Are You Saving Too Much for Retirement? (From Investopedia) (Part 2 of 3) [4 Articles]
~ Monday, October 30, 2023 Blog Post ~
By Lisa Smith, October 26, 2023
One boring little word seems to be the key to many personal finance quests: Save. Want to buy a new home? Save for a down payment. Send your kids to college? Save from the day they’re born. Retire on an island retreat? Save, save, and save some more.
The problem with all this saving is that it’s not nearly as much fun as spending. That brings us to a new headline-grabbing theory from a number of academics, economists, and authors who argue that many Americans are actually saving too much for retirement.
Some in the saving-too-much camp blame the financial services industry for promoting excessive saving so it can profit from managing all those assets. Considering the industry’s history of customer relations, this theory has a certain appeal.1
KEY TAKEAWAYS
- Some argue Americans are saving too much at the instigation of the financial services industry.
- Retirement costs may be lower than guidelines suggesting retirees will need 70% to 80% of their pre-retirement income, some studies suggest.
- Many Americans haven’t saved nearly enough for retirement, leaving them reliant on a Social Security system facing a long-term funding shortfall.
- To right-size your savings, estimate the amount you and your family will need to retire comfortably.
Why You Shouldn’t Save
While many experts say retirees need 70% to 80% of pre-retirement income to meet their spending needs, the critics argue this number is inflated. They can point to a study showing people spend about 20% less in retirement than those benchmarks assume, and another suggesting most retirees live below their means. They may also note that many retirees will have their mortgage paid off and kids raised, that Social Security will provide some income, and Medicare will cover the bulk of their healthcare costs.2
Important: Some studies show retirement costs are lower than planning guidelines suggest. Consider your unique circumstances when making your plan, including a margin of safety for risks such as medical problems and escalating out-of-pocket healthcare costs.
Uncertainties about retirement have given retirement savings a new role as an all-purpose security blanket, a personal insurance policy for life’s risks. As a result, over half of the retirees surveyed say they have only taken the required minimum distributions, and “only 21% feel confident about drawing down their assets.”3
If the retirement nest egg has turned into the key measure of how well prepared we are for a future with few guarantees, little wonder many want to grow it beyond what they are likely to need, while some, like those in the Financial Independence, Retire Early (FIRE) movement, race to do so.
Now there’s “Die With Zero,” which argues that the FIRE crowd’s savings zeal will cause it to miss out on some of the best investment opportunities in life — the extraordinary experiences that can bring happiness again and again as we revisit their memories. Its message is that persistently deferring consumption is often not the path that maximizes long-term happiness.4
Why You Should Save
The trouble is, persistently deferring savings is much easier and also unlikely to end well. Less than half of the workers surveyed for the annual retirement survey from the Transamerica Center for Retirement Studies had household retirement savings of less than $65,000 in 2022, including 22% with less than $10,000 and 9% with none.5
Meanwhile, Social Security benefits provide more than 50% of retirement income for more than half of those over 65, and more than 90% for nearly a quarter of retirees. While the average monthly Social Security payment to retirees is set to increase in 2024 by the 3.2% cost-of-living adjustment (COLA), that’s unlikely to provide lasting comfort to those struggling to make ends meet on the benefits. Nearly 12% of those aged 65 to 69 and more than 18% of those 80 and older report living in or near poverty.67
Social Security trustees project the program’s main trust fund will run out of reserves in 2033, at which point payroll tax receipts will cover 77% of scheduled benefit payments. A funding fix by Congress is likely to include higher taxes, benefit cuts, or both.8
Medicare is also at risk, with the program’s hospital insurance trust fund projected to deplete reserves in 2031 as a result of rising healthcare costs and the aging of the U.S. population.8 By 2023, more than half of people eligible for Medicare were enrolled in a Medicare Advantage supplemental policy.9 (These are regulated private insurance plans. Medigap is another type of supplementary coverage used by some consumers.)
Varying Circumstances
Not all Americans reach the age of 65 or 70 with the mortgage paid off and the kids grown and gone. For starters, many adult children are moving back home long after tradition suggests they should be independent. Many older Americans are saddled with their children’s student debt. They may have other debt eating into their income as well. And about 27% of Americans were renters, not homeowners, and rent is a cost that can keep on growing.10
The key questions then become: Does anyone really know with absolute certainty how much money they will need to finance retirement? Would you be willing to bet your financial security on that calculation?
Educated Guesses
In truth, financial planning — and saving for retirement — requires plenty of educated guessing. A projection of required retirement income is based on the expected costs and your planned lifestyle. Like all financial forecasts, it is no sure thing.
For instance, consider the sharp increases in housing costs during the late 1990s and 2000s, and in healthcare spending over recent decades. In 2019, Medicare enrollees’ out-of-pocket drug costs totaled 12% of the population’s median income, and that’s not counting the escalating cost of supplemental Medicare coverage.11
The rising cost of living, in general, must also be a cause for concern since your retirement income from personal savings won’t get a COLA bump annually.
Retirement Reality Check
So, is the “saving-too-much” theory flawed? For many Americans not saving anything at all, it’s not even applicable. You need a calculator, not a financial pundit, to figure out whether you’re saving too much, too little, or just enough for your needs. You should consider the following:
- How much you have saved to date
- How much you plan to save each month
- Your desired retirement lifestyle
- Your projected rate of return on your savings
You’ll need to consider factors that apply to all retirees and those specific to your situation. For instance, will you need to purchase long-term care insurance because of your health profile? In addition to your savings, what income can you expect from sources such as royalties or investment properties? Are there others relying on you for financial support?
The answer to these questions will help you decide whether you can afford to save less and spend more.
Spend or Save?
Most of us would prefer to enjoy our hard-earned money now rather than save for retirement. At the end of the day, saving for retirement is like paying for an insurance policy. You might not need it, but if you do, you’ll be glad you have it.
Of course, saving for the future may be even better than an insurance policy, because if you don’t need the amount you saved, you are free to spend it on life’s little luxuries, leave it to your offspring, or donate it to charity.
If retirement is still on the distant horizon for you, take a look at your own personal circumstances rather than focusing on the theories and trends advanced by experts.
Keeping your money out of the clutches of the financial services industry won’t do you much good if you end up poor in the process.
How Much Money Do You Need to Save for Retirement?
The amount of money needed for retirement will differ for every individual. Factors that this will depend on include how much a person can save, the type of lifestyle they currently lead, the lifestyle they want in retirement, and the expenses that they will have. Experts recommend saving anywhere between 80% to 90% of your pre-retirement annual income.
How Much Does a Normal Person Have in Their Savings?
According to the Federal Reserve’s Board of Survey of Consumer Finances, the average savings for Americans under 35 not including retirement accounts is approximately $13,040. The average savings for those between the ages of 55 and 64, the amount is about $66,850.12
How Much Do People Retire With?
According to Vanguard, participants in their retirement accounts aged 65 and older have an average account balance of $232,710. Those between the ages of 55 and 64 have an average account balance of $207,874.13
The Bottom Line
Saving is important. It allows you to be prepared for emergencies, stay out of debt, and purchase assets, such as homes, that will increase your net worth. Knowing whether or not you’re saving too much can be a difficult question to answer, as it varies for every individual. Assessing your finances, making budget projections, particularly for retirement, and knowing what kind of lifestyle you intend to live in retirement will help you determine how much you need to save and where you can spend.
Article sources:
Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts. We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in our editorial policy.
- Index Fund Advisors. “Where Are the Customers’ Yachts? A Good Hard Look at Wall Street.”
- Morningstar. “Estimating the True Cost of Retirement,” Pages 3, 7, 8, and 11.
- Ameriprise Financial. “Ameriprise Study: Retirees Ready, but Reluctant to Spend Savings.”
- Goodreads. “Die with Zero: Getting All You Can from Your Money and Your Life.”
- Transamerica Center for Retirement Studies. “Post-Pandemic Realities: The Retirement Outlook of the Multigenerational Workforce,” Page 102.
- Social Security Administration. “Cost-of-Living (COLA) Information for 2024.”
- Social Security Administration. “Improving the Measurement of Retirement Income of the Aged Population.”
- Social Security Administration. “Status of the Social Security and Medicare Programs: A Summary of the 2023 Annual Reports.”
- Kaiser Family Foundation. “Medicare Advantage in 2023: Enrollment Update and Key Trends.”
- Board of Governors of the Federal Reserve System. “Report on the Economic Well-Being of U.S. Households in 2022 — May 2023: Housing.”
- Kaiser Family Foundation. “How Much Do Medicare Beneficiaries Spend Out of Pocket on Health Care?”
- Board of Governors of the Federal Reserve System. “Survey of Consumer Finances (SCF): Transaction Accounts by Age of Reference Person,” Select “Units: Mean” and “Display: Under 35 and 55–64.”
- Vanguard. “How America Saves 2023,” Page 53.
Source:
https://www.investopedia.com/articles/retirement/07/save_too_much.asp
Article #2: Advantages Of Oversaving (From Digital Nomad Physicians)
By Dr. Mo, December 2, 2017
Oversaving is a real phenomenon. It’s commonly fueled by the financial industry who stands to profit from this. The average worker may not be aware of it but the drive to oversave is one of the primary shackles for the current wage slave.
Oversaving is supposed to cure fears, decrease risk, and potentially afford one a better lifestyle.
Financial institutions profit from you working longer and holding more assets with them. Oversaving means that you will:
- spend more years working
- spend more money
- have a larger savings account
- take on more debt
- invest more in a brokerage account
- take on more risks
Disadvantages of Oversaving
Before I discuss the advantages of oversaving, let me state the obvious: in order to save more than you need, you will have to trade more free time for more income.
If time autonomy isn’t a motivator for you, realize that the more you work the more risks you take on.
Work is associated with stress which can negatively affect your health.
There is the risk of lawsuits or accidents on the drive to work.
The longer you live a lifestyle reliant on a regular income, the worse off you’ll be should that income stop some day.
Even worse is the false sense of security afforded by having a large stash. In this new fickle economy plasticity is what matters. It’s better to diversify our skills rather than save more money.
The Concept Of Saving
We generate income and save it in cash equivalents which represents our purchasing power. If I spend all of my earnings during my working years then I can’t accumulate any savings. To save more I would need to budget more strictly.
The banks pulled a bait & switch on us when it comes to savings accounts. For decades we have learned to deposit our money in banks which were in charge of protecting our assets and helping them grow. It was a business transaction. The bank was fortunate to have willing clients who allowed them the use of their savings in order for the bank to turn a profit.
Once everyone bought into the banking idea as a standard, banks started taking advantage of our complacency. They made loads of money by selling high-risk debts and returned ever-lower returns on the money we parked in their accounts. All the while, they were making very healthy profits by lending out our money to others.
Read about how banks make their money.
Saving For Retirement
I see 2 methods for saving for retirement:
- saving enough cash to live off of until death (inefficient)
- living off of investment returns (efficient)
If you set aside $50,000 every year using the first method then you’ll have a cash savings account of $500,000 in 10 years. The money will have lost some value due to inflation over this time. This stash will not continue to grow unless you add more money to it.
Using the second method, you’ll potentially have $730,000 after 10 years of investing $50k annually. This money could then continue to grow until you retire. You could take a little off the top every year to cover your living expenses in retirement.
Inflation
Using the first method it’s likely that the healthcare professional would have a much smaller spending potential due to the effects of inflation. Oversaving in this situation would actually be wise. If you aren’t going to be efficiently invested in the market, oversaving would be advisable.
Even though their savings stash might be impressive, the buying power would be lower since money tends to lose value over time.
The same fast-food burger will cost $20, eventually.
Passive Income
Through a passive income method the balance of the portfolio will fluctuate with the market. However, you’ll continue to see it trend towards the positive as long as the securities market continues to exist.
Inflation won’t be an issue over the long-run since index funds tends to keep up with inflation. You can then spend from your assets by either living off of the dividend yields or combining that with selling some appreciated funds.
If you oversave for this method then you may have traded valuable free time for more income. However, I can make the argument that oversaving has some benefits if they are intentional; let’s discuss that now.
Reasons To Oversave
I am against the idea of oversaving when you are using a tried and true investment strategy for the purpose of having adequate funds in retirement. But if you want to leave a legacy behind or if you want the option of living a much more lavish lifestyle, then it can make sense.
1. Leaving Behind An Inheritance
I am struggling with how best to give back to the world now that I am retired and financially independent. I tried volunteering and it didn’t give me the satisfaction I was hoping for.
Before leaving Portland for Barcelona I decided that earning money and giving it to a good cause would most meaningful to me. Extrapolating that into the future, I would like to not have to touch my net worth so that I can do something even more meaningful with it later.
For my readers who have children, oversaving allows you to leave behind resources for the next generation.
2. Having Extra Money To Donate
I could assign my assets to be liquidated upon my death and dispersed to the causes I believe in.
Alternatively, I could create an empire of investments and businesses which can perpetually generate a solid ongoing income and donate that income to the causes I believe in.
The reason I favor this latter option is that it’s more in line with my passion for passive income. The asset would need to be managed. A competent financial adviser should be able to handle that and a lawyer can disperse the profits as instructed.
3. Aggressive Investment Style
If you are exposing your investment to high risk then you likely will need to save a little more to factor for your portfolio’s fluctuations.
High risk is not exactly the same as excess risk. The latter would be investing in junk bonds and trading options.
High risk investing could be done intelligently. The higher the risk the more fluctuance the portfolio will have. Of course that also means that the returns will be higher.
4. Lack Of Investment Experience
Personal finance hobbyists are adamant that you don’t need a financial adviser. It’s believed that paying for a financial adviser is a waste of time.
If you are an expert investor and know exactly what mistakes to avoid when it comes to your finances then you may not need a financial adviser. However, the road to wealth is treacherous. Having someone guide you might be worth a lot more than the couple hundred dollars you spend on them a month.
5. You Plan On Never Working Again
I think it’s incredibly rare that a high-achieving healthcare professional will never engage in income-generating work.
However, if you are planning on never working again and hiding under your blanket polishing off 40 ouncers then it might be wise to save a little extra. Having that extra cushion will get you through even the longest bear markets.
6. Others Will Get Off Your Back
I assure you that no matter how much you save and invest others will say it’s not enough. At the least the higher your net worth the more ridiculous their reasons will become.
“$1M? Nah dude! You’re a doctor, you can’t retire off of that!”
“Yea $2M is great but what you gonna do if you get cancer tomorrow and need a $1M experimental therapy?”
“$8M? Yea I mean it’s good but with that much money you’re like every lawyer’s target. What if you get sued?”
7. Curb Your Own Fears
I’ve pulled the plug on traditional employment and I have less than $1M saved up. There are panic moments when I think that $1M is not even close to enough.
Having more can help you feel more secure. Sometimes the feeling of security is hard to justify but incredibly worthwhile emotionally.
Source:
https://www.digitalnomadphysician.com/oversaving/
Article #3: Oversaving: What it is and What to do About It (From Filled With Money)
By Filled With Money, March 31, 2023
Many people are oversaving for retirement and don’t even know it. They are saving and investing 50%+ of their income for multiple decades without thinking of what the invested amount could turn into by retirement time. There is such a thing as too much of a good thing.
Currently, my retirement account balances total $250,000. That means if I do not contribute any more money to my 401k for the rest of my life, it would grow into $5.4M in 40 years at an 8% growth rate. That is a phenomenal amount of money at retirement.
Sure, $5.4M won’t be worth that much in 40 years, but I suspect it will still be more than 95% of Americans. This is if I do NOT contribute a single dollar more to the accounts. Knowing me, I know that I’ll be contributing more and more each and every year.
This is a classic case of oversaving. If I spend 100% of my paychecks and do nothing with my investments, I will retire a multimillionaire by the end of it all. That means a lot and that’s also a good case for why I shouldn’t be saving more money and instead enjoy it.
Although it is a difficult habit for me to change by now, I want others to learn from my possible mistake so that they don’t make the same mistakes themselves. Too many people deprive themselves of enjoyment in order to have one extra million by retirement.
Which would not have changed their quality of life in any way whatsoever.
What is Oversaving?
Oversaving is when some saves money to a fault. Saving money is a good thing but saving too much money is a bad thing. Oversaving is saving money for the sake of saving and it’s in line with the frugality disease that people might not know they have.
It’s a disorder that makes the person save more money even if they don’t need to save more money in the first place. We can’t take our money with us to the grave. There are certain times when we need to spend money to move forward and level up our lives.
When you make $200,000, you shouldn’t feel guilty about a $10 upgrade in your meal. It’s trying to save too much that you end up saving money at the detriment of your happiness. Whether we like it or not, we enjoy spending money and it becomes a source of our happiness.
Spending money is when we enjoy the fruits of our labor. That all our hard work wasn’t for nothing. Our hard work was for us to increase the quality of life for ourselves and family. However, when you don’t spend money at all costs even if you can afford to is when it’s a problem.
Oversaving is a genuine problem. I would be the last one to say that saving is a problem. However, I recognize that over saving is a problem because it brings us misery when we don’t spend any of the money that we earn. It’s our hard earned money. When we need to spend, we should spend.
We only live once.
Is Oversaving Possible?
After reading the many financial independence blogs and YouTube videos, you may be wondering if oversaving is even possible in the first place. The answer is a resounding yes, without a doubt. There are people who hoard every cent they earn.
Too many people see saving as the holy grail and do not know when they can afford to spend money. I’m currently in the building phase right now and I would like to be a millionaire as quickly as I possibly can. Therefore, I am still saving money and I know I’m doing it to good use.
However, I know that there will come a point where I am oversaving and it is not a good decision to make. When I become a millionaire or come close to becoming a millionaire is when I’m going to let loose with my wallet. I know that I can enjoy my money then.
Money is a tool to allow you to live a better life. There truly is no point in having millions and millions of dollars if you don’t even know what to do with them. Bill Gates famously said he couldn’t spend the money he has, even if he tried to. That is oversaving at its finest.
He can’t take it with him to the grave. Wanting to be rich is definitely a noble and a great goal. However, it shouldn’t consume you so much that it is your only goal. Money isn’t everything. There are many more important things in life than money.
Saving too much money is definitely something that needs to be addressed. You don’t want to sacrifice everything just to have a little more money.
What to do About Oversaving
So then here are the 7 things you can do if you are oversaving.
1) Contribute Less to Your 401k
401k money is NOT liquid. You can’t spend it freely without incurring a tax penalty. Not until you are of retirement age. Yes, there are ways you can bypass this with an SEPP plan. However, it’s still complicated and has a lot of restrictions on top.
Therefore, a way to bypass oversaving is to contribute less to your 401k. Even if you have the income to. These days, people are preferring to save all their money in liquid brokerages instead of investing their money in a 401k. 401ks are wonderful retirement vehicles.
However, the liquidity is the biggest drawback to contributing to a 401k. There’s no point in having $4M in your 401k by your 40s if it means you can’t even a penny of that money in the first place. There has to be a way to access your money free and clear without scrutiny from the government.
2) Designate a Fun Budget
The way to combat oversaving is to designate a fun budget that you’re not allowed to feel guilty for using. One of my friends wanted to purchase a $7,000 antique Mustang car and asked me if it was financially prudent to do so.
I replied that as long as it’s within his fun budget, he’s not allowed to feel guilty. He went through with the purchase with that mindset. He and his wife make a combined $325k+ so I have no doubt he’s doing just fine. The antidote to the oversaving mindset is to spend money on fun.
We need to have a little bit of fun in our life. It’s a necessity and it can’t be neglected. We can’t mindlessly spew out output like we’re a bunch of machines and robots. A fun budget will do wonders for your life and mindset as you navigate through the journey of being a millionaire.
It’s time to reward yourself from time to time.
3) Review Your Spending
After you review your spending, you might realize that you don’t need to save as much money as you think you do. You may realize you’re saving too much money and you need to cut back a little bit! This is why tracking where your dollar goes is crucial.
You just never know how much money you’re not spending until you run the numbers and see it with your own eyes. This year, I spent the most money I’ve ever spent. Mostly because I had to buy a new $14k car due to a car accident.
However, in any case, I have zero regrets with the amount of money I spent.
Even though it’s the most money I’ve ever spent in one year, I’m still OK, mentally and physically. Review your spending to properly and objectively assess whether you’re saving too much money. If you allotted it in your budget, there’s no need to feel bad about spending the funds.
As long as you work more to replenish the funds and then some, everything will be OK.
4) Shift Your Mindset from the Frugality Disease
The frugality disease is not the best mindset and headspace to be in. Saving is a good thing but saving too much money is a bad thing. Not only can being cheap in the short term cost you in the long term, people don’t want to hang out with miserly people.
Oversaving is connected to the frugality disease mindset because not spending any amount of money at all isn’t healthy. Sacrificing present happiness for future money is a good idea, to a point. However, there’s a tipping point where that no longer makes sense.
Especially also if you’re not the only person who the decision is affecting. If you have a family and you are also forcing them to adopt your frugality disease ways, that’s no way to live. That’s not the way to enjoy life and move forward with life. Life is more than dollars in a bank account.
There are multimillionaires out there who harp on their wives for spending an extra $100. That’s saving too much money.
5) Spend Money for Health
If it’s for health, it’s money well spent. Period, end of story. I have bad digestion issues. Therefore, I spent whatever money I needed to help ease my digestion problems. I did things such as go to the PCP and GI. I even bought probiotics and Omeprazole to see if that’d help.
Even though they did help, what really helped was taking care of my diet. I cannot eat foods and drink liquids past a certain time and/or during a certain time of day. There’s not a condition named with mine but it has to do with my digestion system not working as efficiently as others’.
Other people have no problem falling asleep right after they eat. I cannot fall asleep after I eat as easily as others. Sometimes, it takes me hours of tossing and turning before I fully fall asleep after eating. I gladly spent money when it came to that health because ever since my sleep improved, my life improved.
When it comes to health, oversaving should be thrown out the window. It’s money very well spent.
6) Increase Your Quality of Living
Life is all about improving your quality of living as time passes. When I first graduated from college, I lived in a cockroach infested place in Birmingham, Alabama for $640 per month. It wasn’t the best living conditions. However, every year, I moved up from that standard of living.
I slowly moved to an apartment that has no cockroach problems. Then I moved into an apartment that’s 20% bigger. Then I moved into an apartment 20% bigger than that. My quality and standard of living improved every year. You are combatting oversaving if the quality of life improves every year.
One day, I will move into a house and I will live very well. However, until then, I know I have to put in a lot of legwork in order to get there. This is how you make sure you’re not saving too much. It’s when your quality of life increases every year even while your net worth increases every year as well.
You don’t want to live poorly just to save an extra dollar. At a certain point, you become frustrated that you’re living poorly.
7) Realize You Have a Problem
You don’t want to be the richest person in the grave. Oversaving IS a problem. Having too much is better than having too little. However, having too much is still a bad thing. You can’t even enjoy any of your hard work. it’s a good goal to be rich for your future family.
However, that doesn’t mean that you’re not important either. You have needs and wants that should be fulfilled as well. There’s no need to bear the entirety of your family’s burden all by yourself. You have your own wants and needs and they deserve to be taken care of.
It’s a noble goal to protect and ensure your family’s financial wellbeing. However, not when it comes to the detriment of your own sanity. We can’t help someone else with their floatation devices if our own floatation devices aren’t taken care of as well.
Spending money is not the enemy. It’s spending money on things that don’t give you value that’s the enemy.
Oversaving is a Real Thing
Too many people don’t understand the effects that oversaving can have on one’s psyche. It’s an actual real thing that has to be addressed. Luckily, it can easily be tended to. It’s harder to save money than it is to spend it. Spending money is easier than saving as much money as you can.
Therefore, all you have to do is get out the credit card and start spending money on things that add value to you and your family’s life. I’m currently in the saving phase. However, once I have a million dollars, I don’t have to save as much money as I’m doing right now.
I can turn on the brakes a little bit to saving money. The reason why I save so much in my 20s is because a dollar in my 20s is worth $10 in my 60s. That’s too much of a spread for me to NOT save money. And I enjoy saving money, which is the good thing.
Once I start a family, then I know that it’s not just my decision anymore. It will be the decision of the family and what’s in their best interests. Therefore, I will turn on the brakes after I start a family. Before I do, I’m working my butt off to get my finances in order.
Too many financial independence, retire early folks don’t understand the perils of oversaving. It’s high time to be aware of the problems of going too far on one side or the other. We don’t want to be biased, we want to live a balanced life so we don’t go too far off the deep end, one way or another.
Otherwise, we get miserable.
Oversaving: What to do About it Shortlist
- Contribute less to your 401k
- Designate a fun budget
- Review your spending
- Shift your mindset from the frugality disease
- Spend money for health
- Increase your quality of living
- Realize you have a problem
Source:
https://filledwithmoney.com/oversaving/
Article #4: Paradox of thrift (From Wikipedia)
The paradox of thrift (or paradox of saving) is a paradox of economics. The paradox states that an increase in autonomous saving leads to a decrease in aggregate demand and thus a decrease in gross output which will in turn lower total saving. The paradox is, narrowly speaking, that total saving may fall because of individuals’ attempts to increase their saving, and, broadly speaking, that increase in saving may be harmful to an economy.[1] The paradox of thrift is an example of the fallacy of composition, the idea that what is true of the parts must always be true of the whole. The narrow claim transparently contradicts the fallacy, and the broad one does so by implication, because while individual thrift is generally averred to be good for the individual, the paradox of thrift holds that collective thrift may be bad for the economy.
It had been stated as early as 1714 in The Fable of the Bees,[2] and similar sentiments date to antiquity.[3][4] It was popularized by John Maynard Keynes and is a central component of Keynesian economics.
The paradox
The argument begins from the observation that in equilibrium, total income must equal total output. Assuming that income has a direct effect on saving, an increase in the autonomous component of saving, other things being equal, will move the equilibrium point at which income equals output to a lower value, thereby inducing a decline in saving that may more than offset the original increase.
In this form it represents a prisoner’s dilemma as saving is beneficial to each individual but deleterious to the general population. This is a “paradox” because it runs contrary to intuition. Someone unaware of the paradox of thrift would fall into a fallacy of composition and assume that what seems to be good for an individual within the economy will be good for the entire population. However, exercising thrift may be good for an individual by enabling that individual to save for a “rainy day”, and yet not be good for the economy as a whole.
This paradox can be explained by analyzing the place, and impact, of increased savings in an economy. If a population decides to save more money at all income levels, then total revenues for companies will decline. This decreased demand causes a contraction of output, giving employers and employees lower income. Eventually the population’s total saving will have remained the same or even declined because of lower incomes and a weaker economy. This paradox is based on the proposition, put forth in Keynesian economics, that many economic downturns are demand-based.
History
While the paradox of thrift was popularized by Keynes, and is often attributed to him,[3] it was stated by a number of others prior to Keynes, and the proposition that spending may help and saving may hurt an economy dates to antiquity; similar sentiments occur in the Bible verse:
There is that scattereth, and yet increaseth; and there is that withholdeth more than is meet, but it tendeth to poverty.
which has found occasional use as an epigram in underconsumptionist writings.[3][5][6][7]
Keynes himself notes the appearance of the paradox in The Fable of the Bees: or, Private Vices, Publick Benefits (1714) by Bernard Mandeville, the title itself hinting at the paradox, and Keynes citing the passage:
As this prudent economy, which some people call Saving, is in private families the most certain method to increase an estate, so some imagine that, whether a country be barren or fruitful, the same method if generally pursued (which they think practicable) will have the same effect upon a whole nation, and that, for example, the English might be much richer than they are, if they would be as frugal as some of their neighbours. This, I think, is an error.
Keynes suggests Adam Smith was referring to this passage when he wrote “What is prudence in the conduct of every private family can scarce be folly in that of a great Kingdom.”
The problem of underconsumption and oversaving, as they saw it, was developed by underconsumptionist economists of the 19th century, and the paradox of thrift in the strict sense that “collective attempts to save yield lower overall savings” was explicitly stated by John M. Robertson in his 1892 book The Fallacy of Saving,[3][8] writing:
Had the whole population been alike bent on saving, the total saved would positively have been much less, inasmuch as (other tendencies remaining the same) industrial paralysis would have been reached sooner or oftener, profits would be less, interest much lower, and earnings smaller and more precarious. This … is no idle paradox, but the strictest economic truth.
— John M. Robertson, The Fallacy of Saving, pp. 131–132
Similar ideas were forwarded by William Trufant Foster and Waddill Catchings in the 1920s in The Dilemma of Thrift.[9]
Keynes distinguished between business activity/investment (“Enterprise”) and savings (“Thrift”) in his Treatise on Money (1930):
… mere abstinence is not enough by itself to build cities or drain fens. … If Enterprise is afoot, wealth accumulates whatever may be happening to Thrift; and if Enterprise is asleep, wealth decays whatever Thrift may be doing. Thus, Thrift may be the handmaiden of Enterprise. But equally she may not. And, perhaps, even usually she is not.
He stated the paradox of thrift in The General Theory, 1936:
For although the amount of his own saving is unlikely to have any significant influence on his own income, the reactions of the amount of his consumption on the incomes of others makes it impossible for all individuals simultaneously to save any given sums. Every such attempt to save more by reducing consumption will so affect incomes that the attempt necessarily defeats itself. It is, of course, just as impossible for the community as a whole to save less than the amount of current investment, since the attempt to do so will necessarily raise incomes to a level at which the sums which individuals choose to save add up to a figure exactly equal to the amount of investment.
— John Maynard Keynes, The General Theory of Employment, Interest and Money, Chapter 7, p. 84
The theory is referred to as the “paradox of thrift” in Samuelson’s influential Economics of 1948, which popularized the term.
Paradox of thrift according to Balances Mechanics
The paradox of thrift formally can be well described as a circuit paradox using the terms of Balances Mechanics developed by the German economist Wolfgang Stützel (German: Saldenmechanik): It is about saving by cut of expenses, which always leads to a revenue surplus of the individual, so to saving of money. But once the totality (in the meaning of every each) saves at expenses, the revenues of economy only decline.
- Partial sentence: For individual economic entities or a partial group of economy actors it is valid: the lower the expenses the higher the revenue surplus.
- Size mechanics: The expenses decline of a partial group of economy actors can only lead to a revenue surplus if the complementary group does or accepts an expenses surplus.
- Global sentence: A general decline of expenses always leads the totality to a decline of revenues and never to a revenue surplus.[10]
Related concepts
The paradox of thrift has been related to the debt deflation theory of economic crises, being called “the paradox of debt”[11] — people save not to increase savings, but rather to pay down debt. As well, a paradox of toil and a paradox of flexibility have been proposed: A willingness to work more in a liquidity trap and wage flexibility after a debt deflation shock may lead not only to lower wages, but lower employment.[12]
During April 2009, U.S. Federal Reserve Vice Chair Janet Yellen discussed the “Paradox of deleveraging” described by economist Hyman Minsky: “Once this massive credit crunch hit, it didn’t take long before we were in a recession. The recession, in turn, deepened the credit crunch as demand and employment fell, and credit losses of financial institutions surged. Indeed, we have been in the grips of precisely this adverse feedback loop for more than a year. A process of balance sheet deleveraging has spread to nearly every corner of the economy. Consumers are pulling back on purchases, especially on durable goods, to build their savings. Businesses are cancelling planned investments and laying off workers to preserve cash. And, financial institutions are shrinking assets to bolster capital and improve their chances of weathering the current storm. Once again, Minsky understood this dynamic. He spoke of the paradox of deleveraging, in which precautions that may be smart for individuals and firms — and indeed essential to return the economy to a normal state — nevertheless magnify the distress of the economy as a whole.”[13]
Sectoral Balances analysis shows the effect of net savings by the private sector. It must either be funded by a public sector deficit or a by a foreign sector deficit which is equivalent to exports being higher than imports for the country analyzed. Therefore, there exists two types of possible equilibriums for a growing economy. Either the public sector is funding the growth of the private sector via a slight deficit or its current account balance is positive and the country is a net exporter of goods and services.
Criticisms
Within mainstream economics, non-Keynesian economists, particularly neoclassical economists, criticize this theory on three principal grounds.
The first criticism is that, following Say’s law and the related circle of ideas, if demand slackens, prices will fall (barring government intervention), and the resulting lower price will stimulate demand (though at lower profit or cost — possibly even lower wages). This criticism in turn has been questioned by New Keynesian economists, who reject Say’s law and instead point to evidence of sticky prices as a reason why prices do not fall in recession.
The second criticism is that savings represent loanable funds, particularly at banks, assuming the savings are held at banks, rather than currency itself being held (“stashed under one’s mattress”). Thus an accumulation of savings yields an increase in potential lending, which will lower interest rates and stimulate borrowing. So a decline in consumer spending is offset by an increase in lending, and subsequent investment and spending.
Two caveats are added to this criticism. Firstly, if savings are held as cash, rather than being loaned out (directly by savers, or indirectly, as via bank deposits), then loanable funds do not increase, and thus a recession may be caused — but this is due to holding cash, not to saving per se.[14] Secondly, banks themselves may hold cash, rather than loaning it out, which results in the growth of excess reserves — funds on deposit but not loaned out. This is argued to occur in liquidity trap situations, when interest rates are at a zero lower bound (or near it) and savings still exceed investment demand. Within Keynesian economics, the desire to hold currency rather than loan it out is discussed under liquidity preference.
Third, the paradox assumes a closed economy in which savings are not invested abroad (to fund exports of local production abroad). Thus, while the paradox may hold at the global level, it need not hold at the local or national level: if one nation increases savings, this can be offset by trading partners consuming a greater amount relative to their own production, i.e., if the saving nation increases exports, and its partners increase imports. This criticism is not very controversial, and is generally accepted by Keynesian economists as well,[15] who refer to it as “exporting one’s way out of a recession”. They further note that this frequently occurs in concert with currency devaluation[16] (hence increasing exports and decreasing imports), and cannot work as a solution to a global problem, because the global economy is a closed system — not every nation can increase net exports.
Austrian School criticism
The Austrian School economist Friedrich Hayek criticized the paradox in a 1929 article, “The ‘Paradox’ of Savings”, questioning the paradox as proposed by Foster and Catchings.[17] Hayek, and later Austrian School economists agree that if a population saves more money, total revenues for companies will decline,[citation needed] but they deny the assertion that lower revenues lead to lower economic growth, understanding that the additional savings are used to create more capital to increase production. Once the new, more productive structure of capital has reorganized inside of the current structure, the real costs of production is reduced for most firms.[citation needed] Some criticisms argue that using accumulated capital to increase production is an act which requires spending, and therefore the Austrian argument does not disprove the paradox.[citation needed] However, this confuses spending on capital goods with spending on consumer goods. The paradox only refers to saving by not spending on consumer goods and ignores the productive use of those savings.
Sources:
- These two formulations are given in Campbell R. McConnell (1960: 261–62), emphasis added: “By attempting to increase its rate of saving, society may create conditions under which the amount it can actually save is reduced. This phenomenon is called the paradox of thrift … [T]hrift, which has always been held in high esteem in our economy, now becomes something of a social vice.”
- ^ Keynes, The General Theory of Employment, Interest and Money, “Chapter 23. Notes on Merchantilism, the Usury Laws, Stamped Money and Theories of Under-consumption”
- ^ Jump up to:a b c d Nash, Robert T.; Gramm, William P. (1969). “A Neglected Early Statement the Paradox of Thrift”. History of Political Economy. 1 (2): 395–400. doi:10.1215/00182702–1–2–395.
- ^ See history section for further discussion.
- ^ English, Irish and Subversives Among the Dismal Scientists, Noel Thompson, Nigel Allington, 2010, p. 122: “A suggestion that a more equal distribution of income might be a remedy for general stagnation — and that excess saving can be harmful — is implicit in the quotation from the Old Testament on the Reply to Mr. Say [by John Cazenove (1788–1879)].”
- ^ A Reply to Mr. Say’s Letters to Mr. Malthus, by John Cazenove, uses the verse as an epigram.
- ^ Studies in economics, William Smart, 1895, p. 249
- ^ Robertson, John M. (1892). The Fallacy of Saving.
- ^ William Trufaut Foster (1926). The Dilemma of Thrift. Pollak Foundation for Economic Research. Retrieved 8 January 2013.
- ^ Wolfgang Stützel: Volkswirtschaftliche Saldenmechanik. Mohr Siebeck, (2. Auflage) Tübingen 2011. S. 74.
- ^ Paradox of thrift, Paul Krugman
- ^ Eggertsson, Gauti B.; Krugman, Paul (14 February 2011), “Debt, Deleveraging, and the Liquidity Trap: A Fisher-Minsky-Koo Approach” (PDF), The Quarterly Journal of Economics, 127 (3): 1469–1513, doi:10.1093/qje/qjs023, retrieved 2011–12–15
- ^ Federal Reserve-Janet Yellen-A Minsky Meltdown-April 2009
- ^ See section 9.9 and 9.11 http://www.auburn.edu/~garriro/cbm.htm
- ^ The paradox of thrift — for real, Paul Krugman, July 7, 2009
- ^ Devaluing History, Paul Krugman, November 24, 2010
- ^ kanopiadmin (2007–12–06). “Hayek on the Paradox of Saving”. Mises Institute. Retrieved 2019–11–06.
18. Samuelson, Paul & Nordhaus, William (2005). Economics (18th ed.). New York: McGraw-Hill. ISBN 0–07–123932–4.
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