The Broken Window Fallacy

I have a perspective on the "broken window fallacy" that I don't believe is widely held. Llewellyn Rockwell expands the fallacy quite a bit in the linked article, but I feel its necessary to reinforce one of the more subtle points that Rockwell makes, and nail down the fallacy to two core flaws in economic thinking.

Here goes:

The broken window fallacy states simply that "that the destruction of wealth fuels its creation". For example, it is not uncommon for certain experts (it doesn't matter what field) to say that while hurricanes are terrible, the result in the long-term can be a more prosperous local economy after rebuilding because of the boom of construction jobs and the inflow of investment money to rebuild. This, however, is a fallacy. While a particular group may benefit in some ways, society as a whole suffers a number of costs that are not readily counted by the experts.

Those that believe that the broken window fallacy is, indeed, a fallacy, would generally contend that it is not a good thing that cars are always breaking down because mechanics have to be hired to fix them. It would not be a bad thing if a car company developed an engine that did not need any maintenance for 100,000 miles (think turbines and electric motors), even if thousands of mechanics lost their jobs.

The usual argument against the broken window fallacy is one of opportunity cost. If your car doesn't break down, then you might use that money to buy a new couch. Buying a new couch creates jobs for furniture manufacturers. When your car breaks down, you may have hired a mechanic, but some poor furniture manufacturer is out of work. Ultimately, rebuilding or maintaining what you already have does not increase your happiness nearly as much as producing or acquiring more. In terms of opportunity cost, the broken window fallacy fails to recognize that people are happier when they are spending their money on more things instead of spending money maintaining the things they have.

All this is pretty cut-and-dry broken window stuff. As follows are my elaborations. I believe that the broken window fallacy has two parts, and that most economists that point out the errors in the broken window fallacy typically only cover the second part, and neglect the importance of the first:

1) I'll go backwards and start with the second part first. As previously shown, the broken window fallacy fails to account for opportunity cost, and can be thwarted by showing that not all consumption is equal. For those that think of economics purely in terms of dollars and cents, this can be hard to see. But when you view economics in terms of productivity, happiness, and standard of living, it is easy to see. If no one ever had to replace a spark plug or get an oil change, then every car owner would have that much more money to spend on other things that would raise their standard of living and bring them more happiness. As Mr. Rockwell points out, the broken window fallacy can also be applied to lots of government spending programs including the most recent bailouts. Not all consumption is equal, digging holes just to fill them may increase our GDP, but it doesn't make our lives any better off. To Mr. Rockwell's point, bailing out failing enterprises diverts resources from where people want them.

2) Here, however, is core belief that leads to the broken window fallacy: moving money from savings to consumption necessarily creates prosperity. Think about your car again: if you didn't have any savings whatsoever, and your car broke down, you would be screwed. The reason you can afford to fix your car is because you have money saved. The break-down was the event that caused you to remove your money from savings and consume it. This, as some Keynesian Economists would argue, is a good thing. In their view, saving money takes currency out of circulation which reduces economic activity. By taking money out of savings and consuming it, you begin again the cycle of consumption that produces wealth. Especially during times of economic duress, they argue, people should be encouraged to remove money from savings and spend it. So, the fallacy is really that savings does not benefit our economy, and removing money from savings is always a good thing, and any event (even a broken window) that causes people to reduce savings and consume more can be considered an economically beneficial event. Aside from the obvious opportunity costs (you are spending now at the expense of spending on something you want more at a later time), the reduction in the supply of savings will increase the interest rate. When people spend instead of save, lending money becomes more expensive because the supply of savings has decreased. This is difficult to see on a microscale, but if a hurricane were to devastate Florida, and Florida businesses had to borrow money to rebuild, we would certainly see a boom in construction jobs, but we would also see interest rates rise elsewhere in the country because much of the available savings was being lent to Floridians to rebuild. So expanding a business in Detroit becomes more expensive because rebuilding in Florida is raising the price of savings.

When we see that the broken window fallacy is really built on two premises 1) that consumption is better than savings, and 2) that all consumption is equal, we can see that there is a lot of economic activity that we could classify as part of the broken window fallacy. When we lament the loss of jobs to robotics in the manufacturing industry, we are lamenting the fact that businesses are saving instead of consuming. We are secondarily encouraging them, since all consumption is equal, to continue to spend money on manual labor because then the market will not have to adjust to accomodate the changing spending patterns since that change can be costly and, quite frankly, scary.

Our economy is virtually built on this fallacy. Our government believes that we can fuel economic growth through consumption, no matter the consumption, at the expense of savings. We do this through government taxation, redistribution, and consumption. We believe that we can offset the drain that this places on the economy and the supply of savings by printing money and lending it to businesses to invest. We fail to recognize that printing money in order to keep the supply of savings up discourages consumers from saving because it doesn't just reduce lending interest rates, it also reduces savings interest rates. We also fail to recognize that printing money creates malinvestments that lead to the business cycle which is the reason for our current economic funk. All of which can be traced back to a simple flaw in argument because we have chosen to base our policies on anecdotes involving children, rocks, and windows instead of sound, reasoned, economic thinking.