Can you tell the difference between a balance sheet and an income statement? Apparently, many of the instant experts on the economic impact of the earthquake and tsunami on Japanese growth cannot. Even in the sophisticated Wall Street Journal we read that “the great 19th-century economist Frederic Bastiat taught in the ‘fallacy of the broken window,’ the GDP growth that comes from reconstruction brings no net gain in society's wealth. It just replaces, over time, what was lost. ‘Destruction is not profitable,’ he wrote.”
The “fallacy of the broken window” was popularized by Henry Hazlitt in Economics in One Lesson, where he devoted most of Chapter 2 to applying the lesson. Bastiat & Hazlitt insisted that because the owner of the broken window must replace it, he therefore will not spend that money on the new suit that he would have bought, so replacing the window adds nothing to growth that would have happened anyway. The glazier got the money, not the tailor.
“Society’s wealth” is a balance sheet item, akin to shareholder’s equity. And, of course, Japan is poorer for having lost power plants, infrastructure, homes, factories and much of their whaling and dolphin-catching fleet.
But most of the instant experts are not talking about the nation’s balance sheet. They are arguing over whether Gross Domestic Product growth will accelerate, and GDP is an income statement item. Now, there is no doubt that rapidly rebuilding the affected area will create a lot of GDP. In fact, fiber optic lines will replace the old copper wires, Toshiba (TOSBF.PK) 4S nuclear modules will replace the 40-year old GE reactors, new houses with modern conveniences will replace the older ones that fell or were washed away, and the whaling fleet will get bigger engines, faster boats and more powerful harpoons.
But the question is whether this burst of GDP growth will simply replace growth that would have happened somewhere else in the economy, with a net gain of zero. And this is where Bastian and Hazlitt are wrong, at least in this case. Japan has been in slow-growth or no-growth mode for 20 years. To put it in 18th century terms, the owner had no intention of buying a new suit or anything else. He lived in a nation of savers, and was holding on to every yen that passed his way. Now, he is forced by circumstances to spend money to replace the window, and the glazier will see his domestic product go up. Because the glazier also was impacted by the earthquake, he will spend his increased earnings on other goods and services he now needs, and so on in an ever-widening circle.
So the next time someone quotes Bastiat & Hazlitt at you, remind them that wealth is a balance sheet item, GDP is an income statement item, Japan had been a moribund economy for 20 years in desperate need of a kick start, and this tragedy is a classic bushel of lemons ready to be made into lemonade. It probably won’t change their minds, but in the meantime you can buy the Wisdom Tree Japan Small Cap Dividend ETF (DFJ) and laugh all the way to the bank as Japan enters a new growth phase. I have recommended it to my subscribers (at lower prices), and I recommend it to you.
Disclosure: I am long DFJ.