Sunday, October 16, 2011

Financial Journals: The Broken Window Fallacy

(Reproduced from an article taken from "The Daily Crux Sunday Interview" entitled "An economic lie that is ruining America" - An interview between The Palm Beach Letter and one of its authors, Mark Ford)

The Palm Beach Letter: Let's talk about books. What is the best book on economics or investing you've ever read?

Mark Ford: I haven't read all that many. But I'd have to say that the book that had the greatest impact on my thinking was Henry Hazlitt's Economics in One Lesson.

PBL: A classic. How did that affect you?

Ford: It was one of those "eureka!" moments. It was like coming up from a murky basement into a bright room. The book gave me a clear, common-sense explanation of why things were the way they were. I could finally see the fallacies that supported so much stupidity that passed for economic science.

PBL: Such as?

Ford: Such as why public works are so often wasteful, why government credit diverts production, why technological advances are good, not bad, for employment, why spread-the-work schemes inevitably fail, why government price-fixing and tariffs make us poorer, etc.

PBL: So what is the most important thing you got from reading Economics in One Lesson?

Ford: That you can't understand any economic policy unless you look at the whole picture. It's not enough to see the immediate, localized consequences of any public action. You must see its long-term effect on the entire economic community. Hazlitt says that nine-tenths of the economic fallacies politicians use do so much harm because they ignore this lesson. After reading the book, I can't help but agree.

PBL: That's a little abstract. Can you explain?

Ford: Hazlitt explains it beautifully in the second chapter, entitled "The Broken Window."

It goes like this:

A hoodlum throws a rock through a baker's plate glass window. A crowd gathers and talks about what a shame it is. But someone suggests that it is actually a blessing. He points out that the $250 the baker must pay for a new window will make the glazier $250 richer. And the glazier will use that $250 to spend with other merchants. The smashed window, according to this theory, will go on providing money and employment in ever-widening circles.

The logic is that the hoodlum who threw the brick was not a menace at all, but a public benefactor. The crowd agrees.

PBL: It does seem like a compelling argument.

Ford: It does. Yet, it's a logical fallacy.

PBL: So what's the fallacy?

Ford: The crowd is right that the broken window will benefit the glazier. But the crowd is looking only at one part of the picture: the effect on the glazier. That's the fallacy. To view the event properly, one must take into account its effect on not just one person or group, but also on the entire economy.

If you do that, you will quickly see that the baker is poorer by $250. And that means he won't be able to spend $250 on the suit he was planning to buy. The tailor that was to get his order for the suit won't have the $250 that would have come to him. And so he won't be able to spend that money with other merchants.... and so on, down the line.

The crowd was thinking only of two parties – the baker and the glazier – because they can see the window. But they don't consider the tailor because the suit is invisible – it is never made.

PBL: That's good. So how does this apply to governmental policies?

Ford: One example Hazlitt gives is government credit to farmers. (This was a big issue during the 1940s, when the book was written.)

At that time, many politicians supported government credit to farmers because farmers represented a big constituency for them. The argument in favor of farm credits was based on particular farmers who could not get the credit they needed from private lenders (banks, mortgage lenders, and so on).

In proposing the legislation, politicians always told stories about the poor farmer who won't be able to make it unless the government steps in to help him. If we buy a farm (or tractor) for him, he will be productive again and resume his role as an upstanding citizen. His farm will add to the total national product, and he will eventually pay it off with the produce he sells. So the loan actually costs the taxpayers nothing, since it will be self-liquidating.

PBL: Again, it sounds like a compelling argument.

Ford: Yes it does, so long as you look at only part of the picture: the short-term effect on the particular farmer who can't get the loan. But if you have learned Hazlitt's lesson, you will see the fallacy in it.

There is a reason this particular farmer cannot get the loan he wants. It is because the private lending community doesn't think he or his farm is worthy of it. (In other words, he is not credit-worthy.)

As Hazlitt points out, credit – good or bad – is what the farmer already has before he applies for the loan. If he has credit, he will get the loan privately. It is only when he doesn't have credit that the government must step in. In other words, the only purpose of government credit is to provide loans to people or businesses that are not credit-worthy.

To understand the whole picture, you must look at the effect of that loan. To provide the loan, the government must take the money – in the form of taxation – from the private sector. And that money will not be used for whatever purposes it would have been used.

For every $1,000 that is given by the government to a farmer with bad credit, $1,000 will not be spent by some private person or business on a person or business with good credit. The long-term implication is obvious: more risk, greater net losses, and less efficiency. The economy loses out in the long run.

PBL: Yes, I can see that. But that particular farmer, if he doesn't get the loan, will be worse off.

Ford: Yes. In the short term, he will be worse off. Hazlitt doesn't deny this. And that is one of the things I like about his thinking. He does not make the mistake that some free-market theorists make in denying these short-term, limited problems.

Economic progress in a free market always produces limited and temporary hardships, but those hardships are more than offset by an overall long-term increase in wealth. Hazlitt doesn't pretend that free markets will solve all problems. He argues that in the long run they provide the best net result.

PBL: Can you give me examples of how this is relevant today?

Ford: Open up any newspaper and you will see evidence of it in the editorials. Watch any talk show on economics and you'll see it all the time. The broken window fallacy is the go-to gimmick of almost every successful politician, Republican or Democrat.

PBL: For example?

Ford: On the treadmill this morning, I saw a "news" story about what the "reporter" called "the growing problem of hunger in America."

The reporter showed a clip of a young woman who said she was having trouble feeding her children with the $300 a month she gets in food stamps. She said the pain of hunger was "unimaginable." The reporter concluded that something must be done to increase food stamp allocations.

If it weren't for the fact that this young woman weighed about 280 pounds, I would have been moved. But had I believed her, I would have reminded myself that this was the broken window theory in operation.

No mention was made of the fact that the $300 in food stamps she was getting from the government was actually costing taxpayers much more than $300. With all the government bureaucracy involved in qualifying her, tracking the expenses, and reporting them, the cost of those food stamps was probably closer to $500 or $600. And that $500 or $600 was taken from taxpayers that would have spent it elsewhere, providing food and clothing for others.

So the net effect is actually negative. That wasn't part of the report.

PBL: So how does this idea affect you personally? I mean, how can a person use this knowledge to better his life?

Ford: Well, for one thing, I'm very careful about my charitable expenditures. I don't give to major charities, because I'm afraid they may be as inefficient as the government.

I do spend a good amount of money every year on charitable projects, but they are all my projects – ones that I feel responsible for and that I control. I want to know that if I spend $60,000 to build a library in Nicaragua, it will do more good than spending $60,000 on a new BMW. This makes me work much harder to make sure the investment pays off.

This idea has also been important in my business thinking. When I discuss capital expenditures with my client companies, I always stop to think, "Is this the best use of this money? Or would we get a higher return for the whole company if we spent it elsewhere?"

But the most important benefit for me is that it allows me to spend very little time worrying about government policies that attempt to regulate the economy. I know that most of them – regardless of what party favors them – will be wasteful. That gives me extra time to focus on my investing.

PBL: Thank goodness for that.

N.B. The Broken Window Fallacy was first introduced via the Parable Of The Broken Window by Frédéric Bastiat in his 1850 essay "Ce qu'on voit et ce qu'on ne voit pas" (That Which Is Seen and That Which Is Unseen) to illustrate why destruction, and the money spent to recover from destruction, is actually not a net-benefit to society. The parable, other than the Broken Window Fallacy is also known as Glazier's Fallacy, and demonstrates how opportunity costs, as well as the law of unintended consequences, affect economic activity in ways that are "unseen" or ignored.

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