Some misconceptions about how the economy works

What are some of the biggest misconceptions about how the economy works?

Some misconceptions

  • Economists can make reliable forecasts.
  • Presidents control the economy – Policies of government only partially responsible for economic activity.
  • Luddite fallacy. – Misconception that new technology destroys jobs.
  • Broken window fallacy – Misconception paying for damage creates economic activity.
  • The lump of labour fallacy – Misconception that immigrants take jobs from native worker

Forecasters

inflation forecast
Inflation forecasts become more unreliable the further in the future they are.

People tend to place great emphasis on economic forecasts. There was substantial criticism for the relative lack of warning about the credit crunch and 2009 recession. But economic forecasts are intrinsically difficult – if not impossible to make -, especially in the long-run. There are so many factors that influence the economy; it is not possible to incorporate so many factors, unknown variables, unexpected events and uncertain human behaviour.

A good analogy is that of a doctor. A doctor can say if you continue to smoke, drink and take no exercise, you are liable to become ill. But, the doctor cannot make precise predictions of when, how, and if you will become ill. However, when a doctor looks at the symptoms, he can advise what solutions will help ameliorate the situation. The role of the economist is not to predict recessions in the future. But, when they occur, there is substantial knowledge about the likely impact of different policies to respond to the current situation.

“Economists don’t forecast because they know, they forecast because they’re asked.” J. K. Galbraith

Luddite fallacy

The Luddite fallacy relates to the role of new technology and its effect on unemployment. If there is news of automation/new technology – then the instinctive reaction is to blame technology for ‘taking jobs’. From a visible perspective, this seems to occur. When automation is introduced, a firm can produce the same output with fewer workers, so some may be made unemployed. However, it is a mistake to assume this is the end of the story. While some workers will lose their jobs, the automation will create new jobs in –

  • Jobs designing and building the new technology.
  • Greater efficiency of new technology allows lower prices for consumers and greater disposable income for consumers to spend on luxury services and goods. Creating new jobs in these sectors.

The jobs losses are visible; the jobs created are much less visible. Therefore, the impact of technology can be misleading.

  • To confuse matters, it is possible new technology does cause some structural unemployment – if unskilled workers struggle to gain employment in the new jobs created.

Lump of labour fallacy

A similar misconception is the lump of labour fallacy. This relates to the role of immigrants entering an economy and taking ‘jobs’ from native workers. The fallacy is that this assumes the number of jobs stays constant. If immigrants gain employment, this will expand the economy and create new demand and new jobs. Countries with lar

Broken window paradox

The broken window paradox is another example of the difference between immediate visible short-term effects and long-term effects which are less visible. The broken window paradox starts with the observation that if a window is broken, it appears there is a boost in economic activity. The shopkeeper employs a glazier to fix window, and this leads to boost in spending in the economy.

However, this analysis ignores the opportunity cost. If the shopkeeper hadn’t spent money on fixing window, he could have spent money on something more productive like better products. Spending money on fixing a broken window doesn’t create economic activity – it only shifts activity from productive activity to maintenance activity. Broken window paradox.

Presidents/prime ministers steer the economy

If the economy is doing badly, voters tend to blame the current government/President. It is understandable, but often the impact the president has on an economy is very limited. Presidents can be either lucky or unlucky, with most economic events occurring out of their hands.

The state of the economy depends on – private sector innovation, technological development, external events, state of the banking sector, consumer demand. Government policy may account for 10-30% of the state of the economy.

For example, in 1980, Jimmy Carter faced stagflation – higher inflation and low output. This was primarily due to rising oil prices and global inflationary pressures. This was not unique to the US economy but something largely beyond his control. In the 1990s, Bill Clinton and Tony Blair both benefitted from a strong global economy – with sustainable growth and low inflation. You could say they didn’t mess it up, but the strong growth wasn’t directly due to some radical, innovative new policy. From an economic perspective, they were lucky.

Barack Obama was unlucky to become president in 2009, amid the deepest recession since 1931. The global economic recovery was slow because of the nature of the financial crash.  In fact, the US did better than the Eurozone, but people see the recession and slow recover as their fault. Donald Trump was lucky to inherit an economy in strong shape – with low inflation, high growth and falling unemployment. If anything it was the consequence of previous years growth.

This is not to say Presidents and government have no influence over the economy – they have a limited ability to make things better or worse.

  • In 2010, Obama did have an influence on how he responded to the recession. By implementing a mild fiscal stimulus, he did help some economic recovery. Other economists criticised him for being too timid and not going for a bigger stimulus.
  • Donald Trump inherited a successful economy, but his trade war has created a loss of earnings for some exporters and the erratic nature of policy pronouncements have caused uncertainty which have led to lower growth than expected. The big tax cut of 2016, increased the budget deficit but had little impact in long-term boosting investment and spending. However, you could also say that despite a largely dysfunctional president and Congress, the US economy has continued to perform relatively well.

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By on October 7th, 2019

One thought on “Some misconceptions about how the economy works

  1. As always, a very useful post – thank-you.

    One small point: it looks like the “lump of labour fallacy” is incomplete. Could you expand on that a little please?

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