Broken Window Fallacy

Economic Heroes?

With "Cash for Clunkers", the US is simply using a part of its productive energy to go and destroy productive assets. While luckily a drop in the bucket, it is actually destroying value, perversely with the intent of helping out during an economic downturn. Bloomberg columnist Caroline Baum makes a great reference to the Broken Window Fallacy, and is right on the money.

The Broken Window Fallacy basically exposes some very false economic thinking, whereby a boy vandal breaks a shopkeeper's window and some believe that he is actually spurring the economy via his destruction since the shopkeeper now needs to order a new window, then the windowmaker has income to buy new shoes, the shoemaker then has money to buy something from someone else, etc. (and thus the boy stimulates a whole stream of economic activity via his destruction of property). You can read the entire concept via the link above.

The point of it is that many people might falsely find the boy helpful to economy because they ignore the cost to the original window owner via the destruction of an existing productive asset. The window owner could have easily spent the same amount as he did on the broken window, but for something additional and more productive, while still retaining the original window had the boy not broken it.

As Ms. Baum highlights, this broken window parable is pretty similar to the stiuation we have with Cash for Clunkers: The US is destroying cars before their useful life is over, just like the boy is smashing windows before they wear out.

“Cash for clunkers” was touted as a huge success, with cars tearing out of auto showrooms, the program running through its $1 billion appropriation in one week and government servers crashing in response to overwhelming demand from dealers filing for rebates. (At least it wasn’t the drivers that crashed.)

Was the program to induce drivers to turn in old gas- guzzlers for a more fuel-efficient vehicle a success? That depends on how you define success.

Consumers got a “discount,” automakers sold more cars and trucks last week than they would have, and all that “stimulus” -- spending begets income begets spending -- has to be good for the economy, right?

With success like that, why limit the rebates to $4,500? Why not give everyone a $10,000 or $20,000 rebate to turn in an old clunker? And why stop at the cars in the garage when you could get rid of a garage full of accumulated junk, with the government providing rebates to households for unloading what they’ve been meaning to get rid of for years?

A reductio ad absurdum, to be sure. Sometimes reducing a proposition to absurdity is the easiest way to expose its flaws.

Exactly. If destroying cars before their useful life is over is beneficial, then shouldn't we just start destroying all kinds of useful assets in order to stimulate new purchases? Why don't we destroy all of our useful assets before they are worn out and rebuild from scratch. That would generate immense need for new purchases... true. Yet what is forgotten is that it would annhilate our aggregate amount of existing productive assets. And that's what those who fall into this logical trap miss. They forget to think about changes in the amount of existing productive assets, staring only at new purchases.

Rather than the above, we'd be much smarter to still make new purchases, but to keep our existing productive assets as well. Then by simple addition we could have new productive assets plus existing productive assets rather than new productive assets minus destroyed productive assets.