Some commentators regard cost cutting by companies in order to secure profits as a major threat to the economy. They hold that if everyone tries to cut costs and save more, demand for goods and services from retrenched workers will fall, which in turn will hurt corporate revenues and thus profits. This allegedly sets in motion new layoffs and again eats into revenues and makes profits disappear. The process supposedly continues until there are not enough workers and salaries left to generate sales and profits.
Economists call this the “corporate paradox of thrift.” If everyone tries to cut costs and save more, then eventually no one saves more. Therefore, if every company decides to cut costs, this will ultimately hurt revenues and hence profits. The conclusion, then, is that collectively it is impossible to raise profits through cost cutting. On the contrary, it will lead to an economic slump. What these economists recommend, then, is that the central bank counter the negative side effect of cost cutting through easy monetary policy.
The “corporate paradox of thrift” follows the famous Keynesian “paradox of thrift,” which asserts that an attempt by an economy as a whole to increase aggregate savings not only will not succeed, but also in fact may lower aggregate output, income, and employment. This is because increased savings at a given level of aggregate income means decreased consumption. With a fall in aggregate income, people will find it much harder to save. This implies that aggregate savings in the economy will decline because people have decided to save more. According to Keynes: “Every such attempt to save more by reducing consumption will so affect incomes that the attempt necessarily defeats itself.”
In this theory, although saving may pave the road to riches for an individual, if the nation as a whole were to decide to save more, the result could be poverty for all.
Does the “Paradox of Thrift” Make Sense?
According to mainstream thinking, saving is seen as a leakage that weakens the flow of spending, thereby weakening the overall economic growth. But this is not necessarily so. When a baker produces ten loaves of bread and consumes one, his saving is nine loaves of bread. The baker may decide to do several things with his saved bread. He could use it to sustain himself over the coming week, he could exchange some of it for other consumer goods, or he could exchange it for various parts that will enhance his oven.
Contrary to conventional thinking, at no point does his saved bread cause a “leakage,” and hence a fall, in economic activity. On the contrary, saving is exactly what sustains economic activity.
When the baker exchanges his bread for shoes and shirts, he enhances his well-being and that of the shoemaker and the shirt producer. His saved bread sustains the shoemaker and the shirt producer, enabling them to continue in their production of shoes and shirts.
By exchanging his bread for various parts that improve his oven, the baker’s productivity increases and more bread production follows. This enables the baker to save more and acquire a greater variety of goods and services.
There are, of course, difficulties in saving various perishable goods, and this is where money comes in handy. Instead of storing his bread, the baker can now exchange his bread for money. His unconsumed production is now stored, so to speak, in money. Money here fulfills the role of medium of saving. It is fully backed by the goods that the producer has produced.
There is, however, one prerequisite for all of this—that the flow of the production of goods and services continues unabated. This means that whenever a holder of money decides to exchange some of that money for goods, those goods are there for him, and that whenever a producer who has exchanged his production for money decides to exchange the money for the goods that he requires, he can always do so.
Note that when the baker exchanges his nine loaves of bread for five dollars with a shoemaker, he in fact supplies the shoemaker with his real savings, which is nine loaves of bread. These loaves of bread will sustain the shoemaker during the production of shoes. Likewise, when a baker decides to exchange his five dollars for the services of a technician to enhance his oven, he is in fact supplying the technician with access to various unconsumed goods, i.e., the real savings of other producers.
For instance, when he exchanges the five dollars for vegetables, the technician in fact exchanges them for a proportionate amount of the vegetable’s real savings. These vegetables, in turn, sustain the technician. Again, at no point has saving caused a “leakage” that weakens economic activity; on the contrary, it reinforces its pace.
Does Money Hoarding Curtail Demand for Goods and Services?
What would happen if people were to decide to hold on to their money and not spend it? Would this curtail the demand for goods and services and collapse economic activity?
Hoarding of money is not saving; it is merely raising the demand for money. What would it mean if people had an unlimited demand to hold money? It would mean that they would not use it to trade for the goods and services they require. Obviously, this is not a realistic scenario.
So long as people want to stay alive, they will exchange money for goods. Moreover, they will have to produce goods and services and trade them. The exchange of one good for others requires the use of money. The whole idea of hoarding money for its own sake, i.e., not using money in exchange, does not correspond to the nature of human beings in that they must consume in order to live.
Now, if everyone were to decide to raise their level of savings, i.e., to raise the amount of final consumer goods supplied to the market, how could this lower the pace of economic activity?
On the contrary, a greater production of goods would only support a greater demand for goods. After all, when a baker produces bread, he is not producing everything for his personal consumption. He exchanges most of the bread that he makes for other goods and services that he needs. Hence, his production enables him to acquire goods and services. Thus, we can conclude that the so-called paradox of thrift is a questionable idea.
Why Cost Cutting Is Good for the Economy
If a company trims costs in order to make a profit, what is wrong with this? By making the transition from a loss to a profit, the company in fact makes more efficient use of its resources. The use of its resources now generates a positive return—i.e., the company has created real wealth. According to Mises,
The only goal of all production activities is to employ the factors of production in such a way that they render the highest possible output. The smaller the input required for the production of an article becomes, the more of the scarce factors of production is left for the production of other articles.
Consider a farmer who plants ten seeds and harvests only five seeds. Obviously, he cannot continue this practice for long before he eventually runs out of seeds. One he does, he will be faced with the threat of starvation. Hence, the farmer is forced to alter his conduct, i.e., to find better land or a better way of planting his seeds. So why would a change that generates a surplus be bad?
With a greater crop, the farmer could improve his well-being and also increase his savings, thus giving rise to a much greater future crop, all other things being equal.
The principle of the example we have employed can be applied to any company. The crux of the matter remains the same: profit adds to real wealth and hence raises the living standards of individuals in the economy. An expansion in real wealth due to cost cutting by an initial wealth producer will strengthen his demand for the goods and services of another wealth producer. This, in turn, will likely boost the demand for the goods and services of a third wealth producer, etc.
What about all the workers who were made redundant by the change? Are not their incomes are likely to fall, weakening the demand for goods and services? In fact, a general rise in profits as a result of cost cutting lifts the overall real wealth in an economy. This generates employment opportunities. In a market economy, retrenched workers would have to adjust to new conditions and find jobs elsewhere; they would have to find jobs that contribute to wealth creation.
Actions aimed at trimming costs are the only way companies can correct erroneous past decisions. When they take these actions in the face of past business errors that resulted in losses, companies are trying to normalize the situation through the liquidation of various excesses. Any attempt, therefore, to stifle their adjustment measures by means of monetary pumping only amounts to a further stifling of the economy and to impoverishment.
The way to eliminate the pain of adjustment is not to increase the dosage of monetary pumping, but to forbid the central bank to pump money and tamper with interest rates in the first place. Also, all the loopholes that allow the banking sector to create credit out of “thin air” must be completely sealed off.
Cost cutting by companies is an important means of correcting previous erroneous decisions in order to return to a situation of real wealth generation. The suggestion that the central bank employ monetary pumping to stimulate demand to counter businesses’ cost cutting measures and keep economic activity “going” is, in fact, a recipe for economic disaster.