all companies will see a fall in demand. It is from these companies that are still successful that we will see rising wages. This will mean more demand from these companies that are producing. This means eventually we will get back to normal.

What do you think?

2

I touched on the paradox of thrift in one of my articles on Mises Daily (“Paul Krugman and the Consumption Myth”). The major weakness of thrift, as Keynes sees it, is that savings disallows the payment of wages. I think one of the major problems of Keynesians, and I notice this a lot when I read Stiglitz, is their consolidation of “aggregate demand” under “consumption”. Savings, or money invested, is still spent on wages and on goods, but instead of consumed they are invested in order to create even more capital, or wealth. So, Keynes’ fear of lost wages is simply unwarranted.

Most of Keynes writing is interconnected. A Keynesian would prob. respond by pointing to Keynes’ theory on interest, where he did not recognize money held as affecting the rate of interest. But, what entrepreneurs are interested in is not the money per sé, but the capital-goods they can buy with that money. The prices of capital-goods would simply adjust to the amount of money in circulation.

3

is the so-called paradox of thrift a disingenuous doctine anyway?? a deliberate lie iow??

4

There’s a fundamental difference between an increased savings rate (the demand for future goods) and an elevated demand for cash holdings. The former reduces the aggregate demand for finals goods and services (present goods) but lowers interest rates and elongates the structure of production, which, in turn, lowers costs per unit at each successive stage of production (the natural rate falls, and the market rate follows). Essentially, output prices fall faster than input prices (costs). There’s (a) a reallocation of production towards intermediate goods which lowers marginal costs, (b) a lower interest rate, and (c) a lower employment of the original means of production at each stage (all of which lowers costs).

The latter, on the other hand, forces individuals to sell off bonds/assets and/or individuals may also limit consumption and increase sales in order to satiate their demand for cash. Both conditions will elevate the market rate of interest above the natural rate, constrict the structure of production, and output prices will fall faster than input prices (bad deflation). It is my belief that Keynes mistakenly conflated both condition one (actual increase in savings) and condition two (an elevated demand for cash holdings); that is, he focused solely on what Hayek called the “secondary phenomena,” and ignored the effects of a malformed capital structure, brought about by credit-expansion, which needs to be re-aligned (the first part of the cycle–the boom).

Essentially Keynes had no capital theory and this lead to torrential confusion and the introduction of the most spurious concepts ever conceived of by any economist: (1) the acceleration principle (that there is no short-run trade-off between consumption and investment), and (2) that investment is not sensitive to interest rates, that is, that interest rates can fall to zero during recessions and that this will not stimulate investment.

(1) Is easily refuted by simple logic; inflation cannot replace real savings for capital investment, since the printing press cannot make steel, coal, oil, ect fall from the sky. Investments, that can be completed (without drawing resources away from other more warranted productions), require actual resources, that is, a society must differ consumption in order to increase the capital stock (paper money and fiduciary media don’t have magical powers). If savings is required for investment then you cannot, by definition, increase consumption and investment simultaneously. (2) is just an assertion that doesn’t pass the laughing test. We’ve seen, time and time again, the effects of low interest rates on investment in capital goods and long-term durable goods (housing bubble, for example).

Thus, the “paradox of thrift” is just a spurious concept put forth by a very confused economist.

5

this Murphy article was part of the reading this week in the Mises academy class:

6

Even if people want cash rather then savings as mentioned above and this will reduce the amount of trade that take place which will lower the increase in material wealth.

Well then you have to ask why do people want cash? All values can’t be measured by economistis … having high liquidiy does however clearly create some kind of utility for people or they wouldn’t be hoarding money. There is some kind of insecurity imposed in there lives and having high liquidy makes them feel safer and create a better material situation for them if they are actually affected by said insecurity.

Forcing people to spend the money by creating inflation will decrease there utility. The real solution to this problem would be to get rid of the insecurity, however unless we where the cause of it in the first place that isn’t likley to be possible.

Real investments should end up as spending too though. You just buy capital goods instead of consumer goods when you invest your money.

Keynsian theory seems to have it’s falliacies in focusing completley on aggregates in the short run.

Sure we can have a massive GDP the year that everyone just go out and consume all they own. But we are doing is eating our factors of production as capital is one of them. Basically we take all our future consumption and move it to this year and sure it will look great in the aggregated figures but then we will starve to death.

Another problem with drawing any conclusions from aggregates at all is of course that distortions are accumulated as well. We can put all our labour and capital into making 2inch nails and it will look very good in the aggregated production figures … until the free market is allowed to adjust the price of 2inch nails…

7

“Even if people want cash rather then savings as mentioned above and this will reduce the amount of trade that take place which will lower the increase in material wealth.”

The “material wealth” will decrease when capital is consumed, i.e., no longer maintained, abandoned, etc.. . Only an increase in time preference, under the given institutional circumstances, can lower the “material wealth”. Just the act of people increasing [or decreasing] their cash balances says nothing about their change in time preference. Prices adjust so that the purchasing power of the money unit can increase or decrease. No final reduction in amount of trade needs to result. If it did then the “paradox of thrift” would be not so incorrect.

8

In aggregates like national net-worth it doesn’t make a difference if people are trading. This is only further proof why such aggregates are usless. My utility and everyone else do however increase when we trade and get things we want for things we don’t won’t even if there is zero production going on. So the velocity of money does play a role in generating wealth.

Yeah, if you simply burn some money it makes no difference, except to redistribute some wealth among everyone else with money and distort some indicatiors for entreprenours.

But horaring is differnt. If everyone go out at once and start buying stuff again but only bid with a fraction of the money availiable what you say will happen but that is not really what is going on. People are actually refraining from current consumption while preparing themselves for expected unpredictable needs in the near future. So actual demand for materal goods is down too and less trade will take place.

This is just the market reacting to people not knowing exactly what they will need, it takes a “pause” while everyone figure out what has happened and what they actually need to demand and produce. When you look at it this way it should be clear what complete insanity it is force spending in a situation like this. Instead of entreprenurs trying to figure out why no one is buying there stuff and what is actually needed business will just keep producing the wrong stuff.

Also I don’t think anything like this is very likley to happen in a free modern economy. Usually this hoarding would be triggered by government policy. But there could be external factors like war, natural disasters, technological revolution, blockaded foreing trade or whateva. In any case busniess needs to get the wake-up call that something major has changed rather then just being able to keep selling the same stuff because there is inflation and no one want money.

So in the short run hoarding should actually reduce production and trade. But only the aggregates and it is a vital and importaint signal that the products that make up that aggregate are the wrong ones and need to be replaced for something different cause something major has changed in the economy.

Except of cause if it just the government meddling creating the illusion that something is changing. But the remedy to that is obviously not more government meddling like Keynes suggest.

As far as proper saving goes it is much easier to debunk the argument. If everyone start living on a bare minimum and invest everything they make all that will happen is that spending will shift from consumer goods to capital goods (in particular technology and knowledge). The increase in production capability due to technological advances in a society where everyone live in the future so to speak would be quite extrodinary.

9

“distort some indicatiors for entreprenours.”

This is not distortion. This is a change in real conditions. People are buying less and selling more in their attempt to acquire more money.

These changes are the result of changes in preferences and not artificial tampering with interest rates via money supply. Entrepreneurs exist on the account that there is change. Any change!. Goodness, that’s why you have speculators!

It is nonsensical to refer to real changes as “distortions”. The market is a continueously changing process.

10

Did you really read the full sentece? I said if some is just burning money…

Burning enough dollars to have an effect on the economy is something only government would do in the first place. Even if it is done my some madman it will reak total havoc on the economy and make all price indicators more less usless (distorted) for the time being. The information the free market provides is never perfect, it is always slightly distorted by changing conditions but if nothing really crazy is going usually not so much that it really matters for the economy as a whole.

11

Suppose the commodity money of the day is firewood.

12

“Suppose the commodity money of the day is firewood.”

To take a common example of this from reality go with cigarettes instead. However I think it is fair to say that quality of information about real conditions a cigarett-money based economy is capabale of providing is quite poor in comparison to for instance a gold-money based one.

13

Isn’t there a need for a higher degree of specificity in the data for the case of an increased demand for cash holdings? Based on the savings rate remaining constant, won’t the economic structure settle back towards an ERE position where there is a uniform savings/consumption rate? And so, isn’t the result an economy much the same as before, but with less money?

Thus the question is what will happen in the interim. It seems to me that in order to say, as Esuric did, that an increased demand for money impels a change in which temporarily input prices fall faster than those of the output, one must assume more than an increased demand for cash. Consider the following 3 scenarios:

  1. During this period from 1 state to the next, the additions to cash balances come more so from consumption. (An intermediate increase in overall savings rate)
  2. The additions come more so from savings. (An intermediate decrease in overall savings rate.)
  3. The additions tend to be balanced so that the savings rate remains constant throughout the whole period of adjustment.

Isn’t it true that only case #2 unambiguously results in what Esuric described? My point is that 1 of these cases must be postulated as the nature of the datum in question and thus it is not true that an increased demand for money necessarily results in “bad” deflation.

14

dsimo04: "Isn’t it true that only case #2 unambiguously results in what Esuric described? "

#1 implies an increase in demand for cash associated also with a decrease in time preference

#2 implies an increase in demand for cash associated also with an increase in time preference

#3 implies an increase in demand for cash without any change in time preference.

None of the above should result in what Ensuric described since he refers to a temporary market rate of interest higher then the natural rate.

All 3 above are changes reflecting real changes in preferences of market actors with respect to their cash holdings, and time preference, as in the cases of #1 and #2. I believe Ensuric is conflating cash induced changes that result from a contraction of the money supply with cash induced changes that result from an increase in demand for money. The first can indeed cause a temporary rate that is higher then the natural rate, for it is basically just the reverse process of artificial credit expansion, which temporarily depresses the rate below the natural rate. The latter reflects a real change preference. If interests rate rise or fall it is the result of conditions #1, #2, but those are real and not temporary changes in time preference.

15

Sorry, I don’t understand your refutation, however I wrote another refutation of the paradox of thrift which can be viewed here and I thought you might be interested.