Blogger “Unlearning Economics” — I comment a lot on his work, because his thoughts are worth commenting on — discusses some problems he has with common applications of different fallacies. One of these, which is the one I will focus on, is Bastiat’s “Broken Window Fallacy.” Austrians should be very comfortable with this fallacy, since it is commonly use to criticize any and all government spending. Unlearning Economics argues that the fallacy does not apply in two cases: (i) where money is idle, and (ii) where what is “broken” needs replacement.

On the face of it, what Bastiat tells us is that wanton (and unproductive) consumption of capital does not lead to an increase in wealth. This is because the shop owner, who suffered the broken window, must now replace it. In effect, the same amount of wealth now costs twice as much. Otherwise, the shop owner would have spent the same amount of mine, but would have enjoyed both the window and another, alternative, product (such as a suit).

Why, according to Unlearning Economics, does the fallacy no longer apply in the case of sub-optimal employment and when capital must be maintained? In the first case, hoarded income represents a decrease in the total incomes of others, leading to a fall in aggregate demand. If a broken window forces the owner to spend his income, then the potential for deficient aggregate demand is no longer a problem. In the second, Unlearning Economics holds that if the window needs replacing, then even replacing it after it has been broken will bestow upon the shop owner some benefit.

I disagree on both accounts.

The broken window fallacy is above all a story that explains the importance of looking at opportunity cost — this is what is “unseen.” The opportunity cost in the parable is having a suit and a window, where in reality the shop owner now only has a window that cost him twice as much. The point is that society is less wealthy than it would otherwise have been. Neither idle money nor capital maintenance trumps this fundamental concept.

Idle Money: Idle money supposedly causes a problem because it leads to a fall in aggregate demand. For monetary equilibrium theorists, this leads to changes in relative prices between inputs and outputs, causing a shortfall in profits and therefore a general industrial decline. For Keynesians, a fall in total spending means a fall in total income, s denying a worker of a wage. This results in a greater fall in total spending, and therefore a greater fall in employment. I think both theories are bad theories, but rather than explain along these lines I will approach the topic from another angle. That is: there is a subtle difference between taxation and outright destruction.

I hold that, generally speaking, government redistribution of income leads to a negative opportunity cost (there is a loss in potential wealth creation). I base this off my understanding of how market coordination works (read the linked article). However, this opportunity cost is different from that which arises from the deliberate consumption of capital. If the shop owner faces a broken window and is therefore forced to replace it, we have a situation where he forgoes the suit and pays double for a single window. If the shop owner faces income redistribution, he keeps his window (and pays double for it), but now someone else may use that redistributed income towards productive purposes (this is theoretically possible). The opportunity cost of the latter is, generally speaking, less than the former.

Note, the broken window fallacy (the emphasis on opportunity cost) still applies, but one could make the claim that redistribution is better than all-out capital consumption (and, it depends on who the money is redistributed top; redistribution to consumers will still end up as capital consumption).

We need to think about the crucial question: is holding income a means of economization? I think that, clearly, it is. Those interested in macroeconomics may hold that this will result in sub-optimal (on the basis of Kaldor-Hicks efficiency) outcomes. This is up for debate — a debate I have joined in the past and will probably comment on in the future. But, this is where the real debate is.

Capital Maintenance: The only person in a position to judge benefits and costs is the owner. If the owner believes he can benefit enough from repairing the window, then he will make the expenditure. Individuals juggle between different means and ends. That an individual will benefit from a lower-ranked end does not mean that achieving this end is more beneficial than achieving a higher-ranked end. My point is that we still suffer an opportunity cost, and therefore the broken window fallacy still applies.

The broken window fallacy would only not apply when there is not an opportunity cost which is higher than the outcome caused by capital consumption.