Many of us have heard about the broken window fallacy. But for those who might be unfamiliar or need reminding, let us briefly go over this.
Suppose the economy in my town is struggling and I want to do something to help. What could I do to help the local economy along?
Let us suppose that I am a good Keynesian. I agree with Keynes that spending money is itself a good way to stimulate the economy. I figure that perhaps I should try to find ways to get people to spend more money on stuff. Now how to do that?
I pass by a construction site and see a big pile of discarded bricks. Next to that is a row of shops with nice sparkling new windows. Those look nice and expensive. Someone surely paid a lot for them. I wonder how much it would cost to replace them…
And that is when I get a brilliant idea! What if I were to take the bricks and smash the windows! Not just these nice new windows, but as many windows as I could? Then the shopkeepers would have to spend money buying new windows.
Instead of hoarding all their money in big fat bank accounts, they would put their money to good use and give it to the glaziers to replace their windows! All that spending would be good for the economy!
That would be more money for the glaziers and then they could spend that money somewhere else and so forth. Imagine the economic boon to be gained. And all I have to do is run around town smashing windows! See, this is very literally a broken window fallacy we are talking about in this example.
It might seem rather obvious that this is an extremely foolish plan. Surely nobody would do this. And indeed, very few people would ever do this. Many people might accept that this is indeed a very bad idea.
So why mention it? Because while a lot of people might not go around smashing shop windows, this illustrates the serious flaws in a lot of peoples economic thinking.
Perhaps the most obvious problem with this is that it focuses very much on only the most immediate consequences of this act of vandalism. The shopkeeper will indeed have to replace his window. The glazier will indeed receive some money for his work.
But we must look beyond this and look at the bigger picture. Now the shopkeeper has a broken window and he must pay, say, $500 to replace it. That is $500 he could have used to invest in his business.
He could have bought stock, spent it on advertising or hiring extra help during busy times. He could have used that money to help grow his business and get more customers or increase the productivity of his business.
Perhaps he was planning on saving that money or investing it in some other business. Either way that money could have been used to help fund other businesses and make them productive. All while earning the shopkeeper a little interest on his $500.
Either way, before he lost his window, he had the value of the window and $500 he could have spent on growing his business, paying staff, put in the bank or any number of things which are of unquestionable economic benefit. But after the window was broken, he has only the value of the window and no $500.
Yes, the glazier is $500 richer, but how much does that matter? His gain is the shopkeeper’s loss and so the economy is not any better off than it was before. The $500 simply exchanged hands.
Perhaps this helps to show why spending is not itself any kind of economic boon. Just because money has changed hands, it does not follow that the economy is growing or that wealth has been created.
We need to ask ourselves if the mere act of spending money is an economic plus. Does the fact that money changes hand mean that wealth has been created?
No. If we want to improve the economy, then we need to do more than simply pass money around. Several other things must happen, either in isolation or in tandem.
Producers must find something to expand the productive capacity of the economy. By creating new products that increase the productive capacity of the economy. Or they must find a way to work more productively.
Note that this typically requires producers to make investments. Well, where is this money to come from? This is where savings come in. Savings allow money to be invested in things like this. Be it the savings a producer himself saves or savings borrowed from other people.
It is savings which are important here and not spending. If you want to make your business more productive or to otherwise expand its economic activity, it is saving that you need.
Ah, but you might counter that if someone goes around breaking windows and you are a glazier, then you can get lots of money and invest that. Well, sure, you can, but this misses the big picture.
Suppose you save up $10,000 to invest in your business so that you can purchase better tools with which to fit glass. That $10,000 will let you reduce costs by 10%, meaning you can create the same quality windows for less money.
Suppose I came along and break enough windows for you to make a $10,000 profit fixing all the windows. You indeed have $10,000.
But all the shopkeepers have spent some of their money fixing their windows and now they have that much less money to spend on growing their businesses.
They cannot use that money to grow their businesses and generate wealth. They cannot save that money and now some other business might not be able to borrow the money they need. Not at a sufficiently cheap rate and they might not be able to grow and create more wealth.
So, while you have $10, 000, that is offset by the fact that others have lost money and gained nothing from having to get new windows. Not only do they have less money now, but they will also have less money available to expand production later on.
And so will anyone else the shopkeepers might have chosen to spend the repair money on. Now the shopkeepers cannot spend their money at the electronics store buying things.
No, instead they had to effectively pour their money down the drain just to keep their shops running. They had to spend their money entirely non-productively.
You might be richer. As indeed will any other glaziers these people turn to have their windows fixed. But the other shopkeepers are poorer now and they are less able to expand their businesses. Not only have they lost $10,000, but they have also lost any other money they might have gained by growing their businesses.
What is missed here is that spending is merely the process of cash changing hands. But cash changing hands cannot itself grow the economy. That requires an increase in production/productivity. In other words, it requires an increase in production not an increase in the velocity of cash circulation.
So, let us conclude by returning to the broken window fallacy. What is it? It is the fallacy that destruction can be a benefit because it stimulates spending. As though the mere act of spending could be a benefit to an economy.
But we have seen that far from being a benefit, destruction is bad for the economy. Destruction reduces the potential for economic expansion and thus hurts the economy.
We should expect this. Common sense tells us that running around committing vandalism cannot be good for anyone. Despite what Keynes and his disciples might think, we cannot justify it by appealing to the magic of “spending”, as though bits of paper changing hands somehow creates wealth.
The problem with the broken window fallacy is that it glorifies destruction as an economic benefit. It looks only at the immediate benefit to one party, the glazier, while ignoring the cost to everyone else.
It looks at only one consequence while ignoring all the others. While ignoring the long-term cost of the act of breaking windows.
The broken window fallacy is a short-sighted narrow focus on the benefit to one party while ignoring the bigger picture. And is an example of the fetish of spending.
In the next installment of “Economic Fallacies”, we will see this fetish on spending taken to far more perverse extremes when it is used to paint war as an economic boon! That is not so much a broken window fallacy as a broken nation fallacy! Stay tuned for that.