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Rick Davis Addresses “The Broken Window Fallacy”

Posted by Larry Doyle on February 18, 2011 5:33 AM |

I recently commented to Rick Davis of Consumer Metrics Institute that I love his site because each and every time I visit, I learn something. How good is that? Outstanding and further reason why Rick continues to elevate himself within the Sense on Cents Hall of Fame. Do yourself a favor and throw Consumer Metrics Institute in your favorites. You will not be disappointed.

What does Rick bring us lately? A great piece hearkening back to the mid-1800s. Let’s navigate as Rick writes,

We have received a number of thought provoking responses to our back-of-the-envelope calculations about the impact of mortgage delinquencies (and so-called “strategic defaults”) on consumer spending. One such correspondence has been with Jeff Harding at The Daily Capitalist. Jeff correctly pointed out that our calculations ignored the offsetting damages that the defaults were inflicting on banks, making the spending gains that we calculated a present-day example of Bastiat’s “Broken Window Fallacy.”

For those unfamiliar with the “Broken Window Fallacy”, in 1850 Claude Frédéric Bastiat published an essay containing an economic parable that illustrated the hidden costs associated with destroying the property of others. Bastiat imagined a situation where a shopkeeper’s son carelessly breaks a window in the shop. The fallacy centers on subsequent comments by onlookers — who offered that “it is an ill wind that blows nobody good. Everybody must live, and what would become of the glaziers if panes of glass were never broken?” The onlookers (and by extension most casual economic observers) sense that the shopkeeper’s loss is the glazier’s gain, a zero-sum game.

Bastiat asserted that the onlookers completely missed the macro-economic loss of the previously productive window. If the shopkeeper had not needed the replacement window, he might very well have used those same funds to purchase new shoes from the cobbler. When you include the cobbler’s lost sale, it is no longer a zero-sum game. Ultimately the economy is net poorer by the amount of the capital lost when the window was broken.

Although our perspective of the economy is limited to what on-line consumers are doing, Jeff has persuasively argued that Bastiat would ask: “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 the economy needs now is not (consumer) spending, but savings.”

We agree that more pain for the banks probably does not bode well for the economy down the road. And however unsympathetic the character of some banks may be, at some fundamental level large-scale defaulting on debt contracts is a defacto violation of the rule of law that is essential to any desirable society.

The Broken Window Twists

There are, however, some interesting twists to the present-day incarnation of the parable. In no particular order:

1) The sainted John Maynard Keynes would disagree that there is any fallacy involved at all. He was so focused on what he mis-labeled as a “Paradox of Thrift” that he literally felt that the ultimate goal of governmental stimuli was simply to spend, however wasteful that spending may be. He would have lauded the shopkeeper’s son for stimulating the economy.

2) In Bastiat’s parable the fallacy is fundamentally based on the fact that there is a net macro-economic loss: the broken window is itself a loss of productive capital for the economic collective. It is not a zero-sum game. In the case of present-day mortgage defaulters, however, the sums are somewhat more muddled. In many (if not most) cases the ultimate economic loss will be shouldered by Fannie Mae or Freddie Mac; i.e., the American taxpayers. This means that most of the $90 billion per year in delinquency “found money” is ultimately coming from Mr. Bernanke. The sainted John Maynard would love it.

3) Again, in the parable there is an implication that the loss was neither natural nor inevitable, but rather a case of third-party carelessness — for which the shopkeeper is blameless. It is hard to see how bankers, Fannie Mae, Freddie Mac and politically motivated HUD administrators are blameless for the present-day debacle. Would Bastiat still see a fallacy in his parable if the glazing had failed because of the shopkeeper’s bad maintenance decisions?

It is probable that in the end a large portion of the $90 billion per year in delinquency/default “found money” will simply be a transfer of taxpayer funds to the most financially stressed subset of American consumers — in some regards not at all that functionally different from extending unemployment benefits. And while the banks are hardly blameless shopkeepers, it may also be hard to find taxpaying Americans that didn’t benefit to at least some extent from the same asset bubble that eventually blew out the window. The ultimate collective loss from this particular incarnation of Bastiat’s parable may lie in the memories of the rewards reaped by those institutions that have most egregiously abused moral hazards, and the wealth transferred to those individuals who have successfully shirked debt. The real losses may be in the sanctity and innocence of credit obligations.

Just how many broken windows can one nation take and think there might not be real losses? I wrote to a friend the other day that the costs associated with our current debacle may not be known for decades and may never be truly and honestly calculated.

Navigate accordingly.

Thank you Rick and Jeff Harding as well.

Larry Doyle

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I have no affiliation or business interest with any entity referenced in this commentary. The opinions expressed are my own and not those of Greenwich Investment Management. As President of Greenwich Investment Management, an SEC regulated privately held registered investment adviser, I am merely a proponent of real transparency within our markets so that investor confidence and investor protection can be achieved.

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