Among the ideas that gained traction in economic debate in the late 1920s was an idea called the “dilemma of thrift”, also referred to as the “paradox of thrift” or “paradox of saving”. The thrust of this theory is the contradictory effects that saving has on the economy: on one hand, it is necessary for future investment and therefore growth, but on the other hand, it reduces the funds slated for current consumption and represents a short-term drag on the economy. The underlying assertion that Hayek identifies which such an idea is “that saving renders the purchasing power of the consumer insufficient to take up the volume of current production,” an assertion which he says “is almost as old as the science of political economy itself.”
Some of the most prominent original exponents of this idea were a pair of American economists: William Trufant Foster and Waddill Catchings, who together wrote several works that outlined this idea, particularly The Dilemma of Thrift (1926) from which the concept gets its name.
Hayek comes down as skeptical at best as to this theory, and the English version of his The “Paradox” of Saving (1931) reflects his critical view by its use of quotation marks in the title. In this post, we’ll cover Hayek’s summary of Foster & Catchings’ work, and Hayek’s own critique of that work.
Foster & Catchings: Crowning Consumption
The Original Dilemma of Thrift
In one sense, the repeated emphasis on consumption as the engine of economic activity that Foster & Catchings resort to is a hallmark of what we now call Keynesian thinking. It was Keynes himself who considered consumption the “obvious…sole end of all economic activity.” One need hardly dispute that consumption is the end of economic activity, but it remains for us to determine whether it is also the means by which changes in that activity are affected.
This is where Foster & Catchings come in. In their 1925 book, Profits: “The one thing that is needed above all others to sustain a forward movement of business is enough money in the hands of consumers [emphasis mine].” In Hayek’s paraphrase, the economic evils of unemployment, idle factories, and trade crises occur “when the buying power in the hands of the consumers is insufficient to purchase the whole industrial output at prices that cover costs.” Elsewhere in Money (1928—Foster & Catching certainly didn’t overthink their titles), the two Americans assumed:
- A constant price level.
- A constant volume and velocity of currency.
- All wages are received/spent and all goods produced in the same period, and all goods are sold in the period immediately following their production.
By the calculations Foster and Catchings make, they indicate that the sum of goods sold can equal to sum of consumption funds if only “industry continues to return to consumers in some way all the money that it took from consumers in the sales price of its product, and as long as consumers spend all that they receive.” But as they explain, neither of these assumptions hold if:
- A producing company retains some of its earnings to invest in future growth (which we could call “corporate saving”).
- Consumers refrain from spending any part of their income.
They explain an example of this in The Dilemma of Thrift: suppose that a corporation “uses…one million dollars of profits to build additional cars, in such a way that all this money goes directly or indirectly to consumers. The company has now disbursed exactly enough money to cover the full sales-price of the cars it has already marketed; but where are the consumers to obtain enough money to buy the additional cars? The corporation has given them nothing with which to buy these cars.” The new cars will not be sold “unless the deficiency (in consumers’ income) is made up from outside sources.”
Hayek summarizes the central paradox according to Foster & Catchings: “Now since the results of corporate saving and of individual saving must be alike, since individuals as well as corporations must save if they are to progress, but since, if this theory is correct, they cannot save at present without frustrating to a certain extent the social purpose of saving, the Dilemma of Thrift is inescapable.”
How to Solve the Paradox
The root cause of these imbalances, according to Foster & Catchings, was that (again Hayek’s paraphrase) “under the existing system of money and credit, additional money gets into circulation, not on the side of the consumers but on the side of the producers, and thus only aggravates the evil of the discrepancy between producers’ disbursements and consumers’ money expenditure.” In short: in periods which producers are likely to expand capacity by retaining profits for investment, those producers are also most likely to receive access to credit funds to further this objective—access which is unavailable to consumers at large.
In Profits, Foster & Catchings outline their theoretical solution: “It is always possible to add to the money circulation in such a way as to benefit the community…In any conceivable situation…an all-wise despot could make a net gain to the community by increasing the volume of money in circulation…If any safe and practicable means could be devised, in connection with increased public works and decreased taxes, or in any other connection, of issuing just enough money to consumers to provide for individual savings and to enable them to buy an enlarged output, and business men were confident that issues to consumers would continue at this rate and at no other rate, there would be no drop in the price-level and no reason for curtailing production, but, on the contrary, the most powerful incentive for increasing production.”
The short version: free money. There are a lot of implications for this which we will mention briefly below, although each of the points mentioned is well worth of a blog post all its own:
- The argument in short seems to reach a similar conclusion to that of universal basic income advocates today, but through a very different set of arguments.
- One wonders how Foster & Catchings would have reacted to the COVID-19 stimulus payments in the United States, which were the closest thing to no-strings-attached free money that country had ever seen. This case would likely fail to meet the criteria that “business men [sic] were confident that issues to consumers would continue at this rate and at no other rate.”
- One also wonders if the increased extension of credit to consumers—home loans, car loans, credit card loans, etc.—qualify as a relevant alleviation of this problem according to the theory.
- Foster & Catchings are right to assume this policy would prevent drops in prices—but they don’t address that such a policy may be inflationary due to the expansion of the money supply.
- The theory also seems to imply a “closed” economic system in which domestic producers serve domestic consumers. Removing this assumption likely creates several problems, as monetary actions that weaken one currency would impact the imports and exports to/from a country, with consequences for the availability of goods and the prices of those goods.
The Great Economic Joust
As Hayek tells it, Foster & Catchings popularized their work by creating an independent panel of adjudicators and offering prize money to any economist whose work was deemed to refute their thesis. 435 essays were submitted to challenge Foster & Catchings theory. One such challenge: lower costs per unit likely arising from the increase of productive capacity following corporate investment.
Yet Hayek claims most of the objections to Foster & Catchings raised in the Prize Essays miss the crucial points. And the 3-member panel ruled the case in favor of Foster & Catchings, that “notwithstanding all that had been said against it, the substance of the theory remained untouched.”
Success Goes to Foster & Catchings’ Heads
Following the defense of their thesis, Foster & Catchings took their arguments in appeal to the general public, outlining them in the form of a novel, The Road to Plenty. But it is in their 1928 Progress and Plenty: A Way out of the Dilemma of Thrift that truly shows their leap from theoretical to practical proposals to solve the problem. Hayek paraphrases their plan thus:
- An expansion of available economic data to include “a complete and reliable index of retail prices; [and] statistics of all factors influencing these prices (i.e. all possible economic data).”
- “On the basis of such statistics, all public works and all financial operations of the government should be directed in such a way as to even out fluctuations in the demand for consumption goods.”
As Foster & Catchings put it themselves: “Progress requires a constant flow of new money to consumers. If, therefore, business indexes show the need for a reinforced consumer demand which cannot be met without additional Government expenditure, the Board [a proposed “Federal Budget Board”] should bring about such expenditure, not only out of funds previously accumulated for that purpose, but at times out of loans which involve an expansion of bank credit. The feature of the plan is essential. It follows that the Government should borrow and spend the money whenever the indexes show that the needed flow of money will not come from other sources.”
Foster & Catchings of course assume “that all this is not to be regarded as inflationary,” and would avoid “unlimited issues of fiat money.” Hayek’s only response to this: we’ll see about that.
This recommendation is essentially the Keynesian premise that the government should spend—using borrowed funds if necessary—whenever consumer demand is weak, in order to prop up that demand. And even writing in the early 1930s, Hayek admits that such proposals “seem to have had an extraordinary effect.” He cites “President Hoover’s pledge to carry out, within practical limits, such a regulation of public works as would alleviate unemployment,” and also a New York senator’s plan for a “Federal Unemployment Stabilization Board,” effectively a real incarnation of Foster & Catchings’ “Federal Budget Board”.
At this point, Hayek has defined his purpose: to debunk the theory on which such interventionist economic policy proposals are based. In the rest of his essay, the ideas are his own.
Hayek’s Rebuttal
Having outlined the basic premises of Foster & Catchings’ thinking, Hayek now turns to his evaluation of their theory. He finds their theory “fosters” many inappropriate assumptions. Fortunately, Hayek is “catching” them.
Impacts of Investment
As Hayek explains, Foster & Catching consistently assume that “the investment of savings for the extension of production necessarily increases the total costs of production by the full amount of the invested savings…the value of the increased product is raised by the amount invested…therefore it can only be sold profitably for a proportionately higher sum.”
The American duo can only make this assumption by claiming that “the increased volume of production brought about by the new investments must be undertaken with the same methods as the smaller volume produced before.” Foster & Catchings assume that investment and increased capacity does not result in any innovative changes to methods of production.
Instead, the proper framing of this problem to Hayek is one of “roundabout” production, which is a concept he draws on throughout his critique. The key idea here is that the investment of savings “will serve the purpose of transferring a portion of the original means of production previously employed in producing consumers’ goods to the production of new producers’ goods.” This is tantamount to “more capitalistic” production, in which the extension of total productive capacity of consumer goods is brought out by an increase in production of producers’ goods, which are by definition the foundation of future productive capacity.
Fear not: Hayek will recur shortly to further elucidate this idea. But first, he touches on another key issue with Foster & Catchings’ original work.
Everything, Everywhere, All at Once
Recall the Americans’ assumption of “single-stage production,” in which the money received for sale of consumption goods must equal the money received spent on production goods in any given period. This assumption is as if there were “a single enterprise in which all goods are produced from beginning to end.”
The real economy is far more complex than a single-stage production model can illustrate—and Hayek considered this to be readily evident. “For at every moment of time raw materials, semi-finished products, and other means of production are coming into the market, the value of which is several times greater [emphasis mine] than the value of the consumption goods that are simultaneously offered in the market for consumption goods.”
Because of this, and because this multi-stage structure can look different at given times, the key question is saving’s impact on the distribution of incremental demand for productive goods.
Roundabout Production in Action, Part 1
Hayek offers some brief numerical illustrations of how roundabout production is affected by savings. We’ll apply these to a key staple of the Southern California economy: In ‘N’ Out Burger. We could pick any industry we wanted to illustrate Hayek’s point—but for fun, let’s try it with fast food.
It should stand to reason that In ‘N’ Out Burger’s supply chain is complex. For simplicity, we will examine the supply chain of their sponge-dough buns.
- The In ‘N’ Out Burger branch: sells hamburgers to consumers.
- A commercial baker who bakes the buns (they may make them in-house, but let’s assume not in this case).
- A large flour mill which provides the flour to the bakery.
- A shipping line which moves the raw grain to the flour mill.
- A wheat farm which grows and harvests the raw wheat.
- The manufacturer of large agricultural machines—tractors, combines, etc.—used on the farm.
- Various machine shops that make components for the tractors & combines.
- The steel and aluminum mills that provide the materials for those machine shops.
- Iron and bauxite mines that furnish raw material for the mills.
We can borrow some of Hayek’s numbers to assume the following. Let’s say that in a given day, an In ‘N’ Out branch sells $1,000 worth of buns alone—in this example, scores of customers are clamoring for a burger with no meat, cheese, or spread: just the bun, please. This $1,000 is spent at Stage 1 in our model above, and represents the “demand for consumption goods”—the end product. Hayek further assumes that, in this example, the total value of all “means of production coming to market” during this same day is eight times the value of the consumption goods sold: $8,000. This is the demand spread across Stages 2 through 9—from the bakery to the iron mines.
For simplicity, Hayek illustrates this as eight non-consumption stages of production, each with demand valued at $1,000. But it’s critical to note that he does not claim the value of demand at each stage is necessarily equal. He makes it so in his examples to help make them more intuitive—but the true distribution of demanded value for producers’ goods need not be uniform.
In our example, therefore, we have the following in a single day:
- $1,000 worth of hamburger buns changes hands.
- $8,000 worth of non-consumption goods to support the production of those buns also changes hands. We can assume if we like that it is $1,000 at each of the eight non-consumption stages.
- Total demand for all goods is $9,000.
- The ratio of consumption demand to producers’ goods demand is 1:8.
Now, we’ll see what happens when Southern California is struck by an epidemic of frugality.
Roundabout Production In Action, Part 2: Saving
Let’s say now that these bun-craving, fast food-loving Californians decide to save a portion of their income: spending $900 a month instead of $1,000, and saving the remaining $100. This saving, when converted into investment by the producers, means that now $8,100 is available to buy producers’ goods (the original $8,000 plus the $100 in savings).
The ratio between consumption and production has shifted from 1:8 to 1:9. This must also entail that “the average number of stages of production must increase from eight to nine.” We can illustrate this like so, adding a stage to our previous supply chain model:
- The In ‘N’ Out Burger branch: sells hamburgers to consumers.
- A commercial baker who bakes the buns (they may make them in-house, but let’s assume not in this case).
- A large flour mill which provides the flour to the bakery.
- A shipping line which moves the raw grain to the flour mill.
- A wheat farm which grows and harvests the raw wheat.
- The manufacturer of large agricultural machines—tractors, combines, etc.—used on the farm.
- Various machine shops that make components for the tractors & combines.
- The steel and aluminum mills that provide the materials for those machine shops.
- Iron and bauxite mines that furnish raw material for the mills.
- Makers of mining equipment: boring machines, drills, excavators, etc.
The total amount for all goods is still $9,000. But now a greater portion of it is dedicated to the purchase of producers’ goods instead of consumption goods. Hayek refers to this change in several ways:
- As a more “capitalistic” method of production.
- As a “lengthening” of the structure of production.
What does this mean? “This demonstrates at any rate the possibility that, by an increase in the money stream going to production and a diminution of that going to consumption [i.e. more capitalistic production brought about by saving], production can still be organized in such a way that the products can be sold at remunerative prices.” In short, it means that the paradox of saving does not exist in the sense that Foster & Catchings described. By contrast, Hayek seeks to prove that by such adjustments to the structure of production, “the purpose of saving is achieved in the most favorable way.”
Vertical Integration Killed Foster & Catchings
The case which Foster & Catchings build their argument on is one “in which production is completely integrated vertically…all stages of one branch of production are united in one undertaking.” In our example, this is as if In ‘N’ Out bought up shipping lines, flour mills, bakeries, iron mines, farmland, tractor plants, and more.
To this, Hayek says “bet”. Under such a system, the flow of money and goods between stages of production becomes irrelevant: the productive system is simply a black box into which flow the original means of production (land and labor) and out of which flow consumption goods—each of which is exchanged against money.
If this were truly the case, “there would be no inducement for that undertaking to save money, or to take up the money savings of private individuals; and there would thus be no opportunity for private individuals to invest their savings. If that undertaking is the only one of its kind, and therefore the only one using original means of production, it can—just as the dictator of a socialist economy can—determine at will what proportion of the original means of production shall go for the satisfaction of current consumption, and what proportion to the making or renewal of means of production.” Wholly-integrated monopolies have no incentive to save or invest. It is competition between firms and between stages of production that creates this incentive.
The underlying idea that Foster & Catchings missed was “the function of and the necessity for this relative increase in the demand for production goods and the corresponding diminution in the sales of consumption goods.” They missed this assumption largely because their economic model only allowed for:
- One single productive firm.
- One single period in which all goods are produced.
How Did They Go Wrong?
Another assumption of Foster & Catchings that Hayek disputes is their endorsement of “that uncritical fear of any kind of fall in prices,” which tempts them to suggest injecting money into the economy through public programs.
Even more glaring to Hayek was Foster & Catchings’ fundamental lack of exposition around any concept of capital or interest, which Hayek calls a “gap in their analytical equipment”.
Warning Against Keynesian Policy
The interventions in the economy that Foster & Catchings recommend are considered disastrous by Hayek, who demonstrates that the credits they would propose to offer—to both producers and consumers—would be followed by a shortening of the structure of production. An expanding economy is illustrated by a lengthening structure of production. This makes sense, as it means consumers are forgoing some current consumption by saving and facilitating investment in future productive capacities. A shortening of this structure results in crisis, especially in the earliest stages of the production process, which see their demand virtually disappear.
Hayek admits that such policy could “perhaps, be made to prevent crises,” if it was applied “with extraordinary caution and superhuman ability.” This could be done if the demand for consumption goods could always be adjusted in a way so as to exactly cancel the demand for means of production that investment effects. Yet a policy of regular government interventions to stabilize markets for consumption and production goods renders the economic system stagnant:
“Such a policy would effectively prevent any increase in capital equipment and completely frustrate any saving whatever. There can be no question, therefore, that in the long run, even a policy of this sort would bring about grave disturbances and the disorganization of the economic system as a whole.”
This conclusion is a consistent one throughout Hayek’s work: ambitious, sweeping exercises of government muscle in economic spheres tend to lead to disastrous and unforeseen consequences. He picks up this theme further in some of his later works, The Road to Serfdom and The Fatal Conceit.
Next, we’ll cover Price and Production, a more comprehensive summary of Hayek’s economic worldview.