In this article, I explain the main differences between neoclassical and postkeynesian approaches regarding the role of saving in the economy.
The paradox of thrift is one of the main results of Keynesian economics. It states that, contrary to the classical approach, the habit of thrift while might be beneficial at the individual level, could be harmful at the aggregate level (this is also known as an example of the fallacy of composition). It turns out that this discrepancy reveals fundamental differences between Neoclassical and Keynesian economic thought. In the following lines, I will explain the underlying assumptions and mechanisms of both economic schools in order to understand why Neoclassical economists deny the paradox of thrift whereas Keynesian and Post-Keynesian agree in characterizing the economies with this paradox.
Let’s consider the economy from a Neoclassical’s point of view. One of the features of this school of thought is its particular conception of the economy. Specifically, the economy is compounded by households that offer their workforce and capital to firms that, at the same time, are owned by these households (Sørensen Whitta-Jacobsen 2005). There is no clear distinction between entrepreneurs and workers and each individual makes decisions on current consumption and saving in order to maximize its utility function. Moreover, Neoclassical economists conceive that the supply of goods produces its own demand. This is called Says’s law and implies that crises cannot arise as a consequence of endogenous dynamics and, in particular, that the economy works at full capacity so there is no idle capital. This feature is crucial since it enables thinking of the total output as something constrained only by supply-side factors. In the Neoclassical world, the demand will always accommodate the supply of goods, thus the ultimate element that determines the level of output relies on the cost of production rather than demand factors. Under the condition of full capacity, the equilibrium will be achieved through changes in prices instead of quantities.
Hence, cheaper borrowing, lower wages, or any other condition that reduces capitalist’s costs will boost investment, therefore increasing the rate of growth. This conception of the economy will determine a specific role applied to savings. Let’s imagine a sudden increase in the habit of thrift. When this happens, the amount of disposable funds ready for use is higher. Since prices are the adjustable variables, and the credit’s price is the real interest rate, then the equality between saving and investment is going to be achieved by a reduction of interest rates, which consequently will enhance investment (Sørensen Whitta-Jacobsen 2005). Thus, the habit of thrift is a good thing 1 since it fuels capital accumulation. Moreover, Neoclassical growth models point out that the economy tends to arrive at the steady-state level for long-run per capita outcome and capital intensity. These levels are endogenous and depend upon structural parameters, saving rate included. Therefore, the habit of thrift is seen as the stuff that wealth is made of. Moreover, this is considered how first capitalists could create and accumulate wealth in the initial stages of capitalism (Wood 2002), and this good habit is regarded as something still valid in modern economies.
When we approach the Keynesian view, how the economy work is very different. To begin with, the normal state of the economy is not at full capacity, instead, unemployment and idle capital are perennial phenomena under capitalist economies. This fact is exacerbated during crises, therefore the driver factor of the aggregate output is the demand-side of the economy. Here, the notion of effective demand comes into action, and also a new variable appears, which is capacity utilization (u). Effective demand is compounded by two parts, induced demand and autonomous demand (Lavoie 2014). The former one is, in a closed economy, the demand which depends on current economic activity (consumption) whilst the latter element is not determined by the state of the economy; an example of this autonomous demand is investment.
Contrary to the Neoclassical approach, higher real wages will not wane labor demand. In fact, there is a positive relationship between real wages and total output since labor demand is an increasing function of wages (Lavoie 2014). Furthermore, while in Neoclassical theory the economy is compounded by households who are the firm owners, Post-Keynesian models arrive at a conception of the economy based on social classes; workers who earn wages and capitalists who earn profits. According to this view, each class has different consumption behaviours, involving that capitalists have a bigger propensity to save than workers or, put another way, workers consume more of their income than capitalists. Consequently, the distribution between profits and wages enters into consideration, and, differently from the Neoclassical view, total saving is a partition of profits instead of national income. In general, Post-Keynesian models assume workers do not save and thus all savings correspond to a proportion of total profits.
The Keynesian principle of effective demand leads to the Cambridge equation. Following the classical saving assumption according to which saving must be equal to investment, we obtain the following equation: I= spP . 2 Dividing this equation by stock of capital K and rearranging it, we get: g = spr3 which represents the saving function. The combination of the previous saving function with an investment function that depends on the expected profit rate determines the actual profit rate and the capacity utilization (Lavoie 2014). Thus, it is possible to determine an expression for the investment’s rate of growth which is compatible with the long-run equality between realized and expected profit rates, and also it is negatively related to the rate of savings4 (Lavoie 2014). Basically, in Post-Keynesian models savings alter first the effective demand through adjusting capacity utilization and the rate of profit, while the profit cost curve, namely the supply side of the economy, remains unchanged. Hence we have a framework in which demand-side considerations play a major role, the economy is led mainly by effective demand and the equilibrium is achieved by changes in quantities (output) instead of prices.
To sum up, we have seen there are fundamental dissimilarities between Neoclassical and Post-Keynesian approaches. We have identified at least three important differences that make possible opposite results with respect to the habit of thrift. First of all, the Neoclassical school denies the existence of social classes and considers the household as the basic unit which offers capital and labor to firms that are owned by themselves. All this is diametrically opposed to Keynesian economics. For instance, Post-Keynesian models emphasize the relevance of distributional conflict between wages and profits in the determination of macroeconomic variables. Secondly, while the Neoclassical economy is driven by supply factors, in other words, production costs, the economy in the Keynesian view never functions at full capacity so it is driven by demand factors. This draws a positive relationship between labor demand and real wages. Finally, these differences led to opposite considerations of saving. It turns out that a bigger saving rate is beneficial for the whole economy in the Neoclassical approach, however, the propensity to save has different nature in Post-Keynesian models. If everybody saves more, the aggregate effect turns out to be negative via depressing the effective demand. Contrary to Neoclassical school, the sacrifice of current consumption is a bad prescription to the economy and this is the so-called paradox of thrift.
References:
Lavoie, M. (2014). Post-Keynesian economics: new foundations. Edward Elgar Publishing.
Sørensen, P. B., Whitta-Jacobsen, H. J. (2005). Introducing advanced macroeconomics: growth and business cycles. McGraw-Hill Education.
Wood, E. M. (2002). The origin of capitalism: A longer view. Verso.
Tweet- It is important to mention that in one-sector Neoclassical growth models there is an optimal level of saving which maximizes current consumption, so in theory, there is a bound according to which higher saving levels are detrimental to the economy, or at least to household’s welfare. But in general, is assumed that saving is not enough. For instance, during recessions, a conventional Neoclassical policy is austerity
- Where I is investment is equal to the propensity to save sp multiplying profits P
- The growth of saving is equal to the propensity to save out of profits times profit rate
- This result is expressed in the reduced forme of capacity utilization and profit rate in which the propensity to save appears in the denominator. Thus, any increment of the saving rate is contractionary