Thursday, 23 July 2009

Broken window fallacy

Every so often I'm surprise by people's understanding of economics. In this case, not in a good way. The following comes from a comment by Craig Glen Eden left on the posting Same old failed ideas at The Standard:
What a load of crap Paul. Heres one example when the actions of Government/Governments can increase Long Term economic growth its called war.
This is just so wrong on so many dimensions. It is, of course, just a version of the Broken Window Fallacy. If it was true, we could increase economic growth by destroying all our capital, all of the time! After all, that's what war does, it destroys capital, both human and physical, on a very large scale.

People who argue like Craig would say that at the end of World War Two Germany and Japan had an advantage over the USA because their old plant had been destroyed by the Allies and they could replace them with the most modern plant and equipment available. This, it would be argued, meant that Germany and Japan could produce more efficiently and at lower cost than the Americans who still had to produce with their older and half-obsolete factories. But if this really was an advantage then the Americans could have easily offset it by destroying their own plant and equipment. In fact all countries could scrap all their old equipment every year and replace it with the latest plant and equipment.

The truth is of course that there is an optimal rate of replacement, a best time for replacement, of plant and equipment. It is an advantage to have your plant destroyed only if the time had arrived when, through deterioration and obsolescence, your equipment has acquired a zero or negative value just as the plant is destroyed by an act of war. So it is never an advantage to have one's plant and equipment destroyed unless the said plant have already become valueless due to normal business activity.

Post World War Two there was rapid economic growth in Europe and Japan, at least as measured by standard economic methods, but much of this growth was needed just to replace what had been destroyed by the war. By having to build new homes and factories people in Europe and Japan had less resources leftover to create anything else. When business was increased in one direction, it was correspondingly reduced in another.

If only more people would read Henry Hazlitt.


matt b said...

I believe M Friedman said something like: if war is such a great stimulus, why not make guns in peacetime and bury them?

Paul Walker said...

I think the problem with war being a stimulus is that you have to use the guns!