Fallacy of Composition

Between 2008-2010, during the depths and aftermath of the financial crisis, pundits envisioned that the ‘old’ status quo would be replaced by a more egalitarian ‘new’ one of less wealth inequality, as well as slower economic growth and asset price stagnation, which some called ‘the new normal’. With the U.S. stock market and and U.S. economy in its eighth strait year of expansion, how wrong they were. All pre-2008 trends are not only intact, but have accelerated, as I predicted in 2011 they would. Had you asked pundits in 2009 that seven years later we would still be in an economic expansion and bull market, the answer would have been a unanimous ‘no’, save for myself and maybe one or two others out of hundreds. But the expansion, already in its eight year, is actually accelerating right now, prompting the fed to raise rates and boost the rate hike outlook for 2017-2019. The fed foresees three rate hikes for 2017 alone, although I doubt more than two will materialize.

The biggest and most common pitfall in predicting the economy, and why so many people got the 2009-2016 bull market wrong, is the fallacy of composition, in which one assumes that a singe single piece of data is indicative or representative the entire economy, when it’s really just predictive of the single data point and not necessarily more. Or in the words of Freud, sometimes a cigar is just a cigar.

The fallacy of composition arises when one infers that something is true of the whole from the fact that it is true of some part of the whole (or even of every proper part). For example: “This fragment of metal cannot be fractured with a hammer, therefore the machine of which it is a part cannot be fractured with a hammer.” This is clearly fallacious, because many machines can be broken apart, without any of those parts being able to be fractured.

Weak job data and a low labor force participation rate is evidence of a weak labor market but not necessarily a weak economy, nor does weakness in one area (labor)mean weakness in another (profits and earnings). The United States economy is bigger than the labor market, although the labor market is an important component of it.

Culture, states, politicians, and national and local governments, too, are just components of a bigger conglomeration. The fallacy is invoked again in the assumption that the failure of one component means failure of the entire system. So the question is, how many components must fail before the entire system fails, and when. That is harder to answer.

Related: The Overton Bubble

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