Home > Macro/Monetary Theory, Uncategorized > Broken Windows and the Theory of the Second Best

Broken Windows and the Theory of the Second Best

While I was on vacation the Keynesians and Austrians have been continuing their immortal struggle over Krugman’s alien attack and Bastiat’s broken window fallacy.  Let me remind the reader that when it comes to Keynesians vs. Austrians I come down in the Austrian camp so I am writing this for their benefit.  Austrians, you are losing this argument because you think you are still just fighting the same intellectual battles of 200 years ago, but they have changed the battleground.  Yglesias’s response is actually spot on.

Austrians seem to be in the habit of going to great lengths trying to explain why a fiat money system and a central bank are bad for the economy and a gold standard would be preferable and then as soon as the subject turns to something like fiscal policy, ignoring the difference and acting as though fiat money and central banks didn’t exist or had no important effect on how the economy works.  In doing this they are not only fighting a losing battle but they are missing the more important point.

So please Austrians (or whomever it may concern) let’s take a step back and reevaluate things.  But let’s begin by recalling a different well-established bit of economic lore–the theory of the second best.

Canadian economist Richard Lipsey and Australian economist Kelvin Lancaster showed in a 1956 paper that if one optimality condition in an economic model cannot be satisfied, it is possible that the next-best solution involves changing other variables away from the ones that are usually assumed to be optimal.[1]

This means that in an economy with some uncorrectable market failure in one sector, actions to correct market failures in another related sector with the intent of increasing overall economic efficiency may actually decrease it. In theory, at least, it may be better to let two market imperfections cancel each other out rather than making an effort to fix either one. Thus, it may be optimal for the government to intervene in a way that is contrary to usual policy. This suggests that economists need to study the details of the situation before jumping to the theory-based conclusion that an improvement in market perfection in one area implies a global improvement in efficiency.

To put it simply: once you screw one thing up, it’s not so obvious what the effects of screwing other things up will be.  Now notice that the whole Keynesian argument turns on two points.  They acknowledge that the broken window fallacy holds when there is commodity money and full employment but that when there are idle resources and fiat money, anything that expands the money supply (even breaking a window or fighting a war) can help.  This could very well be true (in fact I think it is true) but the real question we should be asking is “why is there so much persistent unemployment in the first place?”  It is this original distortion, caused by the monetary system, that is the real problem.  After this distortion is acting on the economy it is no miracle that something else which would be an undesireable distortion if starting from a perfect world, might actually cause an improvement.  It’s just a way of partially undoing the damage caused by an inherently deflationary monetary system.

There are a lot of unfortunate distortions in our economy.  If we got rid of all of them we would be much better off.  If Austrian economists ran the country we would be a lot better off.  We would have real money and no superfluous government intervention or spending.  This would be the first best.  But when you argue that in the face of a serious monetary distortion (among others), an additional monetary distortion can’t possibly benefit the economy, you are inadvertently denying the existence of the first distortion.  We (the proponents of limited government and economic freedom) would do much better to focus on the question “how have we arrived in a situation where we need a war to keep the economy running?”

  1. September 1, 2011 at 5:29 am

    I didn’t see your response to Bastiat’s broken window fallacy. What you said made a lot of sense. Basically, if you have a massive amount of unemployment, Keynesian economics can restore unemployment and restart the economy at the expense of a massive destruction of wealth. You think that Austrian economists ignore this reality and that they need to realize this and ask the question, “Why was there so much unemployment in the first place?” And you think the reason there is so much unemployment is because of how central banks distort the money supply. Did I understand what you were saying?

  2. September 1, 2011 at 5:33 am

    This whole situation makes me think of two students (Hayek and Keynes) who are solving a math problem. Kayek solves the problem using a simple, but very effective solution. Keynes makes a mistake at the beginning, but bases the entire rest of his solution on that same fallacy. He finishes the problem with a solution that is way off. Then Hayek has to go back and figure out everything that went wrong. Does this sound like a proper analogy?

  3. Free Radical
    September 1, 2011 at 8:09 pm

    Yeah but it’s not that simple because the Kenesians and progressives have actually changed the system to make it behave in a way that is contrary to the workings of a natural economy. That is what Austrians seem to be missing. And it’s not as though they aren’t aware of it, they simultaneously argue that it’s terrible of them to have created this system but then they forget all about it when they talk about something like the BWF and act as though we are starting from a natural free market economy.

  4. Free Radical
    September 1, 2011 at 8:17 pm

    And frankly part of the problem, it seems to me, is their willingness to believe that all these “mainstream” economists are just very unintelligent people that haven’t thought carefully about things. I think Krugman and Yglesias and company are misguided but it’s not as simple as they haven’t read Bastiat or they are incapable of understanding these concepts. These aren’t stupid people. They are not making the same arguments that Bastiat was combating, they are saying that there are other things going on. And there are because they actually created those things. But the Austrians don’t seem to me to be addressing these issues they are just making the same argument over and over again. If we’re going to make any progress those are precisely the issues we need to address.

  5. September 1, 2011 at 9:44 pm

    Well, we don’t have a free market that’s for sure. Would you say that we have an economy similar to Nazi Germany’s? Where the state has a massive amount of controls, but doesn’t directly try to plan the economy so the incentives of the market are still (somewhat) in existence. And what is BWF?

  6. September 1, 2011 at 9:47 pm

    The progressives and Keynesians are trying to create or maintain a market economy that has the results that they want to achieve by using the central bank and controls at the same time. Right?

    • February 4, 2013 at 12:50 am

      As mentioned by Shine , this is not a good point. People surf on the ineerntt mainly for fun and information. The content you reading is depends on your purpose. A lot scientists go to scientific news sites and journal sites to get the latest progress, and reading papers online. However, this point is a good reminder for me to reading papers. While I reading paper, I always check the reference when it is mentioned. This is kind of hyperlink. Thanks!

  7. Free Radical
    September 2, 2011 at 4:23 am

    Yeah that’s the basic idea, and yes I once had a post where I pointed out that private ownership of the means of production doesn’t equal free markets when the government is controling them and linked to this wikipedia page (I tried to find it but I can’t remember what it was called, I should probably start giving my posts more obvious names)


    However I try not to throw the word Nazi around too much it’s one of those rules of thumb “the first side of a debate to compare the other side to the Nazis loses.” Some of the parallels are becoming hard to ignore though….

    BWF=”Broke window fallacy”

  1. December 20, 2011 at 2:37 am

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