A Keynesian Nightmare: Saving Money Helps Shorten Recessions

There’s a popular notion in Keynesian economic theory known as “The Paradox of Thrift (or Saving).” Since Keynesian economics focuses on Gross Domestic Product (GDP) — which is, frankly, a measurement of spending — saving money is paradoxical because it lowers GDP due to consumers not spending it.

The reason why economists care so much about GDP is because it’s an important indicator of where the economy is in a business cycle (boom or bust). When GDP constantly drops for a period of time, this is known as a recession. How exactly does saving money help shorten a recession?

Understanding GDP

Everyone who takes macroeconomics memorizes one simple equation: C+I+G+Xn = GDP. C is for consumption (consumer spending), I is for investment, G is for government expenditures, and Xn is for net exports, which is our exports minus our imports. This is overly simplistic, but is still a good general way to think about it as an average consumer.

Everyone’s personal consumption relies on how much money they have left over to spend, which is referred to as disposable income. Therefore, the Keynesian model implies that taxes can lower GDP if the government doesn’t spend it elsewhere. However, there are entire books written about this subject and this is the extent in which I will delve into it.

Understanding Recessions

Now that we understand why spending less money on a massive scale can cause a recession, we can understand why this might cause someone to lose their job. When someone loses a job in a recession, it’s often called a layoff, meaning someone was laid off for budgetary reasons. It makes sense, right? If a pizza restaurant doesn’t have enough demand, it can’t afford to employ five delivery drivers. However, a recession doesn’t have to negatively affect the delivery driver.

This might seem a little farfetched at first. We’re told that recessions are negative. But that’s because people tend to lose jobs in a recession and we affix job growth with economic success. There’s a little more to it than job loss.

How Saving Helps Shorten Recessions

Previously, I wrote about how much people should try to have in their savings account. Since it takes the average American about three months to find a new job, all of your necessary expenses should be covered during that timeframe. I understand that’s a lot of money. However, if people were to save like they used to, we wouldn’t have as big of an issue with a recession.

All the would happen in such a scenario is that people wouldn’t be spending more than they had been saving. That pizza restaurant that previously had to let one of its delivery drivers go might be able to hold out through a bad month — remember, it’s the prolonged decline in demand that leads to this, not a single bad month. In other words, a smart business owner in this case might focus on quarterly declines rather than individual months. In fact, a smart business owner might try to temporarily lower their prices before laying someone off.

Business Owners Need More Education

It used to be that many high schoolers across the country had to take economics before graduating. The idea behind this was that it would create more responsible consumers. Today, it doesn’t seem to be the case in states like California. However, there are also several states that don’t actually require economics to be taken as a class in high school. One unintended consequence of this is a decline in economic understanding amongst business owners.

A more elderly business owner who studied economics even while in business school may have been taught to look think in more of a long-term perspective. Naturally, people want to think about the here and now, an irrational fear of how something that may only affect them for a day might come across as affecting them for years to come. A younger pizza restaurant owner in a recession might cause more harm than good if they don’t wait out a recession that might be shorter than we thought.

The bottom line: Small business owners need to learn how to think more about how their quarters are doing rather than their months. At the same time, consumers need to figure out how to save like they used to decades ago. These two phenomena occurring at the same time will help us shorten recessions and keep people employed.