The breaking windows fallacy

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.


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