What would be the economic effect of widespread instances of individuals paying off consumer debt?

In light of the economic impact of the recent shutdowns in response to COVID-19, the Australian Government is considering bringing forward planned tax cuts, that were do to be implemented gradually over the next five years. The tax cuts themselves aren't too large compared to other economic stimuli currently in action, but I read the following statement on a Guardian article:

The Australia Institute paper, by senior economist Matt Grudnoff, concluded that bringing forward the income tax cuts was an “ineffective stimulus”.

He cited the “simple fact of economics that high income earners are more likely to save or pay down debt with the tax cuts, rather than spend the extra funds to help stimulate the domestic economy”.

“A more effective way to stimulate the economy would be to invest heavily in direct employment programs or focus on supporting those who are doing it tough by maintaining or increasing the current rate of the jobseeker supplement.”

This left me wondering what happens to the wider economy when people decide en masse rather than spending their disposable income on consumer goods/services, to instead pay down their debt and save/invest?

This left me wondering what happens to the wider economy when people decide en masse rather than spending their disposable income on consumer goods/services, to instead pay down their debt and save/invest?

tl;dr: Answer depends on the situation/time horizon you are talking about. In long run increasing saving and investment will have no negative impact on economic activity. In fact it can even lead to higher long-run economic growth. However, in short-run and in recession (especially one where economy is in a liquidity trap) it would lower everyone real incomes and depress economic activity.

To see what mechanisms are in play here we can use little bit of math. This can be done with the standard goods market equilibrium model (see Blanchard et all Macroeconomics: a European Perspective) Let us start with output/GDP definition for closed economy:

$$Y =C+I+G \tag{1}$$

where $$Y$$ is the economic output (which in economics must also be equal to people's incomes so I will be using output/income interchangeably). $$C$$ is consumption, $$I$$ is investment and $$G$$ is government spending. In order to get some meaningful answer from the above identity we have to specify what the consumption is. In order to make everything simple lets assume linear consumption function:

$$C= c_0 + c_1 (Y-T) \tag{2}$$

Where $$c_0$$ represents your autonomous consumption - consumption you will consume regardless of your income, $$c_1$$ is your marginal propensity to consume, if $$c_1=0.75$$ that means you will consume $$3/4$$ of your disposable income and save the rest and finally $$Y-T$$ is income minus taxes which is the disposable income.

If we substitute $$C$$ back to the GDP definition and solve for $$Y$$, we get the goods market equilibrium:

$$Y = \frac{1}{1-c_1}\left( c_0+I+G-c_1T\right) \tag{3}$$

This shows that the level of economic output $$Y$$ will actually depend both on consumption and investment (and investment in turn depends on private savings as it is the sum of private and public saving). However, it also shows that if people's marginal propensity to consume increases (that is when $$c_1$$ becomes higher) the whole output multiplier $$\frac{1}{1-c_1}$$ becomes higher and hence for any level of autonomous spending, investment or government spending the output will be higher.

Nonetheless the above is all just a short-run partial equilibrium analysis. Such analysis is appropriate when we are in recession and where investment is unresponsive because for example an economy is in a liquidity trap (a situation where increase in savings wont necessary fuel more investment). However, in long-run we have to acknowledge that investment is not just independent as the formula (3) suggests but also depends on income and interest rates as investment as mentioned above arises from private and public savings.

If we make just one very simple change to the model above and assume that investment is given as $$I= I_0 + d_1 Y -d_2 i$$ , where $$I_0$$ is autonomous investment, $$d_1$$ is the fraction of income that is invested, $$d_2$$ is parameter which determines how investment respond to interest rates and $$i$$ is an interest rate, then the goods market equilibrium will be given by:

$$Y = \frac{1}{1-c_1-d_1}[c_0 + I_0 + G − c_1T] - \frac{d_2}{1-c_1-d_1}i \tag{4}$$

In this case you can see that the multiplier is given as $$\frac{1}{1-c_1-d_1}$$ so multiplier is given by spending not just on goods and services but also by investment spending - if people lower their marginal propensity to consume but increase marginal propensity to invest to offset that nothing will change. Furthermore, ceteris paribus increasing the amount of savings lowers the interest rate (which is the price for savings that can be used as investment). So once we let investment to vary depending on interest rates and income we see that what matters is the amount of all spending no matter whether it is spending on goods and services or investing.

In addition the above is still missing explicit model for money-market and behavior of firms if I would add that in a result would show that in the long run all savings are transformed into investment either directly (which is modeled here) or indirectly through their effect on overall price level but an exposition of full model would be too complex so if you are interested you have a look at some undergraduate textbook (all models presented here are taken from the above mentioned Blanchard et all Macroeconomics but they will also appear in any standard macro book with perhaps different notation).

Furthermore, the discussion above does not factor in economic growth and saving and investment is crucial for economic growth. The main growth model used in modern economic literature are the Solow growth model in which increase in saving rate can result in short to medium term higher economic growth, but not really in a long run per capita growth which will in the model be determined by the rate at which technology progresses. However, for that to happen the economy still requires some level of saving - the model just shows that trying to increase the level of saving in the long run steady state wont make difference (See Romer Advanced Macroeconomics).

However, recently in literature endogenous growth models are becoming more popular (Romer even got his Nobel Prize in economics in 2018 for his work on them) and in such models savings rate actually can increase even long run economic growth (again see Romer Advanced Macroeconomics).

PS: This is little bit of an tangent and hence I included it as a post scriptum but actually this:

He cited the “simple fact of economics that high income earners are more likely to save or pay down debt with the tax cuts, rather than spend the extra funds to help stimulate the domestic economy”.

this is actually not entirely accurate - or at least taken out of context (probably journalist misunderstood statement about particular tax cut as a general one). You can always design a tax cut that specifically targets poor. For example suppose we have flat tax rate of $$40\%$$ we can always decide to cut tax rate to let's say $$10\%$$ only for people below some income threshold. Rather the issue is that taxes generally have lower multiplier attached to them and hence they affect output differently. From equation (3) you can see that if government spending $$G$$ increases by 1 the output will increase by $$\frac{1}{1-c_1}$$ but if the government decreases taxes output increases only by $$\frac{c_1}{1-c_1}$$ and on interval $$0 the former will be always larger as on that interval $$\frac{1}{1-c_1}>\frac{c_1}{1-c_1}$$. This also holds just in short-run though.

• In this context is it best to think of paying down debt as savings (owned by the bank rather than an individual) for later investment? – Brett Sep 7 at 12:19
• That is part of savings since debt is just a negative savings. What I have written above will hold generally. In short run trying to increase savings -even paying down debt (i.e. decreasing negative saving by adding positive saving) might not result in higher investment but in lower income if investment is fixed in the short run - which it will be especially if the country is in recession and more so if the recession is characterized by above mentioned liquidity trap (which usually occurs at nominal interest rates close to 0). – 1muflon1 Sep 7 at 12:23

In this 21 page paper Irving Fisher outlines key points in his debt deflation theory of Great Depressions:

https://fraser.stlouisfed.org/files/docs/meltzer/fisdeb33.pdf

Then we may deduce the following chain of consequences in nine links: (1) Debt liquidation leads to distress selling and to (2) Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes (3) A fall in the level of prices, in other words, a swelling of the dollar. Assuming, as above stated, that this fall of prices is not interfered with by reflation or otherwise, there must be (4) A still greater fall in the net worths of business, precipitating bankruptcies and (5) A like fall in profits, which in a " capitalistic," that is, a private-profit society, leads the concerns which are running at a loss to make (6) A reduction in output, in trade and in employment of labor. These losses, bankruptcies, and unemployment, lead to (7) Pessimism and loss of confidence, which in turn lead to (8) Hoarding and slowing down still more the velocity of circulation. The above eight changes cause (9) Complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in the real, or commodity, rates of interest.

Note when bank loans are paid off in aggregate there is a corresponding reduction in the total level of bank deposit liabilities and an equal reduction of bank assets. There would be an aggregate reduction of the banking sector. Net new loan creation also creates deposits which migrate to bank liabilities and bank equity. Net repayment of loans destroys (cancels) deposits which no longer appear as financial saving on the books of the respective banks.

In the systems we have now asset prices are fueled upward by the credit and debt deals in the markets of interest. Example: the houses in any typical neighborhood have comparable value. The valuation goes up over time as a younger person with sufficient income secures debt and then repays the mortgage. If everyone decides to repay debt at once then the prices of homes and other assets must go down, rather then up, and one theory states that this disrupts the production of new homes and new capital assets. In theory prices of assets should go down until someone with purchasing power sets a price floor for those assets. This can be financed with debt or savings, but only wealthy people have savings, and we prefer to create mild inflation via the finance of assets with debt and credit.

If people tomorrow decide to stop spending money on whatever consumer goods they think are the least important, and instead prioritize paying off their debts, creditors will more quickly replenish their reserves. This allows them to loan out funds for new projects/investments.

While this process takes place, the unbought consumer goods (the least important ones in the eyes of consumers) are not being sold at yesterday's high price. Businesses will either keep them in storage or lower the price. As a consequence of this, there is litte demand for the raw materials (including labour) that go into producing these goods. Therefore, the price of these inputs will also drop. At some point, the price becomes so low that entrepreneurs notice that the raw materials can be bought and used for new goods, that consumers want and can afford to buy.

It's important to be aware exactly what is meant when it is claimed that this or that policy is "good/bad for the economy". In the case you cite, the economist in question considers "a high number of dollars spent and many people doing stuff" to be signs of a "good economy". Therefore any policies that increases these numbers must improve the economy. If one uses a different criterion and asks if money is being spent on goods/jobs that consumers actually demand in their current situation (as opposed to hiring people to build "bridges to nowhere"), or if there are enough funds saved up to engage in new projects, those same policies can be seen as detrimental.

• but prices can take significant amount of time to adjust especially downwards - especially when we talk about wages- during that time the prices/wages will be higher than market clearing price - which will lead to output that would be below market clearing equilibrium. If government would arbitrary set a higher than EQ price (for example min wage) which results in lower economic activity would you still claim: " If one uses a different criterion and asks if money is being spent on goods/jobs that consumers actually demand in their current situation "? If yes then you are at least consistent, – 1muflon1 Sep 7 at 12:04
• but that would not be an interpretation you would find in modern macro literature. Moreover, you did not addressed the issue that in short run savings might not be invested into any productive activities. Otherwise, your conclusion would not be incorrect in the long run (assuming away any potential hysteresis effects), but that is an important caveat as a non-economist reading this will not get - it is especially important since the question is about stimulus during recession and recessions are short-run phenomena. – 1muflon1 Sep 7 at 12:04
• @1muflon. To say that prices/wages don't adjust "quickly enough" raises the question: "in order to/compared to what?". The standard answer is that due to psychological/regulatory factors, wages do not adjust so quickly that a prolonged drop in output + increase in unemployment can be avoided. The measured "number of dollars spent" may drop for an extended period of time, and some will be unemployed until circumstances force them to accept a lower wage. But why exactly is it a problem that money is not spent on unwanted goods, or that people wait as long as they see fit to accept a pay cut? – Ole Krarup Sep 7 at 12:42
• To say that prices/wages don't adjust "quickly enough" raises the question: "in order to/compared to what?" - the answer to that is given in any macro textbook - in order for markets to clear. Also what you say is standard answer is actually not standard answer to your rhetorical question it is an answer to what causes wage stickiness. Furthermore, it is not even the major answer for price stickiness. In fact majority of reasons for price and wage stickiness are non-behavioral (see Blanchard et al macroeconomcis). This causes not just the number of dollar spending to drop - but drop in – 1muflon1 Sep 7 at 14:25
• real output and incomes. Also you say " why exactly is it a problem that money is not spent on unwanted goods, or that people wait as long as they see fit to accept a pay cut?". But problem is that the goods are wanted - but markets cant clear. Again this is the same as if government sets minimum wage well above equilibrium level. Wages will be to high for market to clear but that does not mean firms would not want to hire people at market prices and people work at market prices. In this case markets cant clear because prices are locked in short time not because people are unwilling to – 1muflon1 Sep 7 at 14:28