This discussion expands on and reinforces the 'paradox of thrift' message for the simple three-person economy. I believe that it is worth labouring the point because it is so important. To begin let's simplify things in order to highlight the effects.
Figure 15.1: A basic transaction structure.
Figure 15.1 indicates simply that regardless of what form transactions take what happens is that people always transact with other people. Figure 15.2 completes the circle of transactions which reflects the situation in a real economy. Although this is a simplified picture it is able to illustrate the effect of saving money on wealth creation.
Figure 15.2: People transacting with several other people where the transactions come full circle as they do in a real economy.
Let's say that P5 ('P' is for person), instead of saving money, decides to save half the wealth that she receives from P4 instead of using it. She pays P4 the normal sum of money and receives the normal amount of wealth in return. She puts half on one side for safe keeping and uses the other half. P4 doesn't care what P5 does with the wealth, her only concern is being paid for it. P4 uses the money to buy the normal amount of wealth from P3, P3 from P2, P2 from P1, and P1 from P5. Nothing has changed as far as all the other people are concerned, this little economy keeps on working just as before, but with P5 saving half the wealth she has bought. P5 can go on saving bought wealth if she wants to, and so can any or all the others.
All well and good so far, and all is as expected. But now consider what happens if instead of saving wealth P5 decides to save money. Money needs to circulate, so saving it can be expected to cause problems, and it does. Saving money is very much more likely than saving wealth because money can be exchanged for anything. She pays P4 half the normal sum of money and buys half the normal amount of wealth from P4. P5 is happy with that, she didn't expect any more than half the wealth, after all that's her sacrifice for saving the money. But what about P4? P4 isn't happy at all. P4 has only sold half the wealth she has produced so the other half remains unsold. Even worse she can now only afford to buy half the wealth that P3 has produced, so half of P3's wealth remains unsold, and the same for P2 and P1. When P1 comes to buy the wealth that P5 has produced again she can only buy half the wealth so half of P5's wealth remains unsold. The net effect is that everyone is left with unsold stock and only P5 has any extra money. If P5 had intended to keep saving money then she now finds that she can't because her income has dropped by half. Let's say she spends all her remaining income because she can't cut back any more, so she buys the unsold stock that P4 was left with after the first round. Similarly P4 buys P3's unsold stock, P3 buys P2's, P2 buys P1's, and P1 buys P5's. Now there is no unsold stock, but only half the money circulating in the economy. As a result all decide to cut back on production to avoid being left with unsold stock, and the economy eventually settles down with each producing half the normal amount of wealth and half the original money circulating. The economy is now stable again, but P5 can't save any more money, and by saving just half of one payment great damage has been done to everyone including P5, and there is only half the employment there was originally. This is again Keynes' paradox of thrift that was referred to earlier. Saving money is another example of the confusion between money and wealth. We think that saving money is the same as saving wealth, but as we have seen it as anything but.
When spending drops the economy declines until production matches the new lower level of spending.
This is a simplified illustration and having so few participants exaggerates the effects, but the mechanism it illustrates is accurate and the paradox is very real and very damaging, and is exactly what happens when people stop spending for any reason, and not just any form of spending, but spending on new wealth production. It is what causes recessions and depressions.
Whenever someone cuts back on spending on newly created wealth, either someone else must spend to make up the difference or there will be unused services or unsold stock, which will only clear when production has been scaled back to match the reduced level of spending, the result of which is unemployment.
This outcome is not widely recognised. It illustrates clearly the dangers of treating money as wealth, as most people including economists and especially politicians do all the time. The essential factor that makes it happen is saving that which is intended for trade - i.e. money - rather than saving that which is bought for use - i.e. wealth. Hence it is very much more likely in economies that use money - regardless of the form that it takes - because to have the same effect in a barter economy one would have to save the wealth that one produced for sale to others instead of using it to buy wealth from others, and that is much less likely because if that wealth was wanted for saving then sufficient would be produced both to meet one's own saving requirements and to use for buying wealth from others. In a barter economy the wealth used to buy things is produced by the buyer - its availability is within the buyer's own control, whereas in a money economy the money used to buy things can't be produced by the buyer, it has to be obtained from someone else - from money received as income.
Storing wealth for use in the future rather than using it now is a prudent thing to do as it increases security, providing a buffer against unforeseen events that can damage later production. Storing money seems to serve the same purpose in that it provides entitlement to future wealth, but it is not at all the same thing because as we have seen money is needed to provide another person's income, and the more that is stored the less future wealth that person can create. So although storing money seems logical and makes sense for the individual, it is counter-productive for the economy as a whole. If a lot of people store money at the same time then the only way that the economy can avoid harm is if someone else (normally the government) spends sufficiently to compensate.
Delaying use by storing wealth for the future is prudent, but storing money for future wealth entitlement is counter-productive because it reduces the amount of wealth that can be created.
The foregoing arguments show why the gold standard - when money was fully guaranteed by gold - was a very poor basis for an economy. The supply of money depended on the supply of gold, and when that was in short supply - due to spending on too many imports or hoarding at times of uncertainty about the future - wealth creation necessarily slowed down and people suffered as a result. The only way to get more money into the economy was for the rulers to take it from the hoarders (difficult because gold is easy to hide) and spend it, export more goods to earn gold from abroad, or conquer foreign countries and take control of their gold. It led to a world of hostile competition
In 1924 in his influential publication 'Monetary Reform', Keynes famously said in response to those who advocated a return to the gold standard:
If we restore the gold standard, are we to return also to the pre-war conceptions of bank rate, allowing the tides of gold to play what tricks they like with internal price level, and abandoning the attempt to moderate the disastrous influence of the credit-cycle on the stability of prices and employment? ... In truth the gold standard is already a barbarous relic. (Keynes 1924 p172)