Wednesday, July 8, 2009

The Data Do NOT Show the Paradox of Thrift

. Wednesday, July 8, 2009

I'm seriously beginning to think that Krugman doesn't care about making sense any more. Instead, he'd rather use vaguely economic-sounding arguments and cherry-picked statistics to support his normative priors, and then scream "Treasury View! Treasury View!" whenever somebody questions him. Earlier this week, Krugman willfully misread a graph in order to argue in favor of a second stimulus. In today's example, Krugman misreads the graph below and says that it shows incontrovertible proof that the Paradox of Thrift is real, therefore Keynes was right, therefore Krugman is right, therefore we should have a second stimulus. Look at the graph:

What does it show? It shows that net national saving has gone down since the recession began. This is what an advocate of the paradox of thrift would predict. But why has it gone down? Because the government has spent a ton of money! Personal savings is way up, and corporate savings are only down a small amount (likely due to reduced investment caused by excess inventories and the credit crunch; this could reverse within the next few quarters) and not nearly enough to off-set the rise in personal savings. If you take the government out of the picture, then net national saving has gone up and the paradox of thrift is wrong.

Of course that's a huge "if". It's not clear what the personal savings rate would be if the government were not spending in deficit. But Krugman rejects the rational expectations story (Treasury View!) that individuals react to government deficits by saving for future tax increases. If that is true, then the reverse must be true as well: individuals should not react to fiscal neutrality by lowering savings. And if that is true, then the above graph actually shows that in the absence of government deficits net savings would still go up, so the paradox of thrift is wrong, Keynes is wrong, Krugman is wrong, and the case for a second stimulus is weakened*.

Krugman can't have it both ways: either people alter their behavior in response to government deficits or they don't. If they do, then the stimulative effects of deficit spending are at least partially off-set by reduced demand from individuals (Treasury View!). If they do not, then the paradox of thrift does not exist in the present situation.

Like the Laffer Curve, the paradox of thrift is definitionally true at some margin. But it is not clear that we are at that margin or even anywhere near it.

*Though not destroyed; personal consumption is still negative, so Krugman could still argue that stimulus is needed to boost aggregate demand. This demand-side argument is the crux of Keynesianism. But the supply-side argument doesn't support his case, and actually works against it since some of the demand-side effects will be negated by supply-side responses.


W.E. Heasley said...

Enjoyed your article. Saw in on Seeking Alpha.

W.E. Heasley, CLU, LUTCF
Chief Economist
Heasley Insurance Services, LLC

Sarah Bauerle Danzman said...


Isn't the whole point of the paradox of thrift that individuals, due to a simple PD game, always save during recessions. In order to boost demand and get out of the recession, government steps in and spends the money that individuals won't? If so, I don't understand how the data show something different. And even if there is a rational expectation effect, can anyone show that it totally erases the impact of government stimulus spending? The problem here seems to be one of a counterfactual. What would the world be like without the stimulus?

Kindred Winecoff said...

Sarah -

No. The Paradox of Thrift is that as everyone saves, economic activity decreases to the point that total savings actually goes down. It isn't primarily about "getting out of the recession"... just about savings.

as for rational expectations models of the effects of stimulus: there are lots of them, and they show lots of different things. it depends on the starting assumptions. i'm not entirely convinced by the rational expectations story, but my point in this post was that Krugman is being intellectually dishonest.

finally, we do sort of have counterfactuals of the world without stimulus: Continental Europe.

Sarah Bauerle Danzman said...

thanks for setting me straight. sometimes I really wonder how I was awarded a minor in economics.

btw - can we really compare a non-stimulus continental Europe with a stimulus US given the disparity in non-stimulus social spending between Europe and the US?

Kindred Winecoff said...

true, any Europe/US comparison isn't exactly apples-to-apples. you're right about one of the reasons -- Europe has more "automatic stabilizers" that actually functions as stimulus during downturns -- but also because European countries and the US are different in a million different ways. Germany relies much more on industrial exports than US or France.

but comparisons are never perfect. we do have three major examples of OECD countries engaging in large stimulus spending -- US, UK, Japan -- while the rest of the OECD has mostly stood pat (they've had some bailouts, but so have we). hopefully in the coming years we'll be able to learn more about how stimulus actually works, and these cross-national policy divergences could give us a way to do that.

The Data Do NOT Show the Paradox of Thrift




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