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Intermediate Broken Windows

November 5, 2012

The basic story of the broken window fallacy is one of opportunity costs: instead of repairing the window, Mr. Goodfellow could get a new shoes. Every time a large natural disaster or terrorist attack occurs, there is some economists write tasteless posts about how disasters are good for the economy and other economists jump up and down reminding them of Bastiat. The trite response is “If death and destruction were good, why not simply bomb major cities?”.

The Principle of Charity
Perhaps the hardest rhetorical practice to adhere to on the blogosphere is the principle of charity. Are Morici and Krugman advocating more senseless destruction? No. Presumably, they are taking Bastiat’s metaphor of “government as senseless destruction” and turning it on its head. If government spending is good, then senseless destruction is also good. Maybe it’s convoluted, but I think that’s the best non-straw man version of the pro-broken window side you could possibly give.

Stocks and Flows
The economy isn’t a thing, or a god to be appeased. It’s just people and how those people are fulfilling their goals using scarce resources. If something hurts people, then it hurts the “economy”, even if unemployment is 0 and everyone has lots of income. Suppose you have a person who owns a house worth $100,000, and they have a job which pays $40,000. Then a hurricane knocks down their house. Over two years, they quit their job and rebuild their house. GDP goes from $40,000 to $50,000. The window breakers proclaim: GDP increases by $10,000! That must mean the economy is doing great!

No! “The economy” is just how people are doing. The GDP Uber Alles viewpoint confuses a flow of new goods for total welfare. Welfare is a function of wealth and life situation and a ton of other things not included in GDP. Using GDP growth is an even worse measure of welfare; it’s the rate of acceleration of the value of traded goods. Growth by itself has no bearing on welfare whatsoever. Keynesians sometimes assume that employment generates utility above and beyond the income it provides. That assumption is actually pretty plausible to me, hence my support of abolishing the minimum wage. But higher nominal GDP only generates more employment in the short run, while wages are sticky. For disaster relief spending to improve welfare by creating aggregate demand, you need to have a story of why there would tend to be a lot of slack in the economy prior to disasters.

Government Spending and the Structure of Projection
Economic production is not homogeneous. It requires a specific pattern of skills, capital, and social arrangements. The economy is constantly changing in response to shocks. Sometimes relative prices shift, sometimes there are new technologies which cause creative destruction, or perhaps there are shifts in the amount of human capital the economy has. One explanation for recessions is that they are times when there are more fundamental shifts in the types of production occurring. For example, in 2007, resources were shifting from housing to other sectors, such as health care. These sectoral shifts can be quite costly, hastening the obsolescence not just of physical capital, but more importantly by altering which skills are valuable in the labor market. It is possible, but difficult for an unemployed autoworker to get a job in a totally different field or for a construction worker to move to computer programming. If the government could slow down the pace of creative destruction, it would lower economic growth, but it might ease the transitional pain on those in the declining sector.

If the government could increase political support for more creative destruction by paying off the losers, it might be worthwhile. I am skeptical that such a move would be pulled off, as it is very difficult to sort those who are losing out because of a sectoral shift and those who lose out because they don’t run their companies well. Government run job training programs have a poor history. Administrative and informational problems push me toward supporting a basic income guaranty rather than trying to focus on a few sectors which might have been hurt by sectoral shifts. For the same reasons, as I don’t think the government can reliably identify and help declining sectors fast enough to effectively counterbalance creative destruction, I don’t think government spending is a good way to help the declining sectors.

Regrettable Goods
There are a whole slew of goods which people buy which they would rather not. No one wants to spend a lot of money on health care because they got sick or injured, but when you are sick or injured, you want health care. An ideal economy has positive health care expenditures and positive hurricane repair expenses, even though we’d all prefer not to have heart attacks or hurricanes. Hoping for a better world does nothing to fix the one we’ve got. There is nothing invalid about spending money on alleviating disasters. I don’t mean to imply in this essay that disaster relief expenditures are somehow not valuable, but rather that there are no grounds for artificially inflating them.

Aggregate Demand
One argument in favor of broken windows is that they raise overall spending. But higher nominal spending doesn’t always benefit the economy. If spending is higher than the productive capacity of the economy, it will simply result in more inflation. That’s basically what happened in the stagflation period of the 1970s in America, and anywhere else that has suffered from upwardly spiraling inflation. Now, disaster spending can’t result in long run inflation, simply because it is temporary, and hence only has a transient effect. However, it could result in temporarily higher prices and thus cause the sorts of crowding out which Bastiat originally pointed out.

But let’s assume that the economy is operating below capacity, and that the government can correctly identify this, and that fiscal policymakers can act faster than the price adjustment mechanism, which is unlikely because of knowledge problems, but let’s just assume it is for the sake of the argument. In that case, what is the most efficient way to raise nominal spending back up to the ideal amount? Wait for a natural disaster and then rush to spend boatloads of money fixing it? If the central bank is targeting inflation or NGDP, higher government spending will simply mean less private spending and investment. Since, by assumption, the government knows spending is too low, why not simply use monetary policy, which is much faster and does not require the government to pick specific things to spend money on? In order for fiscal stimulus to work, you need to have a massively incompetent central bank which does not coordinate at all with the fiscal authorities. Sadly, that scenario was true during the Great Depression and is true for modern Japan and Europe. But even in this case, it is far better to advocate better monetary policy than to advocate a third best solution using an obfuscated metaphor which mostly just bewilders both your intellectual opponents and the general public. Ultimately the biggest broken window of all is economists wasting their time writing fallacies and then shooting them down when they could be writing about more important things!

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