Posts Tagged ‘broken window fallacy’

Economics Having Nothing to do with Broken Windows

September 19, 2011 5 comments

Finally, the much-anticipated followup to the wildly popular and controversial “Still More Broken Window Economics.”  For those of you just joining us we find ourselves on an island with one really rich guy who owns all of the means of production except for labor which is owned by a group of peasants.  By assumption there is productive work that the peasants could be doing but they require use of the rich guy’s productive resources in order to do it.  The question is why wouldn’t they be able to come to some mutually beneficial arrangement with the rich guy where they work his land and they split the produce somehow?  And in particular, how can this reason be overcome by a hurricane hitting the island and destroying the rich guy’s stuff?  (To avoid the monopsony problem, going forward I will assume there are several landowners.)

When exchange takes place in real goods (this would include commodity money) in a free market (so without all the things I listed in the last post) there is no reason to think that this would be the case, at least not on a large scale.  Obviously transaction costs aren’t zero and this means you wouldn’t necessarily get the most efficient outcome in every situation but I am quite confident you wouldn’t have a situation like the one described.

The problem stems from the monetary and banking system and to fully understand the problem you have to start from the beginning of said system rather than just look at the downturn.  So take our island economy and imagine it is in a condition of free markets, property rights and commodity money and that the workers are employed at the efficient level.  This means that the marginal cost to them of their labor is just equal to the wage which is equal to their marginal product.

In addition to the efficient allocation of labor, there is also an efficient allocation of consumption and investment over time which is brought about by market interest  (both real and nominal) and inflation rates.

Enter the central bank.  The bank goes to the landowners and says “hey landowner, I can loan you money at a nominal rate lower than what currently prevails in the market.” If the landowner is not too economically sophisticated he will say “cool, in that case I will borrow more and invest more.”  If he is particularly sophisticated he will say “ok, but are you offering that rate to everyone and supplying the funds by just printing more money?  Because if you are, then it will just drive up prices in the short run (inflation) and then drive them down in the long run when people have to pay you back (deflation) so the real rate won’t change and I should invest the same amount, but since this is going to drive prices up I will have to borrow a little more in order to do it.”

If everyone said the second thing, there would be no problem just some inflation and then some deflation and all real variables would remain unchanged.  However, the banker doesn’t allow this, he says “don’t worry I know how to control inflation and I will keep it steady and positive.”  So the landowners say “low rates and high inflation huh?  Ok I’ll take a big loan and invest it and hire some more workers.”  This drives wages and the price of capital up.

Meanwhile, the banker goes to the workers and says “hey workers, I can lend you money at a rate below the current market rate.”  And if they were relatively unsophisticated they would say “great, I will cut back on my savings and/or borrow more and use it to buy more consumption.”  If they were very economically sophisticated they would say “ok but since you’re doing that for everyone, it’s just going to drive prices of consumption goods up now and then down in the future when the loans have to be paid back so I will consume the same amount but I will need to borrow a little more (or save a little less) in order to pay the higher prices for consumption today.”

Of course in the latter case, the banker will say “don’t worry I know how to control inflation and I will keep it steady and positive.”  So the workers say “great, low rates and high inflation and my wage is rising!  I’m gonna borrow more/save less and consume more.  Naturally this raises the price of consumption goods.

So for a while this goes on, prices of everything go up and everyone feels good.  But in a little while people stop borrowing and start paying back loans.  They figured this would be no problem because they figured prices would keep rising.  But since everyone is in basically the same situation they are all trying to pay loans back and not borrowing and this threatens to decrease the money supply which starts putting downward pressure on prices.  If prices fall, the people won’t be able to pay back their loans.  But the banker has a plan.  He offers them even lower interest rates.  And since, again, he promises to keep prices rising, they put off payment of their loans in favor of borrowing even more.  This causes prices to continue to rise fulfilling the earlier promise of inflation.

This goes on for a while but eventually nominal rates hit zero (or very close) and they cannot continue this strategy.  At this point, the money supply starts to fall.  What’s more, it is falling to a point lower than the original (commodity) money supply because all the loans that have taken place were made with interest.  Now everybody is trying to get their hands on some of the shrinking money supply in order to pay back their loans and save their collateral.  The land owners now are not thinking about what could be produced on their land and trading a portion of it for the other resources they need (like labor).  They are thinking about getting some cash to save their land.  If they could produce and sell the produce and get enough to do this they would but there is a problem.  The peasants also have debts which means they are also trying to get their hands on cash to save their stuff which means they are not very willing to pay for the produce of the land owners, they just want to work to get money to pay off their loans.  This means that the landowners can’t profitably employ them because it is no longer about producing real goods, it is about getting money to pay off loans.  Since nobody is willing to buy their produce, the best they can do is shut down (or at least cut back) production and try to hold on to as much of their cash as they can.  In other words you get low interest rates, low inflation, and high unemployment.  Sound familiar?

I know there are some questions that this doesn’t quite answer.  If I had the answers I would be publishing it in the AER not in a third-rate blog.  But hopefully this will get/keep the discussion going so feel free to ask them anyway and maybe we will find the answers.

Still More Broken Window Economics

September 6, 2011 16 comments

Here is a simple explanation of the Keynesian view of “broken window” stimulus.  It makes perfect sense and I agree completely with it (although there is an important distinction between the “economic activity” of a society and the wealth of a society).  But this argument (as all similar arguments I have heard) leave a gigantic question on the table that nobody seems to be talking about.  Why are there so many unemployed subsistence farmers?   In fact, this difficulty is so pervasive that it is inherent in the setup of this example.  After all, a subsistence farmer does not need the wealthy loaner to have work, they work for their own subsistence.  But let’s ignore the reality that a man always has himself (or each other) as the employer of last resort and assume that they do need the rich guy in order to have anything to do.  Maybe he owns all the land and resources that could be used to produce the conveniences and necessities of life.

In this scenario, the peasants represent a resource.  They could be producing things of value to themselves and the rich guy.  Knowing this, why would the rich guy allow them to be idle and starving to death?  By assumption this guy owns land or resources that they could work in order to produce something.  Presumably they would be willing to work on his land to produce something if they got to keep some of it.  Presumably they would be willing to work for less than the full amount that they could produce using his land and/or other resources.  And presumably he would be willing to let them work his land in return for some portion of their produce rather than let the resources (land and labor) go to waste right?  Or is that the rub?  See, this premise seems to assume that the rich guy is completely satiated, that he has no desire for any more stuff.  And not only does he have no desire for any other stuff but he would rather not have any other stuff and he prefers to watch all the peasants starve rather than make any use of his wealth because if he were satiated, he could still let them work and keep all of their produce.  This would make him no worse off, unless of course he just likes to see them suffer.  In this case a hurricane is only a device that undoes the satiation of the rich guy and allows the economy to work again.

So once again we have a model that begins by implicitly assuming there is no scarcity, at least for the rich guy.  Or could there be another reason that there are so many people/resources lying around going unused despite their obvious productive capabilities?  What might account for that?  What if there were a minimum wage that were higher than what they could produce?  Or a union that had the ability to keep them from working for such a low wage?  Or what if the rich guy had to pay taxes and social security and unemployment and medicare and pension and workers comp and liability insurance and hire a lawyer to help him comply with all relevent regulations every time he wanted to hire a peasant?   That would probably have some effect right?  But all that isn’t even the main reason.  The main reason is much more unspeakable than that.

Broken Windows and the Theory of the Second Best

September 1, 2011 9 comments

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?”