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How to Know When to Spend and When to Save

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.