Sunday, March 15, 2009

Broken Window Fallacy

“One of the more enduring myths in Western society,” writes Mike Moffatt, “is that wars are somehow good for the economy.” Indeed, this myth is so prevalent and entrenched today that it has mutated into many other forms. Natural disasters, pollution, and various other economic ills, are all advanced as economic boons based on this same faulty logic. The underlying fallacy, as Mr Moffatt explains, “is an example of something economists call The Broken Window Fallacy.” While I do agree with his appraisal, I must disagree on the fundamental nature of the misunderstanding. The broken window fallacy is certainly one aspect of the problem, but I think the deeper misunderstanding is a failure of the scientisitic approach to economics. In this article I describe the Broken Window Fallacy as I find it best understood in hopes of laying the foundation to better explain the latter concern.

Bastiat’s Parable

The broken window fallacy is so named for Frederic Bastiat’s parable of the broken window, where a child having broken a window is hailed as having created economic activity by the onlookers, who all the while ignore the hidden opportunity cost of the broken window. Bastiat concludes that the flaw in the reasoning is that the onlookers only account for the “seen” (the broken window and consequent activity) and ignore the “unseen” (what would have happened had the window not been broken). For a look at this original formulation of the fallacy, I highly recommend Moffat’s article. However, I find the absurdity illustrated by the fallacy much easier to follow when described in the context of natural disasters.

Natural Disasters

One of the more popular variants of the broken window fallacy is that natural disasters result in economic growth. I remember when Katrina came around, there was no shortage of pundits (recent Nobel laureate Paul Krugman included) describing it as having created economic activity and growth, because, after all, rebuilding all the destruction will add to GDP! But was Katrina really beneficial? Imagine there is a city that is leveled by an earthquake. The residents then rebuild their city. This adds to GDP and is hailed as creating economic activity and growth. But is that an accurate assessment?

First, does it create economic activity? Well, of course it does; it is hard to argue that it does not. However, one must be careful not to reach false conclusions based on this. Doing so, as Bastiat would say, ignores the unseen. It is seen, and definitely true, that the destruction and subsequent rebuilding of the city creates economic activity. However, it is not seen what would have happened had there been no earthquake to begin. In the time the residents lost and rebuilt their city, they could have built a second city, or made improvements to their existing city, or done any number of other things they value. However, because of the earthquake, none of those happened, which is considerable lost opportunity. Thus, although the earthquake creates economic activity (the seen), it does so at the expense of other economic activity (the unseen).

At this point one might respond that the economic activity in response to the earthquake would far exceed anything that might have happened otherwise, especially if the economy was in a recession, where a shortfall of demand, so it is held in the Keynesian paradigm, is responsible for the decline in economic activity. The sophistry in this argument is clearly apparent when one realizes that, despite the economic activity in response to the earthquake, there has actually been no growth! While before there was a city, now, post earthquake, there is again a city and nothing more. Whereas, any economic activity in absence of the earthquake would result in the original city plus whatever was created in addition. Thus, the residents had to work extra hard just to break even.

The Keynesian misunderstanding here is that they do not understand the nature of wealth and economic growth. Real wealth is tangible, physical, goods. Money, as the medium of exchange, is a claim on real wealth. Thus, the earthquake destroys real wealth, which must be restored at great pain. Whereas, no earthquake leaves the residents with ample time and opportunity to create more wealth in addition to what they already have. Stated in this manner, one can easily see that any natural disaster is bad for the economy because it destroys real wealth, and that what the Keynesian is really saying is that we can create growth by destroying our existing wealth. The same is true for wars. Wars destroy wealth. Blowing up cities, killing soldiers or civilians, and everything else that comes with wars destroys wealth. Thus any addition to GDP and decrease in unemployment is only to restore total wealth to its previous state. Not to mention that people would be far better off making shoes, or cars, or anything they actually value and use, rather than munitions, things that get destroyed and destroy other things. As Emmanuel Goldstein famously writes in Orwell's 1984:
The essential act of war is destruction, not necessarily of human lives, but of the products of human labor. War is a way of shattering to pieces, or pouring into the stratosphere, or sinking in the depths of the sea, materials which might otherwise be used to make the masses too comfortable.
How the Keynesian considers this good for the economy escapes me.

Fallacy of GDP

The Keynesian, however, has a further retort, namely that wars and natural disasters boost GDP and lower unemployment. They often mistake the argument above as implying the converse, and since we have clear empirical evidence to support their claim, they conclude that the Austrian criticism must be invalid. However, I do not dispute their claim. In fact, I will gladly admit that GDP receives a boost and unemployment declines. However, the problem is that GDP is an inappropriate concept when discussing economic growth. It is boosted because GDP is a measure of economic output, and not economic growth. You can blow up a city and rebuild it, which creates output, but does nothing for growth. In fact, this is precisely what wars and natural disasters do. They destroy wealth that must be replaced, hence boosting output in the short run. However, the net effect is that there has been zero economic growth, only replacement of the lost wealth. Economic growth is an increase in real wealth, not a temporary increase in output.

And what of lowering unemployment? Surely that is a boon? Actually, no. Employment in and of itself is meaningless unless one considers the kind of employment. We could have half the country dig ditches and the other half fill them up and keep everyone fully employed, but that would be completely useless activity which would make everyone poorer (people would have fewer useful things). Growth is achieved through the process of savings and capital investment which creates the capacity for increased future output of goods that people actually value. The Keynesian misses this simple point because they are concerned not with real economics but silly aggregates that are abstracted to the point where they share little with the underling reality they are intended to model. The Keynesian thus sees rising GDP and falling unemployment and mistakenly concludes economic growth, when what they are really observing is a temporary increase in output to replace destroyed wealth.

To further illustrate this disconnect, consider this simple example: imagine you have a machine that makes widgets. The machine itself is made of widgets. Let us say it can produce 2 widgets a month, and is made of 12 widgets. Every month you take your 2 widgets to the market and buy whatever you need. Thus you produce and consumer 2 widgets every month. Now, consider that instead of selling both widgets every month, you decide to scale back your standard of living and save 1 of the 2 every month. One year later you would have saved 12 widgets and can buy a new machine. Going forward, you can then produce 4 widgets a month and live a better lifestyle. Thus, you gave up present consumption (1 of the 2 widgets) in order to accumulate capital (saved widgets) to ultimately create economic growth (the new machine). While you were saving your widgets, GDP temporarily drops, but ultimately results in real growth.

Conversely, imagine if you had instead of saving 1 widget, taken 1 widget out of the machine every month. With your 3 widgets a month you could live an improved lifestyle for 1 year, until you realize you have completely cannibalized your machine and cannot produce any more widgets. You can increase present consumption by consuming capital, but this ultimately leaves you with no means for future production. However, it does temporarily boost GDP because you are consuming 3 widgets every month, but results in economic contraction once you realize you can no longer produce more widgets with your non existent capital. In reality, capital is not a homogeneous blob as the Keynesians believe, but rather a highly complex structure of production, which is all the more reason to understand that savings and capital investment are the root of economic growth, not consumption, which only creates temporary GDP increases by cannibalizing the productions structure that results in economic contraction.

This simple example should hopefully be illustrative of the fallacy of GDP. More importantly, however, Shostak explains that GDP is a completely empty concept that demonstrates the sheer intellectual bankruptcy of the Keynesian faith.

Krugman Speaks Out

Lest the reader mistake my characterization of the Keynesians as inaccurate, here is a quote straight from the horses mouth:
The fact is that war is, in general, expansionary for the economy, at least in the short run. World War II, remember, ended the Great Depression. [Italics original.]
Or consider this one instead:
What saved the economy [after the great depression], and the New Deal, was the enormous public works project known as World War II, which finally provided a fiscal stimulus adequate to the economy’s needs.
Indeed such naive causal inferences and aggregate based models of the economy shift the discussion from human action towards abstract models, thus losing any connection to catallactics and the underlying processes that comprise the field of economics. A triumph of scientism over truth!

If I am too harsh, dear reader, then I ask you this: do we not rightly condemn witch doctors and snake oil salesman as quacks? Are they not frauds peddling false hope? Then why the double standard with Krugman and his ilk prescribing their own form of snake oil and rain dances for any and every economic malady? Enough people are duped by quacks. Don't be one of them. I hope this article and my blog helps you form the understanding of economics necessary to reject the quackery of Keynes and his scions.

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