TCS Daily

Thrift, Not Consumption, Creates Prosperity

By Christopher Lingle - July 16, 2004 12:00 AM

According to a survey by ACNielsen, Asian consumers are upbeat about the region's economic prospects and slightly more optimistic than they were at the end of 2003. As part of its bi-annual regional consumer surveys by conducts, the percentage of consumers expressing optimism rose from 40 percent to over 55 percent. South Koreans in particular showed an improvement in consumer confidence as debt-laden households shake off some of their gloom.

But does any of this matter....? Well, yes but mostly no.

Policymakers examine often use consumer confidence numbers or other economic indicators to try to finesse policy prescriptions that offer the best chance of maximizing electoral backing. Unfortunately, there is wide support for the idea that additional fiscal commitments make economic good sense. For example, the IMF has recommended that South Korea implement a supplementary budget worth about 6 trillion won ($5.15 billion).

But increased public-sector spending is definitely not what is needed to boost South Korea's sluggish economy. It turns out that economies in recession need more savings rather than less. Or at least, existing savings must be used more efficiently.

Either way, attempts to increase overall spending involve a misspecification of the underlying problems. And so it is that increased spending by households or governments will simply delay the effect of an economic downturn from one time period into the future.

Most of general public and many economists believe that higher consumption and government spending can be the driver of economic growth. However, a clear understanding of sustainable economic growth reveals that the principal requirements are an adequate fuel of savings that allow entrepreneurs to invest in new or better production facilities.

Sustainable economic growth requires a one-two punch of more savings and investments guided by the able hands of entrepreneurs operating in a competitive framework. Increased savings increase the pool of funds for borrowing and lead to lower interest rates so that there can an expansion in production.

There is considerable evidence that savings is more important than consumption. Consider the high economic growth in Asian countries like China, Japan or Korea that have high saving that ratios fueled. Their enviable performance was not based upon domestic consumption.

It turns out that many economists accept the "paradox of thrift" whereby increased savings reduce consumption demand causing a reduction in output and investment that leads to rising unemployment. Thus, individuals attempting to set aside funds for their own future needs will benefit themselves at the expense of the overall economy.

Following this logic, savings is an economic curse. But spending, either by governments or consumers, is portrayed as a virtue.

In the first instance, this thinking involves a disconnection between the micro and macro economy whereby saving and investing are assumed to be unrelated. There is also an assumption that investment is a function of overall spending whereby an increase in consumer demand can lead to increased investment.

The original formulation of this "paradox of thrift" did not actually address the affect of increased savings. Indeed, it is based upon confusion over the effect of sudden increases in the demand for cash balances rather than sudden increases in savings.

Increased consumption means that less is saved so that fewer resources can be used for investment purposes. The reduction in investment will cause the production structure to contract so that future living standards are lower than they would have been.

This misguided argument finds support from politicians who find that trading short-term gains against long-term instability is an attractive proposition. Nonetheless, encouraging consumption cannot strengthen an economy since the real economic problem involves providing the means for of consumption. Governments should pursue policies that stimulate production and savings instead of encouraging consumption.

Saving involves the diversion of expenditure from present consumption to be used by producers as investment goods that allow expanded output of goods that can be consumed in the future. As such, thrift as savings is another form of spending with an extended time horizon. When less is consumed today, more can be consumed tomorrow because the capital structure is longer and more productive.

Since economic growth is the outcome of forgone consumption that allows investment and spending on capital goods, fewer resources should be allocated to consumption. Continued growth and rising living standards require that there be more capital accumulation arising from improved channeling of savings to wealth-generating activities.

In the case of the US, contrary to conventional wisdom, high consumer spending contributed to the most recent downturn in its economy and continues to interfere with the emergence of a sustained recovery. And monetary and fiscal policies that try to direct economic activity towards increased consumption will have temporary benefits while setting into motion a boom-and-bust cycle.

A better remedy for the economic problems afflicting South Korea is to improve the operation of the financial intermediation process that channels savings to investors. As it is, too much capital is directed towards projects that will prove to be non-viable once interest rates shift or government spending lapses.

It would be much better to have more funds directed to young, private entrepreneurs. By investing funds in commercially-viable projects, they will create more jobs and greater wealth that will underwrite any country's economic future.

Christopher Lingle is currently an Adjunct Professor of Economics, Georgetown University.


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