The Rule

Nearly all of the problems faced in any economy could be avoided or corrected by simply heeding one little rule.  Because governments tend towards some degree of state interference in markets, economics invariably becomes politicized.  At one point or another you have probably been faced with questions such as these:

  • How can we end poverty and increase the standard of living of the poor?
  • What should be done about income inequality and the wealth gap?
  • How can we lower unemployment?
  • How can we ensure that all children receive an adequate education?
  • How should we fund the construction of roads and other transportation systems?
  • What are we going to do about the trade deficit with China?

These are major societal issues that affect millions of people.  They are, of course, not things to be ignored or taken lightly.  Due to their magnitude, much sound and fury are discharged by various groups who have conflicting methods of making improvements.  But we must be careful, for rash, ill-informed, or untested actions may lead to unintended consequences that exacerbate the very problem that they are trying to ameliorate, or they may create new ones.

We must have a method of evaluating proposed or implemented policies for their trade-offs and effectiveness at accomplishing intended outcomes.  Most politicians, pundits, and even many economists forget to do the very first step.  This is the most important rule in economics:

When evaluating any economic action or policy, one must not only look at the obvious, immediate consequences, but also at the unseen, long-term consequences.  Alternatively, one must not only look at the consequences for one group, but for all groups.

Failure to follow this rule is known as the fallacy of overlooking secondary consequences.  It is what separates good economists from bad economists.  The bad economist looks only at the direct or intended consequences of a proposed course; the good economist looks at the longer, indirect, and unintended consequences.  The bad economist sees only the effects of a policy for one group; the good economist questions the effects on all groups.

We all know the story of the prodigal son, some through foresight though others may have required experience to learn that particular lesson.  Squandering one’s money on parties and booze, flashy clothes and beautiful women may afford desirable immediate outcomes, but the long-term effects are debt, disease, and a bad hangover.  Yet it is incredible how quickly this lesson evaporates when we enter the arena of public economic policy.  Here we have men regarded as brilliant economists, Nobel-laureates even, who “deprecate saving and recommend squandering on a national scale as the way of economic salvation”.  It is an unfortunate feature of the study of economics, absent in large part from the natural sciences simply because of the special pleading of selfish economic interests.

A vast majority of the fallacies of economics could be corrected by following this simple rule.  Here is one of the most famous examples:

The Broken Window Fallacy

Imagine that you are a homeowner and a young, misguided vandal hurls a stone right through your living room window and shatters it.  As you are mourning your loss and being rather loose with your language, you will almost invariably be visited by a smug friend of yours who, in a vain attempt to consol you, offers this pearl of wisdom:  “You know, on the one hand this is actually a good thing.  If nobody broke any windows, what would happen to the window-makers?  They’d all be out of jobs.  Your broken window is actually helping the economy by stimulating employment!”

Well, why stop there?  After the glazier (window-maker) gets the money he will spend it on other goods and services, where it will then go to other goods and services, and so on, providing money and employment ad infinitum.  If you take this out to its logical conclusion, the vandal, rather than being a public menace, was actually a public benefactor.

To evaluate this claim, we must look at the direct consequences (what is seen) as well as the indirect consequences (what is unseen).  When we look at what is seen, it is obvious that your loss of a window is a gain to the glazier and that this money will in fact circulate through the economy, being of benefit to others.  What is unseen is what you would have spent the money on had your window not been broken in the first place.  Perhaps you were planning on buying a new suit, this would have given business to a tailor who might use it for groceries or a computer or investments.  In this way, the stimulation to the greater economy is equal whether your window is broken or not, but in one situation you have only a window, while in another you have a window and a new suit.  On net, society has lost the value of one broken window.

Imagine what the policy decisions would be if this fallacy were in fact true.  We would say that we should enlist an army of ill-behaved vandals to go around throwing rocks in peoples windows.  This would stimulate the economy!  It would reduce unemployment by providing more demand in the glazier industry.  It seems a ridiculous proposal, but it is precisely that which is endorsed by innumerable politicians and special interest groups, albeit in different circumstances in which complexity veils the comprehension of the fallacy.

Do not forget that in situations such as these, there are three key players.  First there is you, the homeowner, who is reduced by destruction to one luxury instead of two.  Then there is the glazier, for whom your loss is his benefit.  The third, who is so often overlooked as he is absent from the transaction, is the tailor, who is the essential character in exposing the fallacy.  Through him and his loss of business we see the absurdity in the notion of gain or stimulation through destruction.

Examples

I hope to later expand upon some contemporary issues to relate them to the parable of the broken window and other fallacies that do not account for unseen consequences, but for the sake of expediency here are a few brief examples:

War-time Economies:  Wars stimulate economies only in the industries of defense contractors.  The opportunity cost is how all the money that goes into building guns, planes, and bombs would have been spent on the goods and services that the citizens truly needed or desired.  On top of that opportunity cost is the fact that much of what is manufactured for wartime, like munitions and ordnance, has no lasting value as it is destroyed almost immediately after production.

Hurricanes:  After Katrina, a number of “informed” economists, journalists, and politicians used their talking platforms to explain the “silver lining”.  The Labor Secretary at the time said, “[W]hat will happen — and I have seen this in previous catastrophes and hurricanes — there is a bright spot in that new jobs do get created.”  A journalist at the Economist actually wrote this bit: “While big hurricanes like Katrina destroy wealth, they often have a net positive effect on GDP growth, as the temporary downturn immediately after the storm is more than made up for by the burst of economic activity that takes place when the rebuilding begins.”  What this person failed to account for in his calculations was how all the money being spent to “grow GDP” would have otherwise been spent had there been no hurricane.

Green Jobs:  When government programs subsidize certain industries, such as the more recent subsidies to green jobs, they necessarily take money from other sectors of the economy through taxation.  In an attempt to grow a new industry and create new employment opportunities, these programs often decrease employment in other sectors.  A Spanish study concluded that for every green job created through subsidies, 2.2 jobs in other areas were lost.

Notes

The principles of this article were first expressed in Frédéric Bastiat’s landmark 1850 essay “What is Seen and What is Unseen”.  The full English text of this article can be found here.

The same principles were brilliantly retold by Henry Hazlitt in Economics in One Lesson, first published in 1946.  This is in my opinion the best book that one can read to understand elementary economics.  The full text of an updated edition is graciously offered for free by the Mises Institute here.

Here you can watch an excellent brief video created by Learn Liberty that explains the broken window fallacy in detail.