Economics is full of paradoxes.
A paradox is a statement that contradicts itself or defies common sense. Most of the anomalies found in economics are named after the economists that first identified them. Examples include the Edgeworth Paradox, Leontief paradox, or the Solow computer paradox.
The financial crisis and recession of the past years have drawn much attention to the Paradox of Thrift. This unfortunate outcome was attributed to John Maynard Keynes by Paul Samuelson in Samuelson’s widely used economics textbook first published in 1948.
The Paradox of Thrift says that while more saving may good for the individual, it is bad for society. Recessions like that which we have just experienced cause households to save more of their income. But if everyone in a society is saving more, the effect is a large drop in demand, which in turn leads to low output and high unemployment.
Keynes’s antidote for the problem is active fiscal and monetary policies that discourage savings. The idea is that if we give people more money and keep interest rates low they will spend more and save less.
The Keynesian responses to the current weak-economy problem have been relatively ineffective because of the ways households are saving more today. Keynes expected households to hoard cash and other valuables, but today households are not holding onto their cash, they are using it to pay down debt.
The Paradox of Thrift doesn’t fit.
A more precise theory for the current situation is Irving Fisher’s debt deflation. Fisher published his theory about the same time as Keynes, but the work received much less recognition.
Fisher predicted that when households start paying off debt in response to some crisis, assets will most often be sold at distressed levels (think housing foreclosure sales), and the velocity of money, or the frequency of its use, will decline. The current situation closely matches these predictions. Since 2007, total consumer credit is down about 7 percent and the velocity of money has dropped by a third.
Like the paradox of thrift, the lower debt level is good for the individual household but bad for society. Lower debt use and slower turnover of money leads to a reduction in demand for goods and services, thereby producing unemployment and a recession.
Like Keynes, Fisher said these negative consequences for society can only be counteracted by inflation. . That is, their theories propose that the economy will only stabilize or get back to growing if policymakers somehow get prices to rise. Unfortunately, the U.S. Federal Reserve has been unable to produce this supposedly needed inflation.
Since 2007, the U.S. inflation rate has dropped from over 4 percent to only 1 percent . It dropped from 4.4 percent to less than one half of 1 percent here in the Boise-Nampa metropolitan region. The unemployment rate has doubled nationally while rising threefold, from 3 percent to 9 percent, here in the Boise Valley.
The Fed has flooded the market with dollars, but the dollar’s price is not falling. The price of a currency is its exchange value – what it can buy in terms of other currencies. The U.S. dollar compared with all other world currencies is at the same level it was in 2007.
This week the Fed tried talking down the dollar, going so far as to say it is “prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate.” The dollar dropped briefly in value following the announcement but gained again the next day.
Despite all its actions, the Fed has been unable to produce inflation. The Fed doesn’t have a specific target, but has said that a 1.5 or 2 percent annual rise in prices is consistent with its goals of steady economic growth and employment.
Like a coach that finds himself losing at halftime, the Fed should throw out this playbook.
The Fed should stop trying to fight the world capital market and produce U.S. dollar inflation that will just end up hurting us in the long run. Let prices stay where they are, or even fall some, so that businesses will once again be willing to invest and hire workers.
Stop trying to fight a paradox that is not.
Peter R. Crabb is a professor of finance and economics at Northwest Nazarene University in Nampa. He earned his doctorate in international and financial economics from the University of Oregon.