Monetary Policy, the Seen, and the Unseen

My October 15 New York Times blog posting reviews the classic broken window fallacy-the seen versus the unseen-in the context of two issues of contemporary monetary policy. You may read it here.

The Seen and the Unseen - and Fed Policy

By Bob McTeer

Have you heard the one about the young hoodlum who threw a brick through a bakery's plate glass window? A crowd gathered on the sidewalk, shook their heads, and sympathized. It would probably cost the baker at least $1,000 to replace the window. What a shame!

But some in the crowd soon waxed philosophical and found a silver lining. The baker's $1,000 repair bill will become the glass repair man's $1,000 income - income he wouldn't have otherwise. He will probably spend his additional income for something useful, perhaps a new suit, which would give the tailor another $1,000 of new income. And so on, and on.

The crowd decided the new rounds of spending will really add up and generate lots of new income. Someone was even heard to mumble something about a multiplier effect. It's a shame about the broken window, but that brick really stimulated the economy.

Wait! Hold on a minute! Isn't the crowd missing something? If the baker hadn't spent $1,000 for a new window, he probably would have spent it for something else, adding $1,000 to someone's income. That someone would spend it as well. The broken window did generate a flow of spending, but a similar flow of spending would have taken place if the window hadn't been broken. But that flow of spending wasn't seen. It wasn't seen because it didn't happen. It didn't happen because of the broken window. Spending was not enhanced; it was only diverted. The income generated would have been generated anyway, involving different people. Plus, the baker would still have his window.

This classic "Broken Window Fallacy" originated with Frederick Bastiat (1801-1850) and was popularized by Henry Hazlitt in "Economics in One Lesson." Bastiat was a French economist or "pamphleteer." I think of him as the French Adam Smith. He fought for free enterprise in France, especially free trade. His stock-in-trade was his wit and his effective use of satire in debate. He is best known for his tongue-in-cheek petition to the French Parliament on behalf of the French candle makers, pleading for the passage of a law requiring that all blinds, shutters, etc. be kept closed to keep out the sunlight, because the sun has an unfair advantage over candles in the provision of light. He wanted the candle makers to have a "level playing field" and make sure that free trade was also fair trade. Sound familiar?

The broken window fallacy couldn't be more relevant in today's world, where promises are made and outcomes are evaluated by considering only what happens, and is thus seen, while ignoring what is not seen because it doesn't happen. For example, arguments for new stadiums usually promise much more economic activity in the area without acknowledging that it isn't necessarily new activity, but diverted activity. Taxpayers are asked to finance worthy government programs, programs that do good, without comparisons with the good an equal amount of government spending on other projects might do, or, especially, the good the taxpayers might do for themselves if they could keep their money. We see examples of the broken window fallacy every day.

The discussion of the seen and the unseen by Bastiat and Hazlitt was part of a broader set of fallacies that fails to distinguish short-run effects from long-run effects, the effects on one part of the economy vs. the whole economy, and the unintended consequences of an action as well as the intended consequences. These concepts are critical to clear thinking about alternatives in economics and in life. In fact, I think a good definition of economics might be the study of unintended consequences.

One reason Bastiat has been on my mind recently is the dialogue regarding causes and cures of our prolonged financial crisis. Virtually all the discussion fails to compare actual (seen) outcomes to alternative (unseen) outcomes. Instead, policy results are almost always compared to some ideal outcome, which virtually guarantees they'll be viewed with disfavor.

The charge that the financial crisis is Alan Greenspan's fault because of too-low interest rates in 2002 to 2004, for example, focuses only on the presumed (seen) unintended consequences of his policy, without ever considering the (unseen) results of his policy. His low-rate policy was successful in avoiding a double-dip recession and in avoiding Japanese-style deflation, but that is never mentioned, partly because they were unseen. I've defended Chairman Greenspan at length elsewhere, but for now my point is to emphasize the seen versus unseen aspects. Successful monetary policy, in general, usually means that nothing bad happens; therefore, nobody sees inflation or deflation accelerating, but they probably will see any adverse side effect.

Another example is the view that the draconian measures taken by the Federal Reserve over the past year have done little or no good. Granted, they haven't cured the problem, but the relevant comparison is what would have happened without those actions. The relevant standard of comparison is not nirvana.