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The broken window fallacy does not always hold true (Debate Case)

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Austen Posted: Sun, Nov 4 2012 9:22 PM

Total Spending in an economy is equal to total income

In an economy, based on simple arthimetic and common sense, one can see that all spending is equal to income, assuming that the money supply is not increasing. One man's consumption is another man's income. If I buy a fruit at the store, then the store has income, which they would not have If I did not spend my money. If for example, everyone saved their money and nobody spent any money, nobody would have income. 

Total spending = Total income

Therefore, the more spending that occurs in an economy, the higher one's income is.

Another way to think of this is the velocity of money:

M*V = Q*P
This is the quantity theory of money. It states that the velocity of money (how fast money is ciruclating) times money, is equal to the quanity of goods and services, times the price of these goods and serves.

M = money, V = velocity of money, Q = quantity of goods and services, P = price of goods and services.

So as one can see If the velocity of money increases, then so do the quantity of goods and services, so long as prices do not not increase at the same rate.

Prices have been observed to be "sticky" or resistent to change in the short-run and during recessions. Therefore an increase in the velocity of money corresponses to an increase in goods and services.

A broken window causes spending to increase 

So let's say someone's window is broken. This means that someone is needed to fix the window. This corresponds to an increase in income for the glassman and the glassman can use his income to buy other goods and services, and so forth causing a multiplier effect. 

Counterarguments to the broken window argument

Propoents of the broken window argument fallacy argue that a broken window is bad for an economy for the following reasons:
a) The broken window means that real resources have to be used to fix the window, some of which could be used for other goods and services 
b) It ignores the unseen vs. the seen. 
c) The increase in spending will just cause inflation

I will demonstrate why these arguments are wrong.

In a recession or depression, resources are underutilized

A recession occurs If resources are not being fully utilized. This is emperically verified. Many nations have high unemployment and the US has had high unemployment in its past. For example, Greece has an unemployment rate of 25%.

http://www.google.com/publicdata/explore?ds=z8o7pt6rd5uqa6_&met_y=unemployment_rate&idim=country:el&fdim_y=seasonality:sa&dl=en&hl=en&q=greece+unemployment


What this means is that people who are willing to work are unable to do so. This also corresponds to factories not producing at full capacity. The economy is not producing at maximum capacity. The reason the economy is not producing at maximum capacity is because people are not spending their money. As one can see in this chart, the 2008 recession is considered one of the worst recessions since the Great Depression and the result is a skyrocket in savings:

http://farm4.static.flickr.com/3616/3662736447_ff57d9af0b_o.jpg

The same goes with banks that are holding excess reserves:

http://static.cdn-seekingalpha.com/uploads/2012/8/31/saupload_Excess_Reserves_Fred_thumb1.png

Therefore there is no need to worry about taking resources from someplace else during many recessions and depressions.

The person with a broken window could have just saved his money, thus producing no real economic effects 

A counter-argument is that the person with the broken window instead of spending his/her money on the window, would have spent the money on other goods/services, thus the broken window is a net-harm. However, this ignores the fact that the person could have just saved his/her money instead, which would produce no economic benefit at all. 

Prices are "Sticky" so inflation does not necessarily occur. The increase in spending would only cause inflation if the economy is producing near maximum capacity

Prices and wages have been observed to be sticky, For example, during a recession, if there were unemployment problems, then one would expect that wages would just lower and the market would clear itself. However, this has not been observed. One can also see numerous examples of how prices do not change even with changes in demand. For example, movie tickets prices remain the same regardless of how many tickets are sold. The same can be observed with books. The Harry Potter books did not have a spike in prices because there was a spike in demand of people who wanted to read these books. A Harry Potter book costs about the same as most other books. 

Emperical Evidence of the "Broken Window Fallacy" in action

One example of the broken fallacy in action is government increasing its spending during recessions/depressions. This is an example of how spending increases the domestic goods and services in an economy. Emperical results have proven that the fiscal multiplier does exisit. 

http://personal.lse.ac.uk/ilzetzki/research/IMV_101910.pdf

Furthermore, one can look at history. If one looks at World World II after the great depression, the government spent massive amounts of money on the ar efforts. The result was that unemployment decreased dramatically, almost down to zero.

http://upload.wikimedia.org/wikipedia/commons/thumb/5/58/US_Unemployment_1910-1960.gif/350px-US_Unemployment_1910-1960.gif

Economic activity boomed:

http://upload.wikimedia.org/wikipedia/commons/a/a1/US_Employment_Graph_-_1920_to_1940.svg

After the end of WWII, the US was the most powerful economy in the world, and continued to increase its economic growth creating great prosperity. 


Conclusion

While the broken window fallacy is a fallacy if the economy is producing at its full potential, this is not a fallacy during recession and depression times. Real variables, that are considered to be economically positive, such as an increase in gross domestric production, occur If there is a net increase in spending, which can be jumpstarted through any event, such as broken windows.

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Bogart replied on Mon, Nov 5 2012 7:12 PM

    "In a recession or depression, resources are underutilized"

The reason resources seem underutilized is because their is no entrepreneur who believes that consumers will pay him more than the cost of the resources.  Therefore the entire economy is wealthier not using the resource.  Eventually the price of the underutilized resource will become so low, even zero, so an entrepreneur will acquire them.  The worst thing thing to do is to use an agent of force to use a resource without regard to the desirability of the end products to consumers.   So if government uses force to utilitze a resource then the economy ends being poorer as resources must be stolen from others to utilize the resource.

    "The person with a broken window could have just saved his money, thus producing no real economic effects."

This is completely wrong.  The only way to create real wealth is for people to produce and then save what they don't consume.  Entrepreneurs can then purchase these savings for future payoffs and build new products and services.  In a complex economy savings are in the form of unused money.

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"A recession occurs If resources are not being fully utilized. "

Why is that?

“Since people are concerned that ‘X’ will not be provided, ‘X’ will naturally be provided by those who are concerned by its absence."
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Neodoxy replied on Mon, Nov 5 2012 8:26 PM

Already been done, so you might say that I'm qualified.

Government spending cannot selectively target prices. This means that while some inputs will be brought up to their "older" level of demand. Some prices will go up a lot, others a little. This means that some prices will rise, but it will not rise to normal demand. Aggregate demand doesn't exist, only specific demand exists. Furthermore, how is it that, even once demand returns to normal and government spending is cut that the recession will not return?

Finally, while government spending can increase demand in perverse, wasteful, and temporary directions, it will oftentimes increase regime uncertainty which will decrease business activity in a period of uncertainty which is already great. Most import importantly the expectation of the government propping up prices will prevent prices from readjusting to the necessary levels at which point full employment will come about. Government spending makes prices and wages sticky and elongate the readjustment period. There is absolutely zero reason to believe that prices on a free market are sticky, especially over time, so we would expect prices to adjust quickly on the free market and for normal ratios to be restored.

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cab21 replied on Mon, Nov 5 2012 8:54 PM

what storekeeper would rather have a broken window than a paying customer?

what storekeeper would rather pay to fix a broken window than restock a profitable item?

what storekeeper saves money under his bed rather than investing money in the economy?

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Malachi replied on Mon, Nov 5 2012 8:57 PM
No but dont you understand? In a recession people still have money in their wallets! IN CASE BAD STUFF HAPPENS LOL so when the bad stuff happens, hey, free money! Just like buying a hot dog at the state fair!
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Austen,
 
Question: if you're correct, then wouldn't the best thing to do during a recession or depression be to (through government force - taxation) purchase thousands upon thousands of bulldozers and wrecking balls, increasing the circulation of money, hiring people to operate them and wreck EVERY house, store, and building in the country, increasing the circulation of money, and then making everyone rebuild, increasing the circulation of money?
 
Taken to the extreme, it becomes easy to see that what you say is absurd.
 
Another question:
 
If the number of times money changes hands had anything to do with the prosperity of people in a society, wouldn't we just be able to get out of a recession or depression by, for example, forcing everyone to spend their entire amount of savings on the purchase of their neighbor's vehicle, where everyone is forced to sell, and then the next day, everyone takes the money they got for their car yesterday, and buys back their car, and repeating this every single day?
 
If mere circulation was all that was needed to make an economy vital, this would work, right? We'd all be so much richer if we did this!!!!!!!!!!!

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Austen,

I've sort of touched upon this topic (at least, broken windows and idle resources) in two pieces I'm written, including an article published on Mises.org: Disasternomics and "Government Spending is Bad Economics."

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Austen,

I like several things about your post. Most important, that you summarize your opponent's position before you refute it. Second, that you provide links to justify your factual claims. Third, that the whole post has structure, a logical chain of reasoning, as opposed to rambling along. Fourth, that there is no appeal to emotion.

Thus, it deserves a response. The thing is, you have a lot to learn, and even more to unlearn. The ole fingers will wear out addressing your whole post, so let's just look at the very first part, from which all the rest follows. If that is shown flawed, the rest, like a house whose first floor has been demolished by Hurricane Sandy, will fall apart of itself.

So let's examine the Total Spending = Total Income equation, and the conclusions you draw from it.

Yes, the equation is correct. Total Spending does equal Total Income. But Total Income is not a measure of Total Wealth, obviously. For example, if I make $30,000 a year selling all I own, my Total Income is 30 thou, but I am not any better off. So we are barking up the wrong tree from the very start if we are looking to increase Total Income, or its buddy, Total Spending. 

So what is the right thing to look at, if not at Total Spending or Total Income? We can find a clue if we examine the following homely scenario. Say the Govt taxed rich people at 50%, and poor people at zero, and then gave the tax money to the poor. The rich had no intention of spending that money. The poor go out and spend it all, buying all the wine and cocaine the rich had stashed away for future use. Total Spending went up. Total Income went up. But that did not improve the economy at all; the only thing that happened was that wealth changed hands. After the poor wake up from their hangover, what do we have? The rich are poorer, having less wine and coke. The poor are in the exact same boat, poor again. And if the govt repeats this little process again and again, Total Spending and Total Income will keep on chugging away, but all that is happening is that the poor are consuming [=using up, destroying] the wealth of the nation. At some point there will be nothing left, if this is all that's happening in the economy. And yet, according to the numbers, everything is fine. What is wrong with this picture?

The answer, of course, is that "Total Spending = Total Income" is ignoring the variable that really counts, Total Production. You can increase Spending and Income all you want, but if Production is non existent, the economy has not improved in the least. In fact, it has gotten worse, because the stock of goods has been reduced by all that Spending, and is not going to be replenished, since there is no Production.  

Notice that the same flaw inheres in the other equation you quote, MV=PQ. If the MV is spent on previously produced stuff, but nothing new has been produced, an increase in MV just means exactly the same thing as in the above analysis, that the economic situation has gotten worse, not better.

Looking at that equation, the only way to improve the economy is to make good and sure Q, the quantity of goods, goes up. If Q stays the same or goes down, the other variables can dance around all they want, but the economy is not better off.

Before Keynes muddied the waters, this was universally understood. Increased Production is what counts. As J. B. Say put it:

...in every community the more numerous are the producers, and the more various their productions, the more prompt, numerous, and extensive are the markets for those productions; and, by a natural consequence, the more profitable are they to the producers; for price rises with the demand. But this advantage is to be derived from real production alone, and not from a forced circulation of products; for a value once created is not augmented in its passage from one hand to another, nor by being seized and expended by the government, instead of by an individual. The man, that lives upon the productions of other people, originates no demand for those productions; he merely puts himself in the place of the producer, to the great injury of production...

...the encouragement of mere consumption is no benefit to commerce; for the difficulty lies in supplying the means, not in stimulating the desire of consumption; and we have seen that production alone, furnishes those means. Thus, it is the aim of good government to stimulate production, of bad government to encourage consumption...

...Indeed, if the nation be in a thriving condition, the gross national re-production exceeds the gross consumption. The consumed products have fulfilled their office, as it is natural and fitting they should; the consumption, however, has opened no new market, but just the reverse.

Now one may think that since M, V, P, and Q are all tied together in an equation, you can increase Q [=production] by jiggling the other variables. If we just increase M and V in the real world, and lower P, then Q will levitate off the ground automatically, as if it were riding a magic carpet. It's simple arithmetic and common sense, right?

Wrong. To expose the absurdity of such thinking, let's look at what would happen if an engineer tried the same thing with another famous equation, F=ma. The engineer is testing a new tractor. He wants it to push a mound of dirt that weighs 2,000 pounds, but it's not happening. The tractor grunts and groans, but the mound stays put. He analyzes the situation. "Hmm," he says. "The net force required to move the mound is equal to the mass of the mound times the accelaration the mound will have. There is clearly not enough force being applied, because the mound is not moving at all, which is the desired goal. Well F=ma, right? Increase m, the mass of the mound, and you increase F. Simple arithmetic and common sense. All I have to do is put a few more tons of dirt on that mound and the tractor will have increased force." So he drops a few tons of dirt on the mound, turns on the tractor, and of course, the mound isn't going anywhere.

"Where is my mistake, Professor Keynes?" the engineer asks his good buddy. I've seen you do the exact same thing with your equation.

"And I got the exact same result as you did."

"But World War II ended the Great Depression. You increased M and V, and the economy rose up like a pheonix."

"Actually, if you do your reading on mises.org, you'll see that WW2 did nothing of the kind."

"So you made the same mistake I did, Prof?"

"You just ruined your tractor. I ruined the whole world. Do you know exactly what our mistake was? Have you learned anything from this sad experience?"

"Well, Prof. I see now that I confused cause with effect. Increased F applied by the tractor is the CAUSE of an increased ma of the mound. The equation doesn't mention that, but of course it's true. You cannot increase the ma of the mound and hope that the F of the tractor will increase from that alone."

"Yep, my mistake exactly. Increased Q [=production] is the CAUSE of the increase in MV. You cannot put the cart before the horse and increase MV,  hoping that Q will increase from that alone. You have to sit down and think of nuts and bolts ways to actually increase production. You know, by increasing the amount of machinary available, things like that. Not by playing around with the money."

"We were real dummies, Prof, weren't we?"

"But at least I'm dead. What's your excuse?"

 

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Regarding the equation Total Spending = Total Income, what about when people decide to save part of their income rather than spend it? I think that equation basically ignores the time dimension.

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Auto,

I liked your old avatar more. Lent weight to your posts.

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However, this ignores the fact that the person could have just saved his/her money instead, which would produce no economic benefit at all.

In what world? I'm a little worried - do they teach this on "economics" degrees?

 

And as for the "empirical evidence" canard, try this and this.

MV=PQ isn't going to take you very far until you realise the meaning of the terms behind it. And no, the existence of a recession is irrelevant to whether or not the BWF is applicable. If you simply want more "economic activity", give everyone a spoon with which to dig ditches and pay them for it, and watch GDP skyrocket.

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Smiling Dave:
Auto,

I liked your old avatar more. Lent weight to your posts.

Apparently you're afraid to respond to me in a serious, non-dismissive manner.

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Did you as me something? Will gladly answer. And I am not dismissive of you in the least, quite the contrary.

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I had asked a general question. Surely you saw it. So it baffles me why you chose to ignore that question and instead insinuate that my post wasn't at all worth responding to in a straightforward manner. As you well know, my avatar is entirely irrelevant to the content of my post.

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Neodoxy replied on Tue, Nov 6 2012 10:13 AM

"Regarding the equation Total Spending = Total Income, what about when people decide to save part of their income rather than spend it? I think that equation basically ignores the time dimension."

The equation is necessarily true. Everything that someone spends is someone else's income. While you're right that it only works if we pick one "time period" the fact is that if I section off any time period, be it a year or ten days, that every penny spent by one person will be another person's income because you cannot receive new money without someone giving it to you.

Therefore if people decides to save their money rather than spend it then spending goes down, as does income. It's arbitrary at what point you set the time limit, but the equation does include savings.

Phi est aureum,

I find that both of your examples perform conflation which, on their face look helpful but which, on further examination are not.

Now let's take your first example under a Keynesian nightmare world. Let's say that unemployment is at 99.99%, most people are starving and destitute and that the economy will not equilibrate for another 2 centuries. Under this drastic, overboard situation, then, if the Keynesian assumption is correct, then these drastic overboard methods could actually make people better off, instead of 2 centuries of abject poverty you'd have mass production to rebuild everything, which, even if it takes more time, will still make people better off in the intermediate term... This situation also works a lot better if you don't destroy the means of production.

The fact is that most Keynesians don't advocate anything like this. They want to do things which they believe create and raise productivity, like infrastructure.

As for your second point, it doesn't apply at all because the reasons why Keynesians think what they do is twofold. First, they believe that knowledge of future consumption generally leads to production, which it usually does, but it doesn't if you're buying the same car back and forth. Second they believe that most money will be spent on people buying what they want to buy. Spending is to increase employment so that then the employed can buy what they want, not so that they can buy what they don't need.

We have to attack the heart of Keynesianism; the idea of idle resources and sticky prices.

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Wheylous replied on Tue, Nov 6 2012 10:31 AM

Austen - look at the empirical studies of the government multiplier:

http://bastiat.mises.org/2012/11/fiscal-stimulus-or-fiscal-depressant/

Crowding out occurs. Why? Becuase government is not able to specifically target idle resources.

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Bogart replied on Tue, Nov 6 2012 10:50 AM

what storekeeper saves money under his bed rather than investing money in the economy?

The correct answer is that under a hard money system this activity is savings and is good for the economy.  WIth a limited supply of money, any storage of money, even money that is not "invested" only makes the purchasing power of the remaining money higher and makes holders of the remaining money wealthier.

The problem is that the hoarder of money HAS NO CHANCE of impacting  anything against the incredible evil that is the central bank where they can create billions by entering digits into a computer terminal.

 

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I don't understand the question, nor your comment on it.

TS=TI is talking about the past. The total amount spent in the past, choosing whatever length of time you wish, is equal to the total amount other people got in their hands from the spenders. I think this is irrefutable. Spending involves, by definition, giving someone else money.

If, in that  time interval, someone had money he did not spend, it appears on neither side of that equation.

As I mentioned in an earlier post, the problem with the equation is the absurd conclusions people draw from it.

 

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Slightly revised version of the above post right here:

http://smilingdavesblog.wordpress.com/2012/11/06/hurricane-sandy-and-good-ole-mvpq-have-we-broken-enough-windows-to-end-the-recession/

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Bob Murphy took this question head-on, even quoting Krugman writing almost exactly what you wrote in your first paragraph. I hope you'll check it out: http://mises.org/daily/3155

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cab21 replied on Tue, Nov 6 2012 2:05 PM

so a storage unit would be better than a bank( which has a storage unit, it just loans money out with the gold in storage to back up whatever it loans)?

invest and store seems better than store without investing.

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cporter replied on Tue, Nov 6 2012 2:31 PM

If I could name two things that are most responsible for confused theories, it would be these: measuring economics in money, and ignoring time.

The broken window fallacy has nothing to do with the shuffling of money. The point is that there has been a net reduction in the stock of goods, so that now work must be replicated. If work must be replicated just to get us back to where we were before then we are worse off. The fact that you can dip into part of your stock of goods (money) to trade for a replacement window doesn't mean there was no reduction in the stock of goods.

The argument defeats itself here:

Austen:
The person with a broken window could have just saved his money, thus producing no real economic effects 

A counter-argument is that the person with the broken window instead of spending his/her money on the window, would have spent the money on other goods/services, thus the broken window is a net-harm. However, this ignores the fact that the person could have just saved his/her money instead, which would produce no economic benefit at all.
 
If saving your money produces no economic benefit, where does the money come from to replace the broken window? Of course, it came from past savings, and is now being put to use in exchange. If he had no savings he wouldn't be able to do that.

Wealth is measured by what we have, not what we must work to obtain in the future. Break windows, reduce wealth. Simple as that.

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Dang, had to revise the article.

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Yes, the equation is correct. Total Spending does equal Total Income. But Total Income is not a measure of Total Wealth, obviously. For example, if I make $30,000 a year selling all I own, my Total Income is 30 thou, but I am not any better off.

Actually you are better off, ex-ante, or you would not have made the sale.


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