How to Know When to Spend and When to Save

It’s a confusing time to be a consumer. The government, the media and every reliable financial indicator tell us that we are up to our necks in an unprecedented global economic crisis. And to make matters worse, they say it’s our fault.

The root cause of our current financial mess is a decade or more of runaway spending by governments, corporations and — yes — people like you. We bought homes we couldn’t afford. We maxed out credit cards we didn’t need. We buried ourselves under a mountain of personal debt without saving a penny for a rainy day, let alone the torrential downpour we currently face.

The result is that we’ve been seriously humbled. We no longer view the stock market as a risk-free investment. We no longer assume that home prices will continue to rise indefinitely. And we no longer treat saving money as a boring chore, like eating our vegetables.

Saving is, in fact, all the rage. Magazines and TV shows bombard us with money saving tips like sewing our own clothes, growing our own food and making our own toothpaste. According to a recent survey by the Pew Research Center for the People & the Press, 86 percent of Americans have cut their spending or changed their saving and investment plans [source: Hopkins].

Just as Americans are shunning their consumerist ways and going into deep survival mode, the government is selling a competing message: “Spend! Spend! Spend!” It makes sense: Consumer spending in the U.S. accounts for around 70 percent of the country’s total economic activity [source: Crutsinger]. So when consumer spending drops, the economy grinds to a halt. Lower demand means lower production, which leads to mass layoffs, which equals a bad situation for just about everyone.

What, exactly, is a patriotic but poor citizen to do? If we spend money to bolster the economy, then we add to our pile of personal debt. If we bury jars of coins in the backyard, then we kick the chair out from under the economy.

Thankfully, this dilemma has a name: the paradox of thrift. Finding solutions, however, might be a little trickier. We’ll learn more about the paradox of thrift on the next page, then we’ll tackle some different “save or spend” scenarios.

The Paradox of Thrift

John Maynard Keynes was a revolutionary 20th-century economist who popularized the paradox of thrift. In his 1930 book, “Treatise on Money,” he warned against the economic paralysis that results from excessive personal saving.

His rallying cry was directed toward a British populace suffering through the Great Depression. Spending money was the only way out of the economic quagmire, Keynes argued. For every five shillings saved out of “misguided” thrift, another man would lose his job for a day [source: Blankenhorn].

The message of the paradox of thrift is simple but troubling: What’s best for the individual isn’t always good for the economy [source: Brockman]. More paradoxically, what’s good for the individual is ultimately bad for the individual. It comes down to this: If the whole economy falters, then no job is secure — not even yours.

This is why U.S. leaders urged Americans to go out and shop after the Sept. 11 terrorist attacks. The implication was that if the economy faltered, the terrorists would win. This is the same logic that drove Presidents Bush and Obama to extend generous tax rebates in 2008 and 2009. If you put cash in people’s pockets, they will spend it, which will stimulate the economy.

Americans usually don’t need to be prodded to spend. Over the last 30 years, Americans have maintained a spending rate far above other industrialized nations. In 2007, consumer spending peaked at slightly above 70 percent of the U.S. Gross Domestic Product (GDP), while it only amounted to 55 percent of the GDP in Germany and Japan [source: Brockman].

Similarly, saving money has lost favor in the U.S. since the mid-1970s. In 1976, the average personal savings rate in the U.S. hovered around 12 percent. In 2005, that number actually dipped below zero for the first time since the Great Depression [source: Associated Press]. On average, Americans were not only saving nothing, but they were actually draining their savings to finance more purchases.

That’s all changed with the current financial crisis, however. As of July 2009, the U.S. savings rate has skyrocketed to 5.7 percent, the highest level in more than a decade [source: Blankenhorn]. Unfortunately, the timing for the U.S. economy couldn’t be worse. Just when businesses need consumers — and their money — the most, most wallets are shut tight.

Is Keynes right? Are we penny-pinching our way to total economic collapse? How can we know when it’s prudent to be frugal and when it’s safe to spend?

Spending to Save

Many people have been hit hard by the recession, and it seems as if everyone has caught “saving fever” as a result. Of the 86 percent of Americans who have cut their spending or changed their savings and investment strategies during this recession, more than half of them have yet to feel the financial pinch personally [source: Hopkins]. They’re saving money as a buffer against an uncertain economic future.

In addition, despite statistics asserting that Americans carry more than $2.5 trillion in personal debt, millions of American families have money in the bank, mortgages they can actually afford — and no credit card debt [source: Federal Reserve]. These lucky folks are the people who are in the best position to spend money during a recession. However, that doesn’t mean that it’s their patriotic duty to go on wild shopping sprees to make up for the meager consumerism of their neighbors.

Instead, financial experts say, people without debt should look at the “save or spend” riddle from a different perspective. Instead of using their money to consume, they should use it to invest [source: Leonhardt]. When economists talk about investing in this sense, they’re not talking about stocks and bonds. Instead, they’re talking about products and services purchased today that will save you money down the line.

The mantra is “spend to save,” and here are some examples:

  • Increase the energy efficiency of your home to save on energy bills over the long term by adding insulation, weatherizing windows and doors and buying a programmable thermostat.
  • Do preventive maintenance on your vehicles, especially before the summer and winter months when cars are most susceptible to breakdowns.
  • Buy a nice water filter for your faucet instead of purchasing bottled water.

[sources: Leonhardt, Caplinger]

The “spend to save” philosophy is a convenient solution to the paradox of thrift, because the individual is helping himself over the long term while stimulating the economy in the short term.

Of course, in order to save, you have to have money to spend. On the next page, we’ll look at an interesting twist to the paradox of thrift.