When There Can Be Too Much Savings

We’ve probably heard about the virtues of thrift many times by now, but what if I told you that thrift in itself is not always good?

The motivation behind this article was from this Economist article, which discussed about how the large German current account surplus is potentially destablising for the International Economy.

“A” level students are expected to be aware during exams that while a Balance of Payment (BOP) surplus is arguably better than a BOP deficit, the long term Macroeconomic goal for a country should be a balanced BOP (i.e. neither surplus nor deficit).

A long-term Current Account represents long-term net money inflows. This eventually leads to upward pressure on the domestic currency’s exchange rate and can also cause high inflation rates assuming domestic consumption is correspondingly stimulated.

Interestingly, while the goods and bads of savings at the economy’s level (aka BOP in Macroeconomics) is discussed in the “A” level discourse, the same concepts are not typically discussed at the Microeconomics level despite some parallels.

There is little for students to be worried about however – I have yet to come across Microeconomic questions that discuss about the virtues (or lack of) for savings at the level of Individuals.

Nonetheless it would be instructive for students to understand the implications Savings (which is defined as Income not spent) have on Individuals and not just as a macro-level abstraction.

Revisiting the Multiplier Effect.

Consider the following scenario:

There are 2 people in the economy, A and B, and both take turns to be the seller and buyer respectively for each transaction made.

In the beginning, A receives $5 and we assume that both A and B have a Marginal Propensity to Spend (MPS) of 0.5.

Using the first transaction as an example, A therefore spends $2.5 in buying from B, and B in turn spends $1.25 in buying from A.

Based on the circular flow of income, the associated transactions arising from the cash injection of $5 will therefore look like this.

The process actually repeats until the Multiplier Effect has run its course (revise about the Multiplier Effect here), and the “$$$ Transacted” sums to approximately $5 / 0.5 = $10.

Students by now should realise that the Multiplier Effect as taught in “A” level Economics implicitly assumes that the MPS is the same for all individuals in the economy (i.e. homogenous), which isn’t the case obviously in the real world.

It is in that context, that we will go ahead and create the following scenario.

The Thrifty Vs the Spendthrift.

Now let’s modify the scenario such that A is an extremely thrifty person, and saves $1 for each transaction. B on the other hand is a spendthrift who spends every income dollar earned.

The results couldn’t be any more different from the original example. The transactions ended at No. 8, because B was basically broke and couldn’t buy anything else.

Of course the results are not at all surprising using intuition (as any over-spending friend might tell you). However the simple example above captures the worry stated in the article about how the German thrift doesn’t do favours to the world economy.

In the above example, the steady state achieved after the initial injection of $5 is achieved, with A having all $5 and B having $0.

The Rich gets richer and the Poor gets poorer…but only up till a certain point.

Many students would at this point imagine that this is a story of inequality and how being in the shoes of person A would be great for him/her.

Inequality is indeed a major theme in Economics and it is now widely known that Inequality in the long run is bad for the economy on the whole.

However, the implicit assumption to this Circular Income Flow example is that the economy is closed and both A and B are the only people in this economy, and they are transacting to consume goods and services.

In the end, when the transactions stop because B is no longer able to transact further, this can hardly be a great scenario for A even though he is actually rich relatively.

That’s because in the absence of further cash injections to the economy, A can no longer earn any income, and being the stingy person we have assumed him/her to be, A will not be able to consume further, which was the point of earning money!

So beyond just having a scenario where the thrifty rich gets richer, and the spendthrift poor gets poorer, the thrifty rich can actually find themselves worse off in the long run, especially if they earn income by selling to the spendthrift poor.

Sparing a thought for your sellers may go some way in helping yourself.

It should be clear now that excessive savings can destabilise the economy, as transactions will eventually freeze with no way to jumpstart (unlike in the earlier example).

Nor is this the only reason why saving excessively can be bad on the whole for the economy.

Economists have long postulated that excessive savings can cause a Paradox of Thrift, which happens when the savings depress the Aggregate Demand, leading lower National Income, which ironically lowers the savings level overall instead.

So the next time you feel glad about getting many “good and cheap” deals, it pays to bear in mind that given the circular nature of income flows, there can be too much of great deals.

There are indeed good reasons why people save, which we will discuss in the future. But we should be aware that excessive savings may not always be good.

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