So, layoffs have come to the McArdle household, making this a depression by the most commonly accepted definition.  The startup my housemate works for has gone out of business, and as we sat around last night talking about the financial implications of this, I pondered the Paradox of Thrift.

This is Keynes' famous argument that all spending is someone else's income.  If we (hypothetically) decide to eliminate takeout from our menu and eat tuna sandwiches instead, we are saving money.  But the restaurant loses it.  By foregoing spending, we are pulling money out of the economy.  This is the insight behind the liquidity trap--if everyone tries to hoard money by selling more goods and services while buying fewer, the total demand for goods and services will drop, and we will make ourselves worse off.

There's a problem with this crude, version, of course:  it's only true if we hoard the money in the form of cash.  If we put it in the bank and the bank lends it out, that money will be spent by whoever borrows it.

Now, in Keynes' time, this actually wasn't all that unreasonable.  Lots of people did save money in the form of cash, especially after the big bank failures.  Indeed, people who lived through the Great Depression often kept hoarding cash--my Grandmother once idly opened the teapot she was about to put in the church rummage sale bin, only to discover the $3,000 my grandfather had squirreled away there for a rainy day.  And when you're dealing with an economy that largely skates along on cash, there are big delays in the translation of savings into lending.  You have to physically put the cash in the bank.  Someone else has to physically take it out.  Then, after perhaps a delay of several weeks, they physically pay the contractor who upgraded their bathroom.

In the modern economy, of course, what happens is that we just leave the money in the bank longer than we otherwise would have.  No delay.  So what's the problem?

The problem is that the banks aren't lending.  We're hoarding money, and they're hoarding it even more--they don't have to fix the transmission or buy antibiotics.  So as in Keynes' example, the money really is just sitting there.

It's worth remembering that this is why the banks are at the heart of our problems.  Even fixing underlying issues--like forcing write-downs of the home values securing recent mortgages--will not make them lend if they think they need higher capital to ride out potential storms.  That's why even good liberals and Democrats are focused on rebuilding balance sheets, aka giving the banks free money.

Update:  Sorry, let me be super clear that I still have a job.  My housemate worked for a startup that got hit by the credit crunch. 

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