Krugman vs Bastiat

Bastiat's Broken Window Fallacy

As Jeffrey Tucker notes, an absolute howler from Krugman:

The fact is that war is, in general, expansionary for the economy, at least in the short run. World War II, remember, ended the Great Depression. The $10 billion or so we’re spending each month in Iraq mainly goes to US-produced goods and services, which means that the war is actually supporting demand. Yes, there would be infinitely better ways to spend the money. But at a time when a shortfall of demand is the problem, the Iraq war nonetheless acts as a sort of WPA, supporting employment directly and indirectly.

This is a text book example of a broken window fallacy. In the words of Bastiat:

Have you ever witnessed the anger of the good shopkeeper, James Goodfellow, when his careless son happened to break a square of glass? If you have been present at such a scene, you will most assuredly bear witness to the fact, that every one of the spectators, were there even thirty of them, by common consent apparently, offered the unfortunate owner this invariable consolation—"It is an ill wind that blows nobody good. Everybody must live, and what would become of the glaziers if panes of glass were never broken?"

Now, this form of condolence contains an entire theory, which it will be well to show up in this simple case, seeing that it is precisely the same as that which, unhappily, regulates the greater part of our economical institutions.

Suppose it cost six francs to repair the damage, and you say that the accident brings six francs to the glazier's trade—that it encourages that trade to the amount of six francs—I grant it; I have not a word to say against it; you reason justly. The glazier comes, performs his task, receives his six francs, rubs his hands, and, in his heart, blesses the careless child. All this is that which is seen.

But if, on the other hand, you come to the conclusion, as is too often the case, that it is a good thing to break windows, that it causes money to circulate, and that the encouragement of industry in general will be the result of it, you will oblige me to call out, "Stop there! Your theory is confined to that which is seen; it takes no account of that which is not seen."

It is not seen that as our shopkeeper has spent six francs upon one thing, he cannot spend them upon another. It is not seen that if he had not had a window to replace, he would, perhaps, have replaced his old shoes, or added another book to his library. In short, he would have employed his six francs in some way, which this accident has prevented.

(emphasis mine.)

Hazlitt, too, uses the same example, but elaborates the material destruction a little further:

Let us begin with the simplest illustration possible: let us, emulating Bastiat, choose a broken pane of glass.

A young hoodlum, say, heaves a brick through the window of a baker's shop. The shopkeeper runs out furious, but the boy is gone. A crowd gathers, and begins to stare with quiet satisfaction at the gaping hole in the window and the shattered glass over the bread and pies. After a while the crowd feels the need for philosophic reflection. And several of its members are almost certain to remind each other or the baker that, after all, the misfortune has its bright side. It will make business for some glazier. As they begin to think of this they elaborate upon it. How much does a new plate glass window cost? Fifty dollars? That will be quite a sum. After all, if windows were never broken, what would happen to the glass business? Then, of course, the thing is endless. The glazier will have $50 more to spend with other merchants, and these in turn will have $50 more to spend with still other merchants, and so ad infinitum. The smashed window will go on providing money and employment in ever-widening circles. The logical conclusion from all this would be, if the crowd drew it, that the little hoodlum who threw the brick, far from being a public menace, was a public benefactor.

Now let us take another look. The crowd is at least right in its first conclusion. This little act of vandalism will in the first instance mean more business for some glazier. The glazier will be no more unhappy to learn of the incident than an undertaker to learn of a death. But the shopkeeper will be out $50 that he was planning to spend for a new suit. Because he has had to replace a window, he will have to go without the suit (or some equivalent need or luxury). Instead of having a window and $50 he now has merely a window. Or, as he was planning to buy the suit that very afternoon, instead of having both a window and a suit he must be content with the window and no suit. If we think of him as a part of the community, the community has lost a new suit that might otherwise have come into being, and is just that much poorer.

The glazier's gain of business, in short, is merely the tailor's loss of business. No new "employment" has been added. The people in the crowd were thinking only of two parties to the transaction, the baker and the glazier. They had forgotten the potential third party involved, the tailor. They forgot him precisely because he will not now enter the scene. They will see the new window in the next day or two. They will never see the extra suit, precisely because it will never be made. They see only what is immediately visible to the eye.

(emphasis mine.)

Krugman himself admits the fallacy:

Yes, there would be infinitely better ways to spend the money.

but then attempts this completely absurd rationalization:

But at a time when a shortfall of demand is the problem, the Iraq war nonetheless acts as a sort of WPA, supporting employment directly and indirectly.

Per Krugman's logic, and as Keynes famously stated, the government should pay people to dig ditches and others to fill them up, thus creating employment and boosting GDP in a time of failing aggregate demand. As absurd as this notion is, the claim that war is expansionary far dwarfs it. Not only does the government encourage completely unproductive work, it encourages completely destructive work. Wikipedia explains:

However, immense resources are spent merely to restore things to the condition they already were before the war began. After the war, the nation has a rebuilt city; before the war, it had a city and time in which its labour could have been used for more fruitful purposes. Further, the fixed amount of natural resources could have been used to build a second city rather than to rebuild a destroyed city, hence highlighting the occurrence of waste.

War is always a destructive enterprise. Real wealth is destroyed, the replacement of which is hailed as economic growth. At best it is replacement. In reality, it is tremendous lost opportunity.

The Fallacy of GDP

It is true, however, that war and natural disasters boost GDP. So how are we to reconcile this? The fact is that GDP is not indicative of economic growth, it is only indicative of economic output. What Krugman and other Keynesians fail to grasp is that savings and capital investment are the engines of growth, not consumption. By investing in more roundabout methods of productions - presumably for efficiency reasons - entrepreneurs expand the production structure, which is narrowest at the consumer end and expands as you move towards higher order goods. Thus, savings and capital investment expand the production structure creating the capacity for increased future output, while consumption cannibalizes the production structure and decreases the capacity for future output. George Reisman makes this argument quite cogently here.

Unfortunately, we are repeatedly told by economists and economic commentators alike that GDP is the be all and end all of a prosperous society. As we have already seen, various unproductive and destructive things can create one time boosts to GDP because GDP doesn't deduct "broken window costs". Nor can it hope to in any objective manner. Besides that GDP is incomplete as Reisman argues, Shostak argues that it is fundamentally flawed.

Market Implications

For this reason I believe the recent economic stimulus package is a smoke screen that will boost GDP but not actually create a material improvements in the economy. In fact, I think it will create material destruction that will not be realized until later. I will write more on this shortly.

[EDIT: an example from a later article.]

At the risk of over simplifying: assume you have 1 machine that can produce 10 widgets in a year. Assume further that the machine is made of 20 widgets. For the economy to "grow" there must be capacity for increased widget production. To this end, 20 widgets, 10 widgets for 2 years, must be saved to build a new machine. In those 2 years GDP drops to 0, but after 2 years the economy has actually grown 100%. On the other hand, if the first machine is consumed, you have a one time GDP increase of 100%, but have no capacity for future output. There appears to be a disconnect between GDP and economic growth.

This overly simplified example is intended to demonstrate that saving and investment (20 widgets to create the second machine) is economic growth even if GDP falls, while consumption (consuming your first machine) cannibalizes the production structure leaving you with diminished capacity for future output, even if it creates a boost to GDP. Shostak illustrates this idea more carefully using Crusoe economics in his article on the subsistence fund.