Suppose we asked 100,000 random people to flip a coin until it landed on tails.
50,000 would get tails on the first flip. 25,000 would get tails, then 12,500, and so on.
Soon, we would find a few of those 100,000 people had rolled heads 15 times in a row! What skill!
No. It was random chance. But all too often, we observe correlation and assume causation.
Sometimes the link is really there, sometimes not. Getting it wrong can have serious consequences. And I think it’s one of our top economic problems.
The correlation-causation fallacy happens at both micro and macro levels.
For instance, you may see something like this:
“I did [voluntary actions] A, B, and C, and [positive event] Z happened.
You should do it too!”
Countless self-help books follow that formula, on everything from weight loss to stock trading.
They aren’t always wrong. The authors probably did A, B, and C as claimed, and Z subsequently occurred. But it doesn’t mean A + B + C caused Z.
We see the same in other contexts. People blame video games when a young male gamer gets violent. It seems plausible.
But millions of young men play the same games and don’t hurt anybody in real life. Obviously, there’s more to it.
This happens in business as well. Billionaire Joe says, “I had a great idea, worked hard, and hired smart people. That’s the formula for success.”
But it’s clearly not.
Plenty of entrepreneurs have great ideas, work hard, and hire smart people—only to see their companies fail. The formula must have other factors.
Or maybe Joe was the one coin flipper in thousands whom random chance happened to bless.
Faulty Monetary Policy
Central banks like the Federal Reserve think they can use interest rates to stimulate the economy. Make borrowing easier and growth will follow, they believe.
The Fed tried this in 2008 and afterward, dropping short-term rates to effectively zero. The desired effect didn’t follow, at least not fast enough. So, it added quantitative easing to the mix.
A decade later, the economy is growing, although still more slowly than in past recoveries.
Did lower rates and QE do it? We really don’t know, and neither does the Fed. Maybe the recovery would have happened anyway, even without the interventions.
Still, the Fed thinks its policies did the trick. Their staff (who want to get promoted) give them charts and graphs to “prove” it. But no one really knows. The economy is way too big and complex to account for all the factors.
The same applies to fiscal policy. Do lower taxes cause economic growth or reduce it? Smart people argue both ways. We can look at historical examples, but they don’t occur in isolation. Other factors always intrude.
And yet, most policy makers are so certain about something that might have happened purely by chance.
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Sharp macroeconomic analysis, big market calls, and shrewd predictions are all in a week’s work for visionary thinker and acclaimed financial expert John Mauldin. Since 2001, investors have turned to his Thoughts from the Frontline to be informed about what’s really going on in the economy. Join hundreds of thousands of readers, and get it free in your inbox every week.
Patrick Watson is an Austin-based financial writer and senior editor at Mauldin Economics. Follow him on Twitter @PatrickW
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