Recovery versus Growth: The Broken Window Fallacy and the GDP Fixation

Extreme events sometimes cause big shifts in the economic point of view of the market process. The recent financial crisis brought back into scene Keynesian economics as a way to cope with the depression and make the economy recover. The recent tragic events in Japan seems to have brought to surface once more the “Broken Window Fallacy.”

This fallacy, popularized by Frederic Bastiat’s “What is Seen and What is not Seen,” states that if something gets broken, then the economy will receive a bust due to the production activity that is needed to replace what has been broken. In his example, if the window in a shop gets broken by a stone thrown by a kid, then the shop-owner demands a new window and so production increases. As Steve Horwitz mentions in Coordination Problem, some expressions under (or close to) the broken window fallacy applied to Japan are already starting to appear. The argument is that Japan’s economy may receive a bust and see its GDP grow thanks to the recovery work that will be needed. This argument faces two problems.

The first one was already mentioned by Bastiat. What has to be used to buy the new window cannot by used to get other products. For example, if the shop-owner wanted to buy a new suit he now needs to use that money to buy a new window. The increase in the demand for windows is a decrease in the demand for suits. Total demand remains the same. Were the window not to be broken, then the shop-owner would have his original window plus the suit. To have his window broken puts him in a worst situation, not in a better one: The broken window means the shop-owner lost a suit. This fallacy should be clear, one does not bust the economy of a small town by breaking all the windows any more than the economy of a country by blowing up all of its infrastructure.

The second one has to do with what might be called the “GDP illusion” or “GDP fixation.” This is a leading indicator, especially regarding economic growth. If the GDP grows, then it is said the that economy will be better off and the other way around. Then, if Japan’s GDP is expected to grow due to the recovery work that will be needed then Japan will be better off. It doesn’t matter what is happening below the GDP indicator at the microeconomic level, all that matters is the aggregated result in GDP. Then, any economic policy, or event, that results in an increase in GDP is a good thing for that economy. The GDP indicator, however, does not always reflect growth. If the economy grows, then the GDP will grow, but the fact that the GDP grows does not imply that the economy is growing. There are other reasons why GDP can grow other than economic growth. To overlook these possibilities does not only result in a potential wrong diagnosis, but also in inconvenient fiscal policies. If next year Japan were to maintain the same level of GDP we should still conclude that its economy is worst off rather than “the same.” Infrastructure, capital, and lives have been lost.

GDP may grow due to other reasons than economic growth because GDP is a “flow” of how much has been produced, but not of how much has been accumulated, let alone of welfare. Production can increase because a) there is more invested capital per capita and/or better technology, b) through capital consumption rather than investment or c) because we need to reconstruct what has been broken.

Let’s assume 10 houses have been built. GDP cannot distinguish if these are 10 new houses to the total amount or 10 re-built houses due to a natural disaster. These two situations can hardly be considered similar and be referred as economic growth indistinctly. While the first case implies that the total amount of houses is increased by ten, the second one implies that the total amount of houses remains the same. The first case is growth, the second case is recovery.

There are, certainly, other shortcomings with GDP that one needs be careful about. Implied rents or black markets are two common examples. These, however, are statistical problems that are hard to measure. But the conclusion that more GDP an increase in the well-being or the economic situation is an interpretation problem, not an statistical or data collection issue. Even if GDP could be perfectly and completely measure, it would still not be a direct indicator of growth or welfare.

It seems then, that we need to be more careful when interpreting economic indicators. The step from a growth in GDP to economic growth requires an understanding on the part of the economist of what is going on with the economy, it requires a qualitative interpretation of the GDP numbers. This is not an unimportant matter. This “GDP fixation” is not present only in the case of natural disasters or broken things. As long as GDP is understood as a measure of growth and welfare and becomes a central aim for the economic policy, then fiscal and monetary tools will be used to try to make this number go up. But just as GDP can go up because of recovery or because of growth, it can also go up in the wrong direction if its subject to government interference or stimulus. A GDP of 100 can have infinite different microeconomic structures. Only one of them, however, is the correct one. Every time the government tries to stimulate the GDP or the economy affects in a negative way the microecomic structure of the market.

A true sound monetary and fiscal policy should be concerned about the microeconomic structure of the economic rather than on economic aggregate that fail to accurately measure what we want them to mean. Regardless of how much, or less, the government can contribute at that level.

Nicolas Cachanosky is a doctoral student in economics at Suffolk University, as well as a previous Sound Money Essay Contest winner.

Image by Matt Banks / FreeDigitalPhotos.net.

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