The Broken-Window Fallacy

Free-market economists have triumphantly cited the broken-window fallacy whenever someone opines that a destructive act, whether a natural disaster or man-made catastrophe, is paradoxically "good for the economy." The reference is to a classic lesson given by the economist Frédéric Bastiat in 1850.

Especially after Paul Krugman went on CNN and discussed the virtues of faking an alien invasion, libertarians were having a field day with the "broken-window" charge. The so-called progressive Left have been pushing back, claiming that Krugman's critics don't really understand what Bastiat was saying.

In the present article, we'll review Bastiat's original lesson and apply it to modern-day disputes over the possible benefits of destructive events.

Bastiat's Fable

Let's quote extensively from Bastiat's opening example in his classic work, That Which Is Seen, and That Which Is Not Seen:

Have you ever witnessed the anger of the good shopkeeper, James B., when his careless son happened to break a square of glass? If you have been present at such a scene, you will most assuredly bear witness to the fact, that every one of the spectators, were there even thirty of them, by common consent apparently, offered the unfortunate owner this invariable consolation: "It is an ill wind that blows nobody good. Everybody must live, and what would become of the glaziers if panes of glass were never broken?"

Now, this form of condolence contains an entire theory, which it will be well to show up in this simple case, seeing that it is precisely the same as that which, unhappily, regulates the greater part of our economical institutions.

Suppose it cost six francs to repair the damage, and you say that the accident brings six francs to the glazier's trade — that it encourages that trade to the amount of six francs — I grant it; I have not a word to say against it; you reason justly. The glazier comes, performs his task, receives his six francs, rubs his hands, and, in his heart, blesses the careless child. All this is that which is seen.

But if, on the other hand, you come to the conclusion, as is too often the case, that it is a good thing to break windows, that it causes money to circulate, and that the encouragement of industry in general will be the result of it, you will oblige me to call out, "Stop there! Your theory is confined to that which is seen; it takes no account of that which is not seen."

It is not seen that as our shopkeeper has spent six francs upon one thing, he cannot spend them upon another. It is not seen that if he had not had a window to replace, he would, perhaps, have replaced his old shoes, or added another book to his library. In short, he would have employed his six francs in some way which this accident has prevented.

Let us take a view of industry in general, as affected by this circumstance. The window being broken, the glazier's trade is encouraged to the amount of six francs: this is that which is seen.

If the window had not been broken, the shoemaker's trade (or some other) would have been encouraged to the amount of six francs: this is that which is not seen.

And if that which is not seen is taken into consideration, because it is a negative fact, as well as that which is seen, because it is a positive fact, it will be understood that neither industry in general, nor the sum total of national labor, is affected, whether windows are broken or not.

There are two important elements in Bastiat's analysis:

1.       an assumption about what we now call "crowding out" or, what is the same thing, denying that there are "idle resources", and

2.      the distinction between wealth and employment. Below we'll handle each in turn.

Bastiat Assumes "Full Employment," i.e., No "Idle Resources"

In reaching his conclusion that the hooligan boy has conferred no economic benefit on the community, Bastiat first establishes that there is no net stimulus to employment or income. It's true, the glazier's income is higher than it otherwise would have been. This is what is seen. However, Bastiat argues that this undeniable boon to the glazier is perfectly offset by a reduction in income to somebody else in the community, who is now earning less because of the hooligan.

Specifically, Bastiat assumes that the shopkeeper would have spent his six francs somehow, and that the boy has merely forced him to spend the money on repairing the broken window. It is wrong to view the employment of the glazier as a net gain to the economy, because the shopkeeper (in the absence of the broken window) might have spent that six francs getting his shoes repaired, for example. In that case, the glazier's gain is exactly counterbalanced by the cobbler's loss.

Thus, if we assume that the workers in the community would have been "fully employed" had the boy not broken the window, then it's clear that the boy isn't "creating jobs" or "boosting total income." All he's done is to give more work/income to the glazier, at the expense of work/income for some other people in the community.

Wealth versus Income/Employment

At this point, one might think that the whole episode is a wash. Sure, the boy's vandalism doesn't help, but how does it hurt things? Is Bastiat implicitly arguing that it's better to give business to the cobbler, rather than the glazier? Where does he get off making that judgment?

The answer involves the distinction between wealth versus income or employment. Just because "total income," or "total employment," or "total GDP" hasn't been changed by the boy's action — it's just that the composition has been rearranged — nonetheless the hooligan lad has objectively made the community poorer.

Specifically, by destroying the window, the boy has made it necessary for people in the community to devote their scarce labor time (and other materials) in order to merely restore the amount of tangible wealth back to its original state. Yet if the boy had not broken the window, then the labor and other materials would have been used (again, assuming full employment in both scenarios) in order to make the community's tangible wealth grow.

In summary, Bastiat is arguing that the boy hasn't stimulated total employment or income at all; he has merely shifted it from one sector to another. But when all is said and done, the community will have less wealth following the boy's vandalism than it otherwise would have had. Specifically, the gains and losses in the rest of the community wash out — the glaziers will have more wealth while the cobbler has less — but the shopkeeper is definitely poorer. Rather than having a window and a new pair of shoes, now he will only have a window.

Ironically, it has taken several paragraphs of economic analysis to come full circle back to what common sense told us all along: When a hooligan boy breaks a shopkeeper's window (and the shopkeeper is the one who has to pay for replacing it), the shopkeeper is made poorer by the amount it costs to replace it. The boy's action is destructive; it has made the community poorer; he should not be congratulated in any sense. Duh.

The Keynesians Flirt with Praising Disaster

Especially in light of the recent hoax conducted at Paul Krugman's expense, we should tread carefully here. In fairness, let me be clear: Paul Krugman has never actually pined for an alien invasion, nor has he said that he wants another world war.

However, he has indeed written things that understandably gave his critics that impression. This is why so many libertarians were going bonkers with references to the broken-window fallacy. Here are the two most damning quotes from Krugman (in addition to the alien invasion analysis discussed earlier):

Life and business go on; so I guess we have to talk about the economic impact of the Fukushima nightmare.

One set of impacts involves disruption of supply chains…

But what I'm hearing a lot is worries about financial impacts. Japan will clearly have to spend hundreds of billions (dollars, not yen) on damage control and recovery, even as revenue falls thanks to the direct economic impact. So Japan will become less of a capital exporter, maybe even a capital importer, for a while. And this, so the story goes, will lead to soaring interest rates.

What's going on? The story about rising interest rates would be right in normal times. But we're not in normal times: we're — still — in a liquidity trap, with short-term rates up against the zero lower bound. …

So government borrowing doesn't have to come at the expense of private investment, driving up interest rates; instead, it just mobilizes some of those desired but unrealized savings.

And yes, this does mean that the nuclear catastrophe could end up being expansionary, if not for Japan then at least for the world as a whole. If this sounds crazy, well, liquidity-trap economics is like that — remember, World War II ended the Great Depression. (Paul Krugman, March 15, 2011; emphasis added)

And this one:

It seems almost in bad taste to talk about dollars and cents after an act of mass murder. Nonetheless, we must ask about the economic aftershocks from Tuesday's horror.

These aftershocks need not be major. Ghastly as it may seem to say this, the terror attack — like the original day of infamy, which brought an end to the Great Depression — could even do some economic good ….

About the direct economic impact: The nation's productive base has not been seriously damaged. Our economy is so huge that the scenes of destruction, awesome as they are, are only a pinprick…. Nobody has a dollar figure for the damage yet, but I would be surprised if the loss is more than 0.1 percent of U.S. wealth — comparable to the material effects of a major earthquake or hurricane.

The wild card here is confidence …. For a few weeks horrified Americans may be in no mood to buy anything but necessities. But once the shock has passed it's hard to believe that consumer spending will be much affected.

Will investors flee stocks and corporate bonds for safer assets? Such a reaction wouldn't make much sense — after all, terrorists are not going to blow up the S.&P. 500 …. By the time the markets do reopen, the worst panic will probably be behind us.

So the direct economic impact of the attacks will probably not be that bad. And there will, potentially, be two favorable effects.

First, the driving force behind the economic slowdown has been a plunge in business investment. Now, all of a sudden, we need some new office buildings. As I've already indicated, the destruction isn't big compared with the economy, but rebuilding will generate at least some increase in business spending.

Second, the attack opens the door to some sensible recession-fighting measures. For the last few weeks there has been a heated debate among liberals over whether to advocate the classic Keynesian response to economic slowdown, a temporary burst of public spending. … Now it seems that we will indeed get a quick burst of public spending, however tragic the reasons. (Paul Krugman, September 14, 2001; emphasis added)

The relevance of Bastiat's fable to Krugman's (typical Keynesian) analysis should be clear. There is just one last hole to plug in the case against the "silver lining" of broken windows, tsunamis, and terrorist attacks.

What's the Point of Employment?

As I said earlier, the Keynesians lately have been launching a counterattack on the charge that they are committing the broken-window fallacy. One of their responses is to claim that the conservative/libertarian critics are ignoring the distinction between wealth and employment, and that they are unwittingly assuming that there is full employment (i.e., that there are no "idle resources").

Sympathetic onlookers have jumped into the debate, claiming that Bastiat could have been wrong. After all, suppose a hurricane came along and struck a community that initially had a large number of unemployed construction workers. Who would deny that the hurricane might (under the right circumstances) actually lead to more employment and a higher "gross domestic product" as it is currently measured?

At this stage of the argument, I think there are two main answers. In the first place, we have to inquire why are there so many "idle resources" lying around? If it turns out that destructive government and central-bank policies are to blame — and not a sudden unwillingness for people to "spend enough" — then forced expenditures (due to a natural disaster or terrorist attack) won't actually fix the labor market. Mysteriously, the economy will suddenly become "worse than we realized," so that even in light of the new spending, unemployment is still too high. (This is what happened with the Obama stimulus package.)

Second, we can take the critique on frontally. Suppose it really is the case that in the absence of a hurricane (terrorist strike, tsunami, alien invasion, etc.), that people in a community would work fewer hours, and that measured GDP would be lower. Does this mean that there is some "silver lining" to the disaster that might at least partially offset the undeniable loss of wealth?

For example, does it possibly make sense to say, "Sure, the aliens came and blew up a few buildings, and forced us to use up some of our cruise missiles and a lot of jet fuel in repelling them, but at least they stimulated our depressed economy; so we have to add up the loss in wealth on the one hand, and balance it against the gain in economic activity on the other, to see if overall the aliens were a net benefit"?

The standard free-market position on this question is no, it doesn't make sense to talk like this. The goal of economic activity is to produce consumption goods and services. Work is a necessary evil, not an end in itself. As Henry Hazlitt said in a similar context,

It is no trick to employ everybody, even (or especially) in the most primitive economy. Full employment — very full employment; long, weary, back-breaking employment — is characteristic of precisely the nations that are most retarded industrially.

To adapt another analogy from Hazlitt, suppose Jim sees his neighbor sitting in a lounge chair, sipping a martini on a Saturday evening. Jim then decides to set his neighbor's house on fire. Obviously, the neighbor jumps up out of his chair, and spends (let us say) the next hour putting out the fire and minimizing the damage the best he can. Would anyone in his right mind say of this scenario, "Sure, Jim caused some physical destruction of wealth, and that is a bad thing; however, let's not lose sight of the upside: the neighbor used more of his labor than would otherwise have been the case"?

The same principle operates on a communal level, when it comes to hurricanes, terrorist strikes, and alien invasions. The only difference is that specific individuals might actually benefit — yet the community as a whole is still poorer. For example, if an alien spaceship blows up a (deserted) factory and then leaves, it's possible that certain people (such as construction workers and their suppliers) will, on net, benefit. They will have gladly given up their leisure time in exchange for the wages they receive to rebuild the factory.

However, there are other people in the community who are clearly the losers. Not only are they "out" the wealth of their factory but they must then pay enough out of their remaining wealth to induce the construction workers and other people to rebuild it.

When reckoning costs and benefits on a societal level, the fact that hundreds of workers have to give up hours of their time, and that owners of scarce shingles, bricks, concrete, etc., have to give up some of their property, is a cost of the alien attack. Those are not benefits.

It's difficult to see this, because the people involved view it as an "increase in demand" for their services and products. The construction workers are happy to report to the site everyday at 8 a.m. rather than sleeping in, because now they "have a job."

Yet when we push the analysis further and ask why it's good to have a job, the answer isn't that they want to stay fit. The answer, of course, is that they get a paycheck with which they can buy other goods and services.

We have come full circle. The Keynesians assume that a market economy can get stuck in a "liquidity trap" in which mutually advantageous gains from trade are not occurring. The possible benefit of alien invasions and terrorist strikes, in this view, comes from their ability to jumpstart the private sector out of its funk.

Yet for those economists who reject such a notion and instead think that markets can use resources efficiently when they are left alone, there is no upside at all to destructive events. Even though we can imagine situations in which these events confer benefits to particular groups, on net society is always made poorer, because the necessity of applying more labor power — just to return to the status quo in terms of tangible wealth — is a cost of the episode, not a benefit. Other things equal, we are better off when people have to work less to achieve a given level of wealth or flow of consumption.

Robert P. Murphy

Essay originally published at Mises.org  here. With permission