By Monish Chhabra ǀ 2nd April 2013

This highly controversial (and no less interesting) topic in economics was popularized by Keynes in his 1936 book ‘General Theory’, although the concept existed well before that.

The irony of it defies common logic. It argues that something that can be so good for an individual or corporation can be as harmful to the economy as a whole. That something is ‘savings’.

If the entire population saves more money by consuming lesser, the corporate profits would decline, leading to a fall in production and employment, reduction in aggregate income and hence lower savings down the road.

In a nutshell; higher savings today means lower savings tomorrow; what an outrageous violation of intuition!

To Keynesians, ‘aggregate demand’ is the key to business cycles and, ‘excessive saving’ – that is beyond planned investment – encourages recession or even depression. Hence, they support counter-cyclical fiscal measures by the government.

In a recession, as people save more, Keynesians argue for the government to spend more and tax less to stimulate consumption demand, at the expense of bigger deficits and more public debt.

However, during boom times or high inflation, they advocate reducing government outlays and increasing taxes.

The critiques of this theory blame Keynesians for denigrating savings, excessive deficit spending, massive public debts and, increasing taxation to redistribute wealth from savers to spenders.

As early as 1929, Hayek argued that when additional savings are invested, aggregate production will increase at a cost lower than before.

Thus, corporate profits will increase in spite of lower prices of goods, real wages would improve and hence there would be no under-consumption spiral leading to lower future savings.

Austrians like him believe in free market’s ability to manage the business cycles without government intervention, in line with Classical economics view of the invisible-hand proclaimed by Adam Smith.

They hold ‘unsustainable credit creation’ to be the root of business cycles, thus advocating an end to fractional reserve banking as well as central banks. They also believe ‘excessive money supply’ to be the cause of inflation, thus supporting the gold standard.

Friedman built the monetarist challenge to Keynesian view that ‘demand-driven fiscal policy is everything and money doesn’t matter’.

He argued that government spending has no net effect on aggregate demand, due to the countering drag of higher interest rates (owing to big public debt).

Monetarists believe that ‘money supply’ is the key to national output and inflation. However contrary to the hard money economists, they oppose the gold-standard. Instead, they emphasize the central bank’s role in controlling the supply of money, by advocating small increases to support growth of trade.

For someone more interested in investment implications of it all, the way to reach resolution on this paradox is likely in what defines ‘saving’.

It cannot be denied that investment in profitable enterprise - if that is what we mean by ‘saving’ - promotes growth and future savings. However, the ‘saving’ in wasteful unprofitable enterprises destroys wealth at individual level and provides limited relief at the national level.

Equally damaging would be the ‘saving’ of the kind that grows under the pillow, or accumulates in a bank and stays there, both of which threaten growth.

Parts of Europe may find itself in such a situation.

17th March saw the bailout of Cyprus with a $13 billion package from EU. However, $6 billion is being recovered by imposing a one-time levy of 6.75% - 9.9% on all bank deposits.

What is at stake is a massive bank run not only in Cyprus, but also in other EU countries that are at the risk of needing a bailout. People would be justifiably terrorized - enough to take out as much cash as they can and stuff it under the bed; exactly the type of ‘saving’ that causes future saving to fall.

As noted by Alchian and Allen (1972), an increased demand to accumulate money holdings is associated with a decreased desire for consumption at all levels of income.

The paradox of savings may be around the corner in Europe.