During difficult economic times, economists usually start talking about the Fallacy of Composition. This concept is a principle of logic.
The Fallacy of Composition is committed when it is concluded that what is true of the parts of a whole must be true of the whole, without there being adequate justification for the claim.
Here is an example from mathematics. One and three are odd numbers, so four is an odd number, because one and three are part of four (1+3=4). This statement is untrue, because four is an even number.
In economics, the fallacy of composition takes on a special meaning. The fallacy occurs economist treats the economy as if it were a family or business. This leads to the assumption that a policy that will work for a business will work for the economy as a whole. When an economist assumes that what is good for a family is good for the economy, the fallacy of composition has occurred.
The problem is that that theories and practices that apply to a family may not be relevant to an economy containing numerous families. Economies work according to rules of economies and not according to the rules that apply to businesses. Something that is good for a business or family may bad for the entire economy. When economic decision makers interact with each other, the outcome for the whole economy may be different from what was intended by the individual decision makers.
Examples
What is true at the microeconomic level is not necessarily true at the macroeconomic level. Here are some examples.
The best action for a business during a time of recessions might be to lay off staff and reduce production. This makes sense for the individual business, but all firms lay off staff, incomes will fall, sales might decline and the recession might deepen. A response that is good for a particular business might be bad for the economy, if all businesses take the same action.
An individual business can increase profits by reducing expenses. However, one businesses expense is another businesses sale, so if all firms try to increase their profits by reducing expenses, they might all experience a reduction in profits, as sales decline.
If large numbers of investors attempt to get out of debt by selling assets. Irving Fisher described this back in 1933, observing that when people who are deeply in debt get into trouble they usually sell assets. He called it a "stampede to liquidity." Investors dump stocks and property for any price they can get - desperate to pay off their debts before they are dragged into bankruptcy. What is good for every individual investor turns out to be bad for the economy itself. Asset prices fall. Sales fall. Unemployment rises. The slump deepens.
Tariffs can reduce imports providing protection for local manufacturers. However, if every country in imposes trade barriers, world trade will decline and every nation will be worse off. What works for one nation may be harmful for the world economy.
During an economic crisis, a sensible household will reduce spending and save as much as possible to prepare for the uncertainty that lies ahead. However, if all households take this action, sales will decline and businesses will struggle leading to further unemployment. The action that is that sensible for any one household harms all households in the economy. Keynes called this the paradox of thrift.
The paradox states that if everyone saves more money during times of recession, then aggregate demand will fall and will in turn lower total savings in the population. One can argue that if everyone saves, then there is a decrease in consumption which leads to a fall in aggregate demand and thus leads to a fall in economic growth.
Keynes claimed that thrift is good for an individual, but if everyone saves more, it may cause a recession by reducing consumer demand. He argued that the common assumption that thrift is good for the economy, because thrift is good for the individual is a fallacy of composition.
Bad Theory for Bad Times
This fallacy of composition is important for economists. They need to understand how the behaviour of individual businesses and households impacts the economy as a whole. However, there are serious problems with the way that the fallacy of composition is generally applied. The principle is often right, but the context is often wrong, because economists only bring out the fallacy of composition in times of recession.
Applying this theory during a recession is dangerous in two ways. Focussing on the negative effects of thrift and the flight to liquidity prevents economists from seeing the real cause of the recession. More seriously, the fallacy of composition is used as a justification for government intervention and expenditure. If individuals do what is bad for the economy, then the government must counteract by taking actions that economists and politicians decide are good for the good the economy. Political power is expanded.
Cost Cutting is Good
The idea that cutting costs is dangerous is the real fallacy. A good business manages costs at all times, regardless of whether the market is weak or strong. Reducing costs allows prices to fall making everyone better off because they can buy more.
In a free economy, some businesses will perform better than others. Producers who are not able to operate as efficiently as others will close, if they cannot catch up. The more efficient producers will be able to purchase their resources and recruit their clients. If one business has to put off staff, more efficient ones will take them on. Cost cutting pushes resources towards the most efficient producers.
Retaining staff that are not needed, buying inputs that will never be used, or producing goods that cannot be sold, never makes sense. Using the fallacy of composition argument to suggest that uneconomic producers should be encouraged to keep producing is the more serious fallacy.
Reducing cost and staff only becomes a problem after bad government and banking policies have created a false boom in the economy. When this false boom grinds to a halt, every business is forced to cut back at the same time. This is not a fallacy of composition, because the uneconomic activities must be eradicated to strengthen the economy. The real fallacy is arguing that cutting back on uneconomic activity is bad for the economy. The sad thing is that the cutbacks would be unnecessary, if the government and the banks had not collaborated to produce the false boom that had caused the problem.
General Motors provides a good example of this fallacy. For the last few years, GM has been producing cars that cannot be sold at a price that covers the cost of production and provides a return on capital. To solve this problem, GM is now selling cars at zero percent interest. The danger is that the wrong solution to a problem can often make things better in the short term. Marketing cars with zero percent finance may sell cars in the short term, but it does not deal with the underlying problem. GM will only become a benefit to the American economy, if it can start producing cars that people want at a price they are willing and able to pay. Government assistance that enables GM to keep on operating in an inefficient way only puts off the evil day.
Thrift
The paradox of thrift is an example of this problem. Economists claim that personal thrift harms the economy during a recession. If households stop spending, the reduction in aggregate demand slows the economy further. Some people lose their jobs and everyone is worse off. The solution is government spending. Keynesian economists urge governments to increase spending to compensate for household thrift. However, government spending is often wasteful, so this solution does long term harm to the economy.
The same economists suggest that governments should implement policies that will encourage household spending and discourage saving. The problem with this approach is that there can be no investment in capital goods without savings, so policies that discourage savings eventually reduce investment, which harms the economy in the long term.
The fallacy of composition should really be applied during the boom that precedes the recession. The real problem is not the "paradox of thrift", but the "predicament of debt". However, there is no "predicament of debt" in economic theory, because economists are not interested in the real problem. Most prefer a theory that justifies government intervention in the economy, because interventionist governments need more economists to advise them.
The reason that households need to slash spending during a recession is that they have overspent during the prior good times. When central banks reduce interest rates to strengthen the economy, households take advantage of cheap interest rates to buy goods on hire purchase and credit cards. They increase their mortgages and buy houses to take advantage of the increase in house prices. This is the predicament of debt. Massive increases in personal debt allow people to improve their lifestyle, but this is bad for the economy, because speculative bubbles and reduced investment in productive assets eventually produces a recession.
This is the real fallacy of composition. Increasing debt may be good for businesses and households, but it bad for an economy. Therefore instead of taking action to counteract thrift during recessions, governments should avoid policies that encourage excessive spending and debt during the good times that precede and cause the recession.
Savings and Hoarding
Many economists claim that saving is harmful during a recession. This incorrect view comes to us from the 1930s depression, when thousands of banks collapsed and the savings of many people were wiped out. A common response was to draw cash out of the bank and store it under the mattress. This was harmful, because while the cash was under the mattress it was out of circulation. This was hoarding, not saving.
In the current crisis, people are saving, but they are not hoarding. Those who have reduced their consumption are putting the money they have saved in their bank. This is good for the economy, because savings in the bank can be lent to businesses to buy machinery and other capital equipment, which makes them more productive. With the current deleveraging of debt, there is an enormous shortage of capital all over the world. Increased saving is the best way to provide the capital that is now required.
Saving is only a problem, if people hoard cash, because then the savings are not available to fund investment in productive capital.
Hoarding is different from saving. When I hoard something valuable, I do not use it, but I prevent others from using it. This is destructive. When I put my savings in a sound bank, I make what I am not using available to others who can use it efficiently. Many economists who propound the fallacy of composition do not understand the difference between saving and hoarding.
Thrift and Prosperity
Thrift is the key to prosperity, so thrift is good. If households are thrifty during good times, they will not need to go into extreme thrift during bad times. If households are thrifty, everyone prospers and good times do not turn into speculative bubbles that are followed by serious recessions.
Debt is at the root of our crisis. We did not arrive at this bad place because consumers and government were saving too much and spending too little. We will not escape it by carrying on as we did before. There will be no foundation for a lasting recovery until Britain rediscovers the virtue of living within its means.
I despair when retailers say that "the downturn in spending is irrational". No, it's not. People are steering away from the road to ruin. Shopkeepers can no longer expect customers to sacrifice themselves to rescue corporate profits.
Encouraging another burst of mindless consumption, without significant increases in productivity, can, perhaps, palliate short-term financial stress. But in the end, when the drug of excess runs out, the patient is wrecked. (Jeff Randall, Daily Telegraph).
Simple logic would dictate that excessive spending and loose lending standards caused this crash, so excessive spending and loose lending standards cannot possibly cure it. Indeed it is axiomatic that the problem cannot be the solution (Mish Shedlock).
Widespread thrift is disruptive when it follows a consumption boom fostered by foolish bank lending. In a free economy, different people will be in different situations. Some will be at a stage where they need to save for the future. Others will have things they need to purchase. Savers and spenders would balance each other out.
Rich Dad Poor Dad
Another example of the fallacy of composition that is ignored, because it applies during good times is the book called read Rich Dad Poor Dad by Robert Tiyosaki. I read this book several years ago. He explained how a person can build sufficient wealth to live without working by investing in real estate. I understood his approach, but I was never willing to commit sufficient energy to following his plan, so I have not followed his advice.
A key part of the Rich Dad Poor Dad approach is that well-chosen properties will increase in value over time. The value of the investment will grow even faster, if the purchase is highly leveraged (most of the purchase price is borrowed). This teaching is true during a time of inflation. It has been true for the last thirty years, because governments have inflated their currencies almost continually.
The fallacy of composition applies to this practice. Leveraged investing in property is good for the individuals, but it is bad for the economy as the whole. Residential property is unproductive, so speculative investment in property squeezes out investment in productive activities that would benefit the entire economy. Rich Dad activities produce Poor Bad economies.
People who have been successful in property investment should understand that the benefits of leverage (or borrowing) come through government-made inflation. Their wealth is the direct result of government policies that have harmed the economy.
They should also understand that when inflation of the currency stops and property prices begin to fall, the value of the outstanding mortgage is unchanged, so the owner's equity takes the full hit. In a collapsing property market, leverage amplifies the losses, just as it amplifies the profits during the previous period of inflation.
If governments ever give up inflating their currencies, (there is not much sign of this happening yet), the Rich Dad Poor Dad method will stop working. Everyone who follows his advice should understand the consequences.
