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Is the Broken Window Theory a fallacy?

Sandy is the news. A natural disaster that will cost tens of billions of dollars and one that is sure to resurrect the 160 year old debate as to whether destruction of property is a good thing in the long run.

For newbie's, the theory is this in a nutshell:

A hoodlum throws a rock through the baker's window. The baker has to then spend $100 on a new window. The $100 goes to the window maker, who then spends $100 with the grocer to buy groceries. The grocer uses the $100 and spends it with the farmer to buy more food to sell.

Proponents of this theory will argue that it is a good thing the window was broken as jobs were created and economic activity took place.

Opponents of this theory argue this:

What is not seen is that the baker no longer has $100 to spend somewhere else. He could have used the $100 to instead buy a new suit from the tailor. The tailor could have purchased groceries. In the end, the economy is better off this way as this town would have still had a window and also gained a suit. The economy increased in wealth by one suit. In the broken window economy, we are poorer because all we have is the window, and not the suit.

Makes sense on the surface, but as my readers know from previous articles, I like to take on the controversial ideas and break them down to find the real truth.

Today, I will argue that a broken window, or natural disaster like Sandy is very good for the economy, yet very unfair to those whose property is affected.

What the opponents of the broken window theory are missing is the velocity of money argument. We can still gain one suit in the broken window economy. Let me show you:

The hoodlum breaks the baker's window. The baker pays $100 to the glass maker. The glass maker buys a suit with the $100. The tailor uses the $100 to buy groceries. The grocer uses the $100 to buy food from the farmer.

In the end, the economy still gets a new suit added to the economy, but the property damage has taken the suit out of the baker's hands and placed it into the hands of the glass maker. The poor baker is the one who is poorer, but the overall economy has gained wealth by having a window and a suit.

Disaster and property damage are tragic events that are stimulating, but unfair. It is not fair that someone else (the hoodlum) took the new suit out of the baker's hands and put it into the hands of the glass maker. It is not fair when nature strikes either. Natural disasters cause damage that forces the baker to have to buy things he did not want or plan to buy. It is stimulating though in the sense that it forces the velocity of money to take place in an economy. If we assume that the baker is holding on to his savings and not spending it, the tailor is having to wait for his income, and thus remains idle awaiting the ability to exchange his labor for the baker's savings. In that scenario, the tailor is waiting to work, and the glass maker is waiting to work. Everyone is waiting on the baker to spend that money before they have an income. The baker has earned that right. He worked for the money, and he should be allowed to decide when he wants to buy a suit or not.

When the natural disaster or vandalism hits, it forces the baker to spend the money sooner than he may have wanted to spend it, and forces him to spend the money on something he did not desire. They key reason why it is stimulating is that it forces a liquidity event on the economy. Owners whose property is affected are forced to spend, in effect starting the velocity of money process that is needed to get an economy going.

Let me go one step further in my example. Let's assume the baker spends the $100 with glass maker, but the glass maker decides not to spend the money and instead saves it. What we have here is a transfer of wealth from the baker to the glass maker, and we are in the same situation. Money that is sitting and not moving through the economy. If the glass maker decides to buy some baked goods from the baker for $100, the baker is in the same situation as before, except is poorer from the labor he needed to expend to produce the baked goods the glass maker was buying. Take a look:

Before the vandalism:

Baker $100 cash and one window.

Glass maker - $0

Economy = $100 cash and one window

1 happy person and one sad person

After the vandalism:

Baker $0 cash and one window

Glass maker = $100 cash

Economy = $100 cash and one window

1 happy person and one mad person

Glass maker decides to spend $100 with the baker:

Baker $100 cash and one window minus $100 worth of labor

Glass maker = $100 worth of baked goods

Economy = $100 cash and one window and $100 worth of baked goods.

One happy person and one mad/sad person

In this scenario, the economy has gained $100 worth of baked goods, but at the expense of the baker. The baker has the same assets as before, but he is $100 poorer in labor. The glass maker is $100 in baked goods richer. Yet again you see the forced wealth transfer.

Sandy is unfair to those who are being affected by the disaster. It will force them to spend money when they didn't want to, and on things they didn't need. The forced spending though will be a boon for those who exchange their labor for the forced spending. In a perfect world, these new workers will have pent up demand for goods and services that they didn't have the money to purchase before. Even if a portion of the new work force is made up of spenders, this disaster will have stimulating effects for the U.S. economy.

For example, if the baker had $100 and was not spending it, the glass maker has excess capacity while idle. Let's pretend there are 2 glass makers in town, and once the window breaks, the baker buys half a window from each for $50 each. As the money gets spread out to more people unfairly, the chances are higher that you will get spenders who create velocity in the money supply. If Glass maker A is a saver like the baker was, then the unfair transfer of wealth does nothing to put the tailor to work making a suit. If there are two glass makers though, the economy has better odds that one of the glass makers will be a spender. Take a look at the example below:

Before the vandalism:

Baker $100 cash and one window

Glass maker A and B idle and no savings

Economy = $100 cash and one window

1 happy person

After the vandalism:

Baker $0 cash and one window (not fair!)

Glass Maker A (Saver) = $50 cash

Glass Maker B (Spender) = $50 cash

Economy = $100 cash and one window

2 happy people and one mad person

After Glass Maker B spends money on a suit:

Baker $0 cash and one window

Glass Maker A (Saver) = $50 cash

Glass Maker B (Spender) = Cheap Suit

Tailor = $50

Economy = $100 cash, one window, one cheap suit

3 happy people and one mad person

As you can see, the velocity of money moving in this economy is at the expense of the one who originally earned it and deserved it. Not fair, but in fact stimulating. It has forced economic demand that was not there before the disaster. As you can see in the chart below, in the U.S. Economy those who sell products could sure use some velocity of money. It would be most ethical and moral if that velocity was natural from demand and investment, not forced. But in the end, as tragic as the storm is to many lives, it is sadly and in a twisted way helpful to many others.

(click to enlarge)

Those who oppose the Broken Window Theory sarcastically make statements like "If it is good for the economy, then just hire a bunch of people to break windows!" There is some truth to this statement. It is good for the economy, but the reason it should NOT be done is that it is unfair to those who have to pay for the window. When we break their window, the decision to spend their hard-earned money is made for them. That is socialism. That is not fair. Opponents of this theory should spend more time arguing about the unfairness rather than the ineffectiveness of the idea to stimulate an economy.

Investors looking to move funds around to mitigate the effects of this phenomenon will want to buy stocks of companies that will be the recipient of this unfair wealth transfer, and sell stocks who are being forced to spend money due to this event.

In essence, it's easy to think you can buy most any company in the S&P 500 (SPY) and sell the insurance companies (KIE, IAK, PIC). But that would be too cute. Insurance companies will raise rates on every company over time, thus transferring the costs of the forced spending from them in the short term to every company through higher insurance premiums. One needs to do the hard work of finding the glass makers, as they will be the largest winners in this unfair transfer of wealth taking place before our eyes.

Source: Natural Disasters: Unfair Stimulus