McTeer's paradox

Ramesh Ponnuru asks "But [Robert McTeer] endorsed, in his piece, both Keynes's ?paradox of thrift? and Bastiat's ?parable of the broken window.? Aren't these lessons contradictory?"

Yes they are. As I wrote in a previous post, the approach that Austrian economics takes is called praxeology - the study of human action. Human action, at the individual level, can show us why these two lessons are contradictory.

Let me start with the Parodox of Thrift. According to Keynes, savings is harmful to the economy because it causes a drop in aggregate demand, which in turn weakens the overall economy. If people 'hoard' instead of spend, they consume less, demand for goods and services falls, and workers will get fired. In turn, these unemployed workers will consume less due to diminished income, and the vicious cycle sets it. Thus, the 'paradox' occurs that aggregate savings will decrease from the very fact that people try to save. The underlying assertion behind the ?paradox? is that demand is what drives the economy.

A metaphor used to describe the Paradox of Thrift is to imagine a bucket of water as being the economy. A hole in the bottom of the bucket would represent ?leakage? of savings out of the economy. If you enlarge the ?savings hole? in the bottom of the bucket, i.e., try to increase savings, water drains out faster initially, but as the water level drops, the pressure forcing it out of the bottom decreases, and the rate of water drainage (saving) slows. Or something like that.

What does the study of human action say about this 'paradox'? Consider the case of Fred the fisherman. Fred catches a certain amount of fish on average, say 50, in a day. He can use a few, say 4, of these fish to feed himself and his family for that day. The remaining 46 fish comprise his savings. The Paradox of Thrift says that by saving these extra fish, Fred is harming the economy by not exchanging (spending) them right away. It says that these 46 fish have 'leaked' out the economy.

However, what might Fred do with the 46 fish he has saved? He could put them away in his freezer and use them to feed himself and his family for another week or two, perhaps in order to free himself up for other tasks such as fixing things up around the house. Or he could trade them for logs from Larry the lumberjack and/or candles from Chandler the chandler. If he does the latter, not only does he obtain logs and candles that he believes would fulfill his own ends, but he also helps Larry and Chandler make a living. Or he could exchange some portion of his saved 46 fish for a new fishing net (capital) that will help him boost his daily fish production from 50 fish a day to 75 fish a day. Or he could do any combination of the three.

We can easily see that no 'leakage' from the economy has occurred from savings. There has been no fall in economic activity. There is no 'paradox.' In fact, Fred's saving the 46 fish is what helps maintain economic activity. It helps Larry and Chandler make a living, and it helps Fred raise his production by allowing him to invest in capital.

In a highly complex economy, money becomes the medium of savings. The savings do not ?leak? out of the economy. They are used for future purchases and capital investment. Keynesians attempt to make a false demarcation between consumption, which they regard as being vital to the economy versus savings, which they regard as being somehow external to the economy. Human action tells us otherwise. Savings is not a detrimental to the economy; rather, it is vital to economic growth.

Now, consider the Broken Window Fallacy. Consider the case of a baseball breaking a window. It may seem that the result has been destruction of property and harm to the economy, but the Keynesian would step up and claim that no, this is actually a blessing in disguise, because it generates income for the glasscutter, who in turn will use this money to buy clothes from the tailor, who in turn will support the baker, etc. As a result, the great engine of the economy will churn faster.

However, that analysis is only focusing on what is seen. Bastiat focused also on what is not seen, namely that the resources used to finance the repair of the window and the workers who perform the repairing would have been put to more productive uses, rather than to repair what was once whole and unblemished. Carrying the Broken Window Fallacy to its logical conclusion, it would be beneficial to the economy if people went around throwing baseballs through windows all the time. Or that destruction on an even greater scale such as war and the bombing of the twin towers are also good for the economy. Again, this fallacy rests on the notion that demand for goods and services is what drives the economy.

I do not have access to McTeer's article because I am not a subscriber to the WSJ. However, I have read this speech by him where he talks about both topics. It is true that one cannot without contradiction, endorse the Paradox of Thrift, which is built on premise that aggregate demand drives the economy, while also endorsing Bastiat's critique of the Broken Window Fallacy, which tears that very premise down.

Is anyone surprised that the president and CEO of the Federal Reserve Bank of Dallas still believes in the Paradox of Thrift?

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