Home > Uncategorized > “Paradox of thrift was the norm before industrial revolution” Richard Koo

“Paradox of thrift was the norm before industrial revolution” Richard Koo

Exhibit 1. Economic growth became norm only after industrial revolution

Koo 1

Looking further back in history, however, we can see that economic stagnation due to a lack of borrowers was much closer to the norm for thousands of years before the industrial revolution in the 1760s. As shown in Exhibit 1, economic growth had been negligible for centuries before that. There were probably many who tried to save during this period of essentially zero growth, because human beings have always been worried about an uncertain future. Preparing for old age and the proverbial rainy day is an ingrained aspect of human nature. But if it is only human to save, the centuries-long economic stagnation prior to the industrial revolution must have been due to a lack of borrowers.

For the private sector to be borrowing money, it must have a clean balance sheet and promising investment opportunities. After all, private-sector businesses will not borrow unless they are sure they can pay back the debt with interest. But with little or no technological innovation before the industrial revolution, which was essentially a technological revolution, there were few investment projects capable of paying for themselves. Businesses also tend to minimize debt when they see no investment opportunities because the probability of facing bankruptcy is reduced drastically if the firm carries no debt. Given the dearth of investment opportunities prior to the industrial revolution, it is easy to understand why there were so few willing borrowers. Because of this absence of worthwhile investment opportunities, the more people tried to save, the more the economy shrank. The result was a permanent paradox of thrift in which people tried to save but their very actions and intentions kept the national economy in a depressed state. This state of affairs lasted for centuries in both the East and the West.

Powerful rulers sometimes borrowed the funds saved by the private sector and used them to build social infrastructure or monuments. On those occasions, the vicious cycle of the paradox of thrift was suspended because the government injected the saved funds (the initial savings of $100 in the example above) back into the income stream, generating rapid economic growth. But unless the project paid for itself – and politicians are seldom good at selecting investment projects that pay for themselves – the government would at some point get cold feet in the face of a mounting debt load and discontinue its investment. The whole economy would then fall back into the paradox of thrift and stagnate. Consequently, many of these regimes did not last as long as the monuments they created.

Countries also tried to achieve economic growth by expanding their territories, i.e., by acquiring more land, which was the key factor of production in pre-industrial agricultural societies. Indeed, people believed for centuries that territorial expansion was essential for economic growth. This drive for prosperity was the economic rationale for colonialism and imperialism. But both were basically a zero-sum proposition for the global economy as a whole and also resulted in countless wars and deaths.

Richard Koo


  1. July 13, 2016 at 9:50 pm

    Bagehot commented on this too in ‘Lombard Street’. He pointed out that businesses which borrowed to develop could do so much faster than those which simply used retained profits. He didn’t spell it out, but clearly as technological innovations came thick and fast in the late 19th C when he was writing, a business that waited for sufficient retained profits would miss the opportunities of the new developments that businesses which borrowed could take up immediately.

  2. July 14, 2016 at 12:05 am

    The graph above is very hard to use because it is not logarithmic.

    “Looking further back in history, however, we can see that economic stagnation due to a lack of borrowers was much closer to the norm for thousands of years before the industrial revolution in the 1760s.”

    Don’t you mean “due to a lack of spenders”? There is no law against the funds for consumption coming from wages.

    “But if it is only human to save, the centuries-long economic stagnation prior to the industrial revolution must have been due to a lack of borrowers.”

    Non-sequitur. No relationship between saving vs spending choices and economic growth can be made until you understand the banking system in place and whether a particular economy is production-constrained or consumption-constrained. Remember that purchases = sales according to the laws of basic accounting. Only a religiously devout supply-sider would start off with the assumption that capacity for sales is always strictly greater than capacity for purchases.

    “For the private sector to be borrowing money, …”

    The private sector does not borrow money. It clears it. Certain elements of the private sector borrow from certain other elements, with the net having less to do with the supply of money for individuals to borrow than it does with the faith of the public in government.

    “But with little or no technological innovation before the industrial revolution, which was essentially a technological revolution, there were few investment projects capable of paying for themselves. ”

    If you are going to make a car go, you need three things: gasoline, oxygen, and spark. Similarly, if you want to grow an economy, you need production resources, consumption capability, and a culture of innovation. The essay seems to be making the argument that the culture of innovation had to come first, followed by the production resources, with consumption capability being a gimmie. In my opinion, this is precisely reversed, but if there were a well-written argument for innovation being the limited factor I would read it. “First we had no innovation, then we had innovation” is not an argument for innovation being the limiting factor. A more reasonable argument might be that after we made the laws more consumer friendly and created tariffs that netted out to be worker friendly, manufacturers suddenly had a new market to sell to.

    “But unless the project paid for itself – and politicians are seldom good at selecting investment projects that pay for themselves – the government would at some point get cold feet in the face of a mounting debt load and discontinue its investment.”

    This conflates two issues: 1) the relationship between physical efficiency and financial capital, and 2) the relationship between dollars intended for saving, dollars intended for spending, and the interest rates under which dollars can to some degree be converted between these two modes. Financial projects started by government do not have to be offset by return to government on those projects, but rather by taxes collected by government. This is not tied to physical efficiency except via the psychology of the stakeholders. Instead the taxes collected by government to pay for these projects must be distributed in a way such as to keep the goods and services available for production and distribution from getting too far out of sync with the dollars available for consumption.

  3. Flamant
    July 14, 2016 at 9:22 am

    Richard Koo should read Angus Maddison,and have a look at his very long term statistics of GDP and income, over the last 2000years. He would realize that things were much less as simple as millenium stagnation before the industrial revolution.

  4. July 14, 2016 at 9:25 am

    My reaction to this is that Koo couldn’t have been brought up in a Europe covered with the widely distributed remains of magnificent public facilities in the form of local parish and monastic church buildings, paid for in non-monetary tithes and constructed largely by voluntary or slave local labour under instruction by itinerant experts. Agreed the domestic housing remained primitive except for the 1% of those days, but then there were no books, cars and tvs to accomodate and (swings and roundabouts) the marvels of nature to look at and learn from and enjoy (cf. Chinese and herbal vs chemical medication); no railways and roads enabling the 1% (who had sadly colonised the Church) to whisk away to cities and lay waste all that nature and neighbours had been providing for communities to live on. Koo’s understanding of history seems to have been gained through modern American spectacles. Jeff is right: there is more than one form of an economy, including traditional ones in tune with Nature as well as insane ones like our own, actually TRYING to grow geometrically.

    • visitor
      July 14, 2016 at 1:11 pm

      The Middle Ages were a thicket of economic obligations and taxes, many non-monetary (as currency was rare), from the corvée (forced labour of the population in favour of the local noble, e.g. during harvests, or in favour of the king, e.g. to build roads), to the banalités (obligation for the noble to build and provide specific infrastructure, e.g. a wine-press or a mill, and the converse obligation of the local population to use it for a fee, basically a risk-free monopolistic investment!) Interestingly, those feudal taxes and privileges were mostly abolished at about the time of the French Revolution, i.e. when the first industrial revolution went into full swing.

      My understanding is that the main reason for princes to borrow was because of war — raising and paying troops, edifying fortresses, paying ransoms. They also had a tendency to default when reimbursement was too difficult — bankrupting private financiers.

      I cannot figure out how these two issues change the whole perspective about lack of good investment opportunities, thrift, economic transition, etc, but they surely had an impact.

      • July 14, 2016 at 5:46 pm

        I don’t disagree with this. However, the frontier area where I live is covered with castles, but in roughly 1% proportion with the number of medieval churches. I will say that “labour” was not necessarily “forced”: short periods of harvesting provided traditional and welcome holidays from urban living until quite recently, and like military service both built comararderie and widened young people’s acquaintance with the wider world.

  5. Ben Johannson
    July 14, 2016 at 10:22 am

    Equally fascinating that it took so long to identify the paradox of thrift and even longer to recognize it as a consequence of money expanding from a tool of state provisioning to use in commerce. Also that Keynes’ theories of investment and uncertainty appear to be historically vindicated.

  6. July 14, 2016 at 2:24 pm

    There is no thrift paradox, or How economists fell over their own feet
    Comment on Richard Koo on ‘Paradox of thrift was the norm before industrial revolution’

    Richard Koo’s paper about macroeconomic development* is descriptively accurate and historically rich in detail. It is far above the low level of familiar orthodox and heterodox economics. What is lacking, though, is a sound theoretical foundation. This cannot be otherwise because economics as a whole lacks sound foundations. More precisely, both current microfoundations and macrofoundations are false.

    Koo puts it thus: “Macroeconomics is still a very young science compared to such disciplines as physics and chemistry. It started when Keynes began taking about the concept of aggregate demand in the 1930s, only 85 years ago. As a very young science, it has achieved only limited coverage of the broad range of economic phenomena and remains prone to fads and influences.”

    Reality is actually far worse. Keynes based macroeconomics on logically and conceptually defective foundations and neither Post Keynesians nor New Keynesians nor Anti-Keynesians have realized Keynes’s foundational blunder in 85 years (2014).

    Keynes defined the formal core of the General Theory as follows: “Income = value of output = consumption + investment. Saving = income – consumption. Therefore saving = investment.” (1973, p. 63)

    This two-liner is defective because Keynes never came to grips with profit: “His Collected Writings show that he wrestled to solve the Profit Puzzle up till the semi-final versions of his GT but in the end he gave up and discarded the draft chapter dealing with it.” (Tómasson et al., 2010, p. 12)

    Let this sink in, Keynes had NO idea of the fundamental concepts of economics, viz. profit and income. Because profit is ill-defined the whole theoretical superstructure of macroeconomics is false, in particular ALL I=S/IS-LM models (2011; 2013).

    Koo starts his analysis as follows: “One person’s expenditure is another person’s income. It is this unalterable linkage between the expenditures and incomes of millions of thinking households and businesses that makes the study of the economy both interesting and unique.”

    Note that Koo’s first sentence is identical with Keynes’s. For every economist this proposition is pure common sense ― a mere accounting identity. As a matter of fact, it is provably false and this explodes the whole of macro. Economists do not grasp the elementary mathematics of accounting (2012) and this goes a long way to explain why economics has never risen above the proto-scientific level.

    To get out of failed economic theory requires nothing less than a full-blown paradigm shift from accustomed microfoundations and Keynes’s flawed macrofoundations to entirely new macrofoundations.**

    Ultimately, the paradox of thrift has its roots in the confusion about saving of the household sector, retained profit (falsely termed ‘saving’ of the business sector), profit and distributed profit. The correct profit equation reads: Qm = Yd+I-Sm (2014, p. 8, eq. (18)). Legend Qm: monetary profit, Yd: distributed profit, Sm: monetary saving, I: investment expenditure. The interaction of I and Sm underlies Koo’s description of economic expansion and balance sheet recession. What is entirely missing in Koo’s description is the interaction of Qm and Yd.

    The profit equation gets a bit longer when import/export and government is included.

    Roughly speaking, there are TWO self-reinforcing feedback loops:
    (i) Household sector saving Sm up — profit Qm down — investment I down because of reduced self-financing out of retained profit — profit Qm down — and so on (with wages, prices, and employment down)
    (ii) Household sector saving Sm down or dissaving up — profit Qm up — investment I up because of increased self-financing out of retained profit — profit Qm up — and so on (with wages, prices, and employment up)

    The confusion is, again in rough terms, this: (a) saving of the ‘workers’ is bad because it drags down the economy, (b) ‘saving’ out of profit (= retained profit) is good because it is normally put to use for business expansion = investment. In this case, bankers/financiers/lenders are not needed at all or less so. There are less restrictions to expansion from the monetary side.

    What the Classicals had in mind when they lauded ‘saving’ and ‘frugality’ was in fact retained profit and reinvestment in contradistinction to profit distribution and spending on consumption. What Keynes had in mind was saving of the household sector. The cross-talk about saving and investment goes on until this day: “The truth is, most persons, not excepting professional economists, are satisfied with very hazy notions.” (Fisher, quoted in Mirowski, 1995, p. 86)

    What economic history will some day find out is that the kick-off event of the Industrial Revolution has been a happy combination of DISSAVING of the household sector and credit creation of the emerging banking sector on an ever increasing scale and self-financing out of profits which freed business from lenders and the economy as a whole from the clampdown of a fixed quantity of money. Credit creation that translates directly into an increase of the wage bill (with wage increase = productivity increase) helps to enable a perfectly inflation-free growth. Money out of nothing is a GOOD thing IF DONE PROPERLY.

    Bottom line: saving Sm and investment I develop INDEPENDENTLY. There is NO such thing as an interest mechanism which equalizes I and S. It is neither true that saving ‘causes’ investment as the Classicals claimed nor that investment determines saving via the multiplier as Keynes claimed. The perpetual difference between investment I and saving Sm is the main determinant of profit Qm. BOTH, the Classicals and Keynes got the profit theory wrong. Nothing worse can happen to an economist.***

    Koo’s approach is a clear improvement with regard to the credit mechanism but shares the fundamental conceptual error which is embodied in this simple proposition: Income = value of output.

    Egmont Kakarot-Handtke

    Kakarot-Handtke, E. (2011). Squaring the Investment Cycle. SSRN Working Paper Series, 1911796: 1–25. URL http://ssrn.com/abstract=1911796.
    Kakarot-Handtke, E. (2012). The Common Error of Common Sense: An Essential Rectification of the Accounting Approach. SSRN Working Paper Series, 2124415:
    1–23. URL http://ssrn.com/abstract=2124415.
    Kakarot-Handtke, E. (2013). Settling the Theory of Saving. SSRN Working Paper Series, 2220651: 1–23. URL http://ssrn.com/abstract=2220651.
    Kakarot-Handtke, E. (2014). The Three Fatal Mistakes of Yesterday Economics: Profit, I=S, Employment. SSRN Working Paper Series, 2489792: 1–13. URL
    Keynes, J. M. (1973). The General Theory of Employment Interest and Money. London, Basingstoke: Macmillan.
    Mirowski, P. (1995). More Heat than Light. Cambridge: Cambridge University Press.
    Tómasson, G., and Bezemer, D. J. (2010). What is the Source of Profit and Interest? A Classical Conundrum Reconsidered. MPRA Paper, 20557: 1–34.
    URL http://mpra.ub.uni-muenchen.de/20557/

    * real-world economics review issue #75
    ** For more details see ‘The other half plus the hitherto missing true foundations of
    *** See also ‘I=S: Mark of the Incompetent’

  7. July 14, 2016 at 6:18 pm

    You do have coincidental events during the 19th Century that will affect the rate of economic growth — while the Industrial Revolution is going on in Europe (and especially England) the rise and expansion of the American economy becomes a great investment opportunity for European (and especially English) money.

  8. July 14, 2016 at 9:30 pm

    “Keynes defined the formal core of the General Theory as follows: “Income = value of output = consumption + investment. Saving = income – consumption. Therefore saving = investment.” (1973, p. 63)”.

    “This three-liner is defective because [Kakarot-Handtke] never came to grips with [the role of context in the English language].” As I’ve repeatedly pointed out and Egmont has studiously ignored, Keynes didn’t say this, he said other people said it; and unlike Egmont, he deigned to engage with them with arguments about uncertainty and variable desire for liquidity. From his July 6th comment on “The Economics of the 1%” it seems that such arguments from behaviour and personality get up his nose; but the behaviour and motivation of theorists differs with their personality, and I don’t suppose I’ll get a response from him with the old advice: “Physician, heal thyself”. As it happens, I largely agree with his own argument for structural foundations, if not the adequacy of the language he expresses it in, but the difference between his “science for its own sake” and mine (with Bacon) “for the glory of God and the relief of Man’s estate” is very much the difference of motivation of two very similar personality types compared in http://www.personalityhacker.com/intp-vs-intj/.

    I am very impressed with the clarity and lucid development of Egmont’s paper Essentials of Constructive Heterodoxy: Money, Credit, Interest. SSRN Working Paper Series, 2569663: 1–19. URL http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2569663. However, to so arrange the variables that price is the dependent one, on condition that quantities purchased equal quantities produced, when the subsequent argument on profit and interest rates hinge on their not doing. so sounds to me like the familiar orthodoxy in new clothes, needing a behavioural explanation of the asserted non-equilibrium and not yet going beyond a consumption economy to address the crucial output and pricing of money itself in light of subjective valuation of the securities with which the thrifty save for the future. This paper is good enough for me to be willing to study it in depth and follow up its linked-in references, but my own argument – that abstract structure cannot be seen unless one conveys its form via a schematic diagram – leaves me totally dissatisfied with Egmont leaving the Earth and Humanity out of his equations. A monetary economy serving non-consuming robots would serve no purpose.

  9. Peter T
    July 17, 2016 at 1:23 pm

    Savings, investment and consumption as used here are financial terms, but the drivers of growth for most of history were technical, organisational and demographic – in short the material factors of production. In this material world, “saving” has no meaning, in that reductions in consumption cannot be transferred to increase production, and investment is very strictly limited. It is not even clear that this is no longer the case at bottom (admitting that the bottom is a long way down).

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