Diversity, Homogeneity and the Fallacy of Composition in Current Economic Policy
Finally, consider the surprise that was caused when the subprime crisis produced impacts on real production and employment, producing the most serious disruption to economic activity since the Great Depression.
Here, also, hides the paradox of individual diversity and homogeneity at work. Once the prices of mortgage securities were called into question, there was a uniformity of opinion on their values, which called into question the existence of markets in which to trade them. Not surprisingly, the imaginary prices soon proved to be just that, and financial firms were no longer willing to engage in borrowing and lending, resulting in a severe liquidity crisis and a drying up of funding for productive activities. Indeed, this is just an application of what was called the fallacy of composition. It is best understood by reference to the old story of the optimal behavior against the risk of fire in the movie house. For any single individual, there is an optimal path to the emergency exit. Each individual believes that it is possible to escape in case of fire. When fire breaks out, all individuals attempt to implement the optimal path, but none of them succeeds because they are all trying to execute the strategy at the same time. The same is true of financial institutions that believe that they have assets that can be converted at market prices into liquidity as required. But this implies the existence of diversity of opinion. When all hold the same view and that diversity disappears, there is no liquidity and everyone dies in the fire. Thus the importance of the central bank acting as lender of last resort, taking a diverse view and acting as a residual buyer when everyone is a seller—of becoming the market maker and the price maker.And the same principle is at the basis of John Maynard Keynes’s explanation of the impact of individual decisions on aggregate output.
An individual can increase savings only if someone else is willing to take the opposite view. When everyone seeks to save to offset the losses incurred in the collapse of housing prices, there is no longer a diversity of views, and incomes will fall and stymie the attempt to recover from the crisis. Who will take the opposite view? Keynes’s answer was that only the government had the ability to take a diverse view and dissave in order to allow the private sector to save. The government thus plays the same role as the central bank in providing the required diversity in the face of homogeneity of view: of being the buyer of last resort.The current political discussion appears to be an attempt to introduce homogeneity in the behavior of all sectors of the economy: financial institutions are to reduce leverage to save and build up more capital, households are to reduce expenditures to increase savings to meet their losses from the housing collapse, the business sector is to reduce costs to improve profitability and the government is to reduce leverage by spending less to pay down debt. There is no longer the diversity that is required for a viable economy. But the lack of diversity is the characteristic of the command economy, and diversity the heart of economic survival.
More on the topic Diversity, Homogeneity and the Fallacy of Composition in Current Economic Policy:
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