Uncertainty vs. Risk
As discussed above, life is uncertain; therefore we will assume that not all events that may happen can be predicted, even in a probabilistic sense. Many of our plans may fail, due to circumstances that cannot be fully bounded. Many economists believe that all economic outcomes can be predicted, in the sense that the entire range of possible outcomes can be assessed and a probability distribution assigned such that we can “know” the outcome. A short example may help. Suppose you work for an employer and there is a 75% chance she’ll pay you $10/hr., and a 25% chance that she’ll pay you $20/ hr. Multiplying each probability by the outcome and adding together gives the expected outcome:
$12.50 is the expected outcome (while economists recognize that only one or the other will take place).
Here’s another example. When you take your first test in economics, you may get an A, B, C, D, or F. One of these outcomes will happen in almost all school systems. If you assign a probability to each outcome (say, equally probable at 20%) and assign a point scale to each grade, you’ll find the most likely outcome to be a C. But this same logic does not translate necessarily into economic actions. This economic thinking is wrong, as has been illustrated in numerous cases such as the collapse of the hedge fund Long Term Capital Management (LTCM). LTCM had Nobel prize-winning economists to help design their computer trading programs, yet they were unable to mathematically predict all possible outcomes, and nearly wrecked the entire financial system in 1998. (See When Genius Failed, by Roger Lowenstein, for an excellent outline of this event.)
Christians can also find this reasoning incomplete. Surely the biblical figure Job was unable to quantitatively predict all possible outcomes. What happened to Job was not a risk he could have planned for, but a true, uncertain event that could not have been planned for, and could not have been “hedged” away by buying an insurance policy (Job 1). Because God is sovereign and works all things according to His purposes, this means that we face a world of uncertainty—at least in the events our lives may see—while we also face total certainty that God will work everything together for His glory and for our ultimate good. Ironically, economic thinking that can reduce all events to a probabilistic distribution of risk leads to a deterministic outlook and elimination of free will. A proper understanding of uncertainty allows for free will, while knowing the end result is predetermined by God’s sovereign will.
Fallacies should be avoided at all costs if you want correct economic analysis; but they are all too easy to buy into. Here are some of the more common ones. A fallacy of composition occurs when one assumes what is true of the whole is necessarily true of the parts (or vice versa). For instance, if the government decides to give a “stimulus” check to one constituent, that constituent obviously benefits. But does everybody benefit? We’ll see in this text that everyone does not.
Another fallacy is the post hoc fallacy, from the Latin phrase post hoc ergo propter hoc, which means “after this, therefore because of this.” In statistics classes, the phrase “association does not mean causation” refers to essentially the same thing. If taxes are raised, and the economy subsequently booms, does that mean that raising taxes is good for the economy? Someone that commits the post hoc fallacy would say yes. But as we’ll see later, there are other likely causes that actually improve the economy. A common but obviously wrong example is that if a member of the original National Football League (now the NFC) wins the Super Bowl, the stock market will go up that year. Similarly, if an American Football League (now the AFC) team wins, the stock market will go down. This has actually been a good predictor of stock performance. But just because the stock market rises after the NFC team wins, does that mean a NFC victory is a causal force driving the economy? Sadly, no; this is just fallacious thinking.
The ancient Israelites were guilty of the post hoc fallacy in their rebellion against God. When God challenged them to stop sacrificing to other gods (Jeremiah 44), they responded by noting that when they sacrificed to the other gods things went well, but when they stopped things went poorly. Their faulty reasoning (after this, therefore because of this) led them to sin grievously and suffer God’s wrath. The true causal relationship is that every good and perfect gift comes from the Father above (James 1:17), not from gods who are no gods (Psalm 115:4-7).
A final fallacy to mention here is the broken window fallacy, brilliantly elaborated by the economist Frederic Bastiat and later by Henry Hazlitt. This fallacy is seen in almost every newspaper after an economic disaster. Let’s say a hurricane hits Florida, causing billions of dollars in damages. A common headline will say that the rebuilding of the Florida infrastructure will cause gross domestic product (GDP) to rise as spending accelerates. This is seen as somehow mitigating the damage of the hurricane in that “at least the economy will be stimulated.” The fallacy here is that the money used to rebuild came from somewhere. Had the hurricane not hit, that money would have been spent in some other way, adding to the total goods or services or capital equipment rather than simply replacing what was there before. The spending after a hurricane is almost a total loss, despite what you read in the newspaper.
Next Page: Micro & Macro Economics »