Paradox of Thrift, Fallacy of Composition, Austerity, and Second-Order Thinking

What is the Paradox of Thrift

The Paradox of Thrift refers to the counterintuitive concept that, in many circumstances, when individuals save more money, it leads to a decrease in total savings across an economy.

As individuals choose to save more money, aggregate demand decreases. In a recessionary economy, this deepens the downturn, causing job losses and forcing people to deplete their savings or preventing them from growing their savings. Ultimately, total savings decline — enter the paradox: saving more to save less.

Side Note · Austerity

This is similar as to why reducing government spending (austerity) during recessions - amplifies the recession. It may seem like a counter notion, but an increase of government spending during recessionary periods is key to prevent larger issues and get an economy out of recession.

As for this reduction of government spending (austerity) and it’s correlation to hurting a country in recession; we have a great real world case study - The Great Recession. Not only did reduction in government spending prevent recovery of the recession in many nations that employed this tactic, it also had other negative effects. See this article for that analysis: Austerity in the aftermath of the Great Recession.

Additionally, and notably, extremely negative consequences were evident because of the reduction of government spending during The Great Depression: Fiscal austerity and the rise of the Nazis

Paradox of Thrift · Fallacy of Composition

The Paradox of Thrift is a notable example of the Fallacy of Composition.

The Fallacy of Composition is when one assumes something is true of the whole from the fact that it is true of some part of the whole. This fallacy has relations to other fallacies, but I won’t get into those here - but it is pretty interesting stuff if you are interested definitely look it up.

A very apt example that is an analogous to the Paradox of Thrift and another great example of the Fallacy of Composition, goes as follows:

If one stands up from their seat during a soccer game, they can see better. Therefore if everyone stands up, they can all see better!

Second-Order Thinking

This idea of the Paradox of Thrift and the Fallacy of Composition naturally leads to the concept of second-order thinking, which challenges us to move beyond immediate, surface-level conclusions and consider the broader, often counterintuitive, consequences of actions.

To examine second-order thinking, we will use the examples from earlier to walk through the naive first-order thoughts and then the second-order thoughts. Each of these examples are simplest versions of the examples, but

First-order thinking: Saving is good no matter what because it builds wealth. Second order thinking: Excessive saving during a recession reduces demand, leading to job losses and lower overall savings.

First-order thinking: Cutting government spending reduces deficits. Second order thinking: Reduced spending shrinks the economy, lowering tax revenue and increasing the debt-to-GDP ratio.

Conclusion

Especially with regards to economics, many policies and policy proposals require second-order thinking to determine whether it is a net positive or net negative.

Second-order thinking is important not just for deciding your view on policies but for everyday decisions, especially when confronted with something that sounds true or feels true. Our instinct is often to focus on the immediate, surface-level effects of a choice, which can lead to oversimplified conclusions. Second-order thinking reveals the hidden complexities behind what initially seems obvious and can lead to the exact opposite conclusion.

This deeper thinking requires us to ask questions like, “What happens next?” or “What are the broader implications?” It is not enough to stop at the first level of understanding, because the most important effects are often indirect or delayed. Second-order thinking forces us to go beyond immediate outcomes and consider how a choice might ripple through time and across various contexts. By analyzing the chain of consequences and exploring potential unintended outcomes, we can avoid shortsighted decisions and ensure our reasoning holds up under deeper scrutiny.