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The Campaign Against Cost Cutting

September 9, 2002

Tags Financial MarketsFree MarketsU.S. EconomyBooms and BustsValue and ExchangeSubjectivismBusiness Cycles

Some influential Wall Street economists are alarmed that cost cutting by many companies in order to secure profits is a major threat to the economy. They say that if everyone tries to cut costs and save more, demand for goods and services from fired workers will fall, which in turn will hurt corporate revenues and, thus, profits. This, in turn, sets in motion new firings, and this again eats into revenues and makes profits disappear.

The process supposedly feeds on itself until there are not enough workers and salaries left to generate sales and profits. Economists call this "the corporate paradox of thrift." In short, if everyone tries to cut costs and save more, then no one saves more. Therefore, if every company decides to cut costs, this ultimately will hurt revenues and hence profits.

The conclusion, then, is that, collectively, it is impossible to lift profits through cost cutting. On the contrary, it will lead to an economic slump. What these economists recommend, then, is that the Fed should maintain its easy monetary policy in order to counter the negative side effect of cost cutting. Thus is this theory yet another rationale for inflation.

"The corporate paradox of thrift" is a modified version of 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 in fact may lower aggregate output, income, and employment. This is because increased savings at a given level of aggregate income means decreased consumption. As a result, with a fall in aggregate income, people will find it much harder to save, and this thus implies that aggregate savings in the economy will fall 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."[1]

Also, Baumol and Blinder have suggested: "So while saving may pave the road to riches for an individual, if the nation as a whole decides to save more, the result may be poverty for all!"[2]

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. Is this true? When a baker produces 10 loaves of bread and consumes one loaf, his saving is nine loaves of bread. The baker may decide to do several things with his saved bread. He could use the saved bread to sustain himself over the next week; he could exchange some of the bread for other consumer goods; or he could exchange it for various parts that will enhance his oven.

Observe that, contrary to conventional thinking, at no time has his saved bread caused a "leakage" in economic activity and, hence, a fall in economic activity. On the contrary, saving is exactly what sustained the economic activity.

When the baker exchanges his bread for shoes or shirts, he enhances his well-being and also enhances the well-being of the shoemaker and the shirt producer. In summary, his saved bread sustains the shoemaker and the shirt producer, enabling them to continue in their production of shoes and shirts. Furthermore, by exchanging his bread for various parts that improve his oven, the baker’s productivity increases and his production of bread follows suit. This, in turn, 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, so this is where money steps in and solves the problem of storing perishables. Instead of storing his bread, the baker can now exchange his bread for money. In other words, his unconsumed production is now stored, so to speak, in money.

Note that money here fulfills the role of the medium of savings. Observe also that the money is fully backed up by the goods that the producer has produced. In the case of our baker, the money is a receipt, so to speak, for his saved bread. There is, however, one proviso in 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, these goods are there for him. So whenever a producer who has exchanged his production for money decides to exchange his 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 in his 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, by exchanging the five dollars for vegetables, the technician is in fact exchanging his five dollars for a proportionate amount of the real savings of a vegetable farmer. These vegetables, in turn, will sustain and maintain the well-being of the technician. Again, at no stage has saving caused a "leakage" that weakens economic activity; on the contrary, it reinforces its pace.

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, however, is not saving; it is merely raising the demand for money. But what would it mean that people would have unlimited demand to hold money? It would mean that they would not use it to exchange for the goods and services required for maintaining their life and well-being. Obviously, this is not a realistic proposition.

So long as people want to stay alive, they will always exchange money for goods. Moreover, as long as people aspire to maintain their life and well-being, they will have to produce and trade goods and services. This, in turn, requires that they must use money in the exchange of one good for other goods. The whole idea of hoarding money for its own sake, i.e., not using money in exchange, doesn't correspond to the nature of human beings, in that they must consume in order to maintain their life and well-being.

Now, if everyone decided to raise their level of savings, i.e., to raise the amount of goods and services supplied to the market, how could this lower the pace of economic activity? On the contrary, a greater production of goods and services would only support a greater demand for goods and services. After all, when a baker produces bread, he is not producing everything for his personal consumption. Most of the bread that he is producing is exchanged 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 an erroneous 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. In short, 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."[3]

Consider a farmer who plants 10 seeds and harvests only five seeds. Obviously, he cannot continue with this practice for long before he eventually runs out of seeds. Consequently, 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 acquire a better way of planting his seeds. So why would this change that generates a surplus be bad? With a greater crop, the farmer could improve his well-being and also increase his saving, 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 in that profit adds to real wealth and hence raises the living standards of individuals in the economy. In short, an expansion in real wealth due to the cost cutting by an initial wealth producer will strengthen his demand for goods and services of another wealth producer. This, in turn, will boost the demand for goods and services of a third wealth producer, etc.

What about all the workers that were fired? Surely their incomes will fall and this will hurt the demand for goods and services. We have shown, however, that a general rise in profits as a result of cost cutting lifts the overall real wealth in an economy. In a market economy, fired workers would have to adjust to new conditions and find jobs elsewhere; they would have to find jobs that contribute to wealth creation. 

The currently observed actions of many companies aimed at trimming costs is the only way companies can correct erroneous decisions brought about by the loose monetary policies of the central bank. What various companies are trying to do, in the face of past business errors that resulted in losses, is to normalize the situation through the liquidation of various excesses. Any attempt, therefore, to stifle their adjustment measures by means of a new dosage of monetary pumping only amounts to a further stifling of the economy and to economic impoverishment.

 Obviously, liquidations are painful, but just consider the alternative, which could be even harsher. The only 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. Also, all the loopholes that allow the banking sector to create credit out of "thin air" must be completely sealed off.

Conclusion

The alarm raised by mainstream economists that corporate cost cutting will undermine the real foundation of the economy is based on a flawed view of the essence of savings. On the contrary, cost cutting is an important means in correcting previous erroneous decisions in order to be able to return to a situation where real wealth can be generated again. The suggestion by the proponents of "the paradox of corporate thrift" that the central bank must stimulate demand by means of more monetary pumping is, in fact, a recipe for economic disaster.


Frank Shostak is an adjunct scholar of the Mises Institute and a frequent contributor to Mises.org. Send him MAIL and see his outstanding Mises.org Articles Archive. Dr. Shostak expresses gratitude to Michael Ryan for helpful comments during the writing of this article.


[1] John Maynard Keynes, The General Theory of Employment, Interest and Money, Macmillan & Co Ltd, 1964, p. 84.

[2] William J. Baumol and Alan S. Blinder, Economics, HBJ Second Edition, p. 187.

[3] Ludwig von Mises, Planning For Freedom, Libertarian Press, p. 121.


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