The breaking windows fallacy

by on September 6, 2011 at 7:31 am in Economics | Permalink

Paul Krugman argues that the broken windows fallacy is not a fallacy in a liquidity trap:

…the United States is in a liquidity trap:…[t]his puts us in a world of topsy-turvy, in which many of the usual rules of economics cease to hold. Thrift leads to lower investment; wage cuts reduce employment; even higher productivity can be a bad thing. And the broken windows fallacy ceases to be a fallacy: something that forces firms to replace capital, even if that something seemingly makes them poorer, can stimulate spending and raise employment.

…And now you can see why tighter ozone regulation would actually have created jobs: it would have forced firms to spend on upgrading or replacing equipment, helping to boost demand. Yes, it would have cost money — but that’s the point! And with corporations sitting on lots of idle cash, the money spent would not, to any significant extent, come at the expense of other investment.

What is interesting about this argument is that Krugman has gone one derivative beyond the broken windows fallacy to create an argument requiring even stronger assumptions, let’s call it the breaking windows fallacy.

Bastiat’s assumption of a one-time, randomly broken window is more likely to be stimulative than an increase in the rate of window breaking. A one-time, window-breaking is a sunk cost that does not affect profit-maximization, at least not according to basic theory. (I say basic theory because once we introduce fixed costs, bankruptcy costs and liquidity constraints a one-time negative shock may cause a firm to shut down even when it would continue to produce without the shock, ala Krugman and Baldwin 1989). Thus a one-time window breaking may cause firms to increase spending. An increase in the rate of window-breaking, however, is a change in the marginal conditions for profit maximization that will cause some firms to exit the industry (reduce output) and thus the net effect on spending is more ambiguous.

Krugman implicitly assumes that a regulation is like a broken window but as far as costs are concerned a regulation (regardless of its ultimate benefits) is worse, it’s more like an increase in the rate of window-breaking.  An easy way to see the point is to think of the regulation as a tax where the tax revenues are earmarked for a particular type of spending. Yes, the spending may be stimulative but even in a liquidity trap the taxing is not. Thus, the Keynesian (i.e. stimulus) case for cost-increasing regulations is more difficult to make than the case for increased government spending.

Addendum: See also Bob Murphy on a second, related problem in Krugman’s argument. See also Russ Roberts.

JSK September 6, 2011 at 8:04 am

I say basic theory because once we introduce fixed costs, bankruptcy costs and liquidity constraints

You mean: once the model becomes more relevant with respect to the real world.

Andrew' September 6, 2011 at 8:24 am

Why wouldn’t companies just ship the capital overseas? In fact, requiring a process redesign might accelerate off-shoring.

sc September 6, 2011 at 8:36 am

I’m putting words in his mouth here, but maybe he assumes (as did I, silently, when I read that) that the increased cost eventually (or more or less immediately) vanishes as firms become more productive at adhering to these regulations. He all but says as much, explicitly citing the example of simply “upgrading or replacing equipment.” That is, to use a more familiar concrete example, consider a business replacing all of its computers using 95W Core 2 CPU’s and inefficient power supplies with systems using 35W Core i3’s and 80%+ efficient power supplies *at the same or even lower real cost* as the older systems.

Capital replacement may not be as beneficial for energy producers (though it would be uncontroversial to say that any such technological stagnation would still result from lack of demand) but I don’t understand what’s so confusing about his argument.

Laserlight September 6, 2011 at 10:00 am

Krugman’s argument seems to boil down to “we want you to be LESS efficient so you’ll spend more money”, so he’s not really concerned about reducing the costs.

NOTE: Citing replacing computers is a risky analogy because computer capability has gotten cheaper over time in a way that nothing else has.

sc September 6, 2011 at 11:08 am

He was simply pointing out the obvious fact that in a liquidity trap, suddenly increasing productivity doesn’t look like such a great idea in the aggregate as it does in normal times.

Regarding the decreasing cost of computation (*and* power efficiency I would stress,) I thought that was the whole point of economics as a discipline – the observation that stuff gets better and cheaper in competitive markets.

Andrew' September 6, 2011 at 12:12 pm

If you don’t increase a scheduled regulation, does that count as increasing productivity?

Kidding.

tom September 6, 2011 at 8:40 am

So Krugman’s for broken windows, against higher productivity and thrift. Seems to explain his last decade of columns.

Andrew' September 6, 2011 at 8:47 am

My question is could there ever be thrift that doesn’t hit employment, or ever employment that doesn’t improve quality of life?

He comes ever so close to coming right out and saying that Keynesianism is a fancy way of saying “employment” as I tend to believe.

“…even if that something seemingly makes them poorer, can stimulate spending and raise employment.”

But will the added employment assumed, even if materialized, result in a general improvement in social mood as to juice the animal spirits of investors? Or will investors simply recoil at the populism, for example?

My problem with Krugman et. al. is that their argument always sounds to me like “Assume Keynesianism…therefore, Keynesianism.”

tom September 6, 2011 at 8:43 am

Oh, as to his creating an argument requiring even stronger assumptions: Don’t be a denier.

E. Barandiaran September 6, 2011 at 8:47 am

Alex, this discussion about broken and breaking windows reminds me of why I stopped playing cards and other games with two of my grandchildren. Whenever they were losing, they cried foul and demanded to start the game over but with their rules.

There is one commandment all economists learn from the definition of scarcity –you shall not waste resources. Sinners will argue that we always “destroy” inputs to produce outputs. Yes, we do that but we justify it by arguing that we are creating wealth, that is, we benefit from transforming inputs into outputs. Sinners will reply that we benefit from breaking windows because others will then be busy producing more windows rather than feeling sorry for their fate so their work should be counted as a benefit rather than a cost. In other words, a grandfather should be happy that his grandson is happy because then both will be winning. The pursuit of a free lunch never ends.

Nemi September 7, 2011 at 7:18 am

Of course you shouldn’t “waste” recourses. You should use them in a way that fulfills your objectives (Is it ok if mine is a bit wider than maximizing aggregate “wealth” – say, maximizing utility). Now – if your (instrumental) objective is employment – a second best use of a couple of windows might just be that they break.

The point is obviously that of whether we should kill the old unhappy man to save the baby. If you say yes, that doesn’t mean that you wouldn’t prefer other options if they were available.

BW September 8, 2011 at 12:55 am

Sigh. 10% unemployment is wasting resources. A lot more than factory equipment that hasn’t reached the end of its useful life.

Just try this thought experiment for a minute. Assume for a moment that if the government spent 5T USD, the recession would end and the economy would be back up to normal capacity, and if it didn’t spend that money, the current economic malaise would last X years.

It shouldn’t be very hard to see that there is a value of X such that spending the $5T is a good use of money no matter what items are purchased. Now, if you don’t want to assume that fiscal stimulus works, then you disagree with Krugman. But that doesn’t make his argument fallacious.

buku.banzai September 8, 2011 at 7:04 pm

That’s a great thought experiment.

“Assume that Krugman and other Keynesians are right and that a large enough injection of money will magically heal the economy, whereas if you do not inject the money, the economy will suffer.”

Truly my horizons have been expanded.

The thing that makes his argument fallacious is that it has already been tried and failed.

The stimulus failed, small as Krugman insists it was (in an attempt to make his argument non-falsifiable). The money multiplier was nowhere near what he said it would be. The broken windows fallacy, otherwise known as cash for clunkers, failed. The destruction of supply led to artificially high prices for buyers of used cars going forward.

All of that demand side magical thinking has been tested and found wanting.

Gabriel E September 6, 2011 at 9:25 am

I wonder if this happens to anyone else here.

Whenever Alex posts, I only realize it halfway through reading. Since Tyler usually posts most of the time, I hardly ever both to check who the author is.

But halfway through the post, something seems off to me. Either the tone, or the style, and I realize it’s Alex.

JSK September 6, 2011 at 10:14 am

I try to read the header first.

Pragmaticon September 6, 2011 at 11:21 am

Happens to me all the time.

(And usually it’s like, “Wait, this post is taking a stand on an issue instead of dancing around it” OH, Alex post)

Ches September 6, 2011 at 12:43 pm

was just thinking the same thing……look at Tyler laying down the law….oh Alex, obv

Cahal September 6, 2011 at 12:52 pm

When it happens to me I think ‘jees, am I on Mises.org or Cafe Hay-oh nvm Alex’

gVOR08 September 6, 2011 at 9:34 am

Do something useful. Stop debating Krugman and Bastiat and explain why conservatives find it impossible to understand Krugman’s rather straightforward, obvious proposition. Is it the insistence on assigning moral implications to everything? Is it that they’re so invested in ‘government stimulus bad’ that they can’t accept anything as stimulative?

Cliff September 6, 2011 at 9:54 am

The obvious proposition that layering on additional costly government regulation will juice the economy?

Slocum September 6, 2011 at 9:59 am

The proposition that destroying things of value (which is bad in normal times and makes us poorer just as Bastiat argued) is a *good* thing that makes us richer in this topsy-turvy, liquidity-trap world? That ‘straighforward and obvious’ proposition?

To start with, for most people there nothing even ‘straightforward and obvious’ about Bastiat’s broken windows fallacy and the concept of ‘the seen and the unseen’. So Krugman’s double-secret broken-windows NON-fallacy proposition is surely not obvious. But even so, I don’t think people here are having any trouble understanding it — they just don’t *believe* it is correct.

Laserlight September 6, 2011 at 10:05 am

“Do something useful. Take it on faith that Krugman is right and explain why everyone who disagrees with him must be stupid.”

Andrew' September 6, 2011 at 10:28 am

It’s not that complicated is it? And it doesn’t require any hypocrisy from the right. For example, Krugman says

“More broadly, if you’re going to do environmental investments — things that are worth doing even in flush times —

That depends on your worldview. It is just as easy to assume that now that we know costs matter, we would not do some environmental investments even when we feel flush, because feeling flush may be a false feeling. Krugman could address this kind of critique, and I guess he does, sort of. He says “reference Keynesianism.”

derek September 6, 2011 at 10:31 am

In 2008 I said to my friends that this wouldn’t be over until everyone has lost everything. Little did I realize that it was a prescriptive statement according to Keynesians.

FYI September 6, 2011 at 11:00 am

It is funny how even Krugman fans like yourself sound like him: full of it.

I find it amazing that Krugman actually wrote this post. You could infer this from everything he has written but I thought he would continue to play little semmantic games and never come clean. Any smart Republican will jump on this like there is no tomorrow.

This could be (one never knows) the piece that will haunt him for the rest of his career. It is stupidity at a new level.

Nate September 9, 2011 at 3:47 pm

I dunno, the space aliens one was pretty out there as well.

Zach September 6, 2011 at 9:35 am

A liquidity trap seems to be the all purpose Krugman excuse for doing stupid things.

MAS September 6, 2011 at 9:43 am

Neither Krugman, Alex or any of the commenters so far have mentioned the benefits of stricter ozone regulations. Even if the regulations can be viewed as a tax on certain forms of production, it is a Pigouvian tax which reduces harmful pollution. This in turn generates benefits in lower healthcare costs, improved quality of life, and greater worker productivity due to less illness. Alex is on record favoring Pigouvian taxes on congestion; why not on pollution?

Andrew' September 6, 2011 at 11:19 am

When costs are benefits, who needs benefits?

Cahal September 6, 2011 at 12:59 pm

Andrew you genuinely don’t think environmental regulations are necessary because they might impact the economy negatively?

Andrew' September 6, 2011 at 2:05 pm

Those are the benefits.

andy September 6, 2011 at 9:43 am

“Thrift leads to lower investment”… I think at cafehayek they made the analogy with hurricanes…
– let’s suppose we are really in a “liquidity trap” and people, because of animal spirits decided to forego spending and not to invest; a disaster comes (broken window). Now they are even in worse situation than they were before. Why are they supposed to spend more?

Bill September 6, 2011 at 10:13 am

We can look at how countries that are pursuing austerity with reduced interest rates are doing. No one seems to be talking about England, for example.

The Anti-Gnostic September 6, 2011 at 2:03 pm

England is what happens when the welfare state starts running out of other people’s money.

Bill September 6, 2011 at 3:29 pm

They raised taxes. There’s money, and their tax rates for Europe are low.

Andrew' September 6, 2011 at 3:38 pm

Can you tell me the degree of austerity is not directly related to the size of the problem, e.g. external debt?

Bill September 6, 2011 at 6:13 pm

Yes, they had a choice, and they chose austerity. Their external debt as a percent of GDP was around 40%, which is not high. Where, as a country, they get external debt numbers that are high is when you include their banking sector.

C September 6, 2011 at 10:21 am

MAS:

I wouldn’t speak for anyone other then myself but surely just because you’re for a Pigouvian tax mean you’re for any Pigouvian tax. And in any case the thrust of Krugman’s argument has nothing to do with reducing Ozone per se – Anything that forces business to spend money is (seemingly according to Krugman) a good thing.

C September 6, 2011 at 10:22 am

Damn Typo.

I wouldn’t speak for anyone other then myself but surely just because you’re for a Pigouvian tax doesn’t mean you’re for any Pigouvian tax. And in any case the thrust of Krugman’s argument has nothing to do with reducing Ozone per se – Anything that forces business to spend money is (seemingly according to Krugman) a good thing.

TallDave September 6, 2011 at 12:09 pm

Tyler — I think Krugman would say your argument is beside the point. From his perspective, it really doesn’t matter if we’re destroying wealth, or reducing production for that matter, so long as we’re increasing employment.

In the long run, of course, this type of thinking is going to make us all poorer and more coerced.

Andrew' September 6, 2011 at 4:03 pm

Almost, as long as the employment creates a positive feedback effect on demand. The actual Keynesian offer is that the economy recovers, not just make-work.

TallDave September 6, 2011 at 4:54 pm

(Tyler Alex.)

Andrew — the argument would then have to be that the demand was larger than the destruction of wealth/output so the net effect was positive. I don’t think that is actually claimed. I really think they are just arguing unemployment is so awful (and the poor are suffering so terribly) it must be ameliorated even at the cost of destroying wealth/output.

BW September 8, 2011 at 1:50 am

No. Think a little bit. Labor is a resource that depletes automatically. If unused, it disappears.

It is possible that the value of unused labor greatly exceeds the cost of whatever wealth happens to be destroyed in the stimulus process. Right? Assume for a minute that WWII did in fact create the fiscal stimulus needed to end the Great Depression, and that absent such stimulus, the Great Depression woudl have lasted indefinitely. It’s pretty clear that by, say, 1960 or so, the U.S. became wealthier for having engaged in that destructive war. Yes, resources were diverted into tanks and planes that got destroyed, but the process of diverting them restarted the economy and made possible lots of production that would not otherwise have occurred.

If you don’t agree that fiscal stimulus creates jobs, fine, but that doesn’t make Krugman’s argument incoherent.

Of course, Paul would tell you that breaking windows is a really lousy means of generating stimulus. That it would be much better to, say, fix the nation’s bridges, roads, schools, paint building roofs white to reduce on air conditioning costs, and so forth.

Marian Kechlibar September 8, 2011 at 9:32 am

The reasons why USA has profited from taking part in WWII cannot be reduced to production of tanks and planes. Each participant of the war has actually produced a lot of military hardware, yet most of them were in serious economic crisis just after the war.

USA was in unique situation, because it suffered no infrastructure damage. Many European scientists and businessmen left war-torn Europe for USA – a one-time opportunity which is hard to measure in GDP %, but which, among others, gave the USA its nuclear arsenal and kickstarted the American space program.

Also, all potentially dangerous economic competitors of USA – Germany, France, Italy, Britain and Japan – were in ruins at the same time, thus leaving USA as the only producer of advanced technology for a decade and something.

In my opinion, the mentioned facts are very important in explaining American economical success after WWII.

BW September 8, 2011 at 1:39 pm

The absence of international competitors explains little about American economic success after WWII. If you believe free trade is good, then the diminished volume of trade across the Atlantic should have harmed the economy, not improved it. In any event, American growth in the 1950s was not really export-led.

You are correct that a lack of infrastructure damage is a necessary condition for future economic success. That’s sort of the point. Buliding tanks and places and other consumables — because that’s ultimately what they were, consumed by the military — can spur the economy. Destroying productive infrastructure cannot.

buku.banzai September 8, 2011 at 10:40 am

In his column, he’s specifically advocating implementing costly regulations as a job creator, not “fix the nation’s bridges, roads, schools, paint building roofs”. So his argument is much sillier than what you are trying to make it sound like.

buku.banzai September 8, 2011 at 10:48 am

The more I think about, the more it becomes obvious that Krugman really has gone down the rabbit hole.

In his mind, any expense, even an unneccesary expense, is stimulative. That really is the broken windows fallacy on steroids.

The government should busy itself writing all sorts of costly regulations in order to jump start the economy. It will work, by golly!

BW September 8, 2011 at 1:32 pm

No he’s not. He’s advocating implementing a regulation that would have net benefits for the economy (EPA determined that its benefits exceeded costs; if you don’t agree, take it up with them), by arguing that the costs would be less impactful than usual because of the liquidity trap.

It’s so easy to erect straw men, no?

Anyway, I don’t think that was a post in which he invested much thought or intellectual energy.

And you’re wrong that he thinks any expense is stimulative. Only those expenses that are likely to lead to spur capital investment in the present without causing incremental costs in the future. If you argue that the ozone rule will have incremental costs in the future, I won’t dispute that because I don’t really know, and I suspect Paul would not either.

buku.banzai September 8, 2011 at 6:31 pm

“No he’s not. He’s advocating implementing a regulation that would have net benefits for the economy (EPA determined that its benefits exceeded costs; if you don’t agree, take it up with them), by arguing that the costs would be less impactful than usual because of the liquidity trap.”

That’s a pretty embarrassing attempt at argument from authority . The EPA would claim anything that advances their agenda would have net economic benefits. Obviously the Obama administration thinks otherwise, or else they wouldn’t have delayed the ozone regs until after the election. They believe that the regulations would cost jobs and raise prices for consumers, or else we wouldn’t even be talking about this subject.

“Anyway, I don’t think that was a post in which he invested much thought or intellectual energy.”

Agreed. Seems to be a pattern with him lately.

“And you’re wrong that he thinks any expense is stimulative. Only those expenses that are likely to lead to spur capital investment in the present without causing incremental costs in the future. If you argue that the ozone rule will have incremental costs in the future, I won’t dispute that because I don’t really know, and I suspect Paul would not either.”

So he’s willing to exchange much higher costs for power consumers and onerous new costs for both existing plants and any possible new plants, for jobs doing something that doesn’t need to be done and that will produce nothing of value to either consumers or producers.

Max Tower September 6, 2011 at 12:18 pm

Does the Krugman argument require a cornucopian world view? Does it also have to be anti-environmentalism?

Speedmaster September 6, 2011 at 12:30 pm

>> “Paul Krugman argues that the broken windows fallacy is not a fallacy in a liquidity trap:”

This guy really is like a broken record. ;-)

I’ll say it again, I believe that Krugman long-ago ceased to be a legitimate economist and has instead become a loud Leftist political operative.

BW September 8, 2011 at 1:43 am

When exactly did that happen? Was it before or after he wrote his liquidity trap paper that predicted our current economic malaise and was quickly adopted by the IMF in its economic analysis?

Was it before or after he spent a few months arguing that the stimulus was too small, that its effect would be to staunch the bleeding but not create a recovery, and that the result would be loss of public faith in the idea of stimulus. That is, when he warned Obama that he would have precisely one chance to get it right?

Was it before or after he predicted that QE and QE2 and rising federal deficit would not lead to higher inflation or interest rates? I know conservatives like Cochrane wish they could walk back their hyperbolic venting from Spring 09, but it’s preserved on the web. We can all see how Cochrane predicted an impending hyperinflation as the result of a fiscal stimulus. Oh sure, he didn’t say *when* exactly, so I guess he could still be right. The same way that many subprime RMBS junior tranches are not yet technically valueless, because default rates could still go to zero and the resulting cash flows sufficient to repay the seniors’ principal.

buku.banzai September 8, 2011 at 10:18 am

I think it happened around the time when he was touting the money multiplier of government stimulus being around 1.4, when it turned out to actually be less than 1.

As for him claiming that the stimulus was too small(lol), it’s called hedging your bets. It’s called, “Oh golly, they’re actually going to implement some of the Keynesian ideas I advocate, what if it doesn’t work?” It’s called heads I’m right, tails I’m still right.

The problem with the idea of a much larger stimulus is that it is workable only in a fantasy world where the US government is not headed rapidly towards a fiscal crisis like the one that is currently engulfing Europe. In a context where the old new deal is proving itself to be unsustainable and is rapidly swallowing up an ever larger portion of government expenditures, a NEW new deal is not feasible. And not desirable or useful even if it was feasible.

Jim September 6, 2011 at 12:58 pm

“I believe that Krugman long-ago ceased to be a legitimate economist and has instead become a loud Leftist political operative.”

Well, yeah. Except that he is not loud. Limbaugh is loud. All Krugman does is write a predictable, dull column for a tiny audience.

Problem is, virtually every single person that read his drivel reposts it with their own commentary attached. Lefties use it to confirm how super-smart they are, and righties use it to point out how deeply unhinged the man is.

And thus, the words and thoughts of this dope are inflicted on people who are actually useful. Over and over and over. I can avoid Limbaugh by not listening to him. Krugman is more like a rash that can pop up anywhere, anytime.

AndrewL September 6, 2011 at 1:01 pm

Combine harvesters run on icky fossil fuels that pollute the earth and they do the work of 100 men. If we destroy all of our combine harvesters we could create thousands of jobs to destroy the harvesters, create thousands more jobs to harvest the grains, and when the economy is back up and running, employ thousands more to rebuild the combines. win-win-win!
/sarcasm

FYI September 6, 2011 at 1:47 pm

This is actually an excellent point. Once you throw away the requirement for best utilization and resources and your standard is simply utilization, the destruction of high value targets gets you much more ‘bang for the buck’ so to speak. So Krugman should create a new falacy: the broken computer one. Once we destroy the internet and all computers in the world we would have a HUGE demand for all kinds of work!

Jason Calley September 7, 2011 at 9:23 am

Forgive me if I garble this story, but I heard it long ago and remember only the plot, not the details.

An economist was visiting a damn under construction in China and saw thousands of men with shovels digging at the dirt. “Why don’t you use machines to dig?” he asked his host. He was told, “Machines would destroy jobs. Using men with shovels makes for more employment!” The economist paused for a moment, then asked, “Then why don’t you take away their shovels and let them dig with spoons?”

AndrewL September 7, 2011 at 9:36 am

a google search for “economist” “bulldozers” “shovels” “spoons” brings up excellent results with slight variation in the details. enjoy! http://www.google.com/search?sourceid=chrome&ie=UTF-8&q=economist+bulldozers+shovels+spoons

Sisyphus September 6, 2011 at 3:00 pm

Isn’t Krugman’s problem in this post that he is assuming that savings do not equal investment? Does he think that corporate funds are sitting in a vault somewhere in big piles of cash, doing nothing in some corporate equivalent of putting money under a mattress?

Of course, very little of balance sheet “cash” is actually paper bills in a vault. It is short duration debt, Treasuries and other sovereign risk, demand deposits, etc. In short, that money is invested, either by the company directly or its bankers. It’s just invested in relatively low rate of return, high safety investments instead of Krugman’s preferred ozone scrubbers or whatever other windows he wants to break.

Krugman is also pretending that corporate entities are a unit in equating high cash balance sheet firms with utilities. Though the utilities might not be relatively cash poor, the firms with high amounts of cash are mostly tech firms (e.g. Apple, Microsoft, Intel, Cisco, and IBM) and some industrials/conglomerates (e.g. Berkshire Hathaway). They don’t own power plants, and you aren’t going to directly get their cash moving by this regulation, even if their cash wasn’t already invested.

However, there is a large amount of cash that, AFAIK, is basically doing nothing in terms of investments, but it’s not where Krugman thinks – it’s the Fed’s bank reserves. The Fed could cause a lot of funds to suddenly be available for more investment if it eliminated paying interest on reserves. But that doesn’t accomplish Krugman’s goals of malinvesting funds for political purposes, so he neither acknowledges or suggests it (though I don’t doubt he is well aware of those funds). It also would probably stir up some stronger inflationary tendencies, thus ending Krugman’s ability to leverage his claimed “liquidity trap” for whatever he would prefer others spend their money on.

Cahal September 6, 2011 at 4:39 pm

‘Isn’t Krugman’s problem in this post that he is assuming that savings do not equal investment? Does he think that corporate funds are sitting in a vault somewhere in big piles of cash, doing nothing in some corporate equivalent of putting money under a mattress?’

Savings equals investment is remarkably useless for telling us how the world works, and in many ways is effectively a tautology. It does in no way mean that savings create investment. And yes, corporations are sitting on large surpluses.

Sisyphus September 7, 2011 at 3:07 pm

But there is something important to understand about savings=investment, which is that money saved does not generally disappear from the economy. With the exception of money under mattresses, in vaults (but not retail bank vaults, where it’s held for customers), and possibly the Fed’s bank reserve accounts, money saved is money invested, which means it goes back into the economy to buy assets, goods or services.

Krugman’s problem in this argument is that because he is apparently ignoring that near identity, it looks like he can get something for nothing. Because if the money that was going to be spent on scrubbers wasn’t going to be spent on anything else (or more accurately, the real resources), then you would get an increase in GDP and wealth. But the point of the Broken Windows fallacy is that you aren’t really getting a free lunch when you spend savings to fix something. You are diverting investment funds instead. As I pointed out before, the money that corporations have saved (which again, is mostly not coal power utilities’ anyway) is invested somewhere. It’s either funding the federal government’s deficit in Treasuries, or it’s funding bank and corporate borrowing in the overnight/repo markets, or something similar.

If you were to follow Krugman’s advice to a larger degree than would be necessary to comply with the ozone rule, by other excessive regulations or a true wealth tax or the like, at some point the liquidity you draw out of the financial system (especially money market funds and bank demand deposits) would probably wreck the overnight lending and repo markets. If that sounds vaguely familiar, it’s because the 2008 financial collapse directly resulted from the overnight lending and repo markets freezing up after Lehman collapsed. There are already worries something like that is starting to happen to European banks. I don’t know where the tipping point is for money market fund reductions to cause something similar with the Euro banks, but neither does Cahal or Krugman. There are always unintended consequences and there’s no such thing as a free lunch.

BW September 8, 2011 at 1:13 am

Krugman has addressed your argument many times on his blog. Essentially, you are committing a classic mistake of confusing an accounting identity for a rule of behavior.

Savings = investment only by definition, only because holding cash is considered an investment. When savings increase, that doesn’t automatically create new opportunities for investment. Think about it. Let’s say there is a set of projects X that were at the ROI margin in 2007. That is, they would have been the next projects to be financed by a hypothetical increase in investment in 2007. Now assume savings rates go up in 2009, and consumer demand falls. Does the aggregate revenues of X magically increase? Of course not. The only thing that changes is that the interest cost on the money needed to invest in X, and it’s possible that the decreased interest cost can be the difference between X being profitable and not. This is how conventional counter-cyclical monetary policy works.

But it’s also possible that the reduced interest cost is not enough to make X profitable. In that case, the increased savings does not lead to an increase in economic activity. It leads to an increase in cash holdings on balance sheets, which counts as “investment” to make the accounting identity work, but doesn’t lead to jobs.

As for the idea that all money everywhere is invested, that’s simply wrong. I don’t know what to say. Cash exists on balance sheets. Banks do not lend out all capital at their disposal. People hoard money or assets. Again, just think about with a little bit of logic. Suppose there a world with all cash invested, at the margin in operating capital for producers of consumer products. Now, there’s a sudden drop in consumer demand of 20%. The marginal consumer products factories close and their operating capital needs go to zero. What happens to the money that was invested in that being invested in the operating capital? Do new investment opportunities magically appear? Of course not. Thus, somewhere, somebody has to be holding “cash.”

Andrew Montgomery September 6, 2011 at 5:58 pm

This is an important point – the cash-rich companies (Apple, Google) aren’t the ones who own polluting industrial operations.

Also, if the goal is to get companies to spend their cash piles, this is a very roundabout way of achieving that goal. There must be other ways to do it. Also why just target businesses? There are a lot of rich individuals sitting on large cash piles, let’s find a way to tax them too.

Wealth taxes are coming.

Floccina September 6, 2011 at 4:22 pm

Wasn’t cash for clunkers enough destruction for a while?

dbeach September 6, 2011 at 4:27 pm

I assumed the argument was that in order to comply with the regulations, companies would be making one-time investments in new equipment, not imposing continuously higher costs as Alex is arguing. If that is the case, it seems more like a broken window and not like a tax.

I don’t know enough about the details of the regulations or what it would take to comply with them to know which view is correct.

Morgan Murray September 6, 2011 at 6:29 pm

dbeach is correct. Alex makes the argument that a new EPA regulation is an increase in operating costs rather than a one time fixed cost. He fails to offer why this might be the case, except as a convenient rationalization for opposing environmental regulation. As for the rest of the arguments on this page, its a sad state of affairs in free market ideology lately.

homechef September 7, 2011 at 8:38 pm

The broken windows fallacy is a fallacy unless the windows being broken are in Europe, and are being broken (perhaps at greater rates, in perpetuity) by Hitler.

TomB September 7, 2011 at 9:10 pm

Krugman is Zorg. That is awesome.

http://www.youtube.com/watch?v=krcNIWPkNzA

Zorg is the bad guy from the Fifth Element. Krugman is just like him, apparently.

Script:

Priest Vito Cornelius: I try to serve life. And you seem to want to destroy it.
Zorg: Oh, Father. You’re so wrong. Let me explain.
[Puts and empty water glass on his desk]
Zorg: Life, which you so nobly serve, comes from destruction, disorder and chaos. Now take this empty glass. Here it is: peaceful, serene, boring. But if it is destroyed
[Pushes the glass off the table. It shatter on the floor, and several small machines come out to clean it up]
Zorg: Look at all these little things! So busy now! Notice how each one is useful. A lovely ballet ensues, so full of form and color. Now, think about all those people that created them. Technicians, engineers, hundreds of people, who will be able to feed their children tonight, so those children can grow up big and strong and have little teeny children of their own, and so on and so forth. Thus, adding to the great chain of life. You see, father, by causing a little destruction, I am in fact encouraging life. In reality, you and I are in the same business.

Roy September 8, 2011 at 8:00 am

I forgot that seen, Luc Besson, heir to Bastiat.

BW September 8, 2011 at 1:16 am

By the way, I think some clarification is in order.

Krugman is assuming that the costs of the ozone rule are one-time investments in capital equipment. If that’s true, then his theory is correct. There is a free lunch, because there are idle resources. If you a pay a person who is otherwise sitting on a sofa to build a coal scrubber, then nothing has been lost except that sofa-sitting, which the person probably didn’t want any way.

If, on the other hand, ozone rule compliance leads to increased operating costs, then Krugman is wrong about the ozone rule. I don’t think he really differentiated the two, nor gave that post a lot of thought in general. But almost all of the criticisms expressed here are bogus.

buku.banzai September 8, 2011 at 10:32 am

This is your analysis? Seriously?

“If you a pay a person who is otherwise sitting on a sofa to build a coal scrubber, then nothing has been lost except that sofa-sitting, which the person probably didn’t want any way.”

The company will spend money paying the sofa sitter and buying equipment and technology that up to this point it didn’t need. Those costs will be inevitably passed on to the consumer in the form of higher energy bills. So already struggling consumers will have to struggle even further in order to pay for a make-work project that adds no value.

BW September 8, 2011 at 1:35 pm

Learn some basic price theory before implying that others are idiots. Or for that matter, about electric utility pricing.

Oh, and also you might stop to ponder why where that equipment and technology comes from. It doesn’t pop out of the earth pre-fabricated. Usually it requires, you know, human labor to construct. You know, jobs.

And again, the idea that an ozone rule adds no value is ludicrous.

buku.banzai September 8, 2011 at 6:38 pm

“Learn some basic price theory before implying that others are idiots. Or for that matter, about electric utility pricing.”

Sorry, what about electric utility pricing? Is it immune to the effects of higher production costs?

If you have something to say about it then say it. Otherwise it seems like your just engaging in empty argumentation.

“Oh, and also you might stop to ponder why where that equipment and technology comes from. It doesn’t pop out of the earth pre-fabricated. Usually it requires, you know, human labor to construct. You know, jobs. ”

You just seem to be saying nothing more than, “Jobs goods!” That pretty much seems to be the meat of Krugman’s analysis too. Not terribly compelling.

“And again, the idea that an ozone rule adds no value is ludicrous.”

If the idea is ludicrous, you should be able to tell me straight off what value it adds. Because it would be obvious.

BW September 9, 2011 at 12:33 am

The ozone rule has a beneficial effect on human health. The EPA estimates that it will save $100B a year in health costs. You don’t like that estimate, then take it up with the EPA. But clearly it has some benefits, as even Cato and American Petroleum Institute admit something like $50B in annual savings.

Jobs are good. I’m not really understanding your point here. Jobs aren’t everything, but in a deeply undercapacity economy, they are the most important thing. Again, basic economic analysis: the opportunity cost of the rule is tiny, because generally speaking it would employ people who are otherwise employed. Surely there will be some employees pulled from their present occupations who could not easily be replaced for lack of an available, similarly trained worker, but this isn’t NASA or Los Alamos work. I suspect that most of the cost of the ozone attainment equipment would ultimately present as wages to people who are currently unemployed.

As for my comments about price theory, I cringe eveytime I see someone write that regulations are self-defeating because their costs are always passed along to the consumer. That simply is not true. Costs are NOT simply passed along to the consumer. There is a whole literature on the incidence of costs and taxes that analyzes how much and over what time frame costs get passed on.

Morgan Murray September 8, 2011 at 5:33 pm

Krugman’s argument is very simple and, with his assumptions, absolutely correct. It’s strange that so many people here cannot seem to grasp the argument due to ideological concerns over the conclusion.

GiT September 10, 2011 at 8:16 am

I’m with you. One might think that a professor would know what a fallacy was. But then, right in this post, in search of demonstrating a fallacy, we only get a demonstration of how this type of policy may entail larger costs than a one time breaking of a window. (Even though Krugman clearly seems to be assuming that the regulation will require a one time outlay for new equipment, not a continuous increase in transaction costs analogous to a tax.)

But the magnitude of the costs only matters relative to the net incidental gain. It matters empirically, but not formally. Of course, Alex doubtless disagrees with that incidental gain, but he disagrees because he disagrees with the premises which Krugman explicitly states in his post. And so, as usual, we have a disagreement over the truth status of propositions cast as the exposure of an unsound form of argument.

That’s a great rhetorical ploy for stoking ad hominem attacks against Krugman. But it’s not good argumentation.

JSMill September 8, 2011 at 8:22 pm

Your whole arguement comes back to the bankruptcy constraint – putting firms out of business – that Krugman has already addressed. Corporations are sitting on, and accumulating, large hoards of cash. They are not going to go bankrupt, they are making plenty of money given the current economic parameters. Increasing one part of their costs, in a way that causes them to invest now, is not going to casue them to go out of business. I am not sure what the data say regarding small business, but then it becomes an empriical issue, not the logical one you insist it is.

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