When Henry Hazlitt wrote in Economics In One Lesson that “Economics is haunted by more fallacies than any other study known to man” he knew what he was talking about. Economic fallacies abound — and are even popular. What’s worse, economic illiteracy seems to only increase. In part, this is due to economists trying too hard to be scientific and help policymakers engineer the economy.
Many consider the well-known words of Lord Kelvin obvious, that “when you can measure what you are speaking about, and express it in numbers, you know something about it; but when you cannot measure it, when you cannot express it in numbers, your knowledge is of a meagre and unsatisfactory kind.” That sentiment has been taken to heart by many in the sciences, both natural and social, and also in economics.
After all, without the ability and use of mathematics and statistical data analysis, science would not be able to contribute much knowledge at all. Yet there are limits to the usefulness of measures, as Goodhart’s Law suggests: “When a measure becomes a target, it ceases to be a good measure.”
It is actually even worse in economics, where the use of measures can arguably be a cause of widespread economic illiteracy.
An example of this is the frequent references to inflation in the business press. Experts eagerly note how anything from weakening demand to supply shocks and trade policy will change the inflation rate. The same can be claimed about economic growth, which apparently can not only be generated by economic policy but where government spending “causes” or is essential for economic growth — regardless of how the money is spent.
Both are examples of how economic understanding suffers from what Charles Goodhart recognizes. Inflation is real and so is economic growth, but both are economic concepts with real meaning. In order to investigate them, economists invented statistical constructs — the CPI and GDP, respectively — to simulate approximate measures of the concepts. But both are imperfect.
Inflation used to be understood by economists as the general rise in prices due to the dilution of money. Hence Milton Friedman’s claim that “inflation is always and everywhere a monetary phenomenon.” Prices always fluctuate, but that is just the market’s price mechanism. Inflation was distinct: the effect on prices overall from meddling with money (basically, counterfeiting).
Economic growth explains the increase in the wealth of a nation, which economists understand as the productive capacity. When this capacity increases, the economy can more easily satisfy consumers’ wants. We are richer as a result.
In both cases, the measures are fundamentally flawed but provide some insight into change over time. The CPI captures some of the general rise in prices, but looks at the outcome without recognizing the cause. This has misled people, experts and laymen alike, to believe that increasing prices means inflation. But rising prices can have many causes, often entirely normal upstream effects. A sad result of attempting to measure the outcome is that, for example, a war that affects production “creates inflation.” But higher oil prices are not inflation. This is something that no reasonable economist would have even considered, but now it is presented as a supposed “insight.”
Similarly, the GDP gives an indication of an economy’s productive capacity, but also includes government spending on supposed public goods that are heavily subsidized or provided “for free.” In other words, it appears as if government spending, regardless of what the money is spent on, “creates growth” because it increases GDP. Such spending does not need to actually increase productive capacity — it can even harm productivity — yet still be interpreted as “economic growth” because of its effect on statistics.
Both are examples of how Goodhart’s Law applies — and in fact undermines our economic understanding. This is readily recognizable in how supposed experts claim that price ceilings, or any government effort to control prices (usually by prohibiting high prices), “fights inflation” or that government waste (by virtue of spending) “contributes to economic growth.” They focus entirely on the official statistic, which was originally a poor measurement of a well-understood economic concept, and anything that affects this statistic. But the understanding of the concept is all but lost. And, in fact, they run with it and in the process invent new economic fallacies in order to come across as insightful.
Economics thus remains haunted by fallacies. Rather than dispelling the fallacies or informing policy, some economic indicators and their analyses generate economic illiteracy.
