The Paradox of Thrift

Extract from 'Macroeconomics' by William Mitchell, L. Randall Wray & Martin Watts

Compositional Fallacies are errors in logic that arise when we infer that something which is true at the individual level is also true at the aggregate level.

Compositional Fallacy Example #2:

I've already posted an example of the compositional fallacy as it applies to unemployment using dogs and bones as an example

Here's another one.

“A contemporary example of the flawed reasoning that follows a fallacy of composition is the paradox of thrift, which is that while an individual can increase their saving if they are disciplined enough, the same reasoning does not apply at a macro level. By reducing their individual consumption spending a person can of course increase the proportion they save, and enjoy higher future consumption possibilities as a consequence. The loss of spending to the overall economy caused by this individuals adjustment would be small and so there would be no detrimental impacts on overall economic activity, which is driven by aggregate spending. But imagine if all individuals (all consumers) adopted the same goal at the same time and started to reduce their spending en mass? Surely this would impact sales and hence employment and income at the aggregate level. It is not so clear that after all adjustments are made, we would find that the aggregate saving had risen. This is what Keynes called the paradox of thrift.

Why does the paradox of thrift arise? In other words, what is the source of the compositional fallacy?

The explanation lies in a basic rule of economics, which you will learn once you start thinking in a macroeconomic way: that spending creates income and output. This planned economic activity powers the generation of employment to produce the goods and services. Thus, adjustments in spending drive adjustments in total production (output) in the economy as firms react to higher (lower) sales by increasing (reducing) employment and output.

As a consequence of increased saving, total spending falls significantly, and national income falls (as production levels react to the lower spending) an unemployment rises. The impact of lost consumption on aggregate demand (spending) would be such that the economy could plunge into a recession. Certainly, total saving will be less than individuals planned due to the fall in equilibrium national income. As we will see later, if poor sales due to an increased desire to save negatively impact on investment, aggregate saving would certainly fall.”
~William Mitchell, L. Randall Wray & Martin Watts, 'Macroeconomics'