Examining the EPA Cave-in: Does the Broken Window Fallacy Apply?

Did President Obama get the economics wrong earlier this month when he abandoned stricter air-quality rules, wagering environmentalist loyalty in a bid to avoid job losses from strict new ozone standards? Paul Krugman thinks so, calling the decision to wave off the EPA a “lousy decision all around.” But is Krugman right?

The short-run job-creating move, Krugman contends, would have been for Obama to promulgate the new ozone regulations, which would have forced firms in hundreds of counties across the country to replace and upgrade capital in order to comply with new, stringent pollution abatement requirements. He asserts that because the U.S. economy is in a liquidity trap, wherein conventional monetary policy is insufficient to induce firms to spend, the regulations could have accomplished what the Fed cannot. In such a “world of topsy-turvy,” as Krugman says, the usual rules of economics are thrown out, and even the “Broken Window Fallacy” ceases to hold.

The 19th century French theorist Frederic Bastiat cautioned against concluding that a shopkeeper’s broken window is a good thing because it induces him to employ a glazier to repair the window. Such a conclusion ignores that which is unseen: that the shopkeeper would have employed the shoemaker to replace his worn out shoes had the window not been broken. Hence, the broken window doesn’t increase employment or grow wealth. In fact, it shrinks wealth, leaving the shopkeeper worse off than if he had been able to replace his worn out shoes for the cost of the new window. The deliberate destruction of windows, then, would assuredly be poor economic policy in normal times because it trades wealth-creating spending for wealth-replacing spending.

But what happens in unusual times, like those of a liquidity trap? Krugman contends that shopkeepers are sitting on stockpiles of cash and not spending. So the shopkeeper’s expenditures to replace broken windows won’t crowd out expenditures on shoes since he wasn’t going to purchase shoes in the short run anyway. So, too, Krugman reasons, forced investments on pollution abatement won’t crowd out other investments since they’re not happening anyway. Thus a policy of capital destruction to spur economic activity, like breaking windows or using regulatory fiat to mothball functional equipment, may never make more sense than during a liquidity trap. But that doesn’t mean it makes sense even then.

Let us consider the employment and wealth impacts of new pollution abatement requirements on three classes of businesses: those with savings, those without savings, and those who are considering new entry or expansion. Let us assume, as a liquidity trap story does, that absent new pollution abatement requirements, businesses with savings would not spend down their savings in the short run to buy new equipment or hire new workers. In order to comply with the new regulations, these businesses draw down their savings and make expenditures to meet the new standards. There is seemingly no crowding out of other investments in the short run, though future spending would decline.

But, cash reserves are not “idle” for most businesses; they are providing a hedge during uncertain economic times. If owners of such businesses have decided that their current reserve is optimal, then surely they will seek to maintain that hedge even with the requirement of new pollution-abatement expenditures. In that case, they must reduce other expenditures today in order to retain the hedge. The new expenditures and jobs for pollution abatement, then, are partially or fully offset by reduced expenditures and job losses elsewhere.

What about the business that does not have savings but must spend to comply with the new regulations? Unless these businesses can take on debt, which is doubtful if they are cash constrained, then the new regulations force them to either shutter their businesses or make one-for-one reductions in other expenditures. Among those without savings, then, the broken window fallacy holds strong. In essence, creating a job for a pollution “abater” comes at the cost of a job for a shoemaker or for the shopkeeper, himself.

Finally, what do the pollution abatement requirements do to the shopkeeper who was planning to open a new shop? The compliance costs lower his return on investment from opening a new shop and may cause him to forego opening the shop altogether.

When one considers that which is unseen—the loss of expenditures and jobs by businesses without substantial cash reserves and the loss of jobs among potential entrants—it becomes clear that Krugman’s prescription for job growth may not be the antidote to an ailing economy. And even among those businesses sitting on cash reserves, it is likely that regulatory compliance costs would crowd out other expenditures (and thus other employment) as those firms sought to maintain the cash reserves they deemed optimal in the first place as a hedge against an uncertain economic future.

Even in a world of topsy-turvy, the laws of economics still hold: shopkeepers, glaziers and shoemakers are still utility maximizing agents. And imposing higher regulatory costs on firms still deters job creation and growth. President Obama may not succeed in creating enough jobs to save his job, but, a priori, it’s certainly not clear that his decision to walk back costly new ozone regulations in uncertain economic times was a bad idea.