A further note on the broken windows fallacy

I’d like to second the points by Alex and also Bob Murphy.  An additional factor is that when a window breaks (never mind ongoing regulations and wealth taxes, which as Alex notes will be worse) wealth goes down.  Keynesians tend to overestimate the importance of flows and underestimate the importance of stocks and sometimes they neglect the latter altogether.  Just as there is a spending multiplier, there is also a multiplier from changes in wealth.  For instance declines in perceived wealth will cause people to spend less.  The Keynesian AD gains from a broken window have to stem from the difference between the spending multiplier and the wealth multiplier.  Under the permanent income hypothesis, there’s not a lot of daylight here.  Furthermore the perceived wealth decline, even if it doesn’t lead to immediate one-to-one reductions in spending, can persist over several periods.  Granted, PIH is not exactly correct, but still the net impact of stimulus on current employment and income won’t be that large because of the negative wealth effects.  Fiscal policy remains a weak pill.  The declines in housing prices in recent years really have taken their toll on AD so the wealth multiplier is not to be ignored.  The notion that a stable and sustainable restoration of AD actually requires some increases in perceived wealth is one of the most underrated ideas among today’s Keynesians.

I would make a few more general points:

1. It is possible that a broken window may increase employment and output and under sufficiently unusual assumptions it may also increase welfare.  But it’s not likely.  I think the point, showing the possibility of this exceptional case, should be a footnote in an intermediate macro text but no more.

2. The importance of wealth creation for human well-being is the more important lesson, by far, from economics.  There are plenty of productive investments by which government can improve matters, starting with fixing escalators in the DC Metro system, not breaking them!  Ultimately, in the Hansonian sense, the debate is about how much we should glorify wealth creators and in this regard Hazlitt not Keynes gets it right.

3. A more directly practical point is that tighter ozone regulation will spur some hiring but probably lead to labor market crowding out, rather than targeting the current unemployed. I don’t know if those regulations are a good idea or not but I do think the case for them has to stand on its own two feet and not on Keynesian principles.


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