The Broken-Window Fallacy

Amidst all the destruction caused by Hurricane Sandy, there are a few who have pointed out a silver lining. With between $10-20 billion dollars in damages expected along the East Coast, some are pointing out that the storm might stimulate job growth. Unfortunately, while this idea may be intuitively appealing, it doesn't hold up once you consider the full implications. The theory is known by economists as the Broken Window Fallacy and is from an 1850 paper by Frederic Bastiat. It goes something like this. A shopkeeper's son breaks one of the shop windows. While the proprietor is scolding the boy, passersby tell the father to go easy. After all, if little boys never broke shop windows, what would become of the glass makers? Bastiat argued that this was a fallacy. Granted, the glass maker benefitted from the destruction, as the shopkeeper was forced to replace the window. But presumably, the man would have spent that same money on something else: additional inventory, advertising or even just a nice dinner out with the family. The boy's carelessness merely resulted in a shift in who benefitted from the spending, but not the total amount of spending. Indeed, society as a whole is worse off for the event. Presumably the foregone spending by the shopkeeper would have resulted in either some business benefit or some pleasure enjoyed by the shopkeeper and his family. Now that the spending is going to fix the window it is only serving to maintain the status quo. This same argument can be extended to the extensive damage caused by a hurricane. Sure, spending on construction will increase dramatically in the affected areas. But if that money was going to be spent on other goods, services and/or investments, then the destruction is diverting funds that would have been spent producing new benefits and instead is being spent on maintaining the current level of utility. Of course, economics has come a long way since 1850 and some alternative arguments have been made about Bastiat's parable. Many Keynesian thinkers have argued that the Broken Window Fallacy only holds if the economy is operating at full capacity. If there is excess savings in the economy, then the forced spending that comes about after a natural disaster or a war can indeed be economically beneficial. This is part of why some argue that World War II pulled us out of the Great Depression. Essentially, the argument is that if we have a bunch resources laying idle, including labor, capital, and savings just sitting at banks, destruction of current property doesn't divert funds away from more useful spending. It pulls funds that weren't being used at all into the economy. There is something to this argument, if you believe the problem in the economy is inadequate consumption spending. So, let's walk through how funds will actually flow in response to Hurricane Sandy and see if we think there will be any lasting positive effect. First, we know that in real life most of the major damage will be covered by either government or insurance. The former will pay for repairs to basic infrastructure, and the latter will pay for most of the private damage. Local governments will likely borrow funds in the municipal bond markets to fund the repairs to roads, bridges, beaches, etc. This will indeed take savings (i.e. from the bond buyers) and pull it forward into current spending. Insurance companies will likely liquidate part of their investment portfolios to pay out claims. In both cases, money is being taken from the investment market and diverted into current spending. And to what end? Essentially to bring us back to where we were before the storm. Again, there is a legitimate case that this could be beneficial if current consumption was too low. In that case, pulling investment dollars forward to fund current spending might have a positive multiplier effect. But that isn't actually the problem today. Consumption spending grew at a 2.0% pace in the most recent quarter, according to the Bureau of Economic Analysis. That isn't a blistering pace mind you, but it isn't bad either. The problem is a lack of investing productive assets. Business investment actually contracted last quarter. More concerning is the trend. While investment spending has generally been positive in recent quarters, it remains far below its 2007 peak. Consumption on the other hand, is well above pre-recession levels. The anemic investment spending hampers our ability to grow in the long term, as business investment tends to correlate with future productivity. At some point, there will even be a short-term improvement in measured GDP, as current spending always hits GDP more directly in the short term. But long term, we are definitely no better off.

The Broken-Window Fallacy

Let's walk through how funds will actually flow in response to Hurricane Sandy.

Columnist Conversation

LEAPS Webinar

LIVE EVENT: Chris Versace and "Sarge" Guilfoyle Share Their Stock Market Insights

The Latest AAP Podcast!

COLUMNIST TWEETS

Please Join or Log In to manage and receive alerts.