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Austrian vs. Keynesian Economics & Bastiat’s Broken Windows

The claim of the Austrian School that has scandalized members of other schools for 150 years is the following. The propositions of economics are universal. The principles apply in all times and all places, because they derive from the structure of reality and human action.

What brought about economic growth, inflation, or the business cycle in China 300 BC are the same institutions that drive phenomena in the United States in AD 2008. The circumstances of time and place change, but the underlying economic reality is identical.

That claim has made other economists – to say nothing of sociologists, historians, and politicians – scatter like pigeons. The Historical School poured scorn on this idea, and Carl Menger, the founder of the Austrian School, fought them tooth and nail. The Chicago School of positivists found the claim preposterous, and Mises and Hayek and Rothbard battled them. The Keynesians have long been outraged, and the postwar Austrian generation reasserted the truth. The socialists, who posit that rearranging property titles will transform all of reality, say that the claim is absurd, capitalistic nonsense.

But there it stands. No matter where or when, the essential prerequisite for economic growth is capital accumulation in a framework of freedom and sound money. The consequence of price control is shortage and surplus. The effect of money expansion is inflation and the business cycle. The effect of every form of intervention is to make society less prosperous than it would otherwise be.

The list of universals is endless, which is why every age needs good economists to explain and articulate the truth.

Well, I would like to add that there are universal fallacies too.

Frédéric Bastiat pointed to one: the belief that the destruction of wealth fuels its creation. He explains this by means of an allegory that has come to be known as the story of the broken window. Most famously it was retold as the opening of Henry Hazlitt’s Economics in One Lesson, which is probably the bestselling economics book of all time.

A kid throws a rock at a window and breaks it, and everyone standing around regrets the unfortunate state of affairs. But then up walks a man who purports to be wise and all-knowing. He points out that this is not a bad thing after all. The man fixing the window will get money for doing so. This will then be spent on a new suit, and the tailor too will get money. The tailor will spend money on other items and the circle of rising prosperity will expand without end.

What’s wrong with this scenario? As Bastiat put it, “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.”

You can see the absurdity of the position of the wise commentator when you take it to absurd extremes. If the broken window really produces wealth, why not break all windows up and down the whole city block? Indeed, why not break doors and walls? Why not tear down all houses so that they can be rebuilt? Why not bomb whole cities so construction firms can get busy rebuilding?

It is not a good thing to destroy wealth. Bastiat puts it this way. “Society loses the value of things which are uselessly destroyed.”

It sounds like an unexceptional claim. But herein rests the core case against everything the government does. Perhaps, then, we can see why the allegory is not better known. If we took it seriously, we would dismantle the whole apparatus of American economic intervention.

If you are with me to this point, perhaps you have a hard time believing that anyone really believes that wealth destruction is actually a good thing. Let me try to show that the fallacy is as pervasive as ever.

After every natural disaster, we at the Mises Institute start what we call the Broken Window Watch.

After Hurricane Katrina, the Labor Secretary said: “What will happen – and I have seen this in previous catastrophes and hurricanes – there is a bright spot in that new jobs do get created.”

And The Economist said, “While big hurricanes like Katrina destroy wealth, they often have a net positive effect on GDP growth, as the temporary downturn immediately after the storm is more than made up for by the burst of economic activity that takes place when the rebuilding begins.”

And the New York Times said: “Economists point out that although Katrina has destroyed a lot of accumulated wealth, it ultimately will probably have a positive effect on growth data over the next few months as resources are channeled into rebuilding.”

After last year’s California fires, we heard this. “In the odd nature of economic accounting, this will probably be a stimulus,” said Alan Gin, a University of San Diego economist. “There will be a huge amount of rebuilding in the next couple of years, financed by insurance payments.”

And CBS MarketWatch said: “Economists have noted the perverse reality that in the wake of disasters, re-construction spending helps the economy, even as people are still struggling to recover from their personal losses.”

Note that personal loss here is deemed rather irrelevant compared with the beneficial macroeconomic results. Here we have a theme we find often in economics, the attempt to drive a wedge between what makes sense for individuals and what is good for society. We see this on display in this recessionary environment, when people are told to spend spend spend, even though most people understand that recessions are times for saving.

Continuing on, we find the Broken Window fallacy popping up even after 9-11.

Timothy Noah of Slate wrote: “We live in a very wealthy nation that responds to horrible disasters by spending large sums of money… It will also provide a meaningful Keynesian stimulus to a national economy that, let’s face it, was tottering on the brink of recession well before Sept. 11. The recession may still come, but the countercyclical spending should help shorten it.”

Another economist declared: “Initially, this could provide a significant boost to an economy that had been slumping. The construction industry could benefit from the rebuilding process. There may also be a boon for slumping tech sales, in replacing lost equipment.”

Thus can we see the continuing relevance not only of Bastiat’s allegory but also of the characters in the story. The posturing wiseguy who says that breaking windows is good for the economy keeps reappearing again and again. So entrenched is this mistake that we might call it official economic doctrine for the whole country.

Regards,

Lew Rockwell

25 Comments

  1. mark dobson says:

    guess disasters are an opportunity to be factored in human behaviour as we all want to get rich(natural selection) means good gains in investing are to be realised if one has the conviction to follow through

  2. mark dobson says:

    fix the english in business language that others understand

  3. Cynical says:

    Why do we even naturally accept something written, probably by a 2 bit hack, or hired pen, hiding behind the banner of a big media outlet as wise or even truthful in the first place? The logical fallacy; argumentum ad verecundiam (argument from authority) is rampant. I appreciate your highlighting another one.

  4. mike says:

    ..in the happy debtors’ paradise…a broken window is a mirage at the end of a fiat paper rainbow….

  5. novosonic says:

    lovely article lew, food for thought; along with the interesting comments.

    personally, i think equities look good in the long haul, but i’m not into gambling in stocks, as it makes me too nervous.

    But, reflecting on MISES’s magnum opus HUMAN ACTION, one can only conclude that the SUB-PRIME mess = CRACK UP BOOM.

    PAIN NOW or MORE PAIN LATER.

    If i get motivated, I’ll have to take a look at Rothbard’s POWER AND MARKET again, and compare that to MISES’s theory of capital.

    I highly recommend Joshiah Warren’s TRUE CIVILIZATION (lassiez-faire books use to carry it) in case you can’t find a real edition of Karl Marx’s DAS CAPITAL.

    But to cut to the chase, it’s time to let go of the past, new technologies and new paradigms await us.

    light & love, peace on earth.

  6. grg says:

    “Economists point out that although Katrina has destroyed a lot of accumulated wealth, it ultimately will probably have a positive effect on growth data over the next few months as resources are channeled into rebuilding.”
    As opposed to what you are trying to say, this statement is fallacy free: Wealth gains and losses are not accounted for in the calculation of the GDP, [much like stock market losses] which thus render your problem with the limitation of GDP itself. In fact, whether or not the mechanism of wealth transfer from Insurance Companies to the Insured parties (via construction and other economy outlets) eventually proves healthier than an otherwise “un-shocked” economy, has not been rigorously addressed in this article. I do agree with many of the Austrian school doctrines, but ill researched and “conspiracy-everywhere” arguments will eventually prove harmful to otherwise true critiques.

  7. pupnik says:

    grg’s claim that ‘redistribution’ from insurance companies to the insured after the destruction of capital can yield net positive economic gain reduces to the broken window fallacy. It can not be escaped.

    The 100% destruction of value of the glass can not be compensated by class-based social-value theories of redistributionism. The money that must be spent to restore the prior state is opportunity lost to spend on additional goods and services. His argument rests upon the belief that the money held by insurers is useless unless spent on the working class. The fact is that the money held by insurers is TAKEN from the working class. Spending it on economic activity to restore the broken window simply means higher insurance premiums must be borne by the insured. This represents opportunity cost to them.

    These ‘wise guy’ idiots never stop spewing do they?

  8. grg says:

    GDP as a tool, does not account for wealth lost and regained, it only measures the amount of production. From that perspective, GROWTH DATA (such as GDP) will be positively affected through the restoration process. Hence, claiming that Katrina and other disasters “will ultimately probably have a positive effect on growth data” (not wealth) is in fact true.
    The article is criticizing the wrong examples using a true theory; put in other words for blind readers such as Mr. Poopnik: The consequence of a catastrophe (assuming rebuilding activities to follow) WILL BE POSTIVE when measured by the GDP. And while all the example quotes used in this article spoke of economic growth data, not even one claimed that a disaster will add to the wealth of a nation. So technically they said nothing wrong.

  9. LP says:

    GRG, you’re arguing something completely irrelevant. GDP hasn’t been used as a measure of economic health for decades. Not by any self-respecting economist anyhow. The author isn’t saying that the statement (that GDP growth will occur) isn’t true, he is saying that the implication – that economic health will result from 100% destruction will occur. It’s not all that abstract. Most people believe that GDP = barometer of economy. GDP growth as a result of such destructive catastrophes must therefore = economy growth.

    That is what is being contended.

    Your argument is either irrelevant or intellectually dishonest. The article’s main assertion remains, and stands.

  10. Sean says:

    Let’s say a good number of us lived on an island, and had 1,000 dollars. Let’s pretend that another island close by provides us with coconuts and food. Even if we spent a couple hundred dollars a year to feed us, our money would dwindle away in about four years and we would become bankrupt and starve.. I think that’s where the roll of the central bank takes place. We import so much oil (52% of trade deficit-08′) and other goods, that we have to export securities or “government debt.”
    The main argument for a trade deficit is that other countries will invest and build shops where we can buy there goods. Well, where does the money for those goods come from? We would spend that 1,000 dollars a lot quicker, that’s for sure. The whole point of an investment is to make profit, so other countries are profiting from us by depleting our money supply. This is why we now have a fiat currency and allocate Keynesian funds or securities… The year we started the fiat currency was the first year we drastically lost refined oil and started importing. A trade deficit was inevitable. We couldn’t have a transfer of wealth so we delinked the dollar from gold and made it the world currency. A trade deficit is as good as burning money and it destroys civil liberties by expanding the size of government. “We are all Keynesians” – Richard Nixon

  11. Sean says:

    I was looking at a chart about the value of the dollar and I realized something very important. As long as inflation stays balanced, than there is a limit to how low the value of the dollar can reach. It’s a simple algebraic formula called Infinite Sequence, or Infinite Summation using Geometric Sequencing. For instance.. If I have a hundred dollars and I take away 3% of the value, than it is worth 97 dollars. That is a 3 dollar difference. If I took 3% away from 97 than I would get 94.09. That’s a difference of 2.91 instead of 3. If I then take 3% of 94.09, than I would get 92.0163. That’s a difference of 2.07 instead of 2.91. If I did this over and over about thirty times or for thirty years, than the value lost each year will become so minute that the total value lost will bottom out and reach a stopping point.. Another example. If I had 1/2+1/4+1/8+1/16+1/32+1/64+1/128… and kept dividing it in half an infinite amount of times and added it all together, I would only end up with a total sum of less than 1.

    This is the reason why the chart starts flattening out, because it has reached its limit to how much value it can lose.

    Now what does this mean? This means that the normal rules of inflation don’t apply. The dollar holds a value but different parts in the market experiences pressure squeezes that leads to inflation, or inflating prices. Like the cost of housing goes up when we invest alot in it, but once investments are down the value of the house drops. Oil affects the prices on everything that is shipped including food. Oil prices are controlled by supply and demand. The price of oil raised 1000% in the past ten years. That has something to do with Saudi Arabia’s statements since 1998 about peak oil and a fear of the loss in production.. Hospital prices have gone up because less people are insured, and the list goes on and on.. This is the reason why we are in a neo-economic time and we need to apply neo-austrian theories to help form and shape a new type of economics that applys to 20th century rules.

  12. rick e says:

    If you do your experiment for what you’re saying your answers would end up negative pass the numeral 1 and continue. Nice try though

  13. Sean says:

    The formula is e^-.03x check it out on a graphing calculator.

  14. Sean says:

    It’s like saying we grow 3% a year, but that 3% gets smaller as the country gets larger.

  15. Dan says:

    Sean: Inflation is a tool used by banks to amass wealth, plain and simple. Dilution of wealth by devaluing currency is nothing other than theft, a thing already identified as usury thousands of years ago. The couching of things in a different language serves to distract people from the reality of what inflation and charging interest means (fraud). We try to get around it by forecasting asset values ‘in real terms’, but all it means that unless we are working and toiling, someone is continually robbing us. When people wake up to that fact, they tend to want vengeance.

    To tie this in with the article above, your mathematical formula which essentially describes exponential decay or growth (albeit towards a non-zero equilibrium point), doesn’t help individuals protect their wealth – it serves the issuers of money only, as they use such devices to whittle away people’s savings.

    To put it simply, what used to happen is the bully on the beach controlled the sand castle industry by lending out sand at interest, so that everybody’s sand castle got smaller unless they went to borrow more. It could have gone on forever, actually. But what is now happening is that the bully on the beach is (arbitrarily) going to knock over your sand castle, take his sand back and get you to build his sand castle for him – and then make you promise to suck up to him forever or else he won’t let you play on the beach any more. That’s my take on the economy.

  16. Tim says:

    I am no expert on inflation but I see a flaw in this logic… If inflation actually decreased the value of your money directly then Sean’s theory applies, but, my logic suggests that the movement isn’t against your money directly each year, it’s the increase of prices around your dollars which increase, hence “diluting” the value (buying power) of your 100 cents (dollar). Saying that my dollar will only buy 97 cents next year is a simple explaination but it’s not actually correct in my mind. It will still buy you $1 worth of something; that dollar may not buy you what it did today, that’s the problem! So in saying that the 3% of 100, then 3% of 97, then 3% of 94.09 etc applies to lessen (reduce) the impact of inflation over time is possibly a false theory. Prices can keep going up at 3% of your dollar (3 cents) every year because it’s alway diluting the value of 100 cents. Please feel free to correct my logic if I’m wrong.

  17. Tim, I guess it depends on what you do with your money. If you invest and earn a return above inflation then you retain your buying power and a little more. If you park your money under you bed and earn 0% interest and you don’t get a pay raise at work, then you are probably not doing so well.

    Also inflation is a pretty abstract thing. Just because there might be inflation in an economy does not mean it affects your world as much as the quoted inflation figures. For example inflation in late 2007/early 2008 in Australia was getting a kick up because of high oil prices, but if you walked to work and did not own a car then the impact on your economic life would be less than a someone driving a V8 sports car to the office everyday :)

  18. Ned S says:

    Sean and Tim – Some numbers that show what happens to the price of a basket of groceries that costs $100.00 today (Year 0) over the next 10 years at 3% pa inflation:

    Year Price Increase
    0 $100.00 $-
    1 $103.00 $3.00
    2 $106.09 $3.09
    3 $109.27 $3.18
    4 $112.55 $3.28
    5 $115.93 $3.38
    6 $119.41 $3.48
    7 $122.99 $3.58
    8 $126.68 $3.69
    9 $130.48 $3.80
    10 $134.39 $3.91

    So if you have $100 today you can buy the basket of groceries. But in 10 years time you’ll need $134.39 to buy that same basket of groceries. But if you’ve put the $100 you have today “under the matress” as they say, in 10 years time it will still be $100. So it isn’t going to buy you that $134.39 basket of groceries.

    If inflation is running higher, the calcs get nastier way more quickly. As in at 10% pa inflation, in 10 years time you’d need $259.37 to buy what $100 would buy you today.

    Sean, your calc is wrong because you are working off the flawed assumption that inflation of 3% pa reduces the purchasing power of your money by 3% pa. It doesn’t. Rather, it increases the price of something by 3% pa. I don’t know what a graphing calculator is or how to use one, but I suspect the fact you are putting in a calc that involves -.03 is the cause of the problem. Inflation makes the price of something go up. It’s an increase. Namely a positive amount.

    Tim, you’re closer to the mark. In that you accept you’ve got the same amount of money as you started with. But you are making a mistake when you say “Prices can keep going up at 3% of your dollar (3 cents) every year” – Working off the $100 figure I used above, prices go up by 3% of the original $100 in the first year (namely by $3) and that makes the item’s price $103. So in the second year it goes up by 3% of that new increased price. Namely 3% of $103. Which is an increase of $3.09. And so on with the effect continuing to be cumulative.

    Percentage increases and decreases can be confusing. You have to remember what base figure you are working from. And that every time you get a percentage increase or decrease, the base figure will be different for the next calc.

    An example – Some people might feel quite happy if they’d heard that the stock market went down by 50% then went up by 50% – It could seem quite natural to assume they had got back any loss they’d made. But if a person starts off with a base amount of $100 and that goes down by 50% they will have lost $50. So they’ll have $50 left. And that $50 they have left is the new base number for the next percentage increase or decrease calculation. So when someone says the market has now gone up by 50%, it is 50% of that new base figure of $50 that the market has gone up by. Namely its gone up by $25. So they now have the $50 it went down to, plus the $25 it has increased by. Namely $75. Which is a fair bit short of their original $100.

    And from a practical point of view, don’t swallow any figure of 3% pa inflation (or 4%) or whatever “they” are quoting. That might be the case if you are up to your ears in debt, have to use lots of petrol and go on holidays regularly. But if not, if could well be 10% pa or even higher right now for you. It just depends what you spend your money on/save for.

  19. Ned S says:

    Sorry about the table formatting!

  20. Tim says:

    Thanks Ned, good thorough response. I concur with your view as it expands further on what I was thinking, I just didn’t want to write a novel! I was suggesting that in each individual year inflation will rise at 3% of that years dollar so as to follow the mathematical path you suggested i.e 1.03, 1.06, 1.09 compared to the base year (year 1).

  21. Ned S says:

    Tim: Sounds like you’ve got a handle on it – In the path I suggest the increases are $3.00, $3.09, $3.18 etc (When rounded off to 2 decimal places for money anyway – As in the increases keep getting bigger because every year they are based on 3% of an ever increasing base figure.) Same with your example where the increases are $0.03 each year up until the 7th year when it becomes $0.04 per year when rounded off to 2 decimal places for money.

    The other thing that can make a big difference is the yearly income tax we pay. And when we pay it. For example if inflation is 3% pa and you have money sitting in a bank account that earns 3% pa, you can still be getting behind unless you can find some cost effective way to delay paying the tax on the income earned.

    And another real killer is if an item you are interested in buying is highly sought after for any reason and price pressures are forcing it to go up by considerably more than the after tax rate of return you can get on your savings/investments, then you are still getting behind on your purchasing power re that item.

    It’s for reasons like those that people with some cash will often eventually decide that having cash in the bank earning interest isn’t a great investment and look for other things to invest in. Things that will give them a higher after tax rate of return than cash in the bank. And a higher after tax rate of return than inflation generally. Or even a higher after tax rate of return than the rate of increase in price on some specific asset type they want to purchase. But with higher returns come higher risks; By and large.

  22. william says:

    Mr. Rockwell, what do you propose is done in the event of a “shocked economy” if not to attempt as vigorously as humanly possible to re-establish the community and social life? The effects of these actions taken by both the government and private organizations do bring about a growth in GDP and stimulate job creation; even if it is all subsidized by the unfortunate system of fiat money. Maybe one day these policies will lead to the fall of the current global super-power but with an international market as commonly intertwined as the one in which we live today, I doubt any nation will cut their nose to spite their face.

  23. RF says:

    I fail to understand why nobody sees the obvious fallacy of the broken window allegory: the false dilemma. The allegory assumes that there are only 2 possible outcomes, each leading to the same flow of money: paying for the broken window, or paying for the shoes. Given that the flows are the same, breaking a window is obviously the worse outcome since it leads to a diminished stock. However, this is an over simplification. There also exists the possibility of paying for the window and the shoes, by drawing on credit or taking out money saved for a rainy day. This possibility has a larger flow of money than the other two, therefore leading to comparatively more economic activity. It would be silly to only look at the flows, as the newspapers etc. cited in the article do, but it’s just as silly to look only at the stocks.

  24. mike says:

    “The window she is broken and the rain is comin’ in
    If someone doesn’t fix it I’ll be soaking to my skin
    But if we wait a day or two the rain may go away
    And we don’t need a window on such a sunny day
    (manana, manana, manana is soon enough for me) Oba! Oba!
    (manana, manana, manana is soon enough for me) Oba! Oba!”

  25. notaneconomist says:

    I think the broken window allegory works just fine, Lew. I tend to liken the economy to a garden and pruning things back properly will cause more growth than to have left it alone to begin with. The allegory on it’s own makes perfect sense, but when seen in a larger scope I think the point is extra work and wealth redistribution which alleviates stagnation and lack of demand. Demand is everything.

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