The paradox of Thrift, Wealth Effect, Liquidity trap: Economic Memo #67

Years ago, I was watching the fireworks show at Disney World Castle with my family. My family and I were maximizing our utility (want satisfying power) and enjoying Tinkerbell flying across a wire above us as part of the show. Trouble was, thousands of other families were doing the same thing. The crowd was so thick that physically no one could move. It was a very dangerous situation leaving the event with so many people shoving and pushing to exit. This is an excellent example of the fallacy of composition pitfall of economics. ‘What is true for the individual is necessarily true for the whole.

The Keynesian Economic Theory

Now you are wondering, “What does this have to do with the economy today?” The answer is simple. Our economy is driven by consumer spending (70% of all Gross National Product). After the initial spending spree on food at the start of a recession (have you tried to buy milk, bread, toilet paper recently?), people will hunker down for fear of running out of money in a prolonged recession.

Paradox of Thrift

So, consumption, or spending, drives economic growth. Thus, even though it makes sense for individuals and households to reduce consumption during downturns, this is the wrong thing for the larger economy. A pullback in aggregate spending forces businesses to reduce supply, deeping the recession. The disconnect between individual and group rationality is the basis of what John Maynard Keynes (father of Modern Economics) called the Paradox of Thrift in “The General Theory of Employment, Interest, and Money). An example of this was seen during the Great Recession financial crisis of 2008. During that time, the savings rate for the average American increased from 2.9 percent to 5 percent.

Wealth effect

Another Keynes concept is also at work today. It is called the Wealth Effect. The wealth effect is the change in spending that accompanies a change in perceived wealth. Usually, the wealth effect is positive: spending changes in the same direction as perceived wealth. The trouble is that it works oppositely during an economic downturn. Those of you that have ridden the market down over the last few weeks are acutely aware of the loss of wealth impact. The negative wealth effect deepens the recession.

Liquidity trap

According to the Classical economists, there was no rational reason to hoard money. They defined money demand as transaction demand (daily needs like food, rent, etc.) and precautionary demand (rainy day saving for sickness, unemployment, etc.)

Keynes added another type of demand, speculative demand. He theorized that some people had more money than they needed, and they would make risky investments. If they lost the money, “well that’s not good, but what the heck, my lifestyle won’t change.”

He then hypothesized bonds and stocks were inversely related. The value of bonds increased when stock prices fell and vise versa. Further, if stock prices get so low that the investor thinks it can’t get any lower, or if he or she thinks interest rates will not get any higher, then there is a rational reason to hoard money. Leakage in the economy occurs and worsens the recession.

This is called a liquidity trap, and you see it very rarely. In my lifetime (no comments my age) I have seen it twice – the 2008 recession and now.  With stock prices dropping dramatically the normal reaction is for the money to flow to bonds, but the is not happening. Investors are simply trying to see where the bottom is before they commit their money.

Has COVID19 and the Oil war sent us into a recession? Most experts feel that is the case.  Will the ‘Paradox of Thrift,’ “Wealth Effect,’ and Liquidity trap deepen the recession. Most experts believe this is so.

Is there a light at the end of the tunnel?

The business cycle is a roller coaster that goes through four stages on average, every 8.4 years if the government does not act. Sometimes the worst of all worlds happens, and we get stuck in Stagflation (persistent high inflation, high employment, and stagnant demand).

Government has two primary tools to fight recessions, monetary, and fiscal policy. The Federal reserve can decrease interest rates and increase the money supply (called monetary easing). Yesterday the Fed reduced the interest rate to zero and threw $750 billion into the economy. The trouble is that they have now pretty much used all the arrows they have in the wicker.

That leaves Congress and Trump to use fiscal policy, reducing taxes, and increasing government spending. The house pasted a good start (but only a start) and Trump actually agreed to sign it (surprises never cease). However, the Senate Conservative Republicans may not pass the legislation.

There you have it in a nutshell. It is not a nice picture.

About Larry Hill

Dr. Larry Hill is Chair and Professor of Economics. Areas of interest include economic analysis, energy economics cost benefit analysis and economy. To subscribe to the email list of Dr. Larry Hill's Economic Memos, contact Tracey O'Brien at Credentials include 1967 B.S., Indiana State University, 1968 M.S., Indiana State University, 1976 Ph.D., Northern Illinois University He is a member of honorary fraternities in economics and social science. He is currently writing a book on Managerial Economics and revising previous book, "The Basic Macroeconomics of the American Economy"

One thought on “The paradox of Thrift, Wealth Effect, Liquidity trap: Economic Memo #67

  1. Arend Jan Mulder
    April 5, 2020 at 3:03 pm

    Dear Dr. Hill,

    Great post as it reminds me at my time being a student of yours. During my time as a student we have seen and discussed the liquidity trap for Japan ( which we did witness for about 17 years) back in 2002. Back in Europe we witness a liquidity trap approximately for 5 years now and we don’t even seen the worsening effect of COVID-19 yet on the economy. So the question is, will COVID-19 cause a correction in Keynesian principles we have never witnessed before and will the USA face the same destiny as Europe?

    Best regards,

    Arend Jan Mulder ( the Dutchie, for a long time ago…:-)).

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