The Broken Window Fallacy: More on 'Cash for Clunkers'

Economic Heroes?

With "Cash for Clunkers", the US is simply using a part of its productive energy to go and destroy productive assets. While luckily a drop in the bucket, it is actually destroying value, perversely with the intent of helping out during an economic downturn. Bloomberg columnist Caroline Baum makes a great reference to the Broken Window Fallacy, and is right on the money.

The Broken Window Fallacy basically exposes some very false economic thinking, whereby a boy vandal breaks a shopkeeper's window and some believe that he is actually spurring the economy via his destruction since the shopkeeper now needs to order a new window, then the windowmaker has income to buy new shoes, the shoemaker then has money to buy something from someone else, etc. (and thus the boy stimulates a whole stream of economic activity via his destruction of property). You can read the entire concept via the link above.

The point of it is that many people might falsely find the boy helpful to the economy because they ignore the cost to the original window owner via the destruction of an existing productive asset. The window owner could have easily spent the same amount as he did on the broken window, but for something additional and more productive, while still retaining the original window had the boy not broken it.

As Ms. Baum highlights, this broken window parable is pretty similar to the situation we have with Cash for Clunkers: The US is destroying cars before their useful life is over, just like the boy is smashing windows before they wear out.

“Cash for clunkers” was touted as a huge success, with cars tearing out of auto showrooms, the program running through its $1 billion appropriation in one week and government servers crashing in response to overwhelming demand from dealers filing for rebates. (At least it wasn’t the drivers that crashed.)

Was the program to induce drivers to turn in old gas- guzzlers for a more fuel-efficient vehicle a success? That depends on how you define success.

Consumers got a “discount,” automakers sold more cars and trucks last week than they would have, and all that “stimulus” -- spending begets income begets spending -- has to be good for the economy, right?

With success like that, why limit the rebates to $4,500? Why not give everyone a $10,000 or $20,000 rebate to turn in an old clunker? And why stop at the cars in the garage when you could get rid of a garage full of accumulated junk, with the government providing rebates to households for unloading what they’ve been meaning to get rid of for years?

A reductio ad absurdum, to be sure. Sometimes reducing a proposition to absurdity is the easiest way to expose its flaws.

Exactly. If destroying cars before their useful life is over is beneficial, then shouldn't we just start destroying all kinds of useful assets in order to stimulate new purchases? Why don't we destroy all of our useful assets before they are worn out and rebuild from scratch. That would generate immense need for new purchases... true. Yet what is forgotten is that it would annihilate our aggregate amount of existing productive assets. And that's what those who fall into this logical trap miss. They forget to think about changes in the amount of existing productive assets, staring only at new purchases.

Rather than the above, we'd be much smarter to still make new purchases, but to keep our existing productive assets as well. Then by simple addition we could have new productive assets plus existing productive assets rather than new productive assets minus destroyed productive assets.

Transferring money from taxpayers to car buyers is exactly that: a transfer. The money taken from taxpayers can’t be used for something else.

This is the lesson of Frederic Bastiat’s essay, “That Which is Seen, and That Which is Unseen.” Bastiat, a 19th century French political economist, tells the story of a shopkeeper who has to hire a glazier to repair a broken window, providing work and income for him in the process. That’s what is seen.

What is unseen is what the shopkeeper would have done if he didn’t have to pay the glazier. He might have bought shoes for his children, providing income for the shoemaker, who in turn could buy leather to produce more shoes. The glazier’s gain is the shoemaker’s loss. There is no net gain, no job or income creation, from this transaction.

Broken Window Fallacy

The “broken window fallacy,” as it is known, can be applied to all government spending. The $787 billion fiscal stimulus enacted in February transfers money from taxpayers to the government to allocate as it sees fit. The effect of the government’s expenditures shows up as growth in gross domestic product. Auto manufacturers produce more cars to meet the juiced demand, adding to GDP. This is what’s seen.

What is unseen is what would have been produced by the private sector had the government not confiscated future revenue via taxation..

For readers who feel it sounds pretty dumb for the US to be slaughtering perfectly good livestock, destroying crop fields, or today... destroying cars, hopefully you are pretty surprised to read how this was easily forgotten back in 1933, and should be simply shocked that it has been forgotten again today. Check out these quotes from the pro economists:

"A billion dollars for 'cash for clunkers' looks dramatically more efficient, dollar for dollar, than anything else the Congress has passed yet," Credit Suisse economist Neal Soss wrote in a note last week....

"The essence of what it's going to do," said Nomura Securities economist Zach Pandl, "is move purchases up in time." That in itself, coming at a time when the economy appears on the cusp of recovery, is helpful, Mr. Pandl said. By boosting demand in the near term, the program will help bolster growth after a year of contraction, adding to the confidence of businesses and consumers alike. That, in turn, could lead them to increase spending.

This is a dramatic example of missing the forest for the trees, and it's been missed by everyone from some economists to lawmakers. Step back from it all... With Cash for Clunkers, Team USA is destroying its own productive assets, cheering the resultant growth of new economic activity (all the talk of multiplier effects on the economy) while forgetting the reduction in aggregate existing productive assets caused by the destruction. There are far more intelligent ways to have new economic activity via new purchases of productive assets, without annihilating our existing assets.

Comments

[Truthmeister:]

I understand that you're just using an analogy to make a point, but the 'broken window' that you're mention isn't really accurate. The plan is not just trading a window for another window. It's an old, inefficient car for a newer, more efficient one. Perhaps a more accurate analogy would be if the storeowners crazed, cracked, hard-to-see-through window was broken, forcing him to replace with a new window. Then, with customers able to see his goods inside with more clarity, he sells more to the passerbys on the street. The broken window can become a net gain for the storeowner. More fuel efficient cars, less foreign oil bought, better for our country.

Aug 06 08:03 AM

[Vincent Fer...:]

No the broken window is not a net gain for the storeowner, even if it was dirty and old to begin with. With all due respect, you are falling for the fallacy right here. The clunkers, despite being inefficient, have a net present value, as easily seen by the fact that they have positive resale values. Thus while they are less fuel efficient, their remaining lives and usefulness still results in a net positive value for the vehicle. Thus destroying the vehicles thus simply destroys this present value. If we weren't destroying the vehicles then it would be far better. We'd still have the government spending its money for people to buy new efficient vehicles, but we'd still be able to use up the remaining value from the old vehicles. Your logic only holds if the vehicles have a net negative present value. But again, given that they can command a resale value, either the entire auto market is wrong, or indeed they have net *positive* value. In this same way, in the economic parable, even if it is an old dirty window, the fallacy still stands as long as the window has a net positive value.

Aug 06 08:22 AM

[glb:]

And furthermore, from a purely ecological viewpoint, it costs the earth a lot of resources to produce a new vehicle. As the GAO finally admitted a few years ago, driving your old car until it drops makes a much smaller ecological impact on the earth than buying a new one, no matter how much better the mileage.

Aug 06 09:45 AM

[Mad Hedge F...:]

The original intention was to get these environmental death machines off the road. So now we have euthanasia for cars. The Wall Street Journal tells us that a government condition of the Cash for Clunkers program (see my last report at www.madhedgefundtrader... ) is that clunker buyers total the engines by pouring sodium silicate into them. That way they can’t be resurrected like Frankenstein at the junkyard. What’s next? Free Viagra for the high mileage, new car buyers? There’s a certain poetic resonance there. Anything that works. In the meantime, the Republican Party is publicly slashing its wrists by trying to block an expansion of the most popular program since the end of the mandatory draft. Is Mc Cain trying to lose the election a second time? I think he is oblivious of the warm and fuzzy feelings the clunker clensing is generating, which is far more valuable than any direct economic impact. Don’t they have Ford dealers in Arizona? I never thought I’d run a car company chart again, but here is Ford in all its glory, up a mind boggling 65% since Cash for Clunkers started. Like virginity, confidence is very hard to recover, once it is lost.

Aug 06 11:02 AM

[fletchermic...:]

I contest your assertion in response to Truthmeister. The new window DOES have more value IF it is more suitable. What can be argued is that the destruction of the old window is a loss if it still had usable life left in it. But if the new one has more value than the old one had, the village still has a net increase in wealth. It would be preferable to reuse the old glass somewhere else if it did still have value to someone. Otherwise, recycling the glass into a new window pane can at least capture the residual value.

The "broken window fallacy" parable entails a trade of one piece of glass for another of equal quality. Ergo, there is destruction of wealth for the village. This is why the Cash for Clunkers is a very imperfect (if not specious) example of the fallacy. A pure example would be if citizens or the government bought up new cars and crushed them just to stimulate the economy.

If the pollution costs averted and oil resources saved is greater than the "driving miles remaining" residual value of the Clunkers, then there is a "net" increase in wealth for the village. If they are not, then there is a net decrease in wealth. Also note that unlike the parable where (it's implied) the broken glass is discarded, the Clunkers do have a residual recycling value of refined steel, glass, rubber, plastic, etc. All value is not lost. This must be taken into account in the equation. I don't pretend to know if the final summation is a net positive or negative wealth adjustment but the author of the article totally ignored this aspect and presented a totally one-sided view.

A true "broken window fallacy" is the continued procurement of the F-22 Raptor for which we no longer have the enemy it was intended to counter. The plane is virtually useless according to the secretary of defense. That which is not seen is the money that could be diverted to counter an enemy which does exist.

I also noticed that the article incorrectly used a citizen vs government argument. This has nothing to do with the "broken window fallacy". Whose pocket the payment comes from is irrelevant. If the whole village pays collectively (via their government budget) or just the shopkeeper individually, the amount of village wealth destroyed is exactly the same -- the value of one window. The government vs citizen payment issue is belongs in another venue.


On Aug 06 08:22 AM Vincent Fernando wrote:

> No the broken window is not a net gain for the storeowner, even if
> it was dirty and old to begin with. With all due respect, you are
> falling for the fallacy right here. The clunkers, despite being inefficient,
> have a net present value, as easily seen by the fact that they have
> positive resale values. Thus while they are less fuel efficient,
> their remaining lives and usefulness still results in a net positive
> value for the vehicle. Thus destroying the vehicles thus simply destroys
> this present value. If we weren't destroying the vehicles then it
> would be far better. We'd still have the government spending its
> money for people to buy new efficient vehicles, but we'd still be
> able to use up the remaining value from the old vehicles. Your logic
> only holds if the vehicles have a net negative present value. But
> again, given that they can command a resale value, either the entire
> auto market is wrong, or indeed they have net *positive* value. In
> this same way, in the economic parable, even if it is an old dirty
> window, the fallacy still stands as long as the window has a net
> positive value.

Aug 06 12:37 PM

[Vincent Fer...:]

fletchermic: "The new window DOES have more value IF it is more suitable."
Sorry, this misses the point. I don't say that the new car/window doesn't have more value than the old one. I say that its better to spend money on a new asset without destroying an old asset that has remaining value. You can spend money on a new asset AND still have the old asset, rather than simply spend money on a new asset but LOSE the old asset. That is the key point to take away from the parable.

The parable also doesn't require that the new window be of exact value as the old one. The main point of the parable is to highlight the fact that people forget the cost of destroying the original asset and only look at the asset bought with new spending.

"If the pollution costs averted and oil resources saved is greater than the "driving miles remaining" residual value of the Clunkers, then there is a "net" increase in wealth for the village. If they are not, then there is a net decrease in wealth."
As I replied above: The resale value of a car will represent its net value, inclusive of its gas inefficiency and problems with being old. As the cars have positive resale values, then unless the entire auto market is wrong then they indeed have a positive net residual value even after deducting for their age and fuel inefficency, which means that as you set up in your quote, and I also say in my article, that destroying them is a net decrease in wealth for "the village".

I actually think we're on the same wavelength here judging by the logic you outline just above. We can know whether cars still have net positive by realizing they still have positive resale values.


On Aug 06 12:37 PM fletchermichael wrote:

> I contest your assertion in response to Truthmeister. The new window
> DOES have more value IF it is more suitable. What can be argued
> is that the destruction of the old window is a loss if it still had
> usable life left in it. But if the new one has more value than the
> old one had, the village still has a net increase in wealth. It
> would be preferable to reuse the old glass somewhere else if it did
> still have value to someone. Otherwise, recycling the glass into
> a new window pane can at least capture the residual value.
>
> The "broken window fallacy" parable entails a trade of one piece
> of glass for another of equal quality. Ergo, there is destruction
> of wealth for the village. This is why the Cash for Clunkers is
> a very imperfect (if not specious) example of the fallacy. A pure
> example would be if citizens or the government bought up new cars
> and crushed them just to stimulate the economy.
>
> If the pollution costs averted and oil resources saved is greater
> than the "driving miles remaining" residual value of the Clunkers,
> then there is a "net" increase in wealth for the village. If they
> are not, then there is a net decrease in wealth. Also note that
> unlike the parable where (it's implied) the broken glass is discarded,
> the Clunkers do have a residual recycling value of refined steel,
> glass, rubber, plastic, etc. All value is not lost. This must be
> taken into account in the equation. I don't pretend to know if the
> final summation is a net positive or negative wealth adjustment but
> the author of the article totally ignored this aspect and presented
> a totally one-sided view.
>
> A true "broken window fallacy" is the continued procurement of the
> F-22 Raptor for which we no longer have the enemy it was intended
> to counter. The plane is virtually useless according to the secretary
> of defense. That which is not seen is the money that could be diverted
> to counter an enemy which does exist.
>
> I also noticed that the article incorrectly used a citizen vs government
> argument. This has nothing to do with the "broken window fallacy".
> Whose pocket the payment comes from is irrelevant. If the whole
> village pays collectively (via their government budget) or just the
> shopkeeper individually, the amount of village wealth destroyed is
> exactly the same -- the value of one window. The government vs citizen
> payment issue is belongs in another venue.

Aug 06 02:31 PM

[Truthmeister:]

"We can know whether cars still have net positive by realizing they still have positive resale values."

You're so focused on the monetary value of the car. Just because someone will pay a thousand dollars for it, doesn't make it a net positive. If our community decides that it's in our best interest to improve fuel efficiency and buy less foreign oil, than there is a negative intrinsic value to a car with poor fuel economy. We can't put a dollar sign next to it, but it's still there.

If we set a goal of say 30 mpg national average, and we achieve that goal in 5 years instead of the 10 it would take had we not destroyed the clunkers, then we clearly achieved a net positive gain. But again, it's hard to put a dollar sign and a figure next to it. What value is our national security, dependence on a commodity which we don't control? Good governance requires more than rigid economics.

Aug 06 05:54 PM

[fletchermic...:]

BTW, I do want to be clear that Caroline Baum's assertion that the broken window fallacy can be applied to ALL government spending is flat wrong. If the government is building a new road with our money, we now have more assets with none destroyed -- an increase in village wealth. There is no "that which is not seen" in this example as it relates to the parable.

We are on the same wavelength. There is an aspect of "broken window fallacy" to the Cash for Clunkers program but, as I argued previously, it is nowhere as pure and clear cut as the US defense F-22 Raptor example. That would have been a much better subject to demonstrate the fallacy with a program cost of US$62 billion just for procurement without even considering the carrying cost.

I agree that old assets with value should never be destroyed for the sake of "economic stimulus" and the "broken window fallacy" points out why. Where we differ is in our perspective about retaining old automobile assets. We both agree it's better to destroy an old asset and recycle it if the present value of the carrying cost is greater than it's asset value -- net negative value. This should be reflected in the market value. What I think this subject touches on (and many of us have a "gut feel" about if not consciously realize) is that there are costs to driving that are externalized and, therefore, not properly reflected in vehicle pricing. The two prominent ones are pollution costs and oil usage costs.

In an ideal world, driving would be taxed so as to properly shift those costs to the driver and, therefore, be reflected in the true value of the vehicle. But, alas, we live in a far from ideal reality. Pollution can be surprisingly costly in urban areas due to health care expenditures and lost productivity. Perhaps most costly of the two is oil usage. We (the US) are spending a vast amount of wealth in money and lives to fight wars in the Middle East and provide naval protection to shipping lanes all to guarantee a steady and secure flow of cheap oil -- oil is massively subsidized. Were the external costs to be properly levied onto a barrel of oil, a price figure in the range of $480 for a barrel (about $10/gallon for gasoline) are estimated by Milton Copulus, the head of the National Defense Council Foundation, a former principal energy analyst for the Heritage Foundation, a 12-year member of the National Petroleum Council, a Reagan White House alum, and an advisor to six U.S. Energy Secretaries, various Secretaries of Defense, and two directors of the CIA. See: www.energyandcapital.c...

So in an ideal world just taxing oil to make it pay its own way and reflect its true cost would solve the Clunker gas guzzling problem but probably make even most new cars have net negative value and collapse our economy until we switch to cheaper alternatives! But until then, the Cash for Clunkers program may be a poor and awkward first measure to slowly extricating ourselves from a complex problem even if it has an aspect of "broken window fallacy" to it. I would offer that spending the money on energy efficient transportation like trains would be a better choice if we could get people to ride them.

I do appreciate your article and your effort to educate readers on the fallacy of the "broken window" thinking. Bravo for that!

On Aug 06 02:31 PM Vincent Fernando wrote:

> fletchermic: "The new window DOES have more value IF it is more suitable."
>
> Sorry, this misses the point. I don't say that the new car/window
> doesn't have more value than the old one. I say that its better to
> spend money on a new asset without destroying an old asset that has
> remaining value. You can spend money on a new asset AND still have
> the old asset, rather than simply spend money on a new asset but
> LOSE the old asset. That is the key point to take away from the parable.
>
>
> The parable also doesn't require that the new window be of exact
> value as the old one. The main point of the parable is to highlight
> the fact that people forget the cost of destroying the original asset
> and only look at the asset bought with new spending.
>
> "If the pollution costs averted and oil resources saved is greater
> than the "driving miles remaining" residual value of the Clunkers,
> then there is a "net" increase in wealth for the village. If they
> are not, then there is a net decrease in wealth."
> As I replied above: The resale value of a car will represent its
> net value, inclusive of its gas inefficiency and problems with being
> old. As the cars have positive resale values, then unless the entire
> auto market is wrong then they indeed have a positive net residual
> value even after deducting for their age and fuel inefficency, which
> means that as you set up in your quote, and I also say in my article,
> that destroying them is a net decrease in wealth for "the village".
>
>
> I actually think we're on the same wavelength here judging by the
> logic you outline just above. We can know whether cars still have
> net positive by realizing they still have positive resale values.
>

Aug 06 07:37 PM

[Ernesto Gom...:]

My 1995 mini-van had tons of problems, cost much $$ in constant repairs and got poor mileage. My new 2010 Corolla has none of those problems and I got $4,500 for my junky van because of Clunkers.

It's a good deal for me and I pay enough in taxes already - so I am more than happy to get some $$ back this way as I needed a replacment car anyway, but would have bought used again except for Clunkers.

Aug 09 12:31 AM

[quentinjs:]

If you consider the broken window is replaced with a more efficient window that saves the store owner money as the heating and cooling bill is reduced, then the analogy would be more apt.


On Aug 06 08:03 AM Truthmeister wrote:

> I understand that you're just using an analogy to make a point, but
> the 'broken window' that you're mention isn't really accurate. The
> plan is not just trading a window for another window. It's an old,
> inefficient car for a newer, more efficient one. Perhaps a more accurate
> analogy would be if the storeowners crazed, cracked, hard-to-see-through
> window was broken, forcing him to replace with a new window. Then,
> with customers able to see his goods inside with more clarity, he
> sells more to the passerbys on the street. The broken window can
> become a net gain for the storeowner. More fuel efficient cars, less
> foreign oil bought, better for our country.

Aug 10 03:01 PM

[KH:]

Broken windows fallacy only applies to an economy operating at full capacity. If the economy is undercapacity, then the opportunity cost of the cash spend on stimulus is small, by definition.

Basic macroeconomics, people. But you don't need macro, you just need common sense. If 10% of the people are unemployed, and you pay 1% of them to do something, it is a gain to national welfare because what are they doing otherwise? Nothing. Sitting around collecting unemployment and grousing.

Aug 11 05:55 AM

[Michelle Fi...:]

All these arguments ignore the whole premise, which is destroying someone's property, or stealing from one to stimulate another. It can work all day long, that doesn't make it moral. What these programs do, in reality, is use the long arm of the state to steal on behalf of people who wouldn't dream of holding you at gunpoint and making you pay for someone else's car, or window, but are fine with it as long as the state is holding the gun on their behalf. There are a number of people, for example, that I would argue the world would be much better off without - lawyers, for example - does that make it okay to kill them? No, it doesn't. To say that you support breaking the window, even from an economics standpoint, whatever your excuse ("the window is cracked and dirty") then you are saying you support theft and social engineering/utopianism by force. Period. That's icky, IMO.

On another point, I agree with this being a good example of the Broken Window in theory, but what I can't find is a graph showing it true. I'm looking for a graph showing used car prices before/during/after but cannot find one. We can claim this as a broken window truth, but it isn't one unless I find that graph. Anyone?? Send me an email at citizenenabler AT rocketmail DOT com if you have one... thanks!!!

Oct 13 11:04 AM