Paradox of savings is a fallacy of composition where the perfectly virtuous habit of increasing savings when embraced by everyone generates negative outcomes for the economy as a whole. This is amplified when the economy is facing a recession and aggregate demand is falling. In such circumstances, it is in the interest of the economy if people spend more to shore up the declining aggregate demand.
During the Great Recession, debt-laden households in developed economies, in particular the US, cut back sharply on expenditures and boosted their savings to repay debts.
In response, businesses too have been postponing investments. This coupled with the general trend of businesses to indulge in cost-cutting, mainly through lay-offs, during recessions (so as to, in the main, keep their bottom-lines in tact) means that businesses are sitting on hoards of cash surpluses. At 7% of all their assets, non-financial corporations’ cash and other liquid assets reached $1.9 trillion at the end of 2010, the highest level in the US since 1963.
In the final quarter of 2010, capital expenditures amounted to $975 billion, or 6.6% of gross domestic product — up from a low of 5.4% in 2009 but still well below the 10-year average of about 8%. The non-residential private fixed investments dropped precipitously during the recession.
All this highlights the pro-cyclical nature of their basic economic activities for the two critical stakeholders. When faced with uncertainty, consumers save and businesses postpone investments. In contrast, when the economy is on the up, consumers spend as though there is no tomorrow, while businesses borrow recklessly and over-invest.
Recessions are marked by declines in aggregate demand. Households and businesses shutting-off their spending taps compounds the problem. It is possible, as the East Asian economies and Germany have done on occasions, to export your way out of a downturn. Further, if the recession is not very deep, it is possible to indulge in monetary accommodation and encourage businesses to bring forward investments.
But these were not available options for the US economy at the peak of the Great Recession. Under such circumstances, there is no choice left but for governments to step in and provide a temporary boost to aggregate demand.