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Dec 11, 2018

Three Widely Believed Economic Fallacies

The economic fallacies tackled here are the zero sum game, that order requires design, & that consumption is the key to growth.

Economic Fallacies

Economists could spend all of our time combatting the dozens of economic fallacies found in the media and among the general public. What we might call “folk economics” can be seen just about everywhere people talk about economic issues. Rather than go after a long list of very specific fallacies, I’d like to address three high-level beliefs about the economy and economic growth that are both widely accepted and very damaging.

The Fallacy of the Zero-Sum Game

The first of these fallacies is the belief that market activities, especially exchange, are zero-sum games. Zero-sum games are those in which the total gained from playing the game is zero. So, for example, if each of five people playing poker buys into the game for $100, there is only $500 to be won. Collectively, that’s a zero-sum game. If I have $200 left at the end of the night, then all of the other players together have only $300 to divide among the them. In zero-sum games, one person’s gain is another person’s (or several people’s) loss.

We see this misperception of markets in a variety of forms. At the most general level, the belief that the rich get rich by impoverishing others is a species of zero-sum thinking. This view is held by people talking about the rich and poor within specific countries, but also when people think about the relationships between richer nations and poorer ones. It is a commonly-held belief that the way that the West grew rich was by extracting resources or labor power from the rest of the world, often through colonialism. Note the zero-sum thinking here: there is implicitly a fixed amount of resources to go around and the West “took” them from the rest of the world. There is a similar fallacy at work in the belief that individuals or households within a specific country get rich by “taking” from others.

The fallacy here is the implicit assumption that there is a fixed pie of wealth and that what market activity does is just allocate that among individuals, households, or nations. It ignores the way in which wealth is created through production and exchange. One of the most fundamental insights of economics is that exchange is mutually beneficial and therefore wealth-creating. When Starbucks sells me a coffee, they prefer the two dollars to the coffee and I prefer the coffee to the two dollars. We are both made better off by the exchange. Notice that exchange makes us both “wealthier” by giving us something we value more for something we value less, and that this happens even without any new resources being produced.

When we take production into account, the weakness of the zero-sum view becomes even more obvious. If we back up the Starbucks example a bit, consider their decision to make and sell coffee in the first place. The owners of Starbucks, or any other successful business, have indeed become rich, but not by “taking” from everyone else. As noted above, Starbucks’s decision to make and sell coffee, and our decision to part with our dollars to purchase it, make both of us better off. Their gains in wealth are matched by our gains in having a product we really like. When we then consider the ways in which successful business employ workers and offer returns on investments to those who finance them, the wealth they gain through success does not come at the expense of others, but rather benefits others in the process. Markets are in all of these ways positive-sum games in which it’s possible for everyone to walk away with more than they started.

This argument applies regardless of where the traders live. So when individuals in rich countries trade with individuals in poor countries, that’s mutually beneficial. To the degree that the people in rich countries became rich through trade, they didn’t “take” their wealth from those in poor countries. Both were made better off. Of course the history of international relations has not always been one of trade, and imperialism and other forms of force have certainly mattered. However, over the long run, the adoption of both domestic and global institutions that have facilitated trade explains the gains of wealthy countries far better than alternative explanations.

The Fallacy That Order Requires Design

The second fallacy is the belief that economies require someone or some group to design and/or control them. Often this belief is linked to an argument from complexity: only a simple economy could be left to its own devices. Complex, advanced economies like those across most of the globe require human monitoring and regulation to function properly.

The flaw at the heart of this fallacy is that it ignores the idea of spontaneous or undesigned order. The mainline of economic thinking over the last 250 years has been focused on understanding the ways in which good social institutions can lead self-regarding individuals to cooperate and coordinate in ways that none of them intended. This idea was at the heart of Adam Smith’s metaphor of an “invisible hand” guiding humans to create benefits that none of them intended, and Carl Menger’s work a century later, which asked how it was possible for institutions to emerge that no one had willed into existence. In the 20th century, F. A. Hayek took this line of thought one step further by explaining how markets created coordination and order by making better use of dispersed and tacit knowledge than any other system could.

All of these are articulations of the concept of spontaneous order, which is the claim that many of our most useful norms, practices, and institutions are the products of human action but not human design. Think of the way a path gets trodden through the fresh snow on an open quad on a college campus. People have to take the first steps through the snow. Others see the footprints and walk there, where it’s a bit easier. As the snow slowly gets tamped down, a path begins to emerge. Several such paths will likely cross the quad, all reflecting the directions in which students and faculty need to walk. No one designed that system of paths, and no one put up signs directing people to walk in particular places. Rather those paths emerged as the products of human action but not human design.

We recognize these sorts of spontaneous ordering processes in nature through Darwinian evolution. The whole theory of evolution through natural selection is one of emergent order. There is no designer in nature, rather variations that improve the chances of survival and reproduction are passed on, leading to changes that make living things better adapted to their environments. Order is produced without design. It is also worth noting that Darwin borrowed many of his ideas about competition and evolution from social thinkers like Smith and David Ricardo.

The trouble is that so many who accept that idea for nature cannot see how social systems work in the same way. In fact, the very arguments that are used to support spontaneous order in nature work in society too. The objection that nature could not produce something as complex as the human eye can be rebutted by pointing out that its very complexity could only be produced by a process that operated over a long time span and that had the ability to sift out beneficial marginal changes from harmful ones. That’s precisely how evolution works. And market economies work the same way, though at much more rapid speed thanks to humans’ ability to pass on acquired cultural adaptations.

The prices and profit signals of the market provide the feedback that informs producers whether or not they have created value for others. In a genuinely competitive market, profits indicate that consumers valued the good more than they valued the individual inputs that went into its production. If your ready-to-eat pizza is profitable, that means it is worth more to consumers than the sum of the value of flour, yeast, cheese, sauce, and pepperoni, and labor that went into making it. Firms that create value this way, as indicated by their profits, survive, and firms that destroy value, as indicated by losses, will eventually die off.

This process, and the more general process that create economic order, cannot work unless the institutional rules of the game are right. Unlike biological evolution, where the environment for competition is given by nature, the environment in social competition is the set of rules and institutions that any society adopts. When those rules clearly define and protect private property, enforce contracts, respect the rule of law, and assure sound money, then the competition that takes place within them will produce economic coordination and social progress. By contrast, when the rules are wrong, for example when we penalize profits or subsidize losses, the competitive behavior of individuals and firms will not lead to the unintentional creation of order and social cooperation. Under poor rules and institutions, the signals do not reward value-creating behavior, breaking down the mechanism by which self-regarding behavior is channeled into undesigned social order.

What prices and profits enable us to do under the right institutions is to communicate our own bits of knowledge—some of which we might not even be able to put into words or numbers—to the rest of society through our acts of buying and selling. Those prices and profits form a complex system of communication that shifts and changes as we make decisions to buy or sell. Those changing prices and profits provide both knowledge and incentives to sellers to adjust their behavior accordingly. Those who do so, succeed, and those who do not, find themselves failing.

When governments attempt to design market outcomes, they will find it impossible to obtain all of the knowledge needed to know how best to act, as political action cannot capture all of the knowledge that can be processed by the decentralized communication network of the market. The ability of markets to make use of knowledge in this way, and enable us to communicate across our individually limited fields of vision, enables us to generate a level of economic complexity that designers could never match. Complex modern economies do not require designers. In fact, those who presume to design make matters worse as they stumble their way around, deprived of the illumination of market signals generated by the choices of consumers and producers.

The Fallacy that Consumption is the Key to Growth

The final fallacy is the belief that consumption is the source of economic growth. This belief is widely held by everyone from the citizenry at large up through economic journalists and politicians. We hear it every time the economy enters a recession and begins to recover. Pundits declare that consumers need to start buying things to generate a recovery, and reports about the latest data on consumer spending make the headlines. I see this in my own students, who even after a course or two, like to talk about the importance of consumption spending and the need for money to “circulate” in order for economies to be healthy.

Before getting to the heart of the fallacy, we might consider its source. This is a peculiarly 20th century belief. A number of lesser-known thinkers in the 1920s made early versions of the argument, which they framed in terms of the need to keep up the “purchasing power” of consumers. This general idea informed President Hoover’s decision to try to prop up wages during the early years of the Great Depression. That idea was one of the factors that turned what would have otherwise been a garden-variety recession into the Great Depression. A decade later, John Maynard Keynes put consumption front and center in the most simple version of his macroeconomics. Consumption, along with investment and government spending, were key determinants of national income, and when either consumption or investment was lacking, government was presumed able to step in and make up the difference.

One reason why the focus on consumption as a source of economic growth is a fallacy is that, during the business cycle, the problem is not a lack of consumption. In fact, consumption expenditures vary the least as economies go through booms and busts. The component with the greatest variation is private sector investment. If anything is needed during a recovery, it is more investment by the private sector, not more consumption. Even if one accepts the broad Keynesian framework, the problem is not that recessions are caused by a lack of consumption. The solution, therefore, is not to be found in “stimulating consumption.”

The heart of the fallacy, however, is that consumption consumes things! When we consume goods and services, we destroy their value by using them up. Consuming food does not create anything valuable, it eliminates something valuable. The same is true when we use up part of the productive potential of a household appliance or other consumer durable. It’s why your car is worth less the more miles you put on it. You are consuming, i.e. destroying, its value. The real source of value is production. When we produce goods and services, we create value and create the opportunity for consumers to trade for that value. Buying a new refrigerator moves a valuable object from one party to another, making each somewhat better off in the process. But once bought, we begin the process of destroying that value by using its services. Or think of a meal prepared at a restaurant. Once we buy it and eat it, our act of consuming it, both economically and physically, destroys the object of value. The value is created through production and destroyed through consumption.

If we want to generate economic growth, whether in a recovery or outside of a business cycle, we need to focus on what sorts of institutions and policies encourage economically sustainable production. How do we create an environment in which people are willing to invest their resources in physical and human capital, believing that they will be able to make use of them to create valuable goods and services? That is the more important question for long-term economic growth and short-term economic recovery. Stimulating consumption does nothing to promote recovery and is likely to harm long-run growth, coming as it does as the expense of investment spending.

Conclusion

There are, of course, many more economic fallacies to discuss, but these three are very broad ones that affect the way in which people think about a number of more specific issues. Understanding that markets involve mutually beneficial exchange, that markets are spontaneous orders that require no designer, and that production—not consumption—is the source of wealth can together serve as a useful prophylactic against the more particular fallacies that dominate so much talk about economics. At a time when acceptance of so many of those fallacies is a feature of even the highest levels of the political structure, understanding some of the foundational concepts of economics is more important than ever.