How to Know When to Spend and When to Save

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?