Economics in Wonderland

Economics in Wonderland January 15, 2009

This week’s EconTalk podcast featured Prof. Steve Fazzari talking about Keynesian economics. Prof. Fazzari was rather unflinching in his devotion to Keynesianism, and was a very good expositor of his point of view. After listening to the podcast, I feel like I have a much better grasp on some key Keynesian concepts and arguments than I did before. Unfortunately (for Keynes) this newfound clarity hasn’t raised my estimation of the essential validity of Keynes’ ideas. Just the opposite. Listening to the podcast, I increasingly felt like I had slipped into an economic bizzaro-world* where up was down, bad was good, and paying people to dig holes and then fill them up again was a great way to stimulate the economy.

To give an example of what I’m talking about, consider the paradox of thrift. Suppose that a family decides to save more and so stops eating out at their favorite restaurant. All else being equal, you might suppose that total savings would increase, while total consumption would fall. But, says Prof. Fazzari, you are forgetting that by not eating out, the family has destroyed a portion of the income of the restaurant owner. As such, he is faced with the choice of either reducing his consumption (defined to including spending on his business) or to reduce his savings. If he reduces his consumption, then this will simply foist the problem off on some third party, who then will face the same choice of reducing consumption or savings by the same amount. But if he reduces his savings then overall savings won’t go up, as the increase in savings by the family will be offset by an equal decrease in savings by the restaurant owner. Ultimately, then, overall savings won’t increase, and indeed can’t increase, at least if we are holding total income constant.

If this argument seems persuasive to you (as it did to me for about 20 minutes or so), consider that, from the restaurant owner’s perspective, it doesn’t matter what the family does with the money it is no longer spending at his restaurant. They may save it, use it to go to the movies instead, or just give it to the poor; the effect on his income will be the same. So if Prof. Fazzari is right that the restaurant owner in the example above must respond by decreasing his savings when the family stops spending money at his restaurant in order to save, so by parity of reasoning he must also reduce his savings when they stop spending money at his restaurant in order to spend it on something else. Thus, the implication of Prof. Fazzari’s argument is that whenever people change their consumption habits, total savings must go down (holding total income constant). And that’s not just bizarre, it’s bizarro.

Now you might say that the case of the family that skipped dinner to go to the movies is not really the same as Prof. Fazzari’s example, since in this second case there is a third party (the owner of the movie theater) whose income will increase by the same amount as the income of the restaurant owner decreases, and who therefore will be able to offset any decrease in consumption spending or saving by the restaurant owner. But the same is true of Prof. Fazzari’s example as well. After all, when a family decides to save more, they aren’t going to just keep the extra cash stuffed in their mattress. They will either invest it directly, or they will put the money in a bank, which will then in turn loan it out to some other party. In either case, the ultimate receiver of that money will have his income go up, and will be able to “fill the gap” in spending caused by the lost income of the restaurant owner.

Once you realize that (at least in a modern economy) saving is just another form of spending the whole “paradox of thrift” disappears. And insofar as such ideas provide the argumentative foundations for Keynesianism, then the whole system would seem to be based on little more than a muddle.

*Yeah, I know the title says Wonderland, not bizzaro-world. So sue me.

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