Mises Daily

Hayek on the Paradox of Saving

Chronic underconsumption is an idea most often associated with Keynes. But while the infamous English economist published his General Theory in 1936, Hayek’s 1929 article “The ‘Paradox’ of Savings” analyzes a similar theory advanced by two Americans a decade before.[1] While the two authors have nearly vanished from history, the insights contained in Hayek’s nearly forgotten article are more necessary today than ever.

The two protagonists were college president William Trufant Foster and businessman Waddill Catchings. They aimed to show how the production of goods could increase, with no corresponding increase in the purchasing power of consumers. Under these conditions, not all consumer goods could be sold at prices above producers’ costs. Markets would fail to clear, or producers would take a loss on each sale; the economy would spiral downwards into depression.[2]

In 1920, the two created an economic research foundation to advance their ideas through books, articles, and a competition that drew 435 entries, mostly from professional economists, accountants, bankers, and other highly placed men. A prize of $5,000 (a significant sum in 1920) was offered for anyone who could refute it. But, as Hayek relates,

despite this highly respectable mass-attack of adverse criticism, Messrs. Foster and Catchings remained convinced that their theory still held its own. Moreover, they were able to quote the opinion of one of the umpires, that notwithstanding all that had been said against it, the substance of the theory remained untouched. This sounds extraordinary. But what is more extraordinary is that a candid perusal of the various criticisms which have been published forces one to admit that it is true.

As a side note, the financial media of today would hardly do any better. The media emphasize consumption as the driver of economic growth and they frequently disparage saving.[3] To cite a few examples, they report that retail spending is (or is not) holding up well, that tax cuts for “the rich” won’t help the economy because the money will mostly be saved rather than spent, and that “demand stimulus” is needed to dislodge the economy from recession.

Below, I will summarize the mechanics of the Foster and Catching’s theory, and then proceed to explain Hayek’s response. The “paradox” is an alleged conflict between the efforts of individuals to improve their lot by saving and the ability of the system as a whole to employ their savings productively. In their book, Business without a Buyer, Foster and Catchings strive to show that, while an increase in total savings will increase the supply of goods for sale to consumers, it will not correspondingly increase consumer demand; the economy will slump; and so the efforts of savers to improve their lot will ultimately be frustrated.[4] As Hayek summarizes their argument,

As it is today, certain individuals can save at the expense of other individuals; certain corporations can save at the expense of other corporations; and from the standpoint of the individual and of the corporation, these savings are real. But society as a whole cannot save anything worth saving at the expense of consumers as a whole, for the capacity of consumers to benefit by what is saved is the sole test of its worth. [5]

Foster and Catchings start from an equilibrium position where firms are able to sell their products at prices exceeding their costs. All of the profits are paid out as dividends to the owners. Now suppose that some firms begin to retain their earnings in order to invest them internally in new capital goods — for example, a factory — with the intention of increasing the firm’s productive capacity.[6] While the new factory is under construction, there is no problem. The supply of, and the demand for, consumer goods remain unchanged. The dividend income lost by the shareholders (due to the increase in retained earnings) is paid out to the same (or different) workers building the factory, as wages.

But once the factory is opened and the additional goods begin to roll off the line, “the crisis sets in.” Hayek writes,

In The Dilemma of Thrift, Messrs. Foster and Catchings provide the following description of the events leading up to this crisis: “Suppose however, [the corporation] uses the remaining one million dollars of profits to build additional cars, in such a way that all this money goes directly or indirectly to consumers. The company has now disbursed exactly enough money to cover the full sales price of the cars it has already marketed; but where are the consumers to obtain enough money to buy the additional cars? The corporation has given them nothing with which to buy these cars.”[7]


The money in the hands of the consumer does not increase any further … and, since it is assumed that there is no fall in prices, a proportion of the enlarged product must therefore remain unsold.

While the money that was saved and invested eventually reaches the consumers as wages, so argue the two authors, this would have happened anyway had the savings and investment not taken place. The funds would have been distributed to different people had the earnings been paid as dividends rather than retained. The problem is that firms are producing more goods; but the total monetary income of consumers is the same, so they can buy only the same quantity of goods as before. There is a deficit of purchasing power because the new investment does not provide consumers with new additional purchasing power to buy the additional goods.

Allowing prices to fall — as certainly they would in response to an increase in supply — would not solve the problem; it would accelerate the rush toward insolvency as firms would be forced to sell their output below their cost of production.

In spite of the failure of the 435 contestants to find a serious flaw in the theory, Hayek did not accept its validity. Instead, he provided a detailed — and Austrian — criticism that exposed the errors in their analysis. Hayek argued that, when the additional savings were invested, then production, consumption and aggregate profits would all increase in complementary movements that would bring the entire economy to a new, profitable equilibrium at a higher level of supply and of demand.

Hayek’s explanation relies on the Austrian concept of capital. Capital is the chain of goods and processes used to produce consumer goods. It includes mines, power plants, research, development, basic materials, factories, warehouses, transportation, distribution networks, and retail stores. In an advanced economy, capital is organized into an intricate interlocking structure, which changes constantly in response to profit and loss. Entrepreneurs constantly combine, dissolve, and recombine labor and capital based on their anticipation of the greatest profits. Profitable entrepreneurs retain successful combinations of labor and capital, while those realizing losses are liquidated, thereby putting the labor and capital back on the market.

Hayek criticized Foster and Catchings: “What they entirely lack is any understanding of the function of capital and interest.”[8] By analyzing the effect of savings on the structure of capital in the economy, Hayek showed that the new investment would enable firms to reduce their production costs by more than the amount that prices would fall, enabling firms to make profits at the lower prices. And real wages would rise, providing the “missing” purchasing power.

Hayek noted that the two authors “assume that the increased volume of production brought about by the new investment must be undertaken [without any change in the organization of capital] as the smaller volume produced before the new movement took place.”[9] Foster and Catchings model the process of investment as a simple cookie-cutter replication of the existing capital structure. For example, a 50% increase in investment would entail a new factory for every two existing factories, a new warehouse for every two existing warehouses, and so on. With this model, there would be an equal growth in monetary investment, in the supply of every distinct type of capital good, in total costs, and in output. Per-unit costs would be unchanged.

Hayek showed that economic growth cannot occur according to this model. While a single firm might be able to expand its capital structure exactly in proportion, with costs and revenues rising by the same ratio, the entire economy cannot do so. To see why, consider a small firm consisting of four cafés. The owner plans to increase investment by 25%. This corresponds to one new café. The owner will probably be able to rent one additional storefront and hire three additional baristas and one additional manager, for about the same as he already pays at his existing locations. If the new location is not already saturated with cafés, then the sales at the new location may be about the same as the sale at existing locations. He can expand everything exactly in 25% proportion: capital, labor, revenues, and sales.

The firm can expand in proportion without increasing costs, because it is bidding away existing storefronts, existing workers, and existing sales from alternatives within the same city.[10] There is no new net savings in the city because the additional savings of the café owner are exactly equal to the dissavings of the person who sold him the storefronts. The city experiences growth in coffee serving at the expense of a contraction of some other businesses that previously employed the same capital and labor, perhaps bookstores or hair salons. Workers are laid off by the businesses that closed down.

In the preceding example, net additional savings are zero because the new savings of the store buyer are exactly balanced by dissavings of the store sellers. Hayek pointed out that this example does not help to understand how a net growth in savings works. While one small firm can grow through the dissolution of other small firms, all production in the economy cannot, for where would the new units of capital come from, if we have ruled out the redeployment of existing capital? And where would additional workers come from to operate the new factories, if we have ruled the existing workers changing jobs?[11][12] The two authors’ theory contains a fallacy of composition (something that is true of a part in relation to the whole is not necessarily true of the whole).

The two authors showed only that more workers can produce more goods with the same amount of capital per worker. But as Hayek explained, the real question (and one they could not answer) is, how can the same workers produce more goods? The answer is that the amount of capital per worker must increase. Increased capital in proportion to labor is the only means of producing more without the number of workers increasing.

The additional savings must be used to create more capital. As Hayek explains, initially, more production comes at the expense of less consumption. Hayek wrote, “For in industry as a whole an increase in the available supply of capital always necessitates a change in the methods of production in the sense of a transition to more capitalistic, more ‘roundabout’ processes.”[13]

Entrepreneurs must reorganize and transform the entire structure of capital in the economy, in order to fit the new, more productive capital into the existing structure. The more capital-intensive sectors of the economy increase in proportion to the less capital-intensive sectors. The new factory is built at the expense of (for example) several bookstores or cafes.

Hayek’s demonstration of this point is rather technical, so in the interest of space I won’t try to explain it in detail. A consequence of this capital restructuring is that the real cost of production for most firms is lowered. Hayek’s discussion was based on a model of capital as a sequence of stages from production to consumption, where the output of each stage is the input of the next one. The revenues of each stage constitute the costs of the next one. Firms at every stage are able to make profits even as prices fall because the more capital-intensive stages expand at the expense of less capital-intensive ones; the fall in the prices at each stage is greater for the inputs than for the outputs. Because more goods are sold with the same quantity of money, prices fall and the purchasing power of each unit of money is increased. While nominal wages would fall in some industries, real wages on the whole will increase.

Hayek called attention to another problem in Foster and Catchings’s model. Their model assumes that prices do not change until the final goods come online, and that only the prices of final goods fall. In a real decentralized market economy, Hayek explained, entrepreneurs would not foolishly take avoidable losses; instead they will attempt to adjust prices through their forecasting ability:

If entrepreneurs expect — as if the volume of money were kept constant, they ought to expect from experience — that the prices of the products will fall absolutely, then from the outset they will only extend production in such proportions as to ensure profitableness even if the relative prices of products (as opposed to the means of production) fall.[14]

Hayek demonstrated that the Foster and Catchings’ underconsumption doomsday does not arise. The “missing” purchasing power comes from the increase in the supply of goods that workers are able to produce. As they supply more they are able to demand more. Rather than a collapse into depression, the entire system reaches a new equilibrium at a higher level of savings by means of adjustments everywhere else: in labor and in capital; in prices and in quantities; in production and in consumption.

The true economist takes into account both what is seen and what is unseen. Foster and Catchings failed because they looked only at the effects of investment on one part of the system while ignoring offsetting effects elsewhere. Why was Hayek able to see the error so clearly where so many others had failed, and so many continue to fail today? Because the unseen effects of investment show up as changes in the capital structure. Hayek knew where to look because Austrians incorporate a capital structure into their model of the economy, while modern economics has largely abandoned it.


[1] The Paradox of Thrift was first published in a German economic journal, then later in an English-language journal, then finally reprinted as an appendix to Hayek’s Prices and Production (New York: Augustus M. Kelley, 1935 ed). Citations in the article are to page numbers in the latter version.

[2] Hayek, p. 199.

[3] Mark Skousen, “Which Drives the Economy: Consumer Spending or Saving/Investment?”

[4] It is not evident that this was ever a real problem. While the United States had been happily saving, accumulating capital, and increasing production along with consumption for decades (perhaps centuries) prior to the publication of their work, the two authors saw an enormous crisis looming. Their grandiose pretensions are voiced: “Indeed, it is doubtful whether any other way of helping humanity [than solving the problem of underconsumption] holds out such large immediate possibilities” (p. 212).

[5] Hayek, p. 209.

[6] This paragraph paraphrased and some phrases quoted from Hayek’s explanation on p. 206.

[7] Hayek, p. 207.

[8] Hayek, p. 254.

[9] Hayek, p. 221.

[10] Hayek, p. 234.

[11] See p. 222n1 and p. 224.

[12] Hayek writes, “Foster and Catchings seem to avail themselves of the assumption of an ‘industrial reserve army’ … from which the labour power necessary for a proportional extension of production can always be obtained at will. Quite apart from the incompatibility of this assumption with the known facts, it is theoretically inadmissible as a starting point for a theory which attempts, like Messrs. Foster and Catchings, to show the causes of crises, and thus of unemployment, on the basis of modern ‘equilibrium theory’ of price-determination” (p. 222n1).

[13] Hayek, p. 222.

[14] Hayek, p. 245.

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