The paradox of thrift: Understanding economic behavior in recessions

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Does being “thrifty” mean squeezing out the last drop?

© glebchik—iStock/Getty Images

The paradox of thrift is a concept developed by legendary economist John Maynard Keynes. He noted that, during a recession, individuals tend to save money so they can manage through a tough time—when what the economy needs is for people to spend and invest. After all, historically, recessions, and more extreme depressions, mean job loss, a bear market in stocks, and overall concern that the lean times could be with us for the long haul, Great Depression–style.

Did you get stimulus checks during the COVID-19 pandemic? If so, think about what you did with that money. Government policymakers were hoping you would spend the money as soon as you received it. Did you?

Saving it would be the prudent thing from an individual standpoint. But as a whole, it may have exacerbated the problem. Remember: One person’s expense is another person’s income.

That’s the paradox of thrift.

When the economy is in recession, a nation’s government and central bank may try different activities to stimulate new economic growth. Monetary policy involves a country’s central bank—the Federal Reserve, in the U.S.—making adjustments to interest rates. (In recent days, adding or subtracting assets from the central bank’s balance sheet is also common.) In a recession, the central bank may try to lower interest rates to encourage businesses to borrow money and expand. Low interest rates also make riskier investments such as stocks, alternative investments, and lower-rated bonds look more attractive to savers, which encourages more economic activity.

When the economy is running hot, the central bank may try to slow things down and prevent inflation by raising interest rates. This encourages businesses to maintain operations rather than expand them, and it makes cautious consumers less likely to borrow money.

Although low interest rates are designed to encourage you to borrow money to buy new appliances or a new set of wheels, the reality is that you might not run out and do that. In a recession, you might fear job loss and decide to build up your savings. If you’re working toward a particular savings goal, such as the down payment on a new house, you might need to increase your savings rate to offset the effects of low interest rates, compounding the problem for the economy as a whole.

Before the financial crisis and Great Recession of 2007–08, the Federal Reserve Bank of St. Louis found that the saving rate for a typical American household was 2.9%. By 2011, that rate had risen to 5%, even as interest rates fell.

In other words, consumers cut back while the Federal Reserve was encouraging them to spend. This is the paradox of thrift—also known as the paradox of savings—in a real-world scenario.

Keynes, who did extensive work on how governments can stimulate economic growth, noted that in such situations individuals are making a rational assessment of their risk and responding appropriately, but this response is the opposite of what they should be doing to help end the recession in short order.

When the pandemic caused widespread business shutdowns, the government responded by lowering interest rates and sending people stimulus checks. This provided important financial support for some of us, while others saved the money in hopes of spending it once things got back to normal.

Following the pandemic, the jump in consumer spending (partly due to the increase in government spending) led to inflation. Monetary policy is tricky, and extreme situations like the financial crisis and the COVID-19 lockdown make it hard to execute perfectly.

The paradox of thrift implies that “frugality” (i.e., carefully managing one’s money and other resources) is bad in certain specific circumstances. But classic American culture (think Ben Franklin, for example) values thrift, at least up to a point.

Researchers at the University of Chicago explored the issue of being cheap versus frugal. They concluded that curtailing spending to save for a productive purpose is positive (and such savers would generally be described as “frugal” or “prudent”). But someone compulsively saving funds for the sake of saving—particularly if they also lean on others to pick up the financial slack—would likely be viewed negatively, and possibly described as being “cheap” or “tight.”

In other words, how you spend and save can and does affect the people around you. You can be thrifty at times but generous when needed (and generous with your time when money is tight). In this way, you can be frugal without being “cheap.”

And speaking of affecting the people around you, another factor in American culture (over the last several decades, anyway) is consumerism. Although that spend-spend-spend mentality can help mitigate the paradox of thrift during a recession, so-called conspicuous consumption can also be wasteful and lead to negative externalities, particularly environmental effects.

In the words of Henry Wadsworth Longfellow: “Into each life some rain must fall.” It’s tough to say for sure whether Longfellow kept three to six months’ worth of income in an emergency fund, but we do know that, in a perfect world, you would save money when the economy is good so you can spend in a downturn.

But if you saved your stimulus checks because you had nothing to spend the funds on during lockdown—or if you overspent during the pre-COVID bull market and wanted to use the funds to bolster your depleted emergency savings—you participated in the paradox of thrift.

Human nature being what it is, the paradox of thrift is likely to be a problem in every recession.