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Tuesday, November 20, 2012

Broken-Windows Macroeconomics

As I’ve written before, every time I teach microeconomics I remind students that the fundamental difference between macroeconomics and microeconomics has nothing to do with subject matter. That is, macroeconomics doesn’t tackle the “big” questions while leaving the “small” questions to microeconomics. The real difference lies in what practitioners in each discipline use as their basic units of analysis.

The Keynesian macroeconomist, for example, thinks the basic units of analysis are national-level aggregates and averages, such as gross domestic product, aggregate demand and supply, the rate of unemployment, and the rate of inflation. Keynesian macroeconomic theories involve the interactions of those aggregates and averages.

For a microeconomist, the units of analysis are individual choices and incentives. So a satisfactory explanation for the macroeconomist about rising unemployment—e.g., that aggregate demand is insufficiently low—would not satisfy a microeconomist. The microeconomist would want to know what kinds of incentives confront people in the labor market that might induce them to withhold their labor. For example, do higher unemployment benefits lower the cost of leisure so that not working looks more attractive than working?

It bears quoting the noted Austrian macroeconomist, Roger Garrison: “There are macroeconomic problems, but only microeconomic solutions.”

When it comes to economy-wide recessions, such as the one we’ve been suffering through these past four years, not only can microeconomics explain them, but only microeconomics can explain them. That’s because typical Keynesian macroeconomic fiscal policies are aimed simply at increasing aggregate demand, regardless of where that demand might come from. Indiscriminate government spending tends to miss details of the economy that operate at far more disaggregated levels. Missing those details can very well doom macro policies to failure.

What if an increase in government spending were to find its way into the housing market, which some would like to see—especially politicians connected with housing construction? Would fiscal spending that pushed housing prices up to the artificially high levels we saw just before the housing bubble burst in 2006 be a good thing? Probably not. That would likely mean creating unsustainable conditions, just as it did before. The consequences might be just as perverse as they were then.

In the entrepreneurial market process, profit-seeking people use market prices and their knowledge to guide their investments. In general, trying to out-guess what entrepreneurs in all the various industries and regions of the country would do is unwise. Bleeding taxpayers for resources and pumping those into arbitrary or politically-privileged areas of the economy—where knowledgeable entrepreneurs would not have invested—is no better.

There are several ways to begin to find microeconomic solutions to macroeconomic problems. One is to focus on the concept of capital.

Keynesian economics tends to downplay the role of capital. Indeed, Keynesian theory is preoccupied, one could even say obsessed, with spending—government or private—as long as it affects aggregate demand. Capital is taken much less seriously, perhaps because in a recession it is assumed to be “idle.” But tools, equipment, and know-how will combine and recombine over time to create future output. Sustainable patterns of recombining capital lead to increased productivity later. And yet Keynesian macroeconomists tend to discount the importance of capital, and thus this critical microeconomic process.

Now, I think there’s a strong connection between the Keynesian’s downplaying of capital and the familiar “broken-window fallacy,” which says that destruction, by stimulating spending, can increase the net income of a community.

The fallacy goes like this: A naughty youth chucks a rock through the town baker’s window. The baker is naturally upset because he has to pay the town glazier $100 to replace the window. “But look at the bright side,” says a clever bystander at the scene, “that glazier is now $100 richer than he was before; and he will then spend that money on a suit from the tailor, who will in turn pay the carpenter $100 for a new table, and so on. In the end,” says the bystander, “we’re all richer because of that kid!”

This line of reasoning, uttered most recently by pundits after Hurricane Sandy smashed into the Northeast, goes wrong when it disregards the capital represented by the window. Before the vandalism, the baker had a useful window and $100 in his pocket. Now he’s left with just the $100 and no window. The baker might himself have paid the tailor that $100 for a suit but can’t now because he has to replace that broken window. He and the community as a whole are simply poorer by one window.

There are several ways to connect the broken-window fallacy with Keynesian macroeconomics.

Perhaps the key way is to realize that the window in the story constitutes a part of the baker’s capital. The broken-window fallacy amounts to ignoring the value of the window. One likely explanation is that many have forgotten about the valuable role of capital, in this case the baker’s window. Day after day that window helps the baker by letting light in, keeping flies out, and giving customers a glimpse of his beautiful loaves. In this way the window provides a flow of productive goods and services over time.

But if your focus is simply on spending right now—that is, on the obvious, rather than on the difficult-to-see production processes that take place through time—you may be ignoring the role capital plays over time. That’s true whether you’re talking about baking bread in a single market or producing goods and services over the entire macroeconomy.

The preoccupation with spending, and the failure to grasp the importance of capital, mean fallacies like the broken-window story (and others) flow naturally from the Keynesian mindset.

To learn more about the nature and significance of capital, see these books by Roger Garrison, Steve Horwitz, Peter Lewin, Israel Kirzner, and Ludwig Lachmann.

  • Sanford Ikeda is a Professor and the Coordinator of the Economics Program at Purchase College of the State University of New York and a Visiting Scholar and Research Associate at New York University. He is a member of the FEE Faculty Network.