Spending, saving and the broken window fallacy

I recently posted about Henry Hazlitt’s classic Economics in One Lesson, which is essentially an application of the broken window fallacy to many areas of economics.

Before continuing in the series on this book, I thought it would be useful to look at a common criticism of the broken window fallacy.

In the story of the baker whose window was broken, it is suggested that if his window had not been broken, he would have spent the money instead on a new suit. Hence the glazier benefits at the expense of the tailor – there is no net gain to the economy. However, it is argued that perhaps the baker would have saved this extra money, rather than spent it. Therefore, the act of destruction actually forces the baker to spend money that he was planning to save. In this scenario, it is suggested that the economy is boosted on net, to the value of a new window.

This idea is essentially Keynes’ “Paradox of Thrift”, in which he argues that while saving may benefit the individual, it harms the overall economy by reducing the level of spending taking place. Therefore, local business lose out, less is produced, profits fall, unemployment rises, etc.

It’s certainly a view I hear a lot – from colleagues claiming to be doing “their bit for the economy” by buying that widget they didn’t really need, to the mainstream media’s obsession with retail sales and GDP statistics . It is often quoted that 70% of GDP is consumer spending – and therefore it’s crucial to keep spending! However, GDP does not measure the whole economy, only that which is deemed to be “value adding”. It actually misses out huge parts of our economy.   When all economic activity is included, we find that consumer spending only accounts for 30% of the economy. ¹

But is this view of saving accurate? Can we resolve the paradox of thrift? Can doing what is beneficial for the individual actually benefit the larger economy?

The answer becomes clear if we consider firstly why individuals save, and secondly, various fundamentals of our economy that require savings in order to function.

Individuals save in order to postpone consumption to a later date. Perhaps they are saving for a holiday, a car, a house deposit or for retirement. In each case, spending in the economy has not fallen but shifted to a later date. Such scenarios do not represent a fall in demand, but simply a shift in demand from (perhaps) eating out in fancy restaurants, to the purchase of a new car a few years later.  The economy handles this perfectly well according to the time preference of individuals – the fundamental basis for interest rates.

To see why our economy needs, and benefits from savings, let’s imagine Robinson Crusoe stranded on a desert island, all alone. He spends each day fishing with his bare hands. He is able to collect 2 fish per day using this method, without time for any other activities. He’s a hungry fella, and eats both during the day. In order for Crusoe to increase his fish consumption, he needs to find a better method of collection. But he has no time for this, as each day is filled with catching the required 2 fish. So Crusoe takes a risk, and decides to underconsume , and saves 2 fish by only eating 1 fish over the next 2 days. This leaves him quite hungry, but he can now spend a day to create a basic fishing net, and still have 2 fish to eat that day. The new net can catch 5 fish a day, and so he quickly makes up for those lously 1 fish days. ²

In this simple example, we can see that in order to increase his production, under-consumption, or saving, was required. This reduction in present consumption allows for time to create capital goods, which then produce more of the consumer good in the future. This saving allowed for greater economic growth that would have been impossible if Crusoe had believed in the paradox of thrift and kept on eating both his fish every day.

The ideas here apply just as much to a complex economy of millions as they do an economy of one. Economic growth proceeds by increasing the stock of capital goods, which in turn are able to produce more consumer goods. This increased production is what creates wealth. The only way to increase the stock of capital goods is to save money. If we all spend our paychecks completely, there’ll be no money left over for investors and entrepreneurs to create new businesses, and improve production processes.

Imagine –  I want to open a new factory creating a brand new type of widget. This will take 2 years to build before I see any sales. Maintaining consumer spending won’t help me at all. Through saving myself, and selling equity to others who have saved, and borrowing from banks with countless saver’s money, I can build the factory, and 2 years later, hopefully make a profit.

Any new business requires significant investment and/or borrowing to function. Even simple businesses can take time to get up to speed – and all the staff and suppliers still need to be paid. All investment or borrowing must ultimately come from savings.

There are important consequences of this understanding. Government policy that is designed to increase consumer spending (such as that undertaken by Bush and Greenspan following 9/11) does not create economic growth, but rather inhibits growth by reducing the available capital for businesses.

I’ll return to Hazlitt’s book Economics in One Lesson for the next in the series.

1. http://www.ssees.ucl.ac.uk/publications/working_papers/wp113.pdf – a non-technical paper that highlights the flaws of a singular focus on GDP

2. Thanks to Peter Schiff’s book How an Economy Grows and Why it Crashes, which combines basic economic theory with parables of how we got into our current mess. Highly recommended!

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2 Responses to Spending, saving and the broken window fallacy

  1. hazencage says:

    Income expenditure is an important part of our economy, but we only need consumers to increase spending when there is a gap in output. For example we didn’t get out of the Economic Panic of the 1890’s until the Klondike Gold Rush provided companies the incentive to spend on new things.

    On a second note you point out that GDP does not capture the entire picture of the economy. This is correct, but economic indicators are merely estimates, and therefore they are best used to predict the general trend of things. Furthermore, one of the most important things that Keynes introduced to economics was that he disproved the link between savings and interests. This is important because Classical theorists assumed that such a link not only existed, but would ensure that the economy would return back to normal.

    Additionally, the Parable of the Broken Window when condensed down to more technical terms would be called “Crowding out”. Crowding out is something that primarily occurs when all sectors of the economy are functioning at the optimal rate. For example the Optimal rate for unemployment has been suggested to be around 3-4%, and therefore when such a shift in the labor market occurs it would be a good idea to start discussing the crowding out effect.

    Finally the Parable of the Broken window is often advocated by those whom do not express a well rounded social theory. Normally a good social theory is something that is premised on conditional statements instead of absolute truths. Thus, the individuals whom most often evoke the parable of the broken window are the same individuals that argue for its relevance no matter what the situation in the economy is.

    • andyfrith2 says:

      Consumers being required to increase spending when there is a “gap in output” assumes there is an optimal level of output we should be aiming for – but we can’t define such a level so I don’t see how we can define a gap in output. Mises and Hayek didn’t see panics/depressions etc as a result of a fall in aggregate demand, but rather due to malinvestments and a misallocation of resources, ultimately as a result of expanding credit beyond real savings. Hence, increasing consumer spending in total does not help to solve depressions, as the economy needs to adjust to the actual demands of consumers, backed by real savings.

      I believe the idea of “crowding out” and the parable only applying when the economy is functioning well to be mistaken – although I understand them to be points made by Keynes. If the government chooses to run deficits during a recession in order to pay for “stimulus”, these funds are no longer available for private business to borrow, so the effect of crowding out still occurs. Spending money on A means that we cannot spend money on B – this is true regardless of economic circumstance. Under the Austrian view of the business cycle, stepping in to boost spending and demand during a recession is trying to treat the symptom rather than the disease – namely that the reduced spending is not the cause of the recession, but rather a result of the recession, ultimately caused by a misallocation of resources during the boom.

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