The Fallacy of Composition

Real life is complex. It is full of fallacies and paradoxes. Things that some people would see as ‘just common sense’ are, in fact, nothing of the sort. For centuries, it was ‘just common sense’ that the Earth was flat and people who thought otherwise were laughed at - or worse. Now, of course, most of us know better.

In recent years we have had the policy of austerity forced upon us by successive governments. Times are hard, or so goes the argument, so the country needs to spend less and tighten its belt. Just as individual households have to do when they can’t make ends meet, so the country as a whole needs to do at this difficult time. It’s just common sense.

But a modern economy is not just a very large ‘household’. Rather, it is made up of billions of financial transactions by millions of people exercising their free will.

For an individual household facing financial difficulty it makes sense to reduce spending, to tighten belts. The household accounts would look more healthy and their household wealth would improve. On an individual level, this is the rational thing for them to do. So, common sense would dictate that this approach can be scaled up to the level of a whole country, an entire economy. By reducing consumption and increasing savings, the entire country will be better off.
This is the Fallacy of Composition: the belief that if something is true at an individual level, it is also true at a whole country level. It’s common sense, after all.

But in fact if everyone spent less and saved more, the economy would crash. Shops need people to spend money or they go out of business, increasing unemployment. Money makes the world go round.

Likewise, manufacturing businesses - the toaster factory, for example -  can only stay in business if people continue to buy their toasters. And the businesses which supply them with machines, the businesses which deliver their toasters, the retail businesses which stock and sell their toasters - are all at risk if people decide to tighten their belts and stop buying toasters.

This special version of the Fallacy of Composition even has its own name: the Paradox of Thrift.

In fact, the right thing for governments to do is to encourage more spending. This stimulates demand for goods and services, creating jobs in the economy, creating more wealth as the newly employed spend their wages.

This is what Keynes advocated in the late 1940s to get the economy going after the war. And it worked.

But this step requires bravery. It’s not common sense and is counter-intuitive. Maybe we should just stick to the common sense of austerity. Or maybe not…