Monday, January 05, 2009

FoC (3) - Bad Theory for Bad Times

This fallacy of composition is important for economists. They need to understand how the behaviour of individual businesses and households impacts the economy as a whole. However, there are serious problems with the way that the fallacy of composition is generally applied. The principle is often right, but the context is usually wrong, because economists only bring out the fallacy of composition in times of recession.

Applying this theory during a recession is dangerous in two ways. Focussing on the negative effects of thrift and the flight to liquidity prevents economists from seeing the real cause of the recession. More seriously, the fallacy of composition is used as a justification for government intervention and expenditure. If individuals do what is bad for the economy, then the government must counteract by taking actions that economists and politicians decide are good for the good the economy. Political power is expanded.

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