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Sandy Is Good for Economic Growth? Only if You Don’t Know the “Broken Window Fallacy”

By on October 31st, 2012

I’ve been hearing the expected and annoying “economic growth will be helped by disaster recovery” in the news today. This is the “broken window fallacy” as discussed by economist Frederic Bastiat.

Bastiat’s work explains that there are unseen costs (opportunity costs), unintended consequences, and misallocation of resources that disrupt the flow of other goods (and therefore, incomes).

A good but wordy (no, I didn’t write it; stop making fun of Dr. Joe) explanation can be found on a Wikipedia page devoted to the fallacy:

If there was more profit to be made by destroying buildings, windows or leveling an entire community due to a natural disaster than pursuing other courses of action, then participants in the market would pro-actively and voluntarily destroy property. It is quite clear that far more profit can be earned by recycling, selling, or repurposing an old window pane than could be achieved via random destruction by vandal or nature. Therefore, arguments that propose that destruction ‘might’ be good for the economy have to presume that actors in the economy were missing an opportunity to profit in excess of the value of the goods destroyed. The probability of random destruction being good for the economy is equal to the probability of random destruction being bad for the economy as both are equal to the probability that free exchange has not achieved the best allocation of resources.

The best good that can arise from disasters is the people who had no reason to know or engage each other in the past now have common purpose to aid and assist each other through charitable action and societal concern. We also learn how economic resources are connected, and how rescue procedures and disaster preparations can be improved. But these will always be improved with each disaster because technologies and processes are always changing, and the connections between resources are never static. More knowledge often increases our awareness of what we still don’t know.

The economic loss is a dead weight on economic activity and a drain on savings that reduces future income, which is hard to balance except in the very long run. Those savings were delayed consumption of future goods, such as retirement spending, education, future medical care, or other purposes that now have to be re-scaled for current needs. Insurance companies will need to sell investment instruments to pay for current claims, and customers are likely to see higher future premiums. Insurance companies need to replenish those reserves to prepare for the next round of catastrophic claims, whenever that may be. Those reserves must be built up more aggressively today because rates of return are lower than in the past. For example, we know that Fed actions have made interest rates for bonds and other securities to be very low. Compounding of interest needs more time to have significant effect. In terms of income alone, you need twice as much principal to create income at 3% than you need to produce that income rate at 6%.

Sandy hit an area with great societal wealth and significant capital (money, knowledge, skill, etc.), so recovery will occur with time, and investment will speed it. These geographies are in no danger of being abandoned. But as far as aiding immediate economic growth, some sectors will get a boost while others will see declines, much like Bastiat described in his simple essay.

Bastiat’s original writing from 1850 can be seen online.

  1. 16 Responses to “Sandy Is Good for Economic Growth? Only if You Don’t Know the “Broken Window Fallacy””

  2. By norm katz on Oct 31, 2012 | Reply

    the only thing markets care about is that there will be more short-term fast money
    so the roller coaster continues, and serious investments forsaken
    Instead of new roads, libraries and schools, we get patched up problems for the future

  3. By Ernest Seals on Nov 1, 2012 | Reply

    He does not consider the Ant Hill Theory! ants are quite content to go about their lives until the hill is knocked over and they become aggressive and rebuild bigger and better. Case in point Louisiana and Gulf Coast .

  4. By Dr. Joe Webb on Nov 1, 2012 | Reply

    Whether we like it or not, that “short term fast money” helps reallocates resources and prepares the way for patient investments. Short term money gets punished, often, more than most people realize. The roads, libraries, and schools are so tied up in bureaucratic issues that resources are never allocated well or in timely fashion. Part of the reason is a combination of “tragedy of the commons” and the number of “rent-seekers” who muscle into that process since none of those are privately owned and the flow of capital is impaired.

  5. By Dr. Joe Webb on Nov 1, 2012 | Reply

    Ants are not economic creatures because they cannot evaluate alternative uses (or alternative designs) for their resources, so it’s not applicable. While there is a good lesson about dedication and singular purpose in the analogy holds, it does not describe the issues. Their behavior is instinctual and impulsive and not intellectual and deliberative. Louisiana and the Gulf Coast are great examples, in some cases of what not to do. Rebuilding New Orleans was a mess, but other states like Mississippi and Texas did better and more quickly because they were better run before the disaster. New Orleans has 120,000 fewer residents than it did at the time of Katrina and has 40,000 abandoned properties. http://www.csmonitor.com/USA/2012/0224/New-Orleans-razing-craze-aims-to-clear-way-for-post-Katrina-recovery. Mississippi is still having problems getting issues resolved to this day, even if things were “better” handled.

  6. By Tim on Nov 1, 2012 | Reply

    Thank you Dr. Webb – for sharing this little known bit of wisdom from Bastiat, and for exposing this chimera of “economic growth in the wake of destruction” for what it is. Having read “That Which is Seen, and That Which is Not Seen” many years ago, it continues to amaze me that mainstream business media can continue to talk about the positive economic benefits of rebuilding after a natural disaster and how it will be a boost to GDP, and yet gloss over the negative impact of the destruction and loss of existing capital stock, the loss in many cases being total.

    Anything gained in this process of rebuilding has been completely offset by the loss of existing capital investment, the higher cost for replacement, and future opportunities to invest in other worthwhile endeavors, not to mention the loss in and impact on human life which cannot be replaced at any cost.

    A simple example will suffice – say I have an IPhone 4 I bought last year, and it gets lost or stolen. I now go out and buy a new IPhone 5 to replace it. I may think the new phone is “cool”, and Apple gets to record another unit sold, but the bottom line is the loss of the old one cost me in more ways than one, and the purchase of the new one does not mitigate the loss.

    In today’s turbulent business and low yield investment climate, the funds expended to rebuild are not easily replaced, unless they are simply whipped up out of thin air and disguised as “federal gov’t. disaster aid”, which will add to an ever-expanding deficit that is a travesty in itself.

    The Northeast must rebuild, and rebuild it will, but the event should be called what it is – a tragic and immediate loss, and no amount of media spin is going to turn it into a gain.

  7. By David Lewis on Nov 1, 2012 | Reply

    He also does not take into account the cost of dismantling. One of the hidden secrets of war is that mass destruction is the cheapest way to remove old growth to make way for new.

  8. By Charle Corr on Nov 1, 2012 | Reply

    Once again, Dr. Joe is referencing a radical Austrian economist. I fully defend the right to hold any belief no matter how misguided or discredited so long as it doesn’t cause harm.

    Economic perspectives are generally tied to politics but cloaked in false objectivity. Who is the most prominent US Austrian politician? Ron Paul. If you also believe government shouldn’t fund roads or provide disaster relief you probably agree with Dr. Joe. If you are near the mainstream understand that what has an air of economic fact is a reflection of a radical view. Reader beware!

  9. By Dr. Joe Webb on Nov 1, 2012 | Reply

    Bastiat is not an Austrian School economist. Carl Menger, the economist whose work was the original foundation of the Austrian School was 10 years old when Bastiat died in France. His writings on economomics were about 30+ years after Bastiat died. Re: Ron Paul, his monetary policy is Austrian, but his political actions do not resonate with me. As far as the Austrians being radical, the Austrian School is libertarian and I find reading reading them fascinating. I always make a point of reading things I disagree with, which is how I found them in the first place. I disagree with them often.

  10. By Michael Wyatt on Nov 1, 2012 | Reply

    Charle, don’t think anyone is arguing that we shouldn’t spend money on disaster relief, rather that you’re kidding yourself if you view it as an economic benefit to society.

  11. By Dr. Joe Webb on Nov 1, 2012 | Reply

    Wall Street Journal has a summary of economist comments about the effect of Sandy on economic growth at “Economists React: ‘Naive’ to Think of Sandy as Stimulus”
    http://blogs.wsj.com/economics/2012/11/01/economists-react-naive-to-think-of-sandy-as-stimulus/?mod=djemRTE_h

  12. By Dr. Joe Webb on Nov 2, 2012 | Reply

    From Henry Hazlitt’s “Economics in One Lesson” — Hazlitt was an economics writer for the NY Times, Newsweek, and others, and was also a literary critic. http://en.wikipedia.org/wiki/Henry_Hazlitt He did help Ludwig von Mises to come to the US and get his teaching position in NYU’s economics department. This is from the 1978 edition. Hazlitt died in 1993.

    “It is sometimes said that the Germans or the Japanese had a postwar advantage over the Americans because their old plants, having been destroyed completely by bombs during the war, they could replace them with the most modern plants and equipment and thus produce more efficiently and at lower costs than the Americans with their older and half-obsolete plants and equipment. But if this were really a clear net advantage, Americans could easily offset it by immediately wrecking their old plants, junking all the old equipment. In fact, all manufacturers in all countries could scrap all their old plants and equipment every year and erect new plants and install new equipment.

    “The simple truth is that there is an optimum rate of replacement, a best time for replacement. It would be an advantage for a manufacturer to have his factory and equipment destroyed by bombs only if the time had arrived when, through deterioration and obsolescence, his plant and equipment had already acquired a null or a negative value and the bombs fell just when he should have called in a wrecking crew or ordered new equipment anyway.”

    Since Hazlitt originally wrote this (my guess is that text similar to this was in the earliest editions though the late 1970s was the time when German and Japan comparisons to the US were rampant), the impact of computing technology was not as great, and now that has trickled down to the point where consumer computer goods drive the expectations of what computer technologies that companies have. In the late 1970s, the capital base could be heavy equipment expected to last 20 or 30 years or more, and business owners could look at the calendar and make the assumption that because equipment in Germany or Japan was newer it would be better than what they had. But as Hazlitt writes, the optimum time for replacement had not arrived. That is, the mismatch of demand and their output capabilities was not great enough to spur a new investment. Nowadays, that computer-based production capability is replaced far more frequently, and software-based changes to capital equipment update that capability often. If catastrophe destroyed old and out of date capital equipment that was supposed to last decades, one can understand why the belief that it was a good thing would be embraced. Nowadays, when obsolescence is faster and computer upgrades are quicker, the time aspect of the output gap of old and new is probably not as wide, and the claimed benefit from the destruction of the old would probably not be as great.

  13. By Barry Walsh on Nov 2, 2012 | Reply

    I can’t help but immediately think of Aldous Huxley’s “Brave New World”. To maintain the state economy, all citizens are conditioned from birth to value consumption… being brainwashed in the crib with endless repetitions of “ending is better than mending,” “more stiches less riches”. Which cribs were you guys in…Alpha, Beta or Gamma?

  14. By norm katz on Nov 2, 2012 | Reply

    Your explanation (apology) of short-term money is false. You live in a text-book world of many years ago, before the market became so big and all-powerful. It takes all government stimulus and cheap money and quickly converts it to their short term gain (often overseas). Look at their profits, and look how poor everyone and everything else is. Face current realities and look at our debt.

  15. By Dr. Joe Webb on Nov 2, 2012 | Reply

    Norm, all I explained is what happens and the cycle that occurs. As far as your comments about debt, or debt level is not a problem for the future, it is a problem now because it depresses income and causes irrational investment and greater debt because interest rates are below inflation. The overseas gains are not short term, they are long term because those economies are growing, their populations are rising, and their debt loads are far less as a percentage of GDP. When you look at what Apple does in terms of managing its worldwide cash, something I have written about back in May http://whattheythink.com/articles/57996-half-all-workers-dont-pay-taxes-mantra-starting-get-taxing/. As far as “look how poor everyone and everything else is”, I’ve been the only one writing about economics in this industry that focuses on things like “real disposable per capita income” and other matters. I know quite well what kind of quagmire the economy has been, and more debt will not fix it. When tax avoidance is considered a more worthwhile endeavor than creating new goods, something is out of balance. And as for me, I know the problems of debt, and have never had any except for a mortgage we had for 7 years, and another for 5. Debt means that someone else will be making decisions about your financial future rather than yourself. Sometimes that trade-off is worth the risk. But it often is not. With all of the extra money that the Fed has created, the only way to avoid serious inflation problems is to create goods and services at a rate that will absorb that extra money. The Fed’s balance sheet has grown, somewhat predictably, at 6% per year, until this era of quantitative easing. That 6% is roughly real GDP + the inflation rate. How they unwind this extra money without that could get rocky. Because government debt is so high, there will be great pressure on them to not raise rates because interest payments will increase the annual deficit significantly. Where the Fed claims to not be political, that kind of pressure may be too much for them to bear. Hence, the interest among many to invest in gold (which is still not near its 1980 inflation-adjusted high of about $2600), commodities, and the investment dujour of farmland. In the end, the economy is something that we have to navigate, and debt is a very weighty anchor that limits our range of possible actions greatly.

  16. By norm katz on Nov 5, 2012 | Reply

    One last comment; I’ll be blunt, please don’t take personal offense.
    Anyone that understands “short-term, fast money” has made a fortune in the last 5 years. What’s been yours over 5 ? All the entries on this blog seem coming from very bright individuals. Instead of intellectualizing over ant-hills, wouldn’t time be better spent facing the problems our children and grand-children face and working for economic justice?

  17. By Dr Joe on Nov 5, 2012 | Reply

    Short term fast money has had the illusion of making money over the last five years as purchasing power has been declining. Anyone who has ridden the bond bubble up as part of the QE process has done well. But people of modest means who thought that they could save using CD’s at banks has been brutalized. The best start in economic justice would be to reward savings, especially by those of modest means.