The Fallacy of Composition

After covering last week the Fallacy of Collective Terms by Lawrence Reed, today I discuss the “Fallacy of Composition.”  Reed says:

This error also involves individuals. It holds that what is true for one individual will be true for all others.

The example has often been given of one who stands up during a football game. True, he will be able to see better, but if everyone else stands up too, the view of many individual spectators will probably worsen.

A counterfeiter who prints a million dollars will certainly benefit himself (if he doesn’t get caught) but if we all become counterfeiters and each print a million dollars, a quite different effect is rather obvious.

Many an economics textbook speaks of the farmer who is better off because he has a bumper crop but may not be better off if every farmer has one. This suggests a widespread recognition of the fallacy of composition, yet it is a fact that the error still abounds in many places.

The good economist neither sees the trees and ignores the forest nor sees the forest and ignores the trees; he is conscious of the entire “picture.”

In looking at policies coming from Washington, D.C., I employ this fallacy in two ways.  First, I apply it as written; second, I show how economists and pundits wrongfully apply this fallacy, and make false claims with it.

The latest “stimulus” package has governors, mayors, farmers, college presidents, auto and steel executives, scientists, and other interest groups lining up.  Auto executives claim that bailing out domestic producers will “save American jobs.”  The “alternative energy” crowd does one better: they claim that they will “create new jobs.”

Indeed, new government money given to these groups will benefit people who receive the dollars first.  One benefactor is Al Gore, who is a partner in an investment fund that helps bankroll these subsidized industries.  Obviously, he believes that these subsidies are “good for the country,” when, in fact, they are good only for a small group of people with a huge public relations machine.  Those who are forced to pay higher energy costs (in order to buy inferior ethanol fuel and high-priced electricity) are made poorer, and no amount of rhetoric can change that sorry fact.

However, the wrongful use of the “Fallacy of Composition” also must be addressed.  Perhaps the worst example is the “Paradox of Thrift,” coined by Keynesians, but really goes back to the Mercantilists of the 16th and 17th centuries.

The “Paradox of Thrift” states that saving money might be good for a few people, but if everyone saves, then it retards economic growth and drives the economy into recession.  (The Wall Street Journal recently had an article blaming savers for not spending “just as the economy needs their dollars the most.”  The article referenced the “Paradox of Thrift” as though it were legitimate.)

Obviously, economists and pundits who cite this faux “paradox” are ignorant of how capital formation occurs and how a boost in the savings rate will lessen the impact of a recession and help bring about a real recovery.  These economists, however, are looking at only the immediate impact of spending and saving (I will deal with “short-run” thinking in a future column), not the longer-term effect of capitalization and economic growth.

Economists tend to be divided into two groups.  The first sees the economy as a perpetual motion machine that magically grows even as people consume down the capital stock (which replenishes itself and even expands on its own, just as long as consumers continue to spend).  The second sees economic growth occurring only because people save for the future and create new capital that matches with consumer needs and desires.  It does not take a genius to recognize the “bad” economists and the “good” ones.

Not surprisingly, the “bad” economists fall over the Fallacy of Composition on both ends.  They fail to recognize it when it comes to government spending and misuse it when examining consumer behavior.

Next week: The Fallacy of “Money is Wealth.”