Don’t Throw in the Towel

Someone from the Cato Institute sent me this with the message “I’ve been reading your blog posts on the Obama stimulus plan, and I wanted to bring this to your attention, something I think you’ll find interesting.” I interpret “interesting” to mean “you are mistaken to think fiscal policy can benefit the economy”:

Making Work, Destroying Wealth, by David Boaz: Journalists are telling us that John Maynard Keynes, the intellectual inspiration of the New Deal and its tax-and-spend philosophy, is all the rage again. The Wall Street Journal offers an interesting vignette on Keynes’s view of how to create jobs:

Drama was a Keynes tool. During a 1934 dinner in the U.S., after one economist carefully removed a towel from a stack to dry his hands, Mr. Keynes swept the whole pile of towels on the floor and crumpled them up, explaining that his way of using towels did more to stimulate employment among restaurant workers.

Now I should say that various people report this story, including Ludwig von Mises, but no one cites an original source. Assuming it’s true, though, it just seems to underline the absurdity of the whole “make-work” theory that is back in vogue. Keynes’s vandalism is just a variant of the broken-window fallacy that was exposed by Frederic Bastiat, Henry Hazlitt, and many other economists: A boy breaks a shop window. Villagers gather around and deplore the boy’s vandalism. But then one of the more sophisticated townspeople, perhaps one who has been to college and read Keynes, says, “Maybe the boy isn’t so destructive after all. Now the shopkeeper will have to buy a new window. The glassmaker will then have money to buy a table. The furniture maker will be able to hire an assistant or buy a new suit. And so on. The boy has actually benefited our town!”

But as Bastiat noted, “Your theory stops at what is seen. It does not take account of what is not seen.” If the shopkeeper has to buy a new window, then he can’t hire a delivery boy or buy a new suit. Money is shuffled around, but it isn’t created. And indeed, wealth has been destroyed. The village now has one less window than it did, and it must spend resources to get back to the position it was in before the window broke. As Bastiat said, “Society loses the value of objects unnecessarily destroyed.”

And the story of Keynes at the sink is the story of an educated, professional man intentionally acting like the village vandal. By adding to the costs of running a restaurant, he may well create additional jobs for janitors. But the restaurant owner will then have less money with which to hire another waiter, expand his business, or invest in other businesses. Before Keynes showed up in town, let us say, the town had three restaurants among its businesses, each with neatly stacked towels for guests. After Keynes’s triumphant speaking tour to all the Rotary Clubs in town, the town is exactly as it was, except the three restaurants are left to clean up the disarray. The town is very slightly less wealthy, and some people in town must spend scarce resources to restore the previous conditions. …

Now we are told that “Keynes is back,” and we need a new New Deal, and the Obama administration is going to create millions of jobs by shuffling money through the federal government. And the theoretical underpinning of this plan comes from a man who thought you could stimulate employment by breaking things. …

President-elect Obama proposes that the federal government “create or save” jobs by spending upwards of $600 billion. Where would this money come from? If it comes from taxes, it will be taken out of the more efficient private sector to be spent in the less efficient government sector, and the higher tax rates will discourage work and investment. If it is borrowed, it will again simply be transferred from market allocation to political allocation, and our debt burden will grow even greater. And if the money is simply created out of thin air on the balance sheets of the Federal Reserve, then it will surely lead to inflation. …

You … can’t get economic growth back by breaking windows, throwing towels on the floor, or spending money you don’t have.

It’s easy enough to dispense with this by simply mentioning public goods, i.e. goods with high social value that, because of market failure, will not be produced without government intervention. Producing these goods is just the opposite of “throwing towels on the floor,” and the net benefits from these projects are particularly high now since input costs have fallen so much as the economy has weakened. There are other easy counterarguments as well, but rather than rehashing those, I want to play the window game.

Suppose there is an economy that is humming along at full employment. Then, all of a sudden, out of nowhere, a giant, extremely rare windstorm – it’s like nothing anyone can remember – comes along and blows out many of the windows in town’s homes and businesses. The windows are broken.

This is unfortunate. The town specializes in delicate goods that cannot be exposed to the weather, and when the windows were broken and the weather rushed in all of the inventory, or much of it anyway, was destroyed. In addition, since all of the town’s wealth was invested in the inventory, and then some (i.e. they had borrowed to finance some of the inventory), the people of the town lost both their wealth and their ability to borrow from residents of other towns.

So they are wiped out. With all of their wealth gone and no way to borrow, there is no way to rebuild the town and go on as before. Most people are struggling just to get by each day, they don’t have time to repair the windows, let alone the resources to finance the repairs and then restock the shelves.

Or maybe there is a way. Suppose the government steps in and hires people to replace the broken windows, and then makes loans as needed (or makes loan guarantees, with an appropriate allowance for risk, or even outright grants in some cases) to recapitalize the businesses and cover the cost of the repairs. That way, the business owners can purchase new inventory and go on as before (well, not exactly as before, one condition of the government loan is that windows of a certain strength are installed, by regulation if necessary, so that the government financed inventory is safe from another disaster).

Thus, instead of destroying wealth, the government is essential in creating it. After the economy-wide window disaster, the government ignores the advice to turn its back in a time of need, and instead steps in and provides the help that is needed to get the economy up and running again. Because of the government action, the economy is revived, and they all live happily ever after.

About Mark Thoma 243 Articles

Affiliation: University of Oregon

Mark Thoma is a member of the Economics Department at the University of Oregon. He joined the UO faculty in 1987 and served as head of the Economics Department for five years. His research examines the effects that changes in monetary policy have on inflation, output, unemployment, interest rates and other macroeconomic variables with a focus on asymmetries in the response of these variables to policy changes, and on changes in the relationship between policy and the economy over time. He has also conducted research in other areas such as the relationship between the political party in power, and macroeconomic outcomes and using macroeconomic tools to predict transportation flows. He received his doctorate from Washington State University.

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1 Comment on Don’t Throw in the Towel

  1. Let us view the larger picture of the final example: The government steps in and gives funds, that were aquired through taxation, to the people of the town, with stipulations. In this case, the people of the town have no responsibility for any losses, and we will assume they had absolutely no idea their windows would not be strong enough. In this case, the townspeople are good credit risks, as they were productive before and should be again. Let’s assume that it’s the local government doing the helping, as federal help is akin to forced charity. I repeat, I am assuming no charity, forced or otherwise. I expect everyone to pay their debts. Now, assuming the local government is good for it, the local government borrows money to help its people, and now has a debt to pay off. If it does not pay off the debt, it will merely gain interest and be a millstone around the government’s neck. It is obvious to me that the government assistance is merely an investment in its own people. If it is done fairly, it is possible that the people helped could go on to produce wealth; in the cases of loans, they could be paid off by the recipients, and for grants, everyone could subsequently be taxed, and the debt could be payed off. There is a limit, of course, to how much they can sustain, as the people need to produce enough to survive as well as keep up with interest payments in order to keep the debt manageable. This is possible! It can be a workable scenario, certainly, so long as the debt is eventually paid!

    However, if these people turn out to not be good credit risks, or, more likely, some much worse than others, very few win out in the end; the people can attempt to use their government as a debtor to keep them afloat, but, of course, there are always limits. You see, the government does not create wealth, but reallocate it. Consider that government programs are notoriously inefficient, and you may just be making life more difficult for the entire town, even for those few who did not lose much in the storm. My point is that if the investment were bad or misguided (for which government programs are also notorious), the town would eventually be in a similar situation, or perhaps worse, and the only way to escape the debt and misery would be to move away.

    As for private loans, the asumption that none of the previously productive buisness owners can find a method of borrowing money is absurd. If I were a banker in the town next to theirs, I would invest heavily in their town, and with confidence, unless given a reason not to. Of course, not if the government got involved, as the goverment would be acting as a loser bank, nigh impossible to compete with. There is always the risk that the local economy would be set back because loans could be scarce, but, again, this is a disaster! How can you not expect a setback? It would cost a lot, but it would cost those who lost their property. The ones who were not prepared, lose; If they are not at fault, there is insurance, as well as the fact that they are very good credit risks. Finally, if the insurance could not pay everyone, then they made a bad investment, and would fail. If they would refuse to pay anyone, they would lose their business, and fail. That is harsh, but that is the result of so much lost wealth.

    The windstorm cannot be considered to be serendipitous. Keynes was wrong. Using government at the federal level merely increases the scale of the issue, the inefficiencies (corruption, bureaucracy, inability to reverse bad programs), and the distribution of the distruction. Yes, that would spread it out more, but there are limits! The end of your article should be rewritten as “Because of the government action, the economy is temporarily revived, and they all live happily ever after, if they manage to pay off their debt. If not, they don’t.”

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