Wednesday, 14 August 2013

New York Fed Economists Don't Even Fully Grasp The Broken Window Fallacy

I thought any misunderstandings regarding the "broken window fallacy" were cleared up in the aftermath of Hurricane Sandy towards the end of last year. Apparently not. At least not completely.

In a recent article titled "Could Superstorm Sandy Stimulate the Region's Economy?", New York Federal Reserve economists Jaison R. Abel, Jason Bram, Richard Deitz, James Orr, Kaivan K. Sattar, and Eric Stern discuss exactly that.

I was pleasantly surprised when I noticed they'd devoted a full paragraph to the "broken window fallacy", even including a link to Frédéric Bastiat's writings, ...until I read a couple of sentences in the paragraph that is. They write,
However, it’s important not to fall prey to what economists call the “broken window fallacy.” It argues that the activity associated with fixing a broken window—or replacing a refrigerator—does little to raise economic well-being and, at best, simply brings the window, and the economy, back to where it was before the window was broken—even if this money comes from an outside source. 
Unfortunately, the authors appear not to fully understand the fallacy. In fact, they've almost stepped right into the fallacy itself! For those not familiar with the fallacy, Robert Murphy explains it as follows,
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.
The New York Fed economists mistakes are two-fold. Firstly, the fallacy argues that fixing a broken window actually raises economic well-being. This is why it's called a fallacy, as it's an argument based on poor reasoning. Secondly, as it appears they've got it the wrong way round (referring to almost the opposite of the fallacy instead of the fallacy itself). They should therefore have written that fixing a broken window reduces economic well-being, instead of "does little to raise economic well-being and, at best, simply brings the window, and the economy, back to where it was before the window was broken". Destruction reduces well-being and makes any economy worse of when it happens. Furthermore, the economy is worse off even when that which was broken is replaced. Destruction reduces net worth! And nothing can be done in the immediate aftermath to bring the economy "back to where it was before the window was broken". It is that plain and simple. Below I explain why.

Bastiat in his essay talk about that which is seen and that which is not seen (see the link above). What is seen when a window is broken and replaced is the window guy actually replacing the window, which generates an economic transaction. What is not seen at first however is the reduction in savings by the owner of the window. After the window has been replaced, the owner still has a window. But he now has less money in his bank account (or more debt) which he could have used to buy a much needed new suit from his local tailor or which his bank could have lent out. To sum up, the window guy is better off, while the owner of the window and the tailor now are both worse off. On the net, the three are worse off than if the window was not broken in the first place. If this was not the case, we could all join forces and start breaking stuff to generate economic activity and wealth. Most human beings, even die-hard Keynesian economists and other inflationists, will clearly see the fallacy in such reasoning. And perhaps even Fed economists will do to.

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