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The Paradox of the Paradox of Thrift

Keynes' paradox of thrift holds that if everyone tries to save at the same time during a recession, then the economy continues to contract due to a fall in demand. This sends incomes lower and gives people less money to sock away, so that total savings actually fall instead of rising. The implication for our times is that a new era of frugality might not be what the economy needs.

But in a new IMF paper, Yasser Abdih and Evan Tanner argue that Keynes' paradox might not apply after a financial crisis.

In normal times, companies can finance investment through their own savings. But, after a crisis, corporate balance sheets are in lousy shape. The only way many companies can fund investment is by tapping household savings (channeled through the capital markets). In this vein, Abdih and Tanner provide some evidence that investment and household net worth are closely linked. So, to get back to pre-crisis levels of investment and wealth,  households need to save more, not less.

How much more? Abdih and Tanner estimate that the best chance for a return to 2006 peak levels of investment and wealth by 2018 would involve at least a doubling of the current savings rate of 4.1%, or roughly the rate at which Americans saved during the 1950s to 1970s.