The Broken Window Fallacy: Consumer Metrics Institute vs. The Daily Capitalist

One of my favorite economics lessons is Frederic Bastiat’s parable of the broken window (“That Which Is Seen, and That Which Is Not Seen” from Essays on Political Economy, published in 1850). The lesson is the common idea that when Little Johnny throws a pebble and breaks the shopkeeper’s window, the glazier will benefit from the new economic activity created by the need to repair the window. The unseen consequence of the act is that no one thinks about what the shopkeeper was going to do with the $100 he spent on the window. But for Little Johnny’s act of malice, he would have had the window and his $100. The result is that the shopkeeper wasn’t able to buy a new pair of Air Jordans that he was coveting, thus depriving the shoe seller of a sale. The net result is that there is a loss in the economy.

You would be surprised how pervasive this idea is. I urge you to read Henry Hazlitt’s Economics In One Lesson (one of the best books ever written on economics) for a good discussion of this idea.

So when I saw my friend Rick Davis of Consumer Metrics Institute discuss the recent windfall to homeowners who had stopped paying their mortgages, my “seen and unseen” hackles rose. Now, Rick publishes excellent data which I follow. His article, “Measuring the Impact of “Strategic Defaults and Mortgage Delinquencies on Consumer Spending,” may be found here.

His thesis is that this may amount to a $90 billion windfall to homeowners which would boost consumer spending, with the underlying assumption that this is an economic positive:

If we assume that our defaulters were able to cover most other non-discretionary budget items before the default process began, we can then also assume that most of the cash leaving the cookie jar will end up as discretionary durable goods. If we further assume that somewhere between one-quarter to one-half of the $90 billion actually ends up in consumer spending, we might expect to see discretionary durable goods gaining 2% to 4% annualized at the expense of the mortgage bankers. This may be a partial explanation for the observation that U.S. consumers have recently managed to increase their spending even as real incomes remained nearly stagnant.

I wrote him expressing my belief that this merely was another version of the Broken Window Fallacy. We had several e-mail exchanges which were interesting and challenging for both of us. It may be that some of consumer spending comes from this windfall, but it is also evident that consumers are drawing upon their savings to finance spending. And, by the way, Rick follows Austrian theory economics.

I thought I would republish our correspondence and you can tell me what you think of our respective arguments. Rick also published some of this and he had mixed results. Here it is:

1

Rick:

Regarding your 2/7 commentary on defaulters having excess cash to spend to boost the economy. Isn’t this just another example of the broken window fallacy? What were the lenders going to do with the money that their borrowers were going to pay them?

Jeff

2

Jeff:

As always, it’s great to hear from you! Alas: “the broken window fallacy” …

1) I’m not sure that John Maynard, bless his soul, would agree that the  broken window is necessarily a fallacy. What’s the difference between  overt stimulation of the economy at the expense of the taxpayers (e.g.,  paying some guys to bury some money), and (ironically) a much more  direct stimulation of the consumer economy at the eventual (post-next-round-of-bank-bailouts) expense of taxpayers?

2) I could also argue that putting $1,500 per month in the hands of 5 million households who are economically challenged at the moment has higher velocity than some $792 billion spent on infrastructure projects.

3) So, Jeff, how would the bank actually use that $1,500 per month? Loan it out at reserve limits? Not likely. Building capital accounts? More likely. Funding M&A activities that generate fees? Bingo

4) Actually, the $90 billion per year stimulation of the consumer economy is only relative to the pre-default era. If the levels of delinquencies and foreclosures remains relatively flat, there is no new  net stimulative effect — just a different rolling cohort of defaulters  providing the cash flow. Oddly enough, one could argue that should the  entire “underwater/delinquent” mess suddenly go away it would be a net  $90 billion/year drain on consumer spending.

5) I agree that a broken window requires looking at more than the windfall to the glazier. And frankly I’m not knowledgeable enough with banking issues to fully understand the implications of the $90 billion/year on the global financing system far down the road. In fact,  I doubt that anybody knows that, since everyone’s so busy kicking the can down that very same road. But ultimately the bankers are a somewhat  unsympathetic lot. I think that most “Main Street” Americans would  rather pay the glazier than have the money stay with the shopkeeping, Mr. Sachs.

Sorry for the rant …

Rick

3

Rick:

Thanks for the reply.

Certainly Mr. Bastiat would disagree with Mr. Keynes. I see the issue as a pool of money and if you take it from one end of the pond and stick it in the other, there is no net effect. In addition, I disagree with your assumption that $90 billion would be better in the hands of consumers rather than banks. You cannot say that depriving banks of that much money wouldn’t have a negative economic effect on them. They are stuck with a loss and that has short and long term consequences to the economy. As Bastiat would say, what would the banks have done with the money? Most likely lend more, create more credit for the economy, replace the store of real capital, pay salaries to employees, make profits. What will consumers do? Pay rent, spend on consumer goods? Maybe add to savings, but probably not.

What the economy needs now is not spending but savings. It is my belief that what is happening is inflation and stagnation, i.e., stagflation. While the economy has shown modest growth, I don’t think we will see anything spectacular and that unemployment will remain high. I believe that there is a lack of “real” capital and further spending only depletes real capital more by misdirecting capital to consumer goods. I think a lot of it depends on QE. My belief is that we will probably see QE3, but a lot of ifs. Right now QE is starting to show up in the economy as price inflation (just beginning) and a buoyant stock market. I don’t doubt there is some real growth occurring but that most of what we are seeing that is deemed “positive” is actually just an increase in money supply.

I think we disagree.

Jeff

4

Jeff:

This whole topic probably merits more discussion, lest you think that I  defend the mob a tad too much. There are actually two subtle aspects of  Bastiat’s parable in play here that also deserve mention:

1) The fallacy is fundamentally based on the fact that there is a net  societal loss: the broken window itself is a loss of productive capital  for the economic collective.

2) There is an implication that the loss was neither natural nor  inevitable, but rather a case carelessness — for which the shopkeeper  is blameless.

Would the parable still assign a net economic loss to the incident if  the window had merely been purloined by the cobbler and put into  productive use in his shop? And would Bastiat still see a fallacy if the  glazing had simply failed as a consequence of the shopkeeper’s bad  maintenance decisions?

I do not dispute that the shopkeeper has been harmed in any case. Nor  do I pretend to fully understand the eventual economic impact of $90  billion a year in lost economic rents. I merely assert that we are  witnessing a zero-sum transfer of wealth that results ultimately from  bad underwriting decisions. Furthermore, the final source for those  transferred funds will be the taxpayers, not the banks — because we  don’t live in an Austrian world.

Please understand that I do not defend or endorse the mob, I merely  measure what they are buying on-line. And I’m not smart enough to fully  understand the answers to a number of questions:

1) If the banks are being harmed, are they blameless?

2) Did the now-harmed banks not benefit commensurately from those same  now-bad transactions in the past?

3) If we want the economy to grow, isn’t bad-debt clearing at least as  high a priority as increased savings?

4) Is the current reality that banks would most “likely lend more,  create more credit for the economy”? Please see a note from a source  that I trust:  http://dailycapitalist.com/2011/02/12/are-banks-lending-a-report-from-the-trenches-part-ii/

5) What are the real relative velocities of money in the hands of  economically stressed consumers vs today’s real-world banks? (see 4 above).

6) If the economy does indeed need less spending and more savings,  isn’t at least some of the $90 billion accomplishing that at the margin? As we said in our piece on the delinquencies, we expect that only  25%-50% of the $90 billion actually gets spent on discretionary goods. So figure $45 billion per year is at least shrinking short term debt.

7) Isn’t the real harm to society the implicit reward for debtors? When  compounded with your inflationary scenario, why would anyone want to  save? Thanks to QE2, the mob should simply default and put the $1,500  per month into the equity markets.

Again I apologize for the continued rant. My larger issue, however, is this: Austrians ignore the mob at their own peril.

This recession and it’s aftermath have not been a shared experience  over a wide cross section of the American people. This has been a wealth  transferring event. Socio-economic gaps have widened. Age, gender,  racial and cultural demographic gaps have been impacted as well. Joe  Lunch-Pail (whoever that is anymore) has not fared so well personally as  Mr. Bernanke, Mr. Geithner or their future co-workers at Goldman Sachs.

Even if Keynes is responsible, von Mises should be alarmed that his  consumers have suffered.

In your essay on historical incidents of hyper-inflation, you cite the  dangers of a Mugabe or Peron, who might politicize monetary policy. This  country had that once, in 1832. And look who won.

Thanks again for your response,

Rick

5

Rick:

Thanks for your thoughtful reply. And it is great that you shared our correspondence with your readers.

While I don’t entirely agree with your assessment of Bastiat’s parable, I understand your thinking on this and you raise some excellent points. What I think is the difference between us is that I believe that regardless of the causes of the crisis, the fact that the lender’s money ends up in the pockets of the borrower as a windfall is not an economic positive and represents a destruction of capital.

What Bastiat focuses on is the destruction of capital as not being an economic positive for an individual or the entire economy. As you know, free market economics is not a zero-sum game. But in the present context, valuable capital was lost and spent and it will take some time for the lender to recover the loss of that capital.

To get back to your examples, a theft is a loss of capital for the baker that results in a windfall for the thief. Someone’s gain cannot offset the other’s loss. The baker gets to pay the glazier for a new window instead of keeping his window and buying a new baking pan to expand production.

If the baker is careless [and the window breaks because of his negligence], that too is a loss which means that if he keeps on acting imprudently, his capital losses may be great enough to drive him into bankruptcy. But that is his fault; it wasn’t caused by someone else. That’s fair and that is what competition is all about.

In the present situation with regard to defaults on mortgages, you make some excellent points. While the cause of the capital destruction orgy was the Fed, banks certainly used bad risk models which were bad business decisions that were initially masked by the Fed’s money pumping. All that is true.

But that, and all the other points you raise, still do not turn the windfall into an economic positive for the “economy.” In fact the banks suffered massive capital losses. Some of the capital losses no doubt were not “real capital/savings” in the Austrian sense, but clearly some of it was, and that is never good for the economy. The banks are never going to recover those losses.

Under your logic, why don’t we argue as a national policy for all borrowers stop paying their mortgages and spend the amount “saved”? How would that revive the economy? It doesn’t make economic sense at any scale.

I would like to address several of your comments specifically:

3) If we want the economy to grow, isn’t bad-debt clearing at least as high a priority as increased savings?

Yes, and that is what is hanging up credit, but then, why not have a biblical debt jubilee and see where that takes us? This is not relevant to the argument against the broken window fallacy.

4) Is the current reality that banks would most “likely lend more, create more credit for the economy”?

Ditto from above. There are two sides to this issue. It depends on the extent to which real capital was destroyed and the willingness of businesses to borrow. It’s not as simple as just clearing bad debt off of bank balance sheets. Besides, the main problem with bank credit isn’t residential loans but CRE loans.

5) What are the real relative velocities of money in the hands of economically stressed consumers vs today’s real-world banks? (see 4 above).

I don’t think this has anything to do with recovery. It’s not about spending. As I have said, if spending were the panacea, then Zimbabweans would be rich. Our problem is the lack of real capital.

6) If the economy does indeed need less spending and more savings, isn’t at least some of the $90 billion accomplishing that at the margin? As we said in our piece on the delinquencies, we expect that only 25%-50% of the $90 billion actually gets spent on discretionary goods. So figure $45 billion per year is at least shrinking short term debt.

Yes, you are correct. But you miss the other side of the transaction. As one commentator said it is like single-entry bookkeeping in a double-entry world. The banks have lost $90 billion in capital.

7) Isn’t the real harm to society the implicit reward for debtors? When compounded with your inflationary scenario, why would anyone want to save? Thanks to QE2, the mob should simply default and put the $1,500 per month into the equity markets.

This is a different issue. This issue is about fiat money creation by the Fed. And I would agree that it is bad for everyone. We Austrians don’t look at “society” but rather the individual (marginal revolutions and all that) as the end-all of economics.

Thanks for the stimulating conversation.

Jeff