Rebutting The Broken Window Fallacy: Reader Comment Discussed

A reader posted a comment on my article yesterday, Hurricane Sandy Breaks Windows Throughout New York: Economic Stimulus?, which I began commenting on and as usual it turned into a lengthy response. I have decided to re-post a portion of the comment here and then provide my response. His view is the main crux of the Keynesian argument and was very well spoken and written. It is always good for readers of this site to hear thoughts outside my own. .

"The Citizens would have spent their tax dollars on other goods and services". Attempting to generalize the broken window fallacy to government spending fails because this statement is false. This statement is only true for citizens who spend all their income. When citizens have so much income that much of it is not spent, but instead gets invested (or saved and then invested by banks), then it's possible (and eventually likely) for that saved income to be mal-invested - that is invested in a way that creates production overcapacity or the wrong production capacity - "wrong" in the sense that the production capacity created just perpetuates unsustainable economic growth. Eventually, such overcapacity or unsustainable growth will collapse economic activity. Now, all this is not to ignore that the government can also spend or invest the money (as tax dollars) in similar unproductive ways. However, when the broken window fallacy is extended to government spending, it ignores the potential economic stimulative effects of the governments redistribution of "excess" income - which can potentially increase the net velocity of money or (if spent on useful infrastructure, like the electric grid, for example), increase the productive capacity of the economy as a whole.

First, let's simplify the discussion to make it easier to follow. Let's remove deficit spending (financed by a central bank) for a moment and say that the government decides to spend $100 less per individual in the country and that is seen in $100 less in taxes taken out of their paychecks every month.

Your point was that these people may not spend this $100 and "stimulate" the economy. Ironically, not spending the money (under a normal economic environment) actually stimulates the economy more. Here's how:

The money can be put into purchasing stocks or bonds of corporations. These companies then have the ability to use this money and grow their business - leading to additional hiring, which leads to these new workers earning money and saving (then investing again in stocks or bonds).

The second option for the more risk adverse investor would be to just put the money in the bank and hold it as cash. In a normal economic environment this would lead to additional reserves the bank now has which can be used to lend out to businesses. This lending would create jobs, which would lead to additional savings, which would lead to additional bank deposits.

In this scenario we are assuming these are the only two options for investors because the government is not running deficits (therefore there are no government bonds to purchase).

The next question is then whether you believe the government (keeping the $100) can invest the money in a more effective manner than the private sector. I assure you that after hundreds of years of researching this subject with endless amounts of data, economists have found that this is never the case. The private sector has an incentive to invest to obtain maximum profits (we will see in a moment why this is important) - the government has far less of an incentive to do so.

Let's now take it full circle. What if the major corporation was "greedy" and they did not reinvest their capital into new hiring or the new building of plants? Before I answer that let me ask you why they might not re-invest the money? Most likely it is because there is not sufficient demand to grow. The money will not be invested in an efficient profitable way, therefore it will not be invested at all.

So this "greedy" business owner decides to keep the money in cash at the bank. What happens then?

The money then has the ability to be lent out to another business that has sufficient demand in their sector to grow. The growth in this sector then leads to additional hiring.

This is how a healthy economy grows and looking at this simple example hopefully helps open your eyes to how sick our economy is. We live in an economy now where savings is discouraged (due to artificially lowered interest rates) and investors put their money into government bonds where we hope it will be invested as efficiently as possible and perhaps create some new jobs.

We have moved so far away from the spectrum of a natural healthy economy that people cannot even see how damaging the policies are today to the foundation of the underlying economy. This has been temporarily masked by the low yields and unlimited spending ability of the government as well as the currently low levels of inflation incurred after the Fed's most recent money printing barrage.

Both of these temporary masks have the ability to be removed very quickly, and when they do it will expose the true "health" of the American economy as an emperor with no clothes.

I could continue to write for pages and pages on this topic providing multiple examples of how a healthy economic society functions and compare it to the bizarro world we live in today. For those that want to further their understanding of these issues, and I highly recommend you do, please read the following:

Economics In One Easy Lesson - Henry Hazlitt

How An Economy Grows & Why It Crashes - Peter Schiff

Austrian economics (real economics) is the exact opposite of what you will hear in almost every mainstream publication and in most economic books released today. America's temporary strength due to the most recent injection of heroin/stimulus into the economy only further feeds the Keynesian poison into the minds of the public. Take a moment to step back and really try and understand what is happening.