The Microeconomics of the Broken Window Fallacy

by Russ Roberts on August 30, 2011

in Seen and Unseen, Stimulus, Uncategorized

The Keynesian defense of breaking windows or the economic virtues of hurricanes would go something like this:

Yes, breaking windows is destructive. Yes, it reduces wealth. But when there are large amounts of unemployed resources, say in the glass business, then breaking windows is close to a free lunch. In a world of unemployed glaziers, breaking windows can jump-start the economy by putting the unemployed back to work. They will spend the money they receive for repairing the broken windows.

When confronted with the claim by those of us who like Bastiat, that the money to repair the windows will now be unavailable to spend on something else, the Keynesian responds like this:

But people are sitting on money that is doing nothing. The insurance company that will now pay back the homeowner whose house was damaged by the hurricane was sitting on piles of cash. That cash was sitting in the bank where the bank has excess reserves not being lent out, not being invested. So yes, breaking windows can improve the incomes of glaziers and start a process of recovery.

What do we respond, those of us who are enamored with Bastiat and who think he’s right?

I would re-state the Bastiat story and tell it a little differently than it is usually told. The usual point is that the money has to come from somewhere–we see the repaired window but ignore the things that don’t get built or bought. But I think a better way to tell the story is to point out that the RESOURCES have to come from somewhere. The hurricane increases the demand for glaziers and that is good for glaziers. But that is good for all glaziers, employed and unemployed. It pushes up the price of glass repair. That discourages some folks from having glass work done who otherwise would have done it. So there is some offset of the hurricane’s impact on glazier employment. And as the Hayek character says in “Fight of the Century“:

You see slack in some sectors as a “general glut”
But some sectors are healthy, only some in a rut
So spending’s not free – that’s the heart of the matter
Too much is wasted as cronies get fatter.

So while glaziers (and carpenters) may be unemployed, other sectors (such as the wood market) may not be having such problems. The hurricane has a big impact on the price of wood, discouraging a bunch of would-be demanders of wood from buying as much as they did before. Again, there’s an offset. The point is that “aggregate demand” doesn’t tell the whole story.

But the real problem with breaking windows is that it’s not productive. I know. That’s obvious. But think about what the words mean. Right now, there are a lot of unemployed construction workers. What does a hurricane do? A hurricane IS good for carpenters and glaziers and roofers. But it’s unproductive work. It gets the home owner back to the status quo. It doesn’t create anything new or valuable. I’m not saying the production is wasted. I’m saying it’s a repair. Why is that important?

Imagine a world where there hasn’t been a hurricane and I want to help the unemployed carpenter. Here are two ways to do so. One is to burn my house down and then call the carpenter and give him $100,000 to rebuild my house. Here is the second way. I call the carpenter and say, I feel bad that politicians artificially increased the demand for housing at the end of the 20th century, pulling you into an industry that cannot be sustained at its current leve. I feel bad that you’ve been unemployed for three years. So I’m going to give you $100,000.

Which of those two policies would have the bigger stimulative effect? The charity should have a bigger effect. No offsets from pushing up the price of lumber and so on. But giving people money doesn’t change the underlying problem that there are more carpenters than work available for them. Creating temporary work either by burning down houses deliberatively or accidentally through a hurricane doesn’t change the fact that there are too many carpenters and glaziers relative to demand.

So the hurricane will put carpenters back to work. But it would be even better if there had been no hurricane and people had just given them a check. Charity is more productive than destroying stuff and paying people to get back to square one.

But the charity approach is what we’ve been doing for the last few years. It’s called unemployment insurance. I know, it’s supposed to be stimulative but there’s no sign that it is. Why would it be? It doesn’t solve the problem that there are too many carpenters.

This is related what Arnold Kling calls “Patterns of Sustainable Specialization and Trade.” Repairing houses damaged by a hurricane isn’t sustainable. And if I just give carpenters money because I feel sorry for them, that isn’t trade. That’s charity. Both have the same stimulative effect–very little, because they don’t get at the underlying problem. Prosperity is the way we specialize and serve each other, creating products and services that we each value. Destruction cannot be the source of prosperity.

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{ 114 comments }

kyle8 August 30, 2011 at 2:00 pm

Russ you say : “So the hurricane will put carpenters back to work. But it would be even better if there had been no hurricane and people had just given them a check”

But there is a third way that is even better, use your money to purchase something you need or want, then the stimulated demand pulls the carpenter out of the dead housing industry into something where his skills are needed.

Russ Roberts August 30, 2011 at 2:14 pm

When there are already too many carpenters, your suggestion is very hard to implement. And that’s the problem. If they had something productive to do, the economy would be much healthier.

SaulOhio August 30, 2011 at 2:20 pm

I thought Kyle had it right. If there is not enough demand for carpenters, then the unemployed carpenters need to change careers, do something else productive. Unless real demand for carpentry increases, then no matter what you do, those carpenters are either doing nothing, or just doing busywork. They have to stop being carpenters.

ccresci August 30, 2011 at 2:32 pm

Or the carpenters could just work for less money.

Russ Roberts August 30, 2011 at 3:17 pm

I misread it. You’re right and so was Kyle.

Justin P August 30, 2011 at 3:31 pm

Another problem is one you’ve talked about before. A hurricaneon the East Coast does nothing for the severely unemployed carpenters in Nevada.

Economic Freedom August 30, 2011 at 5:22 pm

1. use your money to purchase something you need or want

2. your suggestion is very hard to implement.

How is using one’s own money to purchase something one wants or needs “hard to implement”?

I take it the reply was meant ironically?

Subhi Andrews August 30, 2011 at 2:26 pm

Bob Murphy had done a good job describing, once again, for the benefit of Keynesians, the Broken Window Fallacy.

http://consultingbyrpm.com/blog/2011/08/the-broken-window-fallacy.html

Brad Clark August 30, 2011 at 2:26 pm

The other fallacy is that the $100k isn’t already being productive. Unless that money is stashed under your bed, someone is putting it to use. Even if it were in the bank, it is capital to back lending for others to put to use. Businesses and wealthy individuals just don’t have piles of cash lying around…it’s in a bank or wrapped up in other productive activities.

kyle8 August 30, 2011 at 3:17 pm

Very good point. I will go even further, there is some utility to money just sitting under the mattress in that it represents your piece of mind or your plans for the future.

vikingvista August 30, 2011 at 4:32 pm

Exactly. Spending now is not always preferable to spending in the future. We all have an interest in our futures well before the long run when we are all dead.

Richard Stands August 30, 2011 at 11:21 pm

And even if you never spend it and prefer to save it for a utility that never comes, and it stays in the mattress and ends up in a landfill, you will have done what you wanted with your excess wealth.

And the rest of us dollar-holders will enjoy that much more value in our remaining dollars.

Economiser August 31, 2011 at 9:53 am

Exactly so.

Russ Roberts August 30, 2011 at 4:35 pm

The claim is that a lot of money is sitting around doing nothing. Banks have excess reserves. Corporations are holding a lot of cash.

Methinks1776 August 30, 2011 at 4:44 pm

Banks have excess reserves and the Fed imposed tighter lending standards on banks.

Corporations are holding onto cash because, in some cases, demand has dropped for their product or, in other cases, regime uncertainty is preventing them from making long term investments. My guess is that in most cases, it’s both.

Even The One finally cottoned on to regime uncertainty and started yammering about some meaningless reductions in regulations so that he can seem responsive without actually dropping a single fascist policy.

vikingvista August 30, 2011 at 5:06 pm

Holding cash to weather a recessionary drop in demand for their services? How dare they rely upon themselves to get through a recession. That’s what government bailouts are for.

Mesa Econoguy August 30, 2011 at 6:10 pm

Yeah, he threw out some crap about eliminating 50 old regulations, and replacing them with 800 new ones.

Methinks1776 August 30, 2011 at 9:01 pm

800? I think you’re missing a couple of zeros.

tdp August 30, 2011 at 8:44 pm

I love the von Mises Institute’s article detailing how Canada didn’t give its economy a huge Keynesian “stimulus” and cut spending and taxes during the beginning of the housing crisis and it has almost entirely escaped the recession.

vikingvista August 31, 2011 at 12:19 am

The best medicine for a recession is to get it over with as soon as possible. That is, don’t get in the way of people cutting their losses, so that they can move on.

Seth August 30, 2011 at 10:20 pm

It seems like the more reasonable approach to this conundrum — if it were established to be true — is to first ask why banks are holding excess reserves and corporations are holding a lot of cash.

The next step would be to consider what actions could be taken to address those reasons.

Ignoring these reasons, or assuming there are no good reasons for this, and carrying out wholly unrelated actions doesn’t seem very reasonable to me.

vikingvista August 31, 2011 at 12:22 am

Doing nothing? I thought they were lending it to Uncle Sam. Kind of hard for Joe Shmo looking for a car loan to compete with Uncle Sam’s borrowing frenzy.

Kevin H August 31, 2011 at 8:13 am

A better way to phrase it would be that they are paying the government to hold their money because they can’t find enough Joe Schmo’s with a job to lend money to.

Joe Schmo (f he has the ability to repay) isn’t competing with the government for loans. To say otherwise is to be completely ignorant of the market reality.

Methinks1776 August 31, 2011 at 12:19 pm

Of course Joe is competing with government. Everyone who competes for credit competes with all others seeking credit. Not being able to get a loan is not the same as not competing for one.

Also, buying treasurys is not paying government to hold the bank’s money. Treasurys have a positive yield. The banks are borrowing at zero and levering up to buy Treasurys, making money on the spread.

No regulator can blame them for taking on too much risk if they lend to the U.S. government instead of you and me. And that’s the problem. It’s not the market dictating behaviour, it’s the government.

GiT September 10, 2011 at 10:04 am

That’s not a fallacy, Brad. It’s an assumption. That all private wealth is being deployed productively is not simply given.

There are strong arguments to think that this is more or less the case (factual claim), that if it weren’t the case no one would be able to know better (epistemic claim), or that it is universally wrong to force someone to use their wealth ‘better’ (moral claim), but disagreeing with those substantive arguments does not make the syllogism ‘if one can truly identify unproductive uses of wealth, one could redirect it in a pareto optimizing manner’ fallacious.

Austrian arguments to the contrary, I have no problem identifying when someone’s decision to purchase heroin just might be pernicious for everyone involved. We’re pretty sure heroin addiction exists. Obviously, the existence of liquidity traps is more contentious.

But, as such, the argument is dependent on the truth conditions of the proposition – ‘liquidity traps exist and can be fixed by force,’ not the soundness if the syllogistic argument built out of the assumption that they exist, are pernicious, and can be addressed politically.

DD August 30, 2011 at 2:33 pm

This is a good argument against broken window fallacy, but enlightened Keynesians would agree with it.

This is what enlightened Keynesians are saying: Yes, it’d be better to give carpenters a check then to destroy windows, but even better to give them a check would be to employ them to do something useful to produce socially beneficial public goods & services. The carpenters are cheaper now than ever before because their wages are low and our government borrowing costs are cheap. There’s no reason to think that at the margin now, employing a few more carpenters is not sustainable in the future once the business cycle recovers. Yes, it’s reasonable to believe the carpenter sector grew too large in the housing bubble and it will need to contract, but the current level of employment in carpenter is below the long-run sustainable level.

The argument against stimulus then comes down to whether it’s feasible at the margin for government to produce socially beneficial public goods & services, whatever that means (goods & services that make everyone better off? goods & services that make lobbyists better off?)

kyle8 August 30, 2011 at 3:21 pm

You can make a tortured case for stimulus if it is being spent on needed infrastructure projects. Even though it would be better if such projects are not built by the Federal government, if they are built, then they at least represent some marginal usefulness to the society.

However, as we saw with the last Stimulus, our modern government is not even capable of doing that, the money is just dispersed to unions and other constituencies of the democrat party. 800+ billion dollars and literally nothing to show for it!

SweetLiberty August 30, 2011 at 3:22 pm

In order to employee the unemployed in the public sector, you must take from those who are employed more money via taxes (or printing money, or borrowing). The government now defines for these taxpayers how to spend those dollars using corrupt and inefficient standards. Yes, it’s possible that government will spend some of the money on projects that are directly beneficial to a given taxpayer, but the majority of taxpayers would benefit more having saved or spent the money on something they would have preferred to the public service chosen for them. Again, this creates an artificial mini-bubble whereby demand for public services goes up in the short term, but is not sustainable long term.

The businesses that the employed spend their money (or invest through savings) will show greater demand and begin hiring. Eventually, this will shift demand away from what the unemployed used to do into what individuals really demand. However, given the artificial manipulations by government and the Fed into the marketplace via stimulus, low interest rates, QE, etc., consumer demand is having a very difficult time reaching equilibrium. But instead of telling many unemployed carpenters the truth – that their skills are no longer in demand – the Keynesian solution seems to be to re-inflate the housing bubble and put them back to work building more houses.

Sorry, I just can’t buy the enlightened Keynesian philosophy that government manipulation creates anything but artificial and short-lived solutions that simply postpone, if not exacerbate, the original problem.

vikingvista August 30, 2011 at 4:41 pm

1. Private investors have better incentive than government bureaucrats to estimate what future carpenter demand will be and when it would be most productive to invest in it.

2. Your investment in carpenter make work projects necessarily comes at the cost of some other future or present spending. Private investors try to make those trade off decisions based upon what is most profitable. Politicians make those trade offs always at the expense of profitable enterprises based upon what yields the most political support.

John Papola August 30, 2011 at 9:41 pm

The process of economic growth is no different during a so-called “recovery” than during any other time. It’s all about problem solving in a world of scarcity and opportunity costs. It’s all about innovation that makes solving problems easier and cheaper. It’s all about discovering which problems are the most valuable to solve and which problems you are best equipped to attack. To quote from the song from another section:

jobs are a means, not the ends in themselves
people work to live better, to put food on the shelves
real growth means production of what people demand
That’s entrepreneurship not your central plan

The great failure of keynesianism, of which the broken window-style nonsense is a symptom, is it’s methodological reliance on aggregation that make it possible for keynesians to pretend that stimulus doesn’t require central planning. It really does matter where the spending goes. That they focus on aggregates is just a mistake, not a legitimate reason to hand-wave away the sectoral concerns.

And so we get talk of the “design” of the stimulus, which gets closer to acknowledging the central planning aspects of the enterprise. But what truly exposes this deeply embedded assumption is the problem of regression once the stimulus is stopped (or the glaciers repair the windows after the hurricane). What now? Are all of those projects profitable? If they were, then government appears to be a good business, hence central planning should work. If those stimulus projects aren’t self-sustaining, they were fake bubble blown by the planners and nothing more. They were just more waste and debt.

The fact is, it’s HARDER to be an entrepreneur in a bust, and that’s true for the planners too. If you believe that the administrators of a stimulus can somehow identify opportunities to employ all these slack resources in a way that is sustainable and profitable, you surely must believe that those planners should keep on planning in good times too.

Methinks1776 August 30, 2011 at 10:06 pm

*LIKE* ^1000

Don Boudreaux August 30, 2011 at 10:51 pm

Spot-on!

vikingvista August 31, 2011 at 12:24 am

“The process of economic growth is no different during a so-called “recovery” than during any other time.”

Nail meets head.

Slappy McFee August 31, 2011 at 9:38 am

Wow — this John guy really should make a rap video. ;)

GiT September 10, 2011 at 10:14 am

Does everyone responding to DD realize that they are not refuting anything he wrote?

Notice how he ended his post?

“The argument against stimulus then comes down to whether it’s feasible at the margin for government to produce socially beneficial public goods & services, whatever that means”

And now, you are all arguing that government cannot do this. Which is fine. But it means you’ve jumped over the ability to use the broken windows fallacy and have had to commit yourselves to a substantive disagreement about what governments can and can’t do relative to markets, because if government could improve on a market allocation, then redistribution would not decrease wealth.

Clearly, you have good reasons for not buying the ‘if’ part of that syllogism. But, also quite clearly, those reasons are not elaborated in the broken windows fallacy. And that’s all DD was saying.

LAD August 30, 2011 at 2:41 pm

A subtle corollary to the broken window fallacy is that it’s not an even transfer from the butcher to the window repairman. As you describe in your post, the change in demand causes price changes. But those price changes result in a reallocation of inputs that is less efficient than the pre-storm allocation of inputs. For this reason (in addition to the fact that we’re using resources to build something we previously had), there is a net loss from the storm, not just a transfer of resources.

SweetLiberty August 30, 2011 at 2:58 pm

Russ –

I appreciate your retelling of the broken window. It demonstrates well the redistribution of wealth from the homeowner to the glazier. Money isn’t lost, simply transferred. And I agree that charity is more efficient than actually breaking the window because charity reduces the time the homeowner is without a window to zero, and it also does not consume the resources to make a new window, including the labor time of the glazier. It makes sense that it is the time and resources that are important here – not the money which simply changes hands.

Also, to the point of kyle8, purposefully breaking windows creates an artificial demand for glaziers – a mini-bubble if you will – that cannot be sustained unless windows are continuously broken. Therefore, if there are more glaziers than are needed for normal maintenance and development, many of those unemployed would be better off doing something in greater demand. But right now, in this economy, many entrepreneurs are having a very difficult time keeping their doors open as anticipating actual demand is complicated by so much uncertainty. And even if you could identify that the world demands more software developers for example, not every glazier can perform the mental gymnastics necessary to becoming a computer programmer.

So if breaking windows isn’t the answer, and charity isn’t the answer, and not everyone can anticipate or retrain into something truly in demand, then where does that leave the 30 million or so unemployed?

kyle8 August 30, 2011 at 3:26 pm

The answer is simple, limit the job destroying actions of government, stop increasing business regulation at an unprecedented rate, stop introducing uncertainty into markets. Lower the high rates of taxation, stop borrowing and spending money that will result in more inflation. Stop attacking the business and energy sectors, stop talking down the economy. Allow energy sources to be utilized.

This recession is almost entirely caused or aggravated by actions of government. Left on it’s own, economies will quickly rebound from corrections.

SweetLiberty August 30, 2011 at 3:56 pm

Kyle,

Oh, sure, if you actually want to work on solutions to fix the problem then we should do as you suggest. But dream on!

You’ve been given a true or false question: Destroying and rebuilding is better for the unemployed than giving them direct charity (T or F)?

Your solution isn’t even on the test (especially if Obama gets a second term).

P.S. Also on the test: I’ve beat my wife harder today than yesterday (T or F)?

vikingvista August 30, 2011 at 5:08 pm

F. I beat her exactly the same amount.

SweetLiberty August 30, 2011 at 5:41 pm

You bastard!

vikingvista August 31, 2011 at 12:27 am

Geez, man. You’d think I killed Kenny or something.

kyle8 August 30, 2011 at 5:22 pm

I reject your reality and substitute my own.

Mesa Econoguy August 30, 2011 at 6:12 pm

Great show – MythBusters.

ArrowSmith August 31, 2011 at 3:46 am

Yes we’ll retrain 30 million unemployed useless people into scientists & engineers.

John Sullivan August 30, 2011 at 2:59 pm

The real fallacy is to measure economic activity, such as its affect on wealth, from the perspective of a producer rather than from how it affects the consumer. The “broken glass” fallacy belongs in that broader category.

Wars, natural disasters, and protectionist interventions all cause prices to rise. Living standards are measured by what money can buy for consumers, not from how some producers are affected by events.

kyle8 August 30, 2011 at 3:29 pm

Correct, add to your list the effects of tariffs and trade restrictions. These cause poverty by literally raising the cost of everything you buy.

John Sullivan August 30, 2011 at 3:41 pm

The term ‘protectionist interventions’ covers those, but thanks. All legislation reduces competition in one way or another, even if it is just to misdirect capital, and always results in a loss of total societal wealth.

Kevin H August 31, 2011 at 8:18 am

The enforcement of contracts reduces societal wealth? You really think we’d be better off without any regulation?

vikingvista August 31, 2011 at 3:50 pm

When you start to realize how regulations naturally arise among free people in a society, you start to see how a centralized regulatory regime is not only unnecessary, but counterproductive. It is the latter, rather than the former, which promotes chaos.

This is the revelation in Friedman’s talk about natural free market regulations, or Nock’s conception of “government” as opposed to “state”.

Thomas A. Coss August 30, 2011 at 3:09 pm

The beauty of the “trades”, carpentry just being one component, is that one can participate in the trade with minimal formal education and hence the rub. It isn’t about keeping carpenters busy, its about addressing the growing need for new skills beyond a high school education. That is, for example, can you take a carpenter and teach them SQL programming? If not, why not?

We’ve skipped over secondary education hoping that colleges will fill fix things, which makes a large presumption that everyone should go to college. What is one to do if they are not gifted in the test taking skills college requires?

kyle8 August 30, 2011 at 3:32 pm

One could make the case that we put way too many people in college, due to government involvement. We actually have a glut of college educated people in all but a few areas of industry. But we have a lack of trades to the extent that we allow or encourage the yearly importation of hundreds of thousands of low wage workers.

SMV August 30, 2011 at 9:16 pm

Why would allowing more people to enter the US cause fewer people to go into trades. Wouldn’t more people result in greater total demand for housing and require more people in the trades?

kyle8 August 31, 2011 at 7:00 am

you miss my point, the demand for trades is so high because we pushed more people into degreed areas. The immigration is used as a way to partially fill this demand.

JS August 30, 2011 at 3:35 pm

If people are uncompetitive at mental work, they’ll be limited to manual labor, although it could be of the types requiring high skills.

Keep in mind that the ‘consumer’ doesn’t care about the particular needs of the producers, or their circumstances. It is up to the producers to adjust their ‘actions’ to what satisfies the consumers, not the other way around, although, through the force of politics, it often gets turned around. The entitlement mentality is the result.

It is vain for a producer to expect compensation for not satisfying the desires of his fellow man. Making a living should not be viewed as separate and distinct from servicing your fellow man. You can’t dig a ditch in your backyard and expect someone to pay you.

People are generally valued by what service they provide others in society. The market place establishes that value and compensation is dervived from it. Compensation isn’t an accident, or a right. In a free market, it is ruthlessly accurate. Many people don’t like the compensation that the consumers have awarded them. They believe that their contribution is greater than what consumers assign to them.They prefer to use politics as a means to bypass consumer sovereignty. They claim that the consumers have values that award the wrong type of people at their expense, and they seek redress through legislation.

indianajim August 30, 2011 at 3:44 pm

You seem to have a romantic vision of carpenters as typified by this:
http://www.youtube.com/watch?v=djY6P4xjTbc

Slappy McFee August 30, 2011 at 3:42 pm

Ok, I’ll play Yasafi until he gets here.

How important is the unseen?

Sure my life is better with Plasma TV, the internet and riding lawn mowers, but would I know it was worse had these things never existed?

Who is happier – the man that dreams and wishes of flying cars but never gets them or the man without the capacity to think of such things?

Richard Stands August 30, 2011 at 11:43 pm

To each his sufferings: all are men,
Condemned alike to groan;
The tender for another’s pain,
The unfeeling for his own.
Yet ah! why should they know their fate?
Since sorrow never comes too late,
And happiness too swiftly flies.
Thought would destroy their paradise.
No more; where ignorance is bliss,
‘Tis folly to be wise.

Thomas Gray

SweetLiberty August 30, 2011 at 3:42 pm

Thomas,

That’s one of my concerns as well. During most of human civilization (and certainly before that), having a high I.Q. was nice, maybe even gave you a leg up in some areas, but wasn’t as necessary to making a living as physical aptitude. Now, as society shifts into the technological era where science, engineering, software, and robotics become skills in greater demand, replacing the traditional craftsman or manufacturer, where do those born with less natural aptitude (or perhaps never given the right education from public schools) fit in?

It seems conceivable that their will evolve a tipping point where many of those born with below average I.Q.s will be displaced by the automated world. Will government invent work for these people that doesn’t really need to be done so that they can feel productive, or simply have them rely on charity? Or maybe pharmaceuticals will advance to create an intelligence enhancement drug in which case we can eradicate all those will inferior intelligence – you know, the liberals.

kyle8 August 30, 2011 at 5:28 pm

As societies increase in wealth, they also drop in their birth rate. Indeed, were it not for continuous high immigration the USA would not be at replacement levels. So the problem sort of takes care of itself. As the need for menial labor decreases so does the supply (again minus immigration)

As formerly poor nations continue to grow wealthier their birth rates similarly decline.

SweetLiberty August 30, 2011 at 5:43 pm

Yes, but a smaller birth rate doesn’t help raise the average I.Q.

vikingvista August 31, 2011 at 2:50 pm

1. Growing economies also have growing demand for human services which do not require high IQ (delivery services, housekeeping, security, many others now, many others not yet imagined).

2. The process of automation decreases the cost of living for all IQ levels, while simultaneously freeing human resources for a growing service industry.

3. A drug can’t enhance something that doesn’t exist.

simon... August 30, 2011 at 3:49 pm

There is one way in which Hurricane “broken windows” is better then Government “charity” – it doesn’t create regime of uncertainty the way politically-driven Government actions do.

Frank33328 August 30, 2011 at 4:02 pm

The key to the argument seems the gentle statement “[b]ut people are sitting on money that is doing nothing.” If the money is truly doing nothing and will for a long time continue doing nothing then does the Keynesian argument have a point? Or does taking money out of circulation result in monetary deflation without impacting employment or productivity? I keep thinking back to Dr. Boudreaux’s point that we’d be better off in global trade if foreigners never used the dollars that they earn from US trade (I hope I got that right) and see that as a case where “money … is doing nothing” albeit it would be doing nothing overseas. I shoulda studies economics…….

Sandra August 30, 2011 at 4:29 pm

“Sitting on money that is doing nothing” is what is wrong here. The whole concept of banking is invented so that money always gets used, not just kept and stored. The reason of why is money sitting and doing nothing should be investigated.

And there must be some other business opportunity around other than repairing broken windows..

Methinks1776 August 30, 2011 at 4:52 pm

Sandra, we’ve got two massive peaces of legislation that will add untold costs – Dodd-Frank and Obamacare. We already know that Obamacare will increase taxes starting in 2013, but since most of the regs in both Dudd-Frank and Obamacare are as yet unwritten, businesses aren’t able to assess future costs. If you can’t project costs, you can’t project the profitability of new projects.

In addition, with fewer businesses resulting from bankruptcies since 2008, regulators are starved for money and have been harassing the remaining companies that have been trying to hang in.

Companies are always trying to make money. And you have to invest to make money. Other than rent seeking, there’s no other way to turn a profit. But, you’re not going to invest if you can’t make sound projections and you’re certainly not going to invest, even if there is demand for your product, if you know costs will increase with increased regulation but you have no idea how much. Worse, that which is known increases costs quite a lot.

Dan J August 30, 2011 at 11:37 pm

Sandra, we’ve got two massive peaces of legislation that will add untold costs – Dodd-Frank and Obamacare. We already know that Obamacare will increase taxes starting in 2013, but since most of the regs in both Dudd-Frank and Obamacare are as yet unwritten, businesses aren’t able to assess future costs. If you can’t project costs, you can’t project the profitability of new projects.- methinks

Yes! Yes! Why in the hell would anyone risk the cash when a new rule can be implemented tomorrow without having to go thru congress and scrutiny?
Also, money is borrowed for freeeeeeee. Rates need to be raised. Making any borrowed money not put to use have losses in interest payments.
Obama promises higher tax rates beyond those in the Obamacare…. Beyond the ‘necessary skyrocketing’ energy from EPA rules and regulations meant to bankrupt coal plants, shut down the oil pipeline from Alaska (killing oil production in Alaska), etc,….. The list goes on.
This admin and it’s appointments are not just anti-business, they are against growth overall. Their ideas are american dream killers.

SweetLiberty August 30, 2011 at 5:58 pm

“The whole concept of banking is invented so that money always gets used, not just kept and stored.”

I think our current banking system was invented so that bankers could profit from lending other people’s money and protect themselves from poor decisions by government mandates. If I desire to store my money under my mattress, the money IS getting used, by me, in a manner I so choose. So is the bowling ball in my closet or the car in my garage.

Storing money used to be called “saving for a rainy day” by our grandparents. Now, it’s called hording and damaging the economy.

Current banking seems to be a flawed system accepted as the norm, but I don’t think it would survive the free market test were it to stand alone without government backing. Who in their right mind would give one investor 90% control of their savings to invest as they saw fit without even examining their track record of success? Yet, that’s what we do every time we make a deposit. Why? Because if the banker fails, the government bails them (or us) out – freeing us from caring and rewarding risky investments with little consequence.

Economiser August 31, 2011 at 10:03 am

I would love to see free banking. Removing FDIC insurance would go a long way towards diminishing the power of the “too big to fail” banks.

vikingvista August 31, 2011 at 3:01 pm

To invest, while simultaneously promising all depositors that they can withdrawal all of their deposits essentially at any time for any reason. Except for banks, people tend to avoid service companies that promise the patently impossible. The government sanctions that impossible promise and then harvests its citizen slaves to try to make it work.

Eran August 31, 2011 at 10:02 am

The myth of “sitting on money” needs to be addressed directly. As I see it, money is too often confused with wealth. Money represents potential claims on wealth, but isn’t wealth in itself.

Set aside the question of whether banks lend money deposited in them or not. Even if the banks truly “sat” on their depositor’s money (or if people chose to hold cash under their mattress), the economy wouldn’t suffer.

Money being “sat on” is out of circulation. It represents a marginal drop in the velocity of money, and consequently has a small deflationary effect. In the short term there is no difference between Bill Gates choosing to bury $10,000,000,000 in cash in his back yards, and the Fed actively reducing the money supply by the same amount. In either case, no real wealth is lost or wasted. Rather, with less money chasing after the same supply of products, the price of those products will tend to decline, and those people who do want to use their money will find it going further.

vikingvista August 31, 2011 at 3:16 pm

The nonuniformity of central bank monetary deflation works the same as inflation, and so it creates winners and losers in the same way. It is effectively the same thing with the good whose value is being bid down via increased market supply by the central bank being USD during inflationary policy, and assets (usually t-bills) during deflationary policy. Either way, the effects propagate over time through the economy like rippling waves with the early wave riders faring differently than the later ones.

The important difference between Gates doing this, and Bernanke, is that Gates is only capable of doing it through a series of market coordinated activities that universally satisfy human wants. Bernenke can do it by fiat.

Sam August 30, 2011 at 5:25 pm

Was thinking about this the other day and wondered if the illustration might be changed to isolate the loss from all the external complexity.

Imagine that, before finding out that his window would need to be replaced, the shopkeeper had intended to create a piece of art that coincidentally required a piece of glass identical to the one that was broken. With the money he was going to use to buy the glass for the artwork, he instead buys the exact same piece of glass to repair the window.

Everything is exactly as it would have been, execpt that the world is out one piece of artwork.

Economic Freedom August 30, 2011 at 5:26 pm

But that is good for all glaziers, employed and unemployed. It pushes up the price of glass repair. That discourages some folks from having glass work done who otherwise would have done it.

“No problemo” says the Keynesian-Interventionist. “Just implement price controls!”

Methinks1776 August 30, 2011 at 6:00 pm

No problem. That’s the next step. From Goldman’s report on what it expects from the Jackson Hole meeting:

There are three main ways in which the Fed could be more radical: (1) an extension of the QE program into markets other than Treasuries and agency MBS, e.g., private sector securities, (2) a much bigger QE program, up to the extreme version of a promise to buy as many securities as needed to hit a specific yield target (i.e. a “rate cap” further out on the yield curve as then-Governor Bernanke suggested back in 2002), and (3) an explicit or implicit change in the Fed’s policy targets.”

http://www.zerohedge.com/news/goldman-presents-three-radical-measures-fed-may-engages-turbocharge-imminent-qe3

Mesa Econoguy August 30, 2011 at 6:27 pm

Ask and ye shall receive, as we learned from today’s 8/9 Fed minutes.

JPM now says

“We believe the minutes lend themselves to our view that there is a somewhat better-than-even chance the Fed takes action at the next meeting [Sep 21] to increase the average maturity of assets on their balance sheet. ”

http://www.zerohedge.com/news/according-jpm-there-now-better-even-chance-fed-action-september-21

Add to this the “disturbing” (-R. Santelli) comments of Chicago Fed President Evans this morning denying any causality of QE2 spurring commodities inflation and price spikes, and calling for additional easing, promptly causing a $40 instant spike in gold, and you’ve got a super-duper radical Fed right at your doorstep.

Methinks1776 August 30, 2011 at 9:16 pm

And who doesn’t love a vicious stock market rally on 50% of the normal daily volume in anticipation of more of that heroin the Fed is dealing? We’re in another round of “good news is good and bad new is better”. After all, if the Fed thinks the economy is in the tank, it’ll have to fire up the printing presses again, right? Gotta make sure the pig is sufficiently lipsticked.

Speaking of which, Europeans are literally lipsticking PIGS.

Methinks1776 August 30, 2011 at 9:21 pm

Actually, just lipstick isn’t doing it for the PIGS. Those oinkers have required full cadaver make-up and they still look dead.

Richard Stands August 31, 2011 at 12:00 am

So they’re considering doing a full-Mugabe?

Methinks1776 August 31, 2011 at 9:16 am

It seems Gideon Gono is Bernanke’s hero.

Mark T August 30, 2011 at 5:30 pm

I would say something similar just phrased a little differently:

Repair work can never constitute “growth” in any substantive sense. Repair work only puts you back where you were before the damage. That prevents a decline in economic activity, perhaps, but it isn’t “growth”. If you simply repair things more often, that extra activity may be recorded as “growth” but it’s just inflation, really – the cost of keeping the same asset is just bigger than before, but it’s still the same asset. Any description or tabulation of economic activity that treats increased repair work as if it were growth is just wrong.

kyle8 August 30, 2011 at 5:32 pm

Now that is a great idea!
http://mises.org/books/fortycenturies.pdf – Forty centuries of price control failure

Slocum August 30, 2011 at 7:58 pm

The way I would make the Keynesian case is this. There may be *multiple* patterns of sustainable specialization and trade, just as there may be multiple evolutionarily stable strategies (which, I assume, is where Kling adapted the idea). But not all stable strategies are equally good.

We could imagine one stable pattern where everybody was extremely risk averse and very cautious about buying anything more than they really needed to survive. And we could imagine another sustainable pattern where people were optimistic, tolerant of risk, and willing buy (and specialize in producing) all kinds of ‘frivolous’ goods and services. I think it’s pretty clear that the second stable pattern is the better one to live in — richer, more interesting, more dynamic, etc.

Now what if an economic downturn happens that is severe enough to ‘shock’ the population into switching from the ‘optimistic’ PSST to the ‘pessimistic’ PSST? How do you get people back to operating in the former ‘expansive’ mode–becoming rich again by buying and specializing in producing lots of things that are valuable and enjoyable, but not truly necessary? How do you turn penny-pinching ‘children of the depression’ back into free (or at least freer) spenders?

That, I believe, is the problem Keynesians are trying to solve. I don’t think their methods actually work (especially when the deficits they’re running up are terrifying people and inducing even more caution — likely making the problem even worse), but it’s not a simple case of not understanding the broken-windows fallacy.

Kevin H August 31, 2011 at 8:39 am

Like. While I don’t necessarily agree with your last paragraph, it does identify what I believe is the actual point of contention.

I haven’t found any arguments against stimulus on this blog to be particularly persuasive. They all seem to rest on either ignoring all nuance in the Keynsian argument or willfully ignoring the facts on the ground.

I’m inclined to accept the stimulus argument in theory (which I think you laid out very concisely) but I’m open to the possibility/liklihood that it may not be possible to impliment in practice.

I

Economiser August 31, 2011 at 10:18 am

Very very few people are satisfied with only the bare essentials. The few who are tend to embrace a specific lower standard of living for cultural/religious reasons (e.g., the Amish). Even those folks don’t live on the MINIMUM possible; they don’t regress to a hunter-gatherer society. The vast majority of people seek improvements to their material standard of living, making such central planning unnecessary and harmful.

Also, if people choose to embrace a lower standard of living, that’s no business of the government’s. A nation of only Amish people shouldn’t be forced into other patterns because of a central planner’s goals.

GiT September 10, 2011 at 10:24 am

And here you’ve made an empirical case for a substantive claim about reality in order to establish or refute the truth conditions for a proposition.

You have not demonstrated a logical fallacy. So, when disagreeing with with people because you think that societies never get stuck in sub-optimal equilibria, say that you disagree on evidentiary grounds, don’t claim a fallacy that doesn’t apply.

Andrew_M_Garland August 30, 2011 at 8:20 pm

The practical effect of a free, capitalist economy is to provide what people want, to the extent that they can arrange mutally satisfactory trades. I can trade for the things which are most valuable to me, within my ability to exchange goods for those things. The consumer is king. The producers have to offer what consumers want.

People without jobs (or with jobs paying less than they want) have not found a way to be productive at the moment, or for weeks and months. They should not be able to say, individually or through government, “I will force you to buy what I want to produce, even if I am paid for doing nothing.”

When Keynesians complain about “inadequate demand”, they point to the unemployed and ask that the government force consumers to indirectly buy what those consumers don’t want. Keynesians take taxes or take value from the money supply (print money), then spend that value to employ favored groups. That employs those groups for a while, then leaves them unemployed in a society which has become poorer. It is an unsustainable program within a downward spiral.

Our current financial difficulties have come largely from government directing the massive production of housing which people could not pay for, under the theory that building anything is good. How could real things lose value? Marxist/Keynesian theory says that things have an intrinsic value from the labor used to produce them. Our current situation is a massive economics experiment to resolve that issue (although it was long ago resolved). In reality, those houses did not retain their value because massive numbers of “buyers” could not pay for them.

The first act of a Keynesian is to steal value from some or most people. Then, he plays Mother Theresa when he hands out the money to the grateful recipients. It is not relevant that he creates some good, when his program starts with a theft.

The final Keynesian argument is that, despite the theft, he creates more value than he stole. This is like a bankrobber claiming that at least he enjoyed the money, rather than let it sit there in the bank.

If the 1935 economist Keynes were correct, then all would be glorious. Unfortunately, the Keynsian multiplier is a mistake, counting transactions as if the entire value of each transaction creates wealth instead of merely valuing or identifying wealth.

If there were a multiplier such as the 1.5 multiplier claimed by the Obama team, then we could Counterfeit Our Way to Wealth.

hee snaw August 30, 2011 at 9:48 pm

Don,

Never comment on here. However as young’un considering majoring in economics, I want to submit that this is the most useful econ-oriented blog post I’ve read this year. After reading Cafe Hayek for a few months (and applying to and then attending an IHS seminar as a result!) I admit you’re a wee bit of an inspiration. Thanks.

hee snaw August 31, 2011 at 7:22 am

My bad, Russ. Mistaking the author doesn’t change I love this post.

Dan J August 31, 2011 at 2:01 am

That post was great. Well executed. Left little room for assumptions and misinterpretations while covering all the bases for why the hurricane will not spur economic growth.

Antonio Mendes August 31, 2011 at 3:06 am

The microfoundations are not useful in this debate. In a credit-based economy like ours the money does not need to come from somewhere. It can be created out of nothing, provided that there is confidence.
The unfortunate circumstance that politicians often only act on crisis situations makes the disaster-led expenditure more mobilizing.
However the expenditure multiplier can be put to work with many other types of expenditure as you can see in my post here: http://marques-mendes.blogspot.com/2011/08/government-stimulus-and-expenditure.html

ArrowSmith August 31, 2011 at 3:44 am

Why are we still arguing this crap? IT’s obvious to anyone with a 3rd grade education that activity != wealth creation.

vikingvista August 31, 2011 at 3:21 pm

Yep. It takes a PhD in economics to obfuscate that fact. Given enough education, I’m sure a third grader could also be eventually convinced that 2+2=5.

Methinks1776 August 31, 2011 at 8:44 pm

This is interesting. I employ the services of a housekeeper who had a hellish childhood in El Salvador. As a result, she has never attended school for even one day.

Yet, she understands this simple concept that seems out of reach for so many economics PhD’s.

Incidentally, she runs her own cleaning business and she reads and writes in two languages. In other words, she’s smarter, more productive and a bigger inspiration than most highly educated economists.

vikingvista August 31, 2011 at 11:49 pm

She managed to escape the Ministry of Truth.

GiT September 10, 2011 at 10:37 am

One would hope it might be obvious to anyone with a high school education that

A =/ W (Activity is wealth creation)

is not logically equivalent to

If A then W (Activity causes wealth creation)

is not logically equivalent to

If A and L and C, then W.

(Activity, given a Liquidity Trap and Various Other Conditions), causes wealth creation).

Is not logically equivalent to

If A and L and C then E

(where E is a beneficial change in rational expectations)

If E then W

(If a + change in rational expectations, then an increase in wealth)

therefore

If A and L and C, then W

But apparently many are still stuck in primary school, banging their heads against arguments no one is making, claiming the existence of logical fallacies without understanding the logical structure of the argument they’re confronting, and mistaking their own considered assumptions about the truth value of propositions for severe idiocy on the part of perfectly intelligent and rational people who disagree with them on /facts/, not basic logic.

OneTrickPony August 31, 2011 at 5:29 am

Finally CH is stepping out of the darkness and we are getting somewhere here.

Now the only difference between you and a keynsian point of view is that keynsians think the unemployment is all over the board because the interest rate is above the market clearing rate of full employment. Although interest rates are at record lows for quite some time already! Liquidity trap.

So we end up with an empirical question whether unemployment is really all over the board and not-structural. Or structural?

Awaiting a follow-up post by you Russ.

Methinks1776 August 31, 2011 at 7:53 am

In college, I learned about that liquidity trap in my macro class. I learned to blame all kinds of complicated things on simplistic and childish, but easy to understand Keynesian explanations that ignore most of what’s going on because most of those other things require would be central planners to sit back and get out of the way.

You cannot claim a liquidity trap when the central planners are raising taxes (skewing the risk/reward ratio by reducing reward for a given level of risk) and jacking up regulation and expensive legislation (raising the risk for a given level of reward along with expenses).

There is no evidence that interest rates are above the market clearing rate because, despite the Fed’s attacks on various parts of the curve, the market sets the interest rate. That’s the lesson of QE2, the Twist, etc.

OneTrickPony August 31, 2011 at 9:29 am

I see… simplistic, childish BUT easy to understand… Weird.

I would say simplistic BUT easily misunderstood as childish

But on topic:
What you are saying is that this unemployment (that is lasting for some time now) is structural.

I hope you are wrong.

Methinks1776 August 31, 2011 at 10:55 am

Yes, simplistic explanations are easy to understand even if they are completely wrong. Is this difficult for you to grasp?

I’m not saying unemployment is structural. I’m saying that you have no evidence we’re in a liquidity trap.

I see you’re Keynes’ target audience.

OneTrickPony August 31, 2011 at 1:23 pm

No evidence? I rest my case. Bend the defenition of Liquidity trap as much as you like but it will not change reality.

Dan H August 31, 2011 at 2:07 pm

The minute we get into an actual “liquidity trap” (which i don’t believe in) is the minute I launch a website where businessmen can exchange contracts for goods and services without the necessity of money until prices stablize. (Holy shit… light bulb!)

Methinks1776 August 31, 2011 at 3:35 pm

Well, I can see why JPM trading hired you, Dan H.

vikingvista August 31, 2011 at 3:59 pm

Dan, your good idea is a perfect example of how economic fallacies like those afflicting keynesiacs rely upon ignoring counterveiling economic forces. What appears to the keynesiac as a pathologic equilibrium condition provides the incentives for its own correction, if people are left free to follow those incentives.

Dan H August 31, 2011 at 4:05 pm

Thank you Methinks! Though I’m not technically on the trading side of JPM yet – any trading I do is done on my own time with what little capital I have – some are starting to take notice and I could very soon be trading for them. I told one manager how I turned $2,500 into $25,000 in 6 months using minimal leverage and the next thing you know people are asking for my resume. Some traders have even been trading on my tips. :-)

But the point stands. For every perceived macroeconomic problem, there are a multitude of minds that see microeconomic solutions. For instance, I have a friend whose father seeded a venture that – if successful – will increase the liquidity of the housing market without the necessity of distorting prices through GSEs. I’m seriously considering running with my idea as well. Maybe as an additional application on Linkedin? Who knows. But people like myself and my friend’s father see problems as opportunities. The keynesian central planners cannot predict entrepreneurship and innovation.

Methinks1776 August 31, 2011 at 9:16 pm

Dan H, whether you develop a trading strategy and build a business around that or you find some other venture, you obviously will find success in something.

What prompted my comment was your lack of willingness to buy into myths (very likely because you can think things all the way through) along with an understanding of how to operate in a changing environment. Setting up bizarre scenarios that not only test people’s understanding of theory, but also their ability to cope with a changing environment is a huge part of my interview process. I’m far more impressed with the way your mind works than your track record because, knowing nothing about your strategy, I don’t know if that return is due to skill or luck. You’ll be very successful in something. I’m sure of it.

If it’s not too much information to reveal on a blog, what part of JPM do you work in?

Dan H September 1, 2011 at 7:56 am

I just graduated college last year. Actually, I began working on a venture of my own with some money I had saved up. I got to the point where I was ready to launch the product, but I needed some angel capital. After months of hitting up every rich guy and angel group around my area – and failing at getting any capital – I began looking for a job, and I found one at JPM. My position is what I would consider “entry level” for a recent college grad. For JPM, I work in one of the many transfer agencies and I’m in quality control. It’s not bad, but it’s not dynamic enough for me.

The annoying part about my seeking capital for my business is that I got the feeling that what I was offering was such a break from the status quo that people were weary of it. The common response was “Well, yeah, I mean that would save our HR departments a lot of money. But, I mean, then they’d have to lay off half of their HR people and that’s never good for publicity. And your concept just seems so, I don’t know, competitive. You’re making recent graduates compete against each other in such a cut-throat way”. I found that there are more James Taggarts in the world than Midas Mulligans or Henry Reardens. It’s a damn shame.

Also Methinks, I just bought a ring for the future Mrs. Dan H, so chalk one up for Russian brides!

Methinks1776 September 1, 2011 at 8:26 am

Dan H,

We all had pretty crappy entry level jobs on Wall Street as fresh graduates. At least you don’t work 100 weeks and pull all nighters in the back office. Also, it’s not at all unheard of for bright and motivated back office staff to make it to the front office.

Maybe things have changed, but competition among college students for jobs in I-banking and trading was vicious in my day. There were the famous stress interviews where the interviewer would ask you to open windows that were sealed shut or simply silently stare at you.

You’re going to fail a million times. Successful people accept that as part of the journey to success. Find the people who are entrepreneurial and appreciate people whose minds are wired the right way. In other words, avoid investment bankers and stick to traders – and not the wild, swing for the fences types who don’t understand that just taking huge risks is not skill. You’ll have your most loyal and least annoying backers from that group and it’ll all be word of mouth.

Good luck with your wedding! I hope you’ll be very happy. Russian women tend to be very opinionated and stubborn, but the upside to that is you’ll never be forced to guess what your wife is thinking!

BMan August 31, 2011 at 7:07 pm

As a consultant to FEMA, I have done literally hundreds of benefit-cost analyses for state sponsored, federally funded, hazard mitigation projects — i.e., the levees, culverts, braces, stilts, etc that reduce the damage from future floods, windstorms, and earthquakes. Invariably, state officials want to know how many jobs will be created by these efforts to mitigate future damage. If I’m in a playful mood, I tell them that the project will create as many jobs as it would create if there was no such thing as an earthquake or storm (thus making the project pointless). Unfortunately, however, because there WILL be future disasters, the mitigation project will eliminate some of the jobs that would have been associated with those disasters. Mind bending.

Actually, the argument state officials could readily understand (and there is considerable truth to it) is the following. Both disasters and the effort to avoid them can bring real resources to your local economy. However, those resources are coming from other regions: either those who are responding to your disaster, or those who are providing funds for your mitigation projects. Because FEMA is a federal agency, it regards those as transfers, rather than benefits. The only benefits that can be counted for a hazard mitigation project are the (net present expected value of) avoided future real-resource costs.

Herman September 1, 2011 at 12:58 am

+1

Invisible Backhand August 31, 2011 at 9:26 pm

It’s called unemployment insurance. I know, it’s supposed to be stimulative but there’s no sign that it is.

Economists Agree That Unemployment Benefits Have A Strong Effect On Job Creation And Growth

http://mediamatters.org/research/201108310027

Methinks1776 September 1, 2011 at 8:28 am

I am convinced that paying people to be unemployed creates jobs and prosperity. Thus, I think we should all stop working and sign up for unemployment. Our GDP and personal welfare should increase by tenfold in no time at all.

alcan September 5, 2011 at 11:15 am

Kyle,

i will take your point a bit farther. I am a small business owner and for the last few years have experienced huge demand. We have added capacity and could easily add more except for one thing: labor. We operate in Alaska and it is very difficult to draw workers up here. IN my opinion the main differences between now and 1981 say or 1930 even are that there are too many disincentives for workers to relocate or work in other fields. It is not a big sacrifice with extended UI to sit around, that is obvious, but even those people who would be inclined to relocate are not going to do it to take jobs they are not trained for. We cannot raise wages high enough to attract these people (who may have college educations but to be truck drivers they are unskilled) because they are not useful (yet).

that is one problem with the stimulus spending as well, if you are talking about infrastructure. In construction type industries (at least here and on the west coast), every good man has a job so you will just pull those guys away from industries doing useful work

TallDave September 6, 2011 at 12:20 pm

Exellent piece, Russ, thanks for sharing.

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