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Why the Abbott Government is doomed to self-destruction

Prime Minister Tony Abbott-200Australia’s Abbott Government is a “sucker” for a host of economic fallacies. That is why its self-destruction is assured, writes economist Bill Waters.

11 June 2014

With the notable exception of economics students, few people have ever heard of the “fallacy of composition”. It is perhaps the most important yet least understood, and least publicised, of all the theories contained in modern economics textbooks.

It is often found in the opening pages of the “Macro Economics” section which studies the performance of the economy as a whole, while “Micro Economics” studies the behaviour of the individual parts (such as consumers and business firms).

Business leaders are usually comfortable with the Micro field but are far less conversant with Macro-economic theory. Tony Abbott’s advisory Commission of Audit (dominated by business figures and pro-business ideology) provides a classic example.

The Commission adopted an absurd simplifying assumption – as the underlying basis for its recommended Budget cuts – that overall unemployment would stay close to 6 percent whether any, some, or even all of its suggestions were implemented.

Anyone trained in modern economics would have understood immediately that substantial expenditure cuts, amounting to billions of dollars, must have significant negative repercussions for the level of national unemployment (which, in turn, would have an adverse impact upon the government’s taxation revenue).

In short, the levels of unemployment and government revenue would both suffer, perhaps very significantly.

“The fallacy of composition” was the main underlying idea behind the theories of eminent British economist John Maynard Keynes who in 1936 produced the iconic General Theory of Employment, Interest and Money which set out to explain the causes of, and remedies for, the world-wide Great Depression of the 1930s. 

Certainly, errors of theory by the pre-Keynesian “classical” economists, and errors of policy by most national governments – based on those same theories – had conspired to widen, deepen, and prolong the unemployment and low-level production of the 1930s.

Almost universally, economists and governments had got it all wrong, essentially because of policy errors based on the fallacy of composition.

“What is true of the parts is not necessarily true of the whole,” was Keynes’ explanation of the fallacy.

For example, pre-Keynesian economists had long argued that, because it is wise policy for an individual family to increase its savings to provide for the future, then it must also be wise policy if all families in society begin to increase their savings.

But as Keynes pointed out, increased total savings by society inevitably meant reduced spending on goods and services by those same families in their role as consumers.

The upshot: reduced sales and lower profits for business firms, which would then be obliged to cut their production and reduce employment – so that recession would result.

Keynes called this “the paradox of thrift”: the attempt by the community to save more, can lead to the community actually saving less, since more and more people will lose their jobs and incomes.

So, thrift may seem wise policy for the individual, but paradoxically be unwise for society. Note how “truth” for the micro unit may be an “untruth” from the macro perspective.

Self-destruct-button-250This is a distinction that so many business leaders, politicians, and non-Keynesian economists neglect when they preach to society on the need for higher community savings – the idea being that this will provide a higher pool of available funds for business firms to then borrow and to invest in new, enlarged productive capacity.

But why would business firms wish to borrow funds (to finance business expansion) when there will have been a significant drop in spending by consumers on the goods and services currently turned out by those businesses?

A second compelling illustration of “the fallacy of composition” (again courtesy of Keynes) is “the real wage unemployment fallacy”. The pre-Keynesians had argued that unemployment in the 1930s was principally due to too high a real wage level. Their remedy was simply for wages to be reduced to entice higher employment by businesses.

Even today, business leaders unite on the same platform: wage costs must be reduced if business is to employ more workers and to expand production.

Now it is true that if one business firm (in isolation) could be provided with wage cuts, then its costs of production would fall, it could compete much more successfully against its business rivals, would expand its production, and employ more workers than previously.

But what is true of the individual parts of the economy is not (as we have seen before) necessarily true of the whole.  So, if all business firms were granted equivalent wage cuts (across the entire economy) then no particular firm would gain any competitive edge over its rivals.

Indeed all firms would eventually be disadvantaged by the reduced wage incomes of their customers-consumers which would inevitably reduce consumer demand for the goods and services turned out by the business sector.

The upshot (for the economy as a whole) is that businesses would eventually have to cut production, and thereby cut employment, in response to falling consumer demand.

Hence, a wage-cutting strategy, which seems advantageous from the individual firm’s point of view, is seen to be disastrous from the vantage point of the economy as a whole (simply because wage-earners are also the economy’s main customers-consumers).

A final example is the false analogy (drawn by “fiscal conservatives” in the Abbott government) between household budgets and the Budget process of the Australian Government. 

It is true that, to eliminate financial imbalance, a household that is spending $100 per week but receiving income of only $90 per week would need simply to cut spending by $10 per week. End of story!  

But what is true of the parts (individual households) is not necessarily true of the whole (a Budget for the entire nation).

For example, if the Australian government is spending $450 billion per year but raising revenue of just $400 billion per year, then the annual Budget deficit is $50 billion.

But is the solution as simple for the whole economy as it is for the individual household parts?

If the Government plans to cut its spending by an exact $50 billion per year, will this automatically achieve Budget balance?

No, because what is true of the parts (individual households) is not true of the whole (the national economy)!

The $50 billion cut in government spending will have repercussions right throughout the economy; for example, cuts in spending on the public service, schools, hospitals, roads, transport, housing and so on will reduce employment in those sectors.

The inevitable flow-on effect will be a reduction in the government’s income taxation revenue, plus the need for the government to pay out more than previously on unemployment benefits: a double-whammy loss.

Hence revenue does not remain constant, but falls, and at least one area of government spending will now have to rise. The Budget will not be automatically balanced by the planned cut of $50 billion.

Whether the ensuing deficit is smaller – or even larger – than previously, depends on the severity of the spending cuts, the seriousness of the subsequent rise in unemployment, and the loss of tax revenue (from income tax, company tax, indirect taxes on goods and services).

The more severe the spending cuts, the greater is the likelihood that the Budget deficit will, paradoxically, rise rather than fall over a period of several months.

Conservative politicians, still mesmerised by the fallacy of composition, adopt the simple-minded “logic” of the pre-1930s conventional wisdom. They claim that the appropriate spending cuts (easily calculated) or compensatory tax rises will always do the trick, and smoothly achieve Budget balance.

They fail to see the complex inter-relationships – including “feedback” connections – between national economic aggregates such as government spending, tax revenue, employment, and economic growth.

The goal-posts keep shifting because of these complex inter-connections which have no counterparts in the simplistic household budget analogies, offered by simple-minded politicians (and by their economically-illiterate business mentors).

Imagine now that I am at a sporting event and cannot see beyond the tall crowd in front of me. Then, standing on a chair might solve my individual problem.

But what is true of the individual part is not necessarily true of the whole. If everyone who has a blocked view adopts my attitude, and scores of people grab a chair, then barely anyone will achieve a better view.

Such logic is unassailable! Why then cannot the same logic be appreciated in the realm of economic theory? The Abbott Government is a “sucker” for all of the economic fallacies explained above. That is why its self-destruction is assured.

Bill Waters holds a Master’s degree in Economics and an Honours degree in Government, both from the University of Sydney. He taught Economics and Government at the University of Sydney, and Politics at the University of New South Wales.

Image of Tony Abbott: Department of Foreign Affairs and Trade website – Register for self-service under a Creative Commons licence.

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