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

by: Vincent Fernando, CFA

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.