The Paradox of Thrift is alive and kicking like crazy
In many parts of the developed world, governments are busy concentrating their minds on cutting budget deficits and debt-to-GDP ratios. It started in the so-called PIIGS countries (Portugal, Ireland, Italy, Greece and Spain), but has spread to several other European countries.
The most recent and acute example is the UK, where chancellor of the exchequer George Osborne revealed swingeing plans to cut government departments’ budgets last week.
On the face of it, this is good stuff; it is becoming obvious that the previous Labour administration left the UK’s finances in a truly parlous state. Like most incumbent governments facing a general election, Labour embarked upon something of a spending spree in the months leading up to the election in May.
But questions are now being asked about the severity of the proposed cuts. In some departments, cuts of up 40% will occur. The only possible outcome from such action will be the wholesale loss of jobs in the public sector. Many in the private sector view the public sector as being a bloated bureaucracy and that job cuts are a necessary evil in reducing waste, and hence the budget deficit.
However, if one takes this argument to its logical conclusion, it becomes apparent that individuals in both the private and public sectors will become far more prudent in their savings and spending habits. Wary of losing their jobs, people will be less inclined to spend and will instead save, even at the pathetically low rates of interest currently being offered by banks and other financial institutions. Traditionally, this savings pool would be transformed into investment, but if demand is perceived as being weak for years to come, investors will have to be extremely long-sighted or stupid to invest heavily now.
This type of behaviour was encapsulated by John Maynard Keynes in his General Theory in the 1930s in the wake of the Great Depression as the “Paradox of Thrift”. Basically, this states that what may well be good for an individual is not necessarily good for the greater economy.
By saving for the proverbial rainy day and thus “under-consuming”, individuals are effectively denying jobs to many of their peers. The Paradox of Thrift, like an economic “black hole”, eventually consumes itself by causing a recession or even a depression.
Investec CEO Stephen Koseff neatly summed things up at a recent pre-close briefing to analysts when he said, “The people to whom we want to lend don’t want to borrow and the people who do want to borrow are not credit-worthy”. Only when these dynamics change and people across the social spectrum are willing and able to borrow to spend will consumption (and by definition economic growth) start improving again.
It will be truly instructive to observe how George Osborne’s strategy plays out. In March, Bank of England governor Mervyn King remarked that the required spending cuts to be made after the May general election were so severe the governing party would be so unpopular that they would be kept out of office for a generation (usually reckoned to be 30 years).
Whoever won the election would have been faced with the same problems; only the length and severity of the remedies were in question. Osborne’s cuts are so severe he has a good chance of reducing the budget deficit by half within a two- to three-year timeframe. People will stop spending, through fear and higher indirect taxes and there is a good chance the economy will shrink during that time. And this is a five-year fixed-term parliament, as agreed to by the Conservative and the Liberal Democrats when they formed their coalition. So the coalition partners must be hoping the economy can turn around sharply in the two years between 2013 and the next election in 2015.
This is a huge gamble. It requires that consumers change their savings habits in a relatively short time and begin spending again from around 2013 onwards. It also assumes the coalition remains intact and the Lib Dems don’t defect en masse in reaction to the impact of budget cuts.
As the late former Labour prime minister Harold Wilson said in 1964: “A week is a long time in politics”. Five years is an awful lot longer.