This will be the first in a series where I spell out an underappreciated concept in economics and how it leads many economists astray in proposing solutions to economic problems. I figured I better get a start on it before the New Year.
Recently, I've gained some insight into the economic debates between the various camps that claim to have a solution to our current problems. In addition to tying up some loose ends regarding a century-old debate, this insight gave me a good explanation of why standard dismissals of the so-called recalculation story (in explaining recessions like the current one) are making a subtle error.
First, a high-speed recap: Way back in the 1800s, Bastiat described what is known as the "Broken Window Fallacy" to refute the prevailing economic wisdom of the age. Many believed that a vandal who broke a window could be doing the economy a favor, reasoning that the owner would have to hire a glazier to fix the window, who would have new money he could use to buy new shoes, which would give the shoemaker the chance to buy something he wanted, and so on. (Note the early shades of the "multiplier effect" argument.)
Bastiat replied, basically, that no, this doesn't quite work, because you have to account for the "unseen" loss to the window owner, who would have engaged in the exact same economic stimulation as the glazier, had the window not broken, because he would have been able to buy something he wanted -- and we'd get to keep the window, to boot!
This mention of the Broken Windows Fallacy is often brought up in response to proposed Keynesian solutions (involving government stimulus spending), where their opponents say that it makes the same error, neglecting the unseen economic activity that would go on in the absence of the government's spending.
Keynesians, in turn, reply that the Broken Window Fallacy only applies at "full employment", where there is no "crowding out" (i.e. forgone projects due to the government's use of resources for different ones). In a depressed economy, they argue, the alternative to a metaphorical broken window (along with its fixing) is not "the window owner buys something else", but rather, "the window owner hoards that money", providing no economic benefit. Therefore, breaking a window in such a case would not have an economic opportunity cost, and so could indeed be good for the economy -- though Keynesians of course admit there are much better ways to increase employment than breaking a window.
The back-and-forth goes on, of course, with each side claiming that the other's position implies or relies on an absurdity. Keynesians accuse the free-market/"Austrian" types of thinking the economy is always optimally using resources, while Austrians accuse the Keynesians of calling a hurricane "God's gift to depressions".
But here, I think, I've noticed something that tremendously clarifies the debate, and gives us insight into why economic activity does or doesn't happen, and why certain events are or aren't good. So, here goes.
Let's go back to the original Bastiat thought experiment about the broken window. Ask yourself this: Why are we assuming the window will be fixed at all?
Don't misunderstand me: it's a reasonable assumption. But we have to be careful that this assumption isn't fundamentally ignoring relevant economic factors, thereby baking in a desired conclusion from the very beginning. And here, I think we have good reason to believe that's exactly what's going on.
So let's start simple: under what circumstances would it be not be reasonable to assume that the window will be fixed, (i.e. that the owner will choose to pay someone to fix it), even during a depression? That's easy: if the neighborhood (along with that building) is run-down to begin with, already littered with broken windows. A lone broken window merits a quick repair, but if it's yet-another-broken-window, why bother? (Note here the substantive similarity to the homonymous "broken window" effect!)
So here we see the crucial, unappreciated factor: the obviousness of certain production decisions. What these thought experiments -- carefully constructed to make a different point -- actually prove is the importance of being able to confidently decide what is the best use of resources. And we can step back and see the same dynamic in very different contexts.
For example, say an unemployed guy, Joe, is trying all different kinds of things to find a job, and nothing is working. Then while driving one day, makes a wrong turn and steers his car off a bridge into the river below. Not good. But there is one teensy-weensy good part: it's a lot easier to prioritize! Previously, Joe didn't know what he should do to make optimal use of his time. Now, he knows exactly what he needs to work on: avoiding death from falling into a river!
And we can step back even more and generalize further: what we are seeing is but a special case of the law of diminishing returns. Abstractly, each additional unit of satisfaction requires a greater input of factors: land, labor, capital ... and thought (sometimes called "entrepreneurial ability"). Generally, the further up you pick the fruit, the harder it is to pick the next branch up, in terms of any factor of production, including and especially thought. Conversely, if you suddenly face a sharp drop in satisfaction by being deprived of more fundamental necessities, it becomes easier to decide what to do: replace those necessities!
That should give you a taste of what I think is missing from discussions of the economic impact of natural disasters and inability to reach full employment. In the next entry, I'll go further to illustrate how deeply this oversight impacts the ability to perform good economic analysis.