By Dr. Joe Webb 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.