The Seven Deadly Fallacies of Bad Economics

It may seem somewhat extravagant to liken bad economic thinking to attitudes and actions which allegedly condemned the soul to hell. Yet economic errors are not to be taken lightly• The errors I call the “seven deadly fallacies of bad economics” can lead and have led to unspeakably destructive consequences. Their seriousness cannot be overstated.

The Fallacy of Forgotten Costs

The first fallacy to be considered might be called “the fallacy of forgotten costs.” This fallacy is admirably discussed by Frederic Bastiat in a pamphlet he penned in 1850 entitled, “What Is Seen and What Is Not Seen.” Writes Bastiat: “Nothing is more natural than that a nation, after making sure that a great enterprise will profit the community, should have such an enterprise carried out with funds collected from the citizenry. But I lose patience completely . . . when I hear alleged in support of such a resolution this economic fallacy: ‘Besides, it is a way of creating jobs for the workers.’”

Continues Bastiat: “The state opens a road, builds a palace, repairs a street, digs a canal: with these projects it gives jobs to certain workers. That is what is seen. But it deprives other workers of employment. That is what is not seen . . . In noting what the state is going to do with the millions of francs voted, do not neglect to note also what the taxpayers would have done—and can no longer do—with these same millions.”

These words, written over a century ago, could have been penned yesterday! Today’s politicians are still prone to justify their high taxing, high spending policies by pointing to the employment opportunities they thereby create—indeed, Lord Keynes provided such politicians with an entire volume of incantations they can mutter when perpetrating what Bastiat called this “ruinous hoax.” Strip away the new terminology, and the old fallacy so castigated by Bastiat is revealed—the deadly fallacy of the forgotten cost.

The full import of this fallacy is concealed if we think of “costs” simply in terms of “prices.” A price is merely a cost expressed in monetary terms. It is extremely useful so to express a cost, relative money prices being the key to economic calculation.

In truth, however, the “cost” of a good a person acquires or of a service a person enjoys or of an activity in which a person engages signifies whatever that person has spent, surrendered, or forgone in acquiring the good, in availing himself of the service, or in engaging in the activity. The cost to me of purchasing a book may be not acquiring a theater ticket. The cost to me of spending a day in a park may be my not acquiring the income I could have earned from writing. The cost to me of using some land I own to grow wheat may be not using that land to run cattle or grow vegetables. Simply, in considering the cost of acquiring some good or using some service or engaging in some activity, one must consider every thing, activity, and state of affairs surrendered or for-gone in opting for one of two or more alternatives. Factors such as comfort, time, ease, anticipated future satisfactions, and the approval of other people may well be involved; indeed, any thing, activity, or state of affairs a person values can enter that person’s calculation of costs.

Some extremely significant implications for sound economic thinking follow from this insight. The primary point Bastiat makes, however, should be crystal clear. The good a person chooses is seen and felt and enjoyed; the money surrendered to acquire that good, and alternative uses to which that money could have been put, are by definition not seen and felt and enjoyed, and hence are easily forgotten.

Politicians, to take but one example, can triumphantly point to the jobs they have saved in, say, the textile and clothing industries by the imposition of tariffs. Not so obvious, however, are the costs these tariffs involve. In the absence of the tariffs, men and women may well have preferred to purchase relatively cheap imported clothing for themselves and their children. They would thus have possessed additional cash to spend on goods and services they value, but rank in importance below a certain amount of clothing.

Workers would have been employed to provide these goods and services. Other workers would have been employed to produce whatever goods the overseas suppliers of textiles di-rectly or indirectly accept in exchange for those textiles. Jobs in the textile industry are protected, but at considerable cost: The additional goods and services consumers could have enjoyed had they been able to purchase relatively cheap clothing, and the jobs in the production of these additional goods and services for home-consumption and the goods exchanged, directly or indirectly, for the imported textiles.

Add to that the even more intangible factor of forgone competition, and the forgone innovations and technological improvements that may well have characterized a threatened industry’s response to competition. Throw in the reality of the forgone liberty of individuals to exchange goods with whomsoever they please and for-gone bonds of interdependence forged between nations. It may be that what is surrendered and forgone is valued by many individuals less than what is realized by the imposition of tariffs, but that is not at the moment the point. The point simply is that what is forgone and surrendered is less visible than what is realized. Thus the ease with which men and women fall for the fallacy of the forgotten cost.

The truth is simple. It is summarized in the proposition, “There’s no such thing as a free lunch.” Every economic choice we make or politicians make for us has a cost. The cost is not obvious, being the valued opportunities for-gone. The beginning of economic wisdom, however, is to keep an eye open for what is not obvious, and thereby avoid the deadly economic fallacy of forgotten costs.

The Fallacy of Misplaced Value

In Canterbury Tales, Chaucer’s Parson states that the Seven Deadly Sins are “all leashed together.” So, it might be suggested, with the seven deadly fallacies of bad economics. They merge and overlap. It could well be claimed that the second fallacy in my list—“the fallacy of misplaced value”—and the first fallacy-“the fallacy of forgotten costs”—belong together. Yet it is useful, I think, to distinguish them.

Many medieval ethicists concerned themselves with what they called “the just price.” In so speaking, they were suggesting that the money prices of economic goods should reflect the “real” or “objective” value of these goods and services. This “real” value of an economic good was perceived as no less a quality of that good, than, say, the good’s weight.

As economic thought developed, a distinction was drawn between the “use value” of a good—the good’s usefulness to human beings—and the “exchange value” of the good—the alternative goods and services for which the good might be exchanged. Attention focused, however, upon the “exchange value.” What, people asked, determines this value? The most promising answer seemed to be that it derived from the productive resources used in its manufacture, labor being the most significant. Thus Adam Smith in his Wealth of Nations wrote that, “If among a nation of hunters . . . it usually costs twice the labor to kill a beaver which it costs to kill a deer, one beaver should exchange for or be worth two deer.” David Ricardo built on this foundation, and later Karl Marx, greatly indebted to Ricardo, developed his version—some would say versions—of the labor theory of value. The value of an economic good derived, insisted Marx, from only one of the productive resources embodied in that good: the “socially necessary labor time” its production involved.

In 1871, however, a radical challenge to this way of thinking appeared in the form of Carl Menger’s Principles of Economics. Menger insisted that the idea of “value” was crucial in economics, but he went on to argue that the value of an economic good was not a mysterious quality inhering in the good. Rather, when speaking of economic value one is referring to the relationship between an appraising mind and an object appraised. Value is invariably “value to someone.” Value, in other words, is subjective, varying from person to person, from time to time, and from situation to situation. Locating that value in a good rather than in the mind appraising that good is what I signify by “the fallacy of misplaced value.”

One distinction must be noted. In determining the value to me of, say, a book, I am ranking the book in relation to other goods on my own value scale. I rank it, let us say, above a theater ticket, and thus acquire the book at the cost of a forgone opportunity to acquire a theater ticket. I might also, however, appraise the purchasing power of a good—that is, estimate how much that good could be sold for. On this matter I can be correct or incorrect. Something “objective” is involved. Yet appraised purchasing power itself rests upon the countless subjective evaluations of my fellow market participants. It is from these hundreds of thousands of subjective evaluations that changing relative money prices in the market are born.

Elaborating how market prices—including the prices of the factors of production—derive from the subjective evaluations of market participants is a fascinating exercise. Linking the subjectivity of value to an understanding of costs in terms of forgone opportunities leads to some extraordinarily significant conclusions.

We are forced, for example, to assert that the cost of an economic choice—be it that of purchasing a book at the cost of the forgone opportunity to procure a theater ticket, or of producing jump ropes at the cost of the forgone opportunity of using the same productive resources in producing clotheslines—is known only to the person or group of people making the choice. We are further forced to insist that an objective measure of cost is simply not available, the individual’s evaluation of a forgone opportunity being by its very nature subjective. If this be granted, talk of “social costs” becomes suspect, to put it gently.

No less fascinating is the study of the attempts of many economists to avoid these conclusions, perhaps the most significant of these being Alfred Marshall’s tortuous synthesis, which featured a productive resource theory of cost on the supply side and a subjectivist analysis of cost on the demand side.

Suffice, however, that we be aware of the fallacy of misplaced value. When we hear Marxists darkly muttering of the “surplus value” expropriated by capitalists, or other economists speaking as though they could objectively compare the “value” of one distribution of economic goods to that of an alternative distribution, we should become suspicious.

The realization that all economic choices involve costs can lead, by a faulty leap of logic, to two further deadly economic fallacies that typically come together: “the fallacy of static wealth” and “the fallacy of the zero-sum game.”

The Fallacy of Static Wealth and the Fallacy of the Zero-Sum Game

These twin fallacies take the form of a sort of picture dominating the thinking of many people. Economic activity is depicted in terms of a poker game. One player’s chips are observed to have increased. Immediately one concludes that some other player has lost chips. Poker is, as they say, a zero-sum game: Gains enjoyed by one party must be balanced by losses suffered by another. So it is, people embracing the fallacies of “static wealth” and “the zero-sum game” insist, with economic exchanges. “Winners” must be balanced by corresponding “losers.”

Such was the “picture” held by advocates of the socioeconomic system known as mercantilism, the system Adam Smith so vigorously attacked. Perhaps the word “system” is somewhat misleading, for, as Thomas Sowell has noted, “[mercantilism] is a sweeping label coveting a wide range of writings, laws, and policies beginning in various European nation-states in the seventeenth century, still pervasive in the eighteenth century, and never completely extinguished till the present day.” (“Adam Smith in Theory and Practice,” in Adam Smith and Modern Political Economy, edited by Gerald P. O’Driscoll [Ames, Iowa: The Iowa State University Press, 1979] pp. 3-18) Yet crucial to the thinking of “the motley collection of businessmen, pamphleteers, and politicians” described as “mercantilists” was the perception of wealth as something static and of economies as gem-sum games.

According to the mercantilists, wealth was a constant, a given—like the chips in a poker game. If one community—and typically the mercantilists thought in terms of communities—improved its overall economic situation, another community must have lost out. That losing community, so it was claimed, must have bought more goods from the winning community than it had sold to that community, the difference having been made up in gold. As the seventeenth-century writer Thomas Mun expressed it, only “the treasure which is brought to the realm by the ballance [sic] of our foreign trade . . . [constitutes the amount] by which we are enriched” (England’s Treasure by Forraign Trade [1664; New York: Kelley, 1965] p. 21). To achieve an export surplus, mercantilist nations were characterized by governmental controls of a magnitude and scope which, as Sowell puts is, “probably exceeded anything seen in the twentieth century, either in capitalist economies or in most socialist economies” (ibid., p. 4).

What Adam Smith perceived, essentially, was first that “wealth” was not something static and given like gold, or, indeed, poker chips, but rather consisted of goods and services that could be created, and second that both parties to an economic exchange could improve their respective situations. This second perception is sharpened if we take seriously the truth ignored by those committing the fallacy of misplaced cost, namely, that the value of an economic good is not a mysterious quality somehow residing in the good but a relationship between an appraising mind and some object appraised.

If, in the absence of coercion, two individuals exchange goods or services, it can be only because each party to the exchange values, at least at the time of the exchange, what is obtained more than what is surrendered. Each anticipates enjoying a more valued situation by making the exchange than obtained before making the ex change. There are two winners, not one. This is a positive-sum, rather than a gem-sum game.

Given that Adam Smith in 1776 exposed the twin fallacies—the fallacy of static wealth and the fallacy of the zero-sum game—and given the clinching of this exposure by the insistence of economists following the lead of Carl Menger that the “value” of a good or service signifies the value of that good or service to someone, one might have thought that the two fallacies could be exorcised from people’s thinking. But not so.

Consider the following statement, taken from the published sermons of a cleric with whom I am fighting a somewhat protracted baffle:

“Think of an economic system in terms of some castaways on a desert island. The castaways have brought with them some fresh water, and they find a supply of bananas and coconuts on the island. Some of the castaways have greedily claimed that they own the water and the supply of food. They feast, but their fellow castaways starve. Some suffer, simply because others are selfish.”

The key phrase in this: “Think of an economic system as . . .” The speaker is describing a static situation: an island with a given supply of food and water. And that is precisely how not to think of an economic system!

If an economic system is to be compared to an island, let it be a large island inhabited by active people. Some people have devised a way of distilling fresh water from sea water. Some have established banana and coconut plantations. Some have become skilled at fishing. Some have bred wild goats. Some have learned to extract iron. Even the simplest are contributing to the process of wealth creation, say by tending a fire used for the distilling of water. The moment one starts thinking not in terms of goods simply provided like manna in the wilderness, but of men and women using the skills and imagination they possess and the raw materials at their disposal to create the goods and services they want, one is beginning to approach the reality of an economic system. And one has escaped from the deadly economic fallacy of finite wealth.

Consider another quotation from the same source:

“One does not have to be a genius to realize that, if some citizens in western nations are getting richer, then other citizens of these nations—or perhaps men, women and children of the Third World—are getting poorer. One does not have to enjoy a university education to realize that, behind newspaper headlines reporting company profits, are the many helpless little people who have been forced to endure losses. If Peter prospers, somewhere there’s a Paul Peter has robbed.”

Frankly, one does not have to be the possessor of a university education to realize that the author of these passages is peddling the discredited economic nostrums of yesteryear. He has embraced, and is luring his listeners and readers to embrace, the twin fallacies under consideration: the fallacy of static wealth and the fallacy of the zero-sum game.

In all fairness, I should add one qualifier. The fallacy of the zero-sum game is only a fallacy if the exchanges made by people are not coerced. The moment coercion enters the picture—be that coercion exercised by individuals who have discovered that improving their well-being by plunder is more congenial than doing so by production and voluntary exchange, or by governments using their coercive power for purposes other than the protection of citizens from such individually initiated coercion—then zero- and indeed negative-sum games abound. Sadly, however, few of those depicting economic activity in terms of zero-sum games are advocating the only economic system which avoids such “games”—the free market.

The Fallacy of False Collectives

The fifth deadly economic fallacy I would bring to your attention is the fallacy of false collectives. All of us are familiar with collective nouns: “the community,” “the state,” “a society,” “the working class,” “aggregate demand,” and even “the market.” These terms can be extremely useful, functioning as a sort of shorthand whereby we refer to numerous individual human beings and particular relationships between them. Problems are created, however, when we start speaking and thinking as though these terms signify “thing-like,” existing entities distinct from these individuals and relationships.

There may be some value, for example, in occasionally using such terms as “aggregate demand” and “aggregate supply.” Mischief is afoot, however, when the real world that economics seeks to understand—the world of people seeking to improve their situations by using what they have to acquire what they want—is Supplanted by a purely imaginary world, a sort of ballet called “the economy” starring the two dancers “aggregate demand” and “aggregate supply.” Lost in that imaginary world one is tempted to get into the act, so to speak.

Why not play choreographer? Why not improve the performance by stimulating “aggregate demand”? There is nothing wrong with this fantasy if fantasy it remains, but when the real world of economic activity is subjected to governmental activities described as “stimulating aggregate demand,” disaster can result.

Indeed, there are dangers inherent in aggregates even if one avoids the fallacy of treating these aggregates as concrete “things.” As Madsen Pirie observes in The Logic of Economics (London: The Adam Smith Institute, 1982), “When we use numbers we lose information.” A study of “apples” dictates indifference to information about the particular weight, shape, taste, and so on of each component apple; a study of “fruit” dictates indifference to further detailed information. Yet in economics, as is the case elsewhere, truth often lies in the details.

Suppose we are thinking of the phenomenon of involuntary unemployment. We are wondering if the phenomenon is related to wage rates. We do our homework. We reach a fairly general conclusion: If men and women are to use what they have to acquire what they want, they must direct their productive efforts in a way that takes account of the changing tastes and preferences of their fellows, the changing skills and technologies available to a community, the changing relative scarcities of raw materials distributed globally, and so on. We further conclude that information about such realities is available only when it is encoded in changing relative money prices in a free market.

We note, for example, that a rise in the price of one product relative to others tells both consumers and producers what they must do to improve their situations, and constitutes an incentive for these people to act. We finally conclude that changes in the prices for various forms of labor in various activities encode the best information available in a large and complex society for what we might call the “distribution” of labor.

A downward move in the wage level available for people of certain skills in a particular industry, and an upward move in the wage level available for people of different skills in another industry, “informs” people as to what skills it is desirable to acquire and in what industry it is desirable to seek employment. We thus conclude, perhaps, that politically determined or sanctioned measures preventing wage rates from moving downward in certain industries or arbitrarily forcing them upward in other industries deprive people of the information they need if some sort of correspondence is to obtain between the distribution of various forms and quantities of labor and the distribution of demand for these forms and quantities of labor.

Suppose, however, that we attempted to tackle the problem, thinking only of some abstraction called the “unemployment rate” and the “average wage level.” There is no way that, so thinking, we would find ourselves looking askance at measures interfering with changes in relative wage rates. Inevitably, economic theorists and politicians embracing the fallacy of false collectives are destined to lead men and women to economic disaster.

The Fallacy of Centralized Planning

The sixth deadly economic fallacy I have called “the fallacy of centralized planning.”

The defining economic question can, perhaps, be expressed thus: “How are men and women to use what they have—skills, raw materials, information, and time—peacefully to acquire what they want?”

Some components of an answer are reasonably apparent. For example, the adverb “peacefully,” which precludes an answer to the question in terms of the oldest labor-saving device known to humanity—the use of violence to expropriate desired goods from men and women creating these goods—demands, I suggest, some adopted practices or accepted institutions protecting people from coercive violence. Any response to the question which goes beyond the most primitive will involve, I submit, at least a rudimentary division of labor. But the activity I particularly wish to focus upon is that of coordination.

Historically, human beings have discovered but three ways to coordinate their productive efforts so that they more or less successfully use what they have to acquire what they want: coordination by tradition, coordination by political edict, and coordination by “the market”—and I am aware, incidentally, that this term “the market” is itself an abstraction or collective of sorts, pointing to individual men and women enjoying private property rights and voluntarily engaging in transactions chosen and negotiated by themselves.

Tradition is a satisfactory means of economic coordination—“planning” if you like—only for the most primitive and static of societies. The two options today deemed viable for large and complex societies are those of coordination by political edict and coordination by the market—the “command economy” and the “market economy.”

The fallacy of centralized planning has it that while in simpler times it may have been possible to coordinate the economic activities of men and women by the market, the complexity and rapid technological changes of today’s world make such a means of coordination impossible. It is claimed that we thus require expert planners working in conjunction with politicians.

I submit that this claim is a fallacy reversing the reality. Only the market can coordinate the economic activities of hundreds of millions of men and women in a rapidly changing world.

Consider, for a moment, a simple tribal society. Assume that the wants of its members are limited, the skills possessed by the “tribe-as-a-whole” are relatively few, and the raw materials available to the tribe remain more or less the same from year to year. In such a situation we can imagine tribal elders, or even the tribe as a whole, meeting and planning the tribe’s economic activities by reference to this readily available information about what the tribe “has” and what tribe members want.

Now consider, in contrast, a large and complex society. A vast menu of possible wants is available, individuals opting for widely different “lists” of wants and diverse rank orderings of these wants. Skills are highly specialized and are diffused through millions of people, and constantly change as new technologies become available. Resources are distributed globally, and are marked by constantly changing relative scarcities. It is literally impossible for political planners, however good and wise, to collate, synthesize, and make economic decisions by reference to this totality of information.

Yet as already noted, this information is available, in an appropriately distilled form, in a market economy. Changing relative money prices, which are determined by the interactions of millions of individuals seeking to improve their situations through what they produce and the voluntary exchanges they make, “encode” this data. There is planning and coordination, but it is the planning of countless individuals doing what they can to acquire what they want, and the coordination of these plans by what Carl Menger called the “organic phenomenon” of the market or what Friedrich Hayek called the “spontaneous order” of the market. The very complexity of modern societies, and the diffused, changing, and essentially private nature of much of the information which coordinated economic activity must utilize, combine to make central planning impossible.

It is tempting to suggest that this sixth deadly fallacy of bad economics is rooted in the first of the old Seven Deadly Sins: the sin of pride. It is humbling to acknowledge that the peaceful activities of the many can coordinate an economy with a subtlety and flexibility the deliberative planning of a super intelligent few could never realize. Perhaps it is this very pride that makes the deadly fallacy of centralized planning so attractive.

The Fallacy of Market Mastery

The seventh and final deadly economic fallacy to which I would draw your attention I have called “the fallacy of market mastery.” This is the fallacy of those who claim that the market is a means whereby some people exercise power over others.

Consider, for example, this frequently heard statement about labor unions: “Were it not for unions, employers could set whatever wages they wished. Their economic power would be absolute!”

The model is clear. Capitalists allegedly enjoy power over those with only their labor to sell. The whim of employers would determine wages were it not for the bargaining power of unions—a power dependent upon the capacity of unions to prevent workers from accepting a wage lower than the “union wage.”

This claim could well lead us into an examination of a range of theories explaining how wages are determined: the subsistence theory of Malthus and Ricardo, the wage-fund theory of John Stuart Mill, and so on. Let us content ourselves, however, with briefly returning for a moment to the days of mercantilism—in particular, mercantilist France.

Unions as such did not exist. The government actually imposed maximum wage laws. Any employer who paid wages above a legally defined ceiling was charged with an economic crime, tried, and if found guilty, may well have been sent off to be chained to an oar in one of France’s sea-going galleys. The shocker is that numerous employers defied these maximum wage laws!

Why? The selfishness of employers, and the forces of even a grotesquely fettered market, led them to engage in their law-defying activities.

Suppose, for example, I am a factory owner in mercantilist France. By taking on an additional worker I can increase the hourly output of my factory by goods I can sell for $40. The money costs of the raw materials involved in producing these additional goods, and the money costs of the additional wear and tear on my machinery, come, let us say, to $20. The maximum wage rate the government allows me to pay each worker is $1. Each additional worker I can put on thus yields me an additional $19 an hour!

Now for the purposes of our discussion, let us assume the same figures apply in all industries. Each additional worker an employer takes on represents an additional $19 in the employer’s pocket. But to acquire my additional worker, I have to attract him from his present employment. To do that, I must content myself with, say, an extra $18.50 an houri can pocket, offering him not $1 an hour but $1.50 an hour.

Simply stated, employers must bid for a worker’s services. In this hypothetical situation, the critical figure is $20 an hour. At any wage rate below that figure, employers benefit by adding employees. At any wage rate above that figure, it doesn’t pay to add an additional employee—hence the damage caused by minimum wage laws. Wage rates tend toward the money value of the productive output of labor, and that is increased as the capital invested per worker increases.

The economic system in mercantilist France was anything but a free market. Yet such rudimentary and lettered aspects of the market as did exist were sufficient to generate what we might call “the mystery of the inexplicably generous employers.” Simply put, the market itself—the self-directed productive and exchange activities of individual market participants—determines wage rates, just as it determines all prices. Indeed, in an unfettered market economy, the profits of the entrepreneur, the interest accruing to the owners of capital and land, and the wages of workers, are all determined in this sort of way. They reflect the relative contributions of the entrepreneur, of the owners of capital and land, and of those selling their labor, to the productive process. That is the genius and, indeed, the beauty of the market.

For our purposes, however, it is sufficient to stress that given a market economy—and that entails the rule of general principles of conduct equally applicable to all proscribing the use of violence or threatened violence by any—the price for which individuals can sell their labor is set by the same process all prices are set, a process of competitive bidding for scarce resources and goods. No person or group of people exercises mastery over the market or is in a position arbitrarily to control the price of anything. All that anyone can do is to offer to exchange goods and services with his or her fellows.

Conclusion

Men and women once took the Seven Deadly Sins with desperate seriousness. Pride, envy, anger, sloth, covetousness, gluttony, lust: the list was familiar. Preachers, and writers such as Chaucer and Dante, depicted in considerable detail the dire consequences of actions informed by these realities.

I have referred to seven fallacies. The fallacy of the forgotten cost. The fallacy of misplaced value. The fallacy of finite wealth. The fallacy of the zero-sum game. The fallacy of false collectives. The fallacy of centralized planning. The fallacy of market mastery. There is no need for me to depict the dire consequences of actions informed by these fallacies. They are familiar to all who contemplate human history, both ancient and contemporary. Familiar also, however, are the consequences for a people who seek to use what they have to acquire what they want in ways rooted and grounded not in these fallacies but in economic truth. May the liberty and the plenty that such truth alone makes possible be enjoyed by ourselves, by our children, and by our children’s children!