Paradox of Thrift in recessions and depressions

The Australian’s economics editor Adam Creighton is today advocating for public sector wage cuts by Australian governments, a policy which may be morally virtuous but would be economically damaging in this time of economic contraction, in my view (see Coronavirus pay cuts: This may make you very, very angry). Creighton writes:

Perhaps a temporary higher rate of income tax cutting [public service wages] is the cleanest solution.

During the Depression, the Scullin government cut public sector pay by 20 per cent.

Regular readers will know I’m in favour of public sector wage restraint, but what Creighton is advocating makes no sense in an economic contraction, where it would make things worse. Indeed, policies such as the Scullin government’s public sector wages cut are widely regarded by economic historians as having exacerbated the Great Depression.

In recessions and depressions, the Paradox of Thrift identified by John Maynard Keynes applies. This Paradox is generally described with reference to households but the logic applies to government spending, too. What may be beneficial for households acting alone is not beneficial for the whole economy, as the impact of everyone saving and reducing spending is to reduce output and income across the economy. It is a fallacy of composition to suppose that what is beneficial at the household level is beneficial at the economy-wide level. This is a first-year economics lesson we need to remember in this time of economic contraction.

Adam Creighton is recommending a perverse fiscal policy. Cutting public service wages during this time of contraction would reduce household incomes and aggregate spending and inflict further pain across the economy.

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6 Responses to Paradox of Thrift in recessions and depressions

  1. Stephen Thornton says:

    Spot on Gene. It’s basic economics that in a downturn we need more money in the pockets of people to (hopefully) spend, not less.

  2. Russell says:

    Hi Gene. I disagree. There is very little except food, rent or mortgages or goods bought online that come for OS to spent money on so having public servants with more money in their pocket paid for by debt to be paid back by the private sector does not seem like sharing the load very well. It is not as if they can support the local cafe or tourist sector or retail businesses. I don’t agree with Andrew Creighton very often, a bit to centre Left for me, but he had good points. Of course, you don’t penalise people on the front line in the public service doing more than their fair share now but sure with our overweight QLD public service curtesy of shoring up the Labour vote a few extra dollars could be found.

    • Gene Tunny says:

      Thanks Russell. Good point there’s not much to spend money on at the moment. I agree we should look to cut the cost of the public service but Creighton’s column appeared to be based on a fundamental misunderstanding of basic macroeconomics to me.

  3. Jim says:

    Gene

    I agree generally with the general idea of the paradox of thrift when applied to total government spending in a recession. But I suspect for most public servants (that are generally on above average wages anyway), the marginal propensity to spend their salary above the basics is very,very low at the moment (unless you are buying big TVs online which simply adds to the trade deficit).

    So providing the money is being spent elsewhere (and it sure is at the moment), progressive cutting of public service salaries above (say) $100K would make little, if any, difference to aggregate consumption. Ans channeling that money to others (as is the case) certainly will increase aggregate consumption.

    And I don’t know about the rest of the contractors reading this blog, but I’ve had two public servant clients this week that have asked us to provide double digit discounts on our lowest hourly rates on work through panels. I think this is absolutely OK if it means keeping more people in the workforce, but when the application of lowering income is entirely on one side of the transaction I find it a bit rich.

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