Wednesday, March 31, 2010

A Video about "The Broken Window Fallacy"

The fundamental principle of macroeconomics is the same as the fundamental principle of microeconomics--scarcity.

A general glut, an output gap, and involuntary unemployment are interesting and important because of scarcity. Many macroeconomic fallacies result from the false notion that the key economic issue is finding things for people to do rather than effectively allocating resources to produce what people want most. The disruptions caused by monetary disequilibrium are problems because they interfere with the market processes that embody the most effective social response to scarcity.

Frederic Bastiat did a great job in exploding fallacies and explaining how scarcity is really the fundamental economic issue.

The video comes from the Atlas Foundation.

In Charleston, South Carolina, we have the Bastiat Society. I strongly recommend the monthly meetings. Lately, the meetings have been at the Harbor Club.


  1. Hi Bill,

    I posted the following argument over at Coordination Problem. I am curious to find out your response:

    "Are there any conditions in which a natural disaster (or similar destructive event) could be economically beneficial? I do not mean to defend the mistaken reasoning of those quoted in the video, but merely to ask whether it is possible for a similar claim to escape the fallacy of the broken window. It seems to me that such conditions could exist, even though I suspect they rarely do.

    The primary condition is a monopolisation of the money supply. I suppose it needn't be a government monopoly, though it probably would be. The secondary conditions would a socialisation of the risk of owning money, and a failure to sufficiently expand the money supply to an increase in demand.

    Anything that lowers the relative risk of owning money will increase the chances of a sharp increase in money demand, because owning money is perceived as a safe alternative to other assets. Government monopolies socialise the risk of owning money: legal tender laws, deposit insurance, bailout precedents, and tax payment each ensure that money retains an artificially high demand. In other words, the risk of owning money does not rise and fall proportionally to the risk of owning other assets. Thus, present government policies intensify swings in the demand for money during times of panic and uncertainty.

    A more volatile demand for money requires more timely and accurate changes in the supply of money. However, central banking institutions popular with governments around the world are limited to extremely crude means of estimating the supply and demand for money. Even if central banks were capable of satisfying changes in money demand in a timely manner, none (so far as I am aware) make it their goal. In fact, most central banks ostensibly pursue modest inflation targets--a goal that can only be achieved by purposefully engineering monetary disequilibrium.

    These two conditions produce a situation favourable to the emergence of Keynes's "paradox of thrift." Since this is quite a controversial claim, perhaps I should further explain its rationale.

    What is true for a part of the economy may not be true for the economy as a whole. Although an individual may increase his savings by reducing expenditure below income, aggregate expenditure and income must be equal--one's expenditure is another's income, and vice versa. Thus, any change in aggregate expenditure must correspond to an equal change in aggregate income. Unlike an individual, it is impossible for the economy as a whole to reduce expenditure below income.

    If the economy as a whole cannot save by increasing cash balances (currency + checking accounts), then how can it save? For the economy as a whole to save it must reallocate resources from producing consumer goods to capital goods. This can be achieved not by reducing aggregate expenditure below income (which is impossible), but altering the composition of expenditure/income, i.e. reducing expenditure on consumer goods while increasing expenditure on capital goods. Although sellers of consumer goods see business decline and workers laid off, sellers of capital goods goods see business rise and workers hired, and the composition of aggregate expenditure/income is altered without any change to its total.

    It may be appropriate to distinguish between three economic processes by which expenditure (and resources) are reallocated between the production of consumption and capital goods. The first two are simple and uncontroversial, but the third may require more explanation. First, direct expenditure on capital goods instead of consumption goods (equity financing). Second, indirect expenditure on capital goods instead of consumption goods by purchasing bonds and the like (debt financing). In both cases, the composition of expenditure changes while the money supply remains constant.

    Continued below...

  2. "The third process occurs with financial intermediaries that offer transactions accounts and/or currency, and their reaction to an increase in demand for their money. For the sake of simplicity, I will hereafter refer to these financial institutions as banks.

    Although we call money placed in a bank account a "deposit," it is actually a loan to the bank. When one "deposits" into an account, one is relinquishing ownership of an asset in exchange for bank IOUs. An account balance is not a record of how much money a customer has "in the bank," but a record of a bank’s debt. Since bank customers do not frequently try to redeem all their IOUs at once, banks can operate successfully while holding only a fraction of total "deposits" on hand, and lending the remainder out to earn a profit. Although customers run the risk that they may be unable to redeem their IOUs if too many other customers decide likewise at once, they are compensated by the elimination of storage fees and perhaps the accrual of interest.

    Since customers' accounts do not decline even as new accounts are opened for borrowers, banks can lend money into existence. However, banks' money creation is constrained by the rate at which customers attempt to redeem their IOUs, i.e. spend money. When customers' aggregate expenditure rises or declines, banks can operate with a larger or smaller fractions of "deposits" on hand to satisfy redemptions. Therefore, if customers save money by reducing aggregate expenditure, banks experience fewer redemption demands for their IOUs, and are empowered to create more money through credit expansion.

    Assuming that people would prefer to lend out all their money which is not immediately being spent if the risk of not being paid back on demand were low enough, the expansion of credit by banks in response to an increase in demand for their services (checking accounts and/or currency) has equivalent consequences to increasing the expenditure on capital goods by purchasing bonds and the like. The money supply may expand in the former case and remain constant in the latter, but aggregate expenditure and its composition between consumer and capital goods will be the same. In other words, the only difference in relative prices between the two processes will be in the composition of expenditure on capital goods.

    Continued below...

  3. "Back in the real world, banks are not in a good position to satisfy changes in the demand for money with changes in supply, because governments operate monopolies on the money supply and regulate banks' money creation. By stifling a process by which saving is transformed into the production of capital goods and increasing the volatility of money demand, government have intensified the peculiar conditions necessary for the paradox of thrift to emerge.

    In an economy with an inflexible money supply and rapidly increasing money demand, total aggregate income declines faster than prices deflate; business profits shrink or disappear, inventories accumulate unsold goods, and workers are laid off. Although resources are "saved," i.e. released from their previous occupations, they are not reallocated to other ends, because nobody else as the enough money to purchase them at prevailing prices. A surplus of goods and labour develops. The seemingly rational response of tightening one’s belt during hard times actually exacerbates the problem by further reducing aggregate expenditure. If one’s increased cash balance is offset by another's increased expenditure, then there is no problem. However, the attempt to reduce aggregate expenditure below income is futile and actually impoverishes the future by creating recession in the present.

    Although there are numerable ways to resolve the systemic disequilibrium depicted by the paradox of thrift, including deflation and credit expansion, another is to decrease the demand for money. This is the approach offered by those who advocate for fiscal stimulus. If aggregate expenditure has fallen because of uncertainty, then money must be considered a relatively safe asset. The government can increase the supply of an alternative safe asset by issuing bonds. Savers who are unwilling to part with their money for anything else may be persuaded to purchase government bonds, and the borrowed money can then be immediately spent to stimulate aggregate expenditure. Whether one agrees that this is a worthwhile trade-off given other problems with fiscal stimuli is another matter.

    Finally, we now approach the thrust of my argument against the fallacy of the broken window. One way of reducing money demand is to destroy assets that people value highly, because while they may be unwilling to spend money on a new TV, they probably will be willing to spend money to replace a destroyed home or car. Although I would never advocate breaking windows as a means of resolving a disequilibrium in the money supply, it is possible that by destroying assets in the short run, money demand can be decreased and the economy more quickly brought out of recession. Thus, the long term benefits to "breaking windows" may exceed the short term costs.

    Sorry that was so long, but when one is arguing for a possible exception to the broken window fallacy, one must explain themselves."

  4. Why didn't the baker buy the suit before the window was broken?

    Simply because he didn't need it. His preference went for savings instead of a suit.

    Now that the window is borken, and he cannot do without, he is going to use the money to replace it.

    This is the context is which destruction is good for the economy.

    So the paraphrase John Maynard Keynes, Savings are destruction when the economy is in need for construction.

    The major flaw with your explanation is that you are assuming that the baker would have bought a suit, when he could have saved the money as well.

    Before the window was broken he had a choice between saving and consumption.But, after the window was broken he had no choice but consumption.

  5. Lee:

    I should read your essay again, but it seemed to me to be a good discussion of saving, investment, monetary disquilibrium, and the Selgin account of the free banking money supply process.

    I think it likely that when there is an excess demand for money, breaking windows will increase the nominal and real flow of income. I am not sure that there will be much of a multiplier. Why doesn't the shop keeper reduce expenditures in the future to rebuild money holdings?

    It would also be possible that the shopkeeper would work longer hours and bake more bread to replace the window. That would raise the flow of income as well.

    But leaving aside some multiplier, the shopkeeper is no better off.

    If the purpose of economic activity is to keep people busy, then breaking things and replacing them might do the job as well as anything. But if the purpose is to produce what people want, then breaking things is no solution.

  6. Africa:

    Perhaps the shopkeeper was leaving the store to get the suit at the very moment his window broke?

    Anyway, you say breaking the window is "good for the economy." The error is to assume that the purpose of economic activity is to give people something to do.

    The purpose is instead to produce goods and services that are useful to people. The shopkeeper is left with just a window.

    If the shopkeeper wanted to save, then what needs to happen is that someone else purchase a suit or else resources be used to produce a sewing machine.

    I think you rather naively identify saving with an excess demand for money. Well, an excess demand for money is certainly possible. And the solution to that is an increase in the quantity of money.

    Whether or not this happens, breaking windows doesn't solve the relevant problem--allocating resources to produce what people want most.

    Breaking things is always bad for the economy. That doesn't mean that there are never serious macroeconomic problems.

  7. "Why doesn't the shopkeeper reduce expenditure in the future to rebuild money holdings?" - Bill

    That is possible. My assumption was that money demand was higher than ordinary *because* of the excess demand for money, i.e. high money demand creates an excess demand for money, which then creates higher money demand, an even greater excess demand for money, and so on.

    My intent was merely to suggest that a situation may exist in which short term destruction is actually beneficial in the long run. Whether any situation in the real world actually corresponds to this hypothetical is another matter.