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The Fallacy of Composition

By William Anderson
Published: 22 January 2009

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.”

9 Comments »

On my site, http://www.AudacityOfCommonSense.com, a conservative “bookmark” site, I link to lots of sites that help Americans keep an eye on their elected officials, access objective journalism (which exists almost exclusively on the web nowadays), read their founding documents and much more.

One of my goals is to educate folks on money. I feature sites on the Federal Reserve, personal money management, where the government is spending our money and so forth. I am adding this site to “Audacity”. I found you through C-Span’s TV book after seeing Burton Folsom’s lecture on FDR: New Deal or Raw Deal.

Thank you for your work helping the public understand these crucial issues.

//Devon Young
26 January 2009 at 11:46 pm

I have read several of these articles on popular monetary fallacies by William Anderson. It is very informative and is helping to increase my knowledge and understanding of current economic issues. Being in High School, it\’s hard to trust what any teacher or textbooks says, so articles of this sort are more helpful than I think the authors know. This is a thank you to Doctor Anderson and the other writers for FEE!

//Alexa M
23 March 2009 at 6:52 pm

You claim that the “Paradox of Thrift” if false, yet you give zero explanation as to why you think this is the case, except that somehow magically growth occurs by “capital meeting with consumer needs and desires”, which seems nonsensical given that an increased consumer savings rate corresponds to reduced effective consumer desires. (By “effective” I mean that the consumer maybe desires more, but by saving money indicates that he is not willing to pay for that desire, which is really equivalent to the desire not being there in the first place.)

On the other hand, proponents of the “Paradox of Thrift” are able to explain their point of view in an easy to follow way with no problem.

Maybe I am not a genius, but as a layperson, you make it very hard for me to believe your case.

//Nicolai Hähnle
2 October 2010 at 9:55 am

Since I am genuinely interested in learning more on this topic, let me perhaps phrase a somewhat silly question. At the very least, this question would somehow have to be answered before I could reasonably consider the “Paradox of Thrift” to be incorrect.

Imagine that everybody saved _all_ their income. As far as I understand what you have written, this is perfect for building up capital and growing the economy. But what are people going to do with that capital? After all, if everybody saves all income, then nobody will buy anything and the economy will simply stop doing anything. It’s the total collapse/standstill.

Yes, that’s a very hypothetical scenario, everybody would have to build up stockpiles of food that will last them for three years or so before that total collapse could happen. Still, from a theory point of view, you should be able to explain how that scenario fits into a world where the Paradox of Thrift is incorrect.

//Nicolai Hähnle
2 October 2010 at 10:21 am

Keynes you must be reminded noted that there are short and long run views to any economic action and in the long run “we are all dead”. In the short run government spending works in the recession/depression economy but in the long run it cannot continue…

//ECON
15 October 2010 at 11:41 am

Saving is investment. If everyone saves – they are investing. And of course they are using their money to invest into the most urgent dissatisfactions necessary to eliminate to maintain their investment capability. To do so, the most urgent discontents are probably those related to their own welfare – shelter and food, social activity. You see, those activities in that context ARE savings! That is, they(eating, sleeping, rest time) are the most rational(as per the valuation of the actor) means toward the ends of increasing future consumption. A society composed of man with the sole purpose to labour – and not to consume at all – is perfectly viable, and not only that, it would the most productive economy imaginable.

//to Nicolai
20 October 2010 at 11:58 am

“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).”

That is the single most disingenuos caricature of Keynesianism I’ve ever come across. You should be ashamed of yourself…

//Philip Pilkington
23 February 2011 at 11:39 am

“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.”

Just to be logically consistent — and to point out where you’ve gotten the Keynesian hypothesis wrong — neither economist (should) see the economy as always starting from a tabula rasa. The economy works dynamically — not statically.

Example: Keynesians don’t assume that capital stock is ‘automatically’ replenished. They assume that as the economy cycles — that is, as the capitalist invests and the consumer spends — it perpetuates itself (this does not deny that the capitalist does not save and invest — this is seen as part of the cycle). A breakdown of either investment OR consumption can lead to the cycle being brought to a halt.

When this occurs, investment falls off and consumers stop spending — that is, BOTH parties begin to ‘save’ WITHOUT investing (in your example, you’ve confused saving with investing — one can save without investing… this is important).

If, for example, the capitalist sees that no consumers are buying his products and that the prices of these are falling (deflation) he may choose to hold onto his money — which, due to deflation, is now increasing in value vis-a-vis commodities on a daily basis.

So, I’m afraid your argument isn’t even internally consistent — let alone being a real exposition of your opponents views.

Sorry. I hope you’re not an academic economist…

//Keynes
17 May 2011 at 6:20 pm

The article is pompous, ignorant nonsense.

//p
12 March 2012 at 9:15 am