How to Know When to Spend and When to Save

The worsening financial crisis has led people to embrace the concept of saving. See more banking pictures.
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It's a confusing time to be a consumer. The government, the media and every reliable financial indicator tell us that we are up to our necks in an unprecedented global economic crisis. And to make matters worse, they say it's our fault.

The root cause of our current financial mess is a decade or more of runaway spending by governments, corporations and -- yes -- people like you. We bought homes we couldn't afford. We maxed out credit cards we didn't need. We buried ourselves under a mountain of personal debt without saving a penny for a rainy day, let alone the torrential downpour we currently face.

The result is that we've been seriously humbled. We no longer view the stock market as a risk-free investment. We no longer assume that home prices will continue to rise indefinitely. And we no longer treat saving money as a boring chore, like eating our vegetables.

Saving is, in fact, all the rage. Magazines and TV shows bombard us with money saving tips like sewing our own clothes, growing our own food and making our own toothpaste. According to a recent survey by the Pew Research Center for the People & the Press, 86 percent of Americans have cut their spending or changed their saving and investment plans [source: Hopkins].

Just as Americans are shunning their consumerist ways and going into deep survival mode, the government is selling a competing message: "Spend! Spend! Spend!" It makes sense: Consumer spending in the U.S. accounts for around 70 percent of the country's total economic activity [source: Crutsinger]. So when consumer spending drops, the economy grinds to a halt. Lower demand means lower production, which leads to mass layoffs, which equals a bad situation for just about everyone.

What, exactly, is a patriotic but poor citizen to do? If we spend money to bolster the economy, then we add to our pile of personal debt. If we bury jars of coins in the backyard, then we kick the chair out from under the economy.

Thankfully, this dilemma has a name: the paradox of thrift. Finding solutions, however, might be a little trickier. We'll learn more about the paradox of thrift on the next page, then we'll tackle some different "save or spend" scenarios.

The Paradox of Thrift

John Maynard Keynes was a revolutionary 20th-century economist who popularized the paradox of thrift. In his 1930 book, "Treatise on Money," he warned against the economic paralysis that results from excessive personal saving.

His rallying cry was directed toward a British populace suffering through the Great Depression. Spending money was the only way out of the economic quagmire, Keynes argued. For every five shillings saved out of "misguided" thrift, another man would lose his job for a day [source: Blankenhorn].

The message of the paradox of thrift is simple but troubling: What's best for the individual isn't always good for the economy [source: Brockman]. More paradoxically, what's good for the individual is ultimately bad for the individual. It comes down to this: If the whole economy falters, then no job is secure -- not even yours.

This is why U.S. leaders urged Americans to go out and shop after the Sept. 11 terrorist attacks. The implication was that if the economy faltered, the terrorists would win. This is the same logic that drove Presidents Bush and Obama to extend generous tax rebates in 2008 and 2009. If you put cash in people's pockets, they will spend it, which will stimulate the economy.

Americans usually don't need to be prodded to spend. Over the last 30 years, Americans have maintained a spending rate far above other industrialized nations. In 2007, consumer spending peaked at slightly above 70 percent of the U.S. Gross Domestic Product (GDP), while it only amounted to 55 percent of the GDP in Germany and Japan [source: Brockman].

Similarly, saving money has lost favor in the U.S. since the mid-1970s. In 1976, the average personal savings rate in the U.S. hovered around 12 percent. In 2005, that number actually dipped below zero for the first time since the Great Depression [source: Associated Press]. On average, Americans were not only saving nothing, but they were actually draining their savings to finance more purchases.

That's all changed with the current financial crisis, however. As of July 2009, the U.S. savings rate has skyrocketed to 5.7 percent, the highest level in more than a decade [source: Blankenhorn]. Unfortunately, the timing for the U.S. economy couldn't be worse. Just when businesses need consumers -- and their money -- the most, most wallets are shut tight.

Is Keynes right? Are we penny-pinching our way to total economic collapse? How can we know when it's prudent to be frugal and when it's safe to spend?

Spending to Save

Spend a little cash on maintenance now and save yourself a lot of trouble -- and money -- down the line.
Spend a little cash on maintenance now and save yourself a lot of trouble -- and money -- down the line.
Justin Sullivan/Getty Images

Many people have been hit hard by the recession, and it seems as if everyone has caught "saving fever" as a result. Of the 86 percent of Americans who have cut their spending or changed their savings and investment strategies during this recession, more than half of them have yet to feel the financial pinch personally [source: Hopkins]. They're saving money as a buffer against an uncertain economic future.

In addition, despite statistics asserting that Americans carry more than $2.5 trillion in personal debt, millions of American families have money in the bank, mortgages they can actually afford -- and no credit card debt [source: Federal Reserve]. These lucky folks are the people who are in the best position to spend money during a recession. However, that doesn't mean that it's their patriotic duty to go on wild shopping sprees to make up for the meager consumerism of their neighbors.

Instead, financial experts say, people without debt should look at the "save or spend" riddle from a different perspective. Instead of using their money to consume, they should use it to invest [source: Leonhardt]. When economists talk about investing in this sense, they're not talking about stocks and bonds. Instead, they're talking about products and services purchased today that will save you money down the line.

The mantra is "spend to save," and here are some examples:

[sources: Leonhardt, Caplinger]

The "spend to save" philosophy is a convenient solution to the paradox of thrift, because the individual is helping himself over the long term while stimulating the economy in the short term.

Of course, in order to save, you have to have money to spend. On the next page, we'll look at an interesting twist to the paradox of thrift.

Saving to Spend

In his campaign to convince British citizens to get out and spend, John Maynard Keynes gave the word "thrift" a bad name. In reality, thrift isn't the same as excessive saving, hoarding money in mattresses or simply refusing to participate in the economy. Thrift, as Benjamin Franklin understood it, was a virtue [source: Blankenhorn]. It's equated with hard work, frugal living and prudent investment. Thrift, when practiced correctly, is the best way to gain wealth.

Franklin's definition of thrift has helped inspire books like Thomas J. Stanley and William D. Danko's "The Millionaire Next Door," which explains that many of America's millionaires bring in modest salaries and live in blue-collar neighborhoods. The trick is that they manage their money wisely and live well below their means. When faced with the "spend or save" conundrum, they almost always save.

The ironic part, therefore, of the Paradox of Thrift is that thrifty people -- those who put away at least 10 percent of their salary a year -- are the very people who are in the best position to spend during a recession [source: Parker].

Thrifty people play a second important role during a recession. Every time they put money in the bank -- whether through a savings account, a certificate of deposit (CD) or a mortgage payment -- they inject crucial liquidity back into the credit system [source: Hamm]. This has been one of the main goals of the bank bailouts that have cost U.S. taxpayers hundreds of billions of dollars over the past year. Banks aren't lending money to businesses, because they don't have any to lend. By continuing to put money in the bank, thrifty people are making banks more liquid and helping to ease their credit freeze.

If Keynes wanted to craft a more precise message, he might have called it the "Paradox of Hoarding." Hoarding, after all, is the only truly damaging activity to the greater economy. As long as money is kept in circulation, whether through modest spending or deposits into bank accounts, then even the thriftiest among us are helping to spur the economy.

The greatest irony of all of this is that the banks have proven to be the biggest hoarders of all [source: McArdle]. They scoop up billions in bailout money -- and sit on it. They are doing the macroeconomic equivalent of burying their savings in the backyard. If Keynes hadn't been cremated, he'd be rolling in his grave.

Saving to Survive

For many Americans, the only financial option left is to save as much money as possible to survive.
For many Americans, the only financial option left is to save as much money as possible to survive.
Justin Sullivan/Getty Images

For a significant number of American families, there is no "save or spend" dilemma. That's because there isn't any money left to spend. For these citizens, patriotic duty will have to wait for better days. The paradox of thrift is yet another luxury they can't afford to worry about. Their only solution is to save, save, save.

In June 2009, the unemployment rate in the U.S. hit 9.5 percent. According to surveys conducted by the Bureau of Labor Statistics, the number of discouraged workers -- unemployed workers who believe no job is available for them -- rose to nearly 800,000. Another 430,000 people have stopped looking for jobs altogether [source: Goodman].

If you are already deeply in debt and out of a job, there's no rational reason to start investing in home improvements or other long-term "spend to save" strategies. The only productive behavior is to use every spare penny to pay down debt and try to dig yourself out of the financial hole.

Some economists are calling on the government to send out a clearer message to American citizens. Instead of falling back on Keynes' call to patriotic consumerism, they want leaders to present two separate but equally important messages: If you have a job and no debt, then do what you can to invest in goods and services now that will save you money later. If you have debt problems or are unemployed, pay off your debts first and try to build an emergency fund [source: Hopkins].

In other words, if you can't spend to save, then save to survive. Once you're back on your feet again, though, you must put your hard-earned lessons into practice. No more maxing out credit cards and no more living beyond your means.

Unfortunately, that might be harder than it sounds. Saving, as we discussed, does not come easy to most Americans. According to one recent survey, 76 percent of respondents believed that Americans would return to their old consumerist ways once the recession ends [source: Parker].

The professionals, thankfully, have a more optimistic view. According to a Wall Street Journal survey of 46 leading economists, 43 believe that we have entered a new economic era and that the saving trend is here to stay [source: Kalita].

For lots more information on debt, personal finance and saving money, follow the links on the next page.

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Sources

  • Associated Press. "U.S. savings rate hits lowest level since 1933." January 30, 2006 (June 29, 2009)http://www.msnbc.msn.com/id/11098797/
  • Blankenhorn, David. "There is No 'Paradox of Thrift.'" The Weekly Standard. June 15, 2009 (June 29, 2009)http://www.weeklystandard.com/Content/Public/Articles/000/000/016/592bjsid.asp?pg=1
  • Brockman, Joshua. "As Economy Falters, Should We Spend or Save?" National Public Radio. October 17, 2008 (June 29, 2009)http://www.npr.org/templates/story/story.php?storyId=95836911
  • Caplinger, Dan. "Spend a Little, Save a Lot." The Motley Fool. June 4, 2007 (June 29, 2009)http://www.fool.com/personal-finance/home/2007/06/04/spend-a-little-save-a-lot.aspx
  • Crutsinger, Martin. "May incomes surge, but savings outpace spending." Associated Press. June 26, 2009 (June 29, 2009)http://www.google.com/hostednews/ap/article/ALeqM5gNiyJ905Ho0Ur96V2TQhsBX19lGwD992GI980
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  • Hamm, Trent. "The Paradox of Thrift: Is Saving Money Bad for the Economy?" The Simple Dollar. May 28, 2009 (June 29, 2009)http://www.thesimpledollar.com/2009/05/28/the-paradox-of-thrift-is-saving-money-bad-for-the-economy/
  • Hopkins, Andrea. "To save or to spend? Reuters. Americans ponder their duty." February 13, 2009 (June 29, 2009)http://www.reuters.com/article/ousiv/idUSTRE51C19J20090213
  • Kalita, S. Mitra. "Americans See 18% of Wealth Vanish." The Wall Street Journal. March 13, 2009 (June 29, 2009)http://online.wsj.com/article/SB123687371369308675.html
  • Leonhardt, David. "To Spend or Save? Trick Question." The New York Times. February 10, 2009 (June 29, 2009)http://www.nytimes.com/2009/02/11/business/economy/11leonhardt.html
  • McArdle, Megan. "Bad news, and the paradox of thrift." The Atlantic Monthly. January 28, 2009 (June 29, 2009)http://meganmcardle.theatlantic.com/archives/2009/01/bad_news_and_the_paradox_of_th.php
  • Parker, Vicki Lee. "Spend some and save some." The Seattle Times. June 21, 2009 (June 29, 2009)http://seattletimes.nwsource.com/html/businesstechnology/2009364092_pfmoneytip21.html