Could Americans saving more and spending less rescue the US economy?

The conventional wisdom is that the US economy won't recover until consumers start spending freely again. But some economists say Americans saving their money may be more advantageous.

By , Correspondent

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    Joana Husain (now unemployed) and her husband, of Westborough, Mass., now host potlucks instead of lavish dinner parties to spend less and traded their BMW for a Toyota to save more money. The Husains, along with other Americans following this financial path, could be helping the US economy recover faster.
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Before the recession, Joana Husain drove a BMW, hosted lavish parties, and frequently vacationed with her family at pricey theme parks. Fifteen months later, she's cut back drastically.

After losing her job as a human resources coordinator at EMC Corp. in Hopkinton, Mass., Ms. Husain traded in her BMW for a Toyota, began holding smaller potluck parties, and swapped Disney World vacations for family road trips.

Ironically, losing a well-paying job has helped Husain and her husband get their finances in order. They've scrutinized their budget, pared expenses, and started saving more – even on half their previous household income.

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"We're cutting down a lot.... [The recession] taught us we need to save more for times like this," says Husain, who lives in Westborough, Mass., with her husband and two sons. "Even saving $20 or $30 a month can add up to a lot." And with a third boy on the way she says, "I'm sure we'll have to tighten our budget long-term."

The recession has brought about a seismic shift in Americans' financial habits, coaxing scores of former spendthrifts to save.

Roughly 6 in 10 Americans now say they prefer saving to spending, according to a recent Gallup poll. And although Americans still have one of the lowest savings rates in the world, they are saving more: Americans saved 5.4 percent of disposable income in the second quarter of 2009, when the recession was near its peak.

By contrast, the savings rate was less than 2 percent in all of 2005 when access to easy credit, sophisticated marketing campaigns, and a culture of consumption lured many Americans to the malls.

Based on conventional wisdom, Americans' newfound penchant for thrift is good for them but bad for the economy. But some economists assert saving more can actually improve the economy in the long run.

Whenever the economy goes sour, consumers are often bombarded with messages to spend, spend, spend, to stimulate the economy.

"If you can afford it, then this is exactly the moment to redo your kitchen or buy a car," wrote Harvard economics professor Edward Glaeser in a 2009 New York Times article titled "If you got money, it's time to spend some." "Not only will you be able to get a good deal, but your spending will help revive the economy."

And on more than one occasion, former President George W. Bush encouraged Americans to shop to spur the economy. It's a familiar refrain throughout history, says Lauren Weber, author of "In Cheap We Trust."

"Everyone's telling us we're doomed unless consumers start spending," says Ms. Weber. "American history is filled with these times when [saving] is demonized and those who do are told they are endangering the American way of life."

Consumption-mongers may be right, to a point.

In a consumer-driven economy like the US, consumption typically makes up 70 percent of gross domestic product (GDP). But as consumers slashed spending and boosted savings during the recession, consumption as a percentage of GDP began dropping. It will be 65 percent of GDP by 2015, according to some reports – and that has some people worried.

It's a problem known as the paradox of thrift, the theory that individual thrift leads to collective misfortune, an idea first proposed by English economist John Maynard Keynes.

One person's spending is another person's income, the theory goes, so if everyone decides to save money by, say, eating out less, someone else loses that income (like restaurants).

Multiplied across the economy, less spending and more saving will slow economic growth. In other words, according to Mr. Keynes, Husain is contributing to a downturn by saving for her sons' college educations.

But some economists say responsible financial behavior may actually help the economy in other ways.

Here are four reasons saving money can save the economy:

1. Savings feeds investments, which feeds growth

"We would have a healthier economy by far if we saved more and invested more," says Robert Frank, professor of economics at Cornell University's Johnson School of Management.

The traditional argument, he explains, is that the savings of individuals provides a pool of money people can borrow from to start new businesses, innovate new technologies, and create jobs. "We would grow more rapidly the more we save and invest," says Dr. Frank. "The more we save, the more we invest, the more [we can fund] new inventions and boost productivity, which are the engines of growth."

History supports his case. During World War II, millions of Americans were put to work on wartime production, but most consumer items were rationed.

Making money with nothing to spend it on, Americans' savings rates soared to more than 25 percent during World War II, in part propelling a huge 25-year economic boom with growth rates around 3 percent. In the 1970s, when savings rates declined to less than 10 percent, economic growth also dipped, to about 2 percent.

"History shows us that more spending is not necessarily equated with growth, in the long run," says Frank.

2. Savings can moderate recessions

If more people saved, says Weber, the recession wouldn't have been as severe as it was. One of the benefits of saving, she says, is that it creates a cushion for "rainy day" emergencies – a car repair or expensive hospital visit – so they won't break the bank.

"When you have a situation where households have no cushion, it makes the economic shock greater," she says. "If more people had a safety net, you wouldn't have necessarily hit the crisis point that we've hit in the last couple of years."

Spending more, she says, is exactly the opposite of what the US needs to climb out of recession.

"What got us into this mess in the first place was excessive spending and borrowing," says Weber. "You can't cure this problem with the same poison that caused it. It's like telling an alcoholic going through withdrawal that they should have a glass of whiskey to calm their nerves."

3. Savings make Americans less beholden to foreign creditors

Each step in the direction of financial responsibility is a step away from potentially dangerous dependence on foreign money. American savings provide a larger domestic pool of money for companies (and the government) to borrow from, making the US less dependent on foreign creditors who currently loan the US hundreds of billions of dollars every year.

"China and Japan are financing the spending spree of American consumers," says Weber. "We are selling our global influence by being profligate spenders; we're mortgaging our global influence."

4. Savings alleviate volatile boom-bust cycles

The most convincing argument for responsible financial behavior will be seen in coming generations, says Greg Daugherty, executive editor at Consumer Reports.

Like the generation that came of age during the Great Depression, young people experiencing hard times in their formative years will be profoundly affected. The upshot? They may be more financially responsible than their parents, says Mr. Daugherty.

"I suspect it's a very formative lesson for children," he says. "I would guess the generation coming up now is going to be less giddily optimistic about the economy, more cautious consumers. And that skeptical eye will probably serve them and the economy well."

Ultimately, their more sober consumer behavior might mean fewer booms and busts, he says. "We might see less of a roller coaster ride of an economy, and more steady, sustained growth."

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