Rubin’s Fallacy and the Paradox of Thrift

When I choose my blog pseudo-name – PGL or ProGrowthLiberal – Angrybear suggested I was a Rubinesque Bear, that is, a believer that fiscal restraint could promote long-term growth through higher national savings. I hate to say this but Paul Krugman had to give a stern lecture to Robert Rubin over the simple issue of transmission mechanisms. Before we get to the details of international macroeconomics, let’s do an analogy drawn from the paradox of thrift.



Classical economists used to have faith that a rise in national savings would automatically lower real interest rates enough to increase investment demand such that the economy would stay at full employment. Keynes noted that sticky prices – or a decision by the Central Bank to peg interest rates – could frustrate this transmission mechanism, which would mean that the rise in the savings schedule could lead to a recession, which would result in less investment and savings. Without further ado, let’s turn the microphone over to Paul by first noting Rubin’s fallacy:

You could have had surpluses that affected the savings rate and would have helped the trade balance. I think you would have had more confidence in the policy framework and you would have had a better dollar,” he says regretfully. He pauses to reflect. “But we are where we are.”

Paul harkens to the doctrine of immaculate transfer noted by John Williamson as Paul notes that accounting identities do not induce expenditure-switching unless they are accompanied by changes in the real exchange rate. Paul also notes that a fall in national savings could lead to fewer imports if it means a recession. But aren’t we trying to avoid a recession as we find means of encouraging more investment and net exports? If so, we should be hoping for lower real interest rates and a real devaluation of the dollar.