The Fallacy of Composition

A common thread in many of the, missteps shall we call them, in economics and politics stems from the fallacy of composition.  This is where one assumes that just because something is good for a part it must in turn be good for the whole.

Thomas Sowell is fond of the analogy of a spectator in the stands at a baseball game.  If he stands up, he can see better.  It does not, then, follow that if everyone stands up, then everyone will see better.  Furthermore, if the one man stands up, he may see better, but it is at the expense of blocking the view of those behind him.

So it often is in economics.  An example I use is steel making.  There have been times where steel workers, their unions, and the organizations of businesses engaged in steel making all join with one voice to decry the evil of low cost imported steel, cutting into those businesses’ market shares and putting those poor steel workers out of work.  They call on the government to do something.  And so the government, seeing a powerful political block that can influence elections, does something in the form of tariffs or import restrictions that reduce or even prevent entirely the influx of cheap steel from overseas.  Steelworkers keep their jobs.  Steel making businesses keep their profits.  Everyone is happy.   And the economy is helped, right?

Not so fast.  The steel making industry might be helped by such a tariff but assuming, without examination, that means it helps the economy as a whole is the fallacy of composition.  And if we make that examination, what do we find?  The first thing we see is that steel as a raw material is more expensive than it would be if the market were allowed to operate undeterred and the American companies were either forced to find a way to compete at the lower prices or were supplanted by the lower cost sources–or maybe going into niches where they provide particular grades and alloys that the foreign companies do not reliably produce.  In any case, more expensive steel.  That means that the costs to everyone who uses steel to make everything from butter knives to locomotives has their cost of materials increased.  And that works its way around to the consumer and higher prices to them.  Which means that for a given income people are able to buy less goods.  And that means that everyone is poorer than they would be were the market allowed to operate freely.  So while the tariffs or other restrictions helped the steelworkers, it was at the expense of everyone else.

Another area where the fallacy of composition comes into play is in so-called government “stimulus.” The government hands out money to various individuals, businesses, or industries with the expectation that they will use that money in ways that will benefit the economy.  Maybe they will and maybe they won’t.  The people who receive the “stimulus” certainly benefit, but what about the economy as a whole?

The first thing one has to ask is where that money the government is handing out came from.  There are only one of three ways the government gets money:  taxes which means taking it from someone else, increased government debt, or increasing the total money supply made even easier in the modern day with so much “money” existing as not even paper but computer records.  Both increasing public debt and increasing total money supply are effective increases in the money supply (See Thomas Sowell’s discussion of fractional reserve banking and credit and how it increases the effective money supply in his book Applied Economics) and in so doing they cause prices to be higher than they would be absent that increase in money supply.

So, any way you look at it, government stimulus is money that is taken from other people either overtly through taxes or covertly through inflation of the money supply reducing the buying power of the money they have.  And those people, if they retained their buying power would also use that money in the economy–even in the simple case of putting it in a bank where it can be loaned to other people for various purposes.  The assertion made by those who advocate government stimulus is that the government will use the money “better” than private individuals.  This assertion, however, is hard to justify empirically.  Indeed, advocates of such stimulus generally predict far greater improvements than ever actually materialize in the economy.  The excuses are many but the results speak for themselves.  And when one considers that a part of any government stimulus is a parasitic bureaucracy both to collect the money (or manufacture it out of thin air) and to disperse it to the “deserving” parties, one sees that the government spending would not only have to be “better” but much better than private individuals using their own money in order to compensate for the extra cost and be a net gain.

In both of these cases:  import restrictions/tariffs and government stimulus, a part of society does benefit.  But that benefit is at cost to the remainder of society that outweighs the gain to those specific parts, that, indeed, must outweigh the benefits to the part.

So when someone proposes a policy to “help the economy” take a moment to look beneath the surface and see if what it actually does is help a small part at the expense of everyone else.

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