Our podcast on the savings rate drew a lot of comments. I promise you we will get back to Social Security and Medicare in much more detail. (See recent bad news here and this grim chart.) But putting that and the intergenerational warfare aside, one of you asked about Kent Smetters' assumption that the savings rate should naturally adjust to an appropriate level.

I've been puzzling over that too. Since it seems to contradict the Keynesian "paradox of thrift" argument that by saving and not spending, we can send the economy into a downward spiral.

I emailed Steve Fazzari, a self described "radical Keynesian" who explained things this way:

 

The Keynesian perspective on saving suggests that there are two, largely independent, perspectives one must consider: micro and macro. From a micro perspective, people choose saving and consumption to satisfy their own goals as they see them individually. While I am skeptical that people make these decisions with a narrowly rational, fully forward-looking perspective, there is nothing fundamentally inconsistent with Keynesian macro with this the rational choice view of saving. For example, forward-looking rational people may look at the current situation and decide that their future wealth looks a lot lower than they thought it would be, so they have to save more to provide an adequate retirement income. This would be perfectly sensible, and it would not be inconsistent with basic Keynesian thinking.

The Keynesian problem involves what happens at the macro level when micro decisions of many individuals are aggregated. No individual sees themselves as destroying someone else's income when they save more. But, indeed, this is what happens (as in the restaurant example from my podcast discussion with Russ Roberts). With inadequate demand, some businesses reduce output, jobs are lost, and productive resources sit idle. Thus, a person's possibly fully rational micro decision will spill over to others with the effect that we get a bad macro outcome: wasted labor and capital.

This much of the discussion, while not widely appreciated in current economic thinking, is really not all that controversial. If people buy less, firms will produce less. But what does become more controversial is the question of whether some kind of "natural" price adjustment will solve the problem. Most economists would say yes, at least over some "long-run" horizon. But more radical Keynesians, like me, are skeptical. This gets a bit complicated, but let me share a little bit of intuition.

The typical assumption is when prices fall people buy more. This seems obvious, but why? Economists identify two factors. First is the "substitution effect:" if the price of apples fall relative to oranges people will substitute away from oranges toward apples, and the demand for apples rises. Second is the "income effect:" if you were buying apples before their price went down, and your money income is constant, a lower price for apples raises your overall purchasing power. Some of this additional purchasing power will be spent on apples, so the demand for apples goes up. This is all perfectly sensible for individual goods, considered in isolation.

But what happens in the aggregate? If the prices of all goods and services fall (including wages) due to a generalized insufficiency of aggregate demand, then there is no substitution effect, since the price of everything is going down. Furthermore, one person's spending is someone else's income, so if the price of everything is falling, so are money incomes. Thus, the income effect disappears when we aggregate.

Things can get much more complicated. There are some channels for price adjustment that are stabilizing and some that are destabilizing. In the end, it's far from obvious that wage and price adjustment will solve the macro problem of under-utilized resources. (The fact that almost all policy makers seem committed to avoiding deflation is a signal that falling prices would not be a cure to our current problems.)

These points are discussed in much more detail in the papers I sent you. One "take away," however, is that the logic of micro demand cannot be easily extended to the whole system. This is an important message of Keynesian macroeconomics.