The paradox of thrift: Understanding economic behavior in recessions

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.

Managing through recessions

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.

Thrift and American culture

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.