Is it beneficial for the economy to have higher household savings, or is it just a fallacy of composition?

By Dr. Tanusree Chakravarty Mukherjee and Sim Hao En

The surge in prices of goods and services since mid-2021 has sparked fears of an impending recession in 2023, causing consumer confidence to dwindle in many countries. In times of uncertainty, it is natural to err on the side of caution and save money. While saving money is a prudent financial move for individuals, it can have detrimental effects on the economy as a whole.

Understanding the impact of a recessionary increase in the government’s deficit on the economy is crucial. By comparing a household’s budget to that of the entire economy, we can gain valuable insights into the effects of such a situation.

In times of budget deficits, families may choose to reduce expenses and increase savings to protect their wealth. This trend was first observed when household savings grew in 1929 during the Great Depression. However, it is essential to note that this approach may not work for the government during periods of economic downturn. Keynes argued that the government should not follow the same fiscal prudence exercised by families during hard times.

Imagine a scenario where all households decide to cut their expenses and increase their savings. Sounds like a reasonable thing to do, right? However, this decision would harm the economy. This is because the decrease in aggregate consumption spending would cause the aggregate demand to decline. As a result, the economy would move through the multiplier process to lower output, income, and employment levels. This is what we call the paradox of thrift.

The paradox of thrift is a phenomenon where the collective attempt to increase savings leads to a decrease in aggregate income. Therefore, it is imperative to understand that if one person decides to consume less, they might increase their savings, but if everyone decides to do so, it could lead to lower savings overall. It is also important to note that an increase in the saving rate is only effective if there is an increase in investment or other sources of aggregate demand, such as government spending on goods and services.

If there is no increase in investment, the outcome will be a reduction in aggregate demand and lower output, which means the actual levels of savings will stay the same. It is a common misconception that what is true for one part of the economy is true for the entire economy, which is known as the fallacy of composition. Therefore, it is crucial to understand that the decision to cut expenses and increase savings could have a significant impact on the economy.

To steer clear of the paradox of thrift, it’s crucial to make certain that any surge in savings is complemented by an increase in government spending or investment in goods and services. This will help safeguard the economy from stagnation and ensure that prosperity is shared equitably among all.

During tough times, preparing for the worst can help households increase their savings and be better equipped to handle emergencies like losing a job or falling ill. However, it’s important to remember that if everyone does this during an economic recession, it can lead to more job losses and cause bad luck for the economy as a whole.

Spending and earning are interconnected, and our spending becomes someone else’s income. To address this issue, the government can help by allowing automatic stabilisers to operate and providing economic stimulus measures like temporarily increasing government spending or reducing taxes. This will help boost consumer confidence and encourage private-sector spending until the economy recovers. Though there may be budget deficits, this approach can avoid a deep recession, as Keynes had realised. Thus, we must remember to prepare for tough times while keeping in mind that our actions can impact the economy.

In times of economic downturn, the government can take measures to boost the economy by reducing taxes or increasing government spending. This is a fiscal stimulus intended to increase the overall demand for goods and services. The government uses a combination of tax cuts and spending increases to achieve this goal. The aim is to counteract the decrease in demand from the private sector.

A tax cut encourages the private sector to spend more while increasing government spending, especially on infrastructure development, directly contributing to the economy’s overall demand. The multiplier effect is a great way for the government to make a positive impact on the economy.

By investing in the economy, the government can generate an increase in output that is usually much greater than the initial spending. This creates a ripple effect, leading to more jobs and economic growth. With this in mind, it is clear that government spending can be a powerful tool for building a stronger and more prosperous society.

Dr. Tanusree Chakravarty Mukherjee is a lecturer in the Accounting, Finance and Economics Department at the Faculty of Business, Curtin University Malaysia. She is a Fellow of the Advanced Higher Education Academy (UK).  Her research interests lie in Applied Economics, Micro and Macroeconomics. She has received funding from the Malaysian Ministry of Higher Education and Curtin University Malaysia for her research projects and has authored book chapters, journal articles and conference proceedings. She can be contacted by email at tanusree@curtin.edu.my.

Sim Hao En is a second-year Accounting and Finance student of the Faculty of Business.