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Wednesday, August 24, 2011

Goodnight, Irene

Let us imagine an isolated valley. In that valley live an extremely wealthy loner, in a vast mansion with extensive grounds, and a large number of extremely poor subsitence farmers. They had been prosperous during the days when the loner had been constructing his estate, but now he is done, and there is no other work around.

Then Hurricane Irene comes along. It causes extensive damage to the loner's estate. Suddenly, he has need to employ all of those other people in the valley again. The economy "picks up."

Now, economic science has nothing to say about whether the valley is better off after the hurricane than it was before -- doing so would require interpersonal comparisons of utility. But it is clear that there is now more economic activity than there was before.

The point of this? Bastiat's "broken window fallacy" is not an a priori truth. It is more or less true, depending on the amount of crowding out that occurs in repairing the broken window. I have carefully contrived a scenario with 0% crowding out. It is implausible, but not impossible, and shows clearly the empirical component of Bastiat's story. Bastiat himself, as Bob Murphy demonstrates, assumed 100% crowding out. That, also, is implausible (at least in a recession), but not impossible.

The extent to which Bastiat's model applies to any real situation is an empirical matter, depending on the particular circumstances of time and place.

44 comments:

  1. I thought this post made some very good points:

    "the problem with the "disasters are good for the economy" nonsense, and GDP more generally, is that it confuses a flow with a stock. GDP measures a flow of activity, not a stock of wealth. Destroying things and then rebuilding them might increase economic activity in the area affected (by drawing resources from elsewhere), but leaves us with less wealth than we would have had without the disaster. That is the real meaning of the Broken Window Fallacy. Interested readers might also see Bob Murphy's blog post on this topic."

    http://www.coordinationproblem.org/2011/08/the-krugman-who-cried-stimulus.html

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  2. Well, Robert, I read that, and I'm not sure what you are indicating by posting it here. Nothing in my post confuses a flow with a stock.

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  3. Hicks-Kaldor would say we're worse off. What you said is only true in the sense that we can be certain that reducing barriers to free trade is a good thing.

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  4. Well, it's not a Kaldor-Hicks improvement. That doesn't mean it's not an improvement. That Kaldor-Hicks does not take into account differences in the marginal value of money is a well-known difficulty with it.

    "What you said is only true in the sense that we can be certain that reducing barriers to free trade is a good thing."

    Well, I said a number of things. To which of them are you referring?

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  5. I do not like your example.

    What you're doing is assuming a fountain of infinite goods (the rich man willing to give people stuff if they work for him) that only spouts when there are disasters and then saying "yes disasters can increase economic activity"

    But that's silly. The world doesn't have any such infinite fountains.

    It does have finite fountains though, in these sense that there are people who saved up money. And it is true that they will spread their wealth around when their house blows up or whatever (as they need to rebuild it) and, sure, that will generate more exchanges. But that can't go on forever, it's only that way cause the rich guy saved his money, and this eats away at his savings.

    Stuff is getting destroyed full stop. Just cause stuff getting destroyed causes an outflow of a rich man's savings to some subsistence farmers doesn't mean the economy is "picking up".

    I mean imagine if the rich guy hadn't saved any money up, or that the previous disaster made him spend his last savings. What then?

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  6. The thrust of what you were saying was that we can make no economic judgment about whether the broken window is bad, using the ultra-strict Kirznerian definition of what constitutes economic "science." The (implicit) social welfare function that we use when arguing that say, free trade is good, is wealth max. It is also the implicit criteria of what we mean when we say we are "better off" if we were to create a new technology, end subsidies, or whatever else. Perhaps your criticism is correct against those who make fun of Krugman while elsewhere asserting that only Kirzner's criteria is "scientific," but it is untrue about those who are willing to take a more pragmatic approach to utilitarian arguments.

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  7. Sorry Gene didn't mean to imply you were making that stock vs flow error. I just thought Horwitz summed up the meaning of Bastiat's parable quite nicely. Which is:

    Destroying things and then rebuilding them might increase economic activity in the area affected (by drawing resources from elsewhere), but leaves us with less wealth than we would have had without the disaster.

    So are you saying that the above is not a priori true and depends instead on the amount of crowding out that occurs?

    Because it seems to me like it is true even in your example. The economy certainly experiences an increase in economic activity (in a narrowly defined sense if we assume all the unemployed are not engaged in any activity that could be later classified as economic activity if turns out they were brainstorming on ways to create a new product etc.) but it still seems clear that there is now less wealth than before due to the destruction caused. Whatever resources used to repair the damage are no longer in existence. And the payment from wealthy loner to unemployed is just a transfer of wealth.

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  8. "What you're doing is assuming a fountain of infinite goods..."

    No, I am not.

    "But that can't go on forever..."

    Right. Who said it could?

    "Just cause stuff getting destroyed causes an outflow of a rich man's savings to some subsistence farmers doesn't mean the economy is "picking up"."

    Of course it does. The stock of wealth has been lowered, but the flow has increased.

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  9. Ryan, wealth maximization strikes me as a very, very poor welfare criterion.

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  10. "but it still seems clear that there is now less wealth than before due to the destruction caused."

    Right. I don't think anyone (serious) disputes that: not Krugman, not Keynes, not DeLong, etc.

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  11. I was going to ask you to clarify your original post because I was having a hard time understanding it. Then I just re-read it!

    The extent to which Bastiat's model applies to any real situation is an empirical matter, depending on the particular circumstances of time and place.(emphasis mine)

    Ya that seems totally reasonable.

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  12. Yes, Robert, and I think often there is a lot of crowding out.

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  13. Hicks himself defended the wealth max on grounds that things even out. Last semester I took a grad level class with an extended section on social welfare functions which concluded that under most circumstances you just get back to wealth max. Neoclassical cost-benefit analysis typically doesn't start applying weights to individuals based on their income for this reason (although it does sometimes happen).

    And while this is perhaps more controversial, I think underlying Human Action is the assumption of wealth max, only with the number of projects for which the government should intervene to maximize wealth is the null set.

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  14. Gene,

    You are correct the flow of goods from the hands of one man to another ( interpersonal trade ) does pick up in the example you provided but this is not the "economy" or "economic activity" picking up, just changing from one form to another.

    According to what little I know of economics, people always engage in economic activity. Maybe they are not trading with each other but in all activity they are at the very least economizing on time, and most probably other resources too.

    So how can you say the economy has picked up, as if one action is somehow more of an "economic action" than another?

    The subsistence farmers without the advent of the disaster would be economizing on their resources and going about their farming business given the situation. When the disaster strikes the situation changes and they go about a different business.

    How can you say that their farming is less of an "economic activity" than their trading with the wealthy man?

    Surely you merely mean to say the economy stays the same, but the amount of inter personal trading therein increases?

    You probably are saying that but if you are I do not understand what is the big deal. Why do people who like free markets get angry at someone saying that the amount of interpersonal exchange may increase due to natural disasters? Seems logical to me!

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  15. "According to what little I know of economics, people always engage in economic activity. Maybe they are not trading with each other but in all activity they are at the very least economizing on time, and most probably other resources too."

    Come on, Avram, there is the praxeological definition of economic activity and the more usual definition. Yes, while watching TV I'm economizing, but in ordinary talk this is not considered an economic activity. You ought to be able to understand this fine.

    Look at it this way: before the hurricane, the valley peasants weren't making any money. After it they were.

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  16. I understand it fine.

    But it stands to reason that if you use the broader definition of economic activity, and not the more narrow one, that in the end you will draw very different conclusions.

    Do you think the more narrow definition is better?

    It seems more appropriate if you want to talk about "the economy" as just goods exchanging hands and being produced (sure, I admit most people do think of the economy as that) but very inappropriate if you want to talk about "the economy" as the system responsible for generating human prosperity (I dunno how many people think of it in this way, but I think its a constructive way to think of "the economy").

    For example in the narrow definition of "economic activity" it might so happen that economic activity increases a lot but for everyone to be worse off than before. Cause it's just the amount and speed of which goods are exchanging hands voluntarily, which has nothing to do with whether people are achieving the things they want to achieve.

    In fact, it's quite comical, the greatest and most healthy economies would be considered ones where people must swap a great deal of items very fast in order to say eat a peice of toast. It's like some kind of Ray Goldberg economics.

    Forgive my imagination.

    Anyway when you talk about recessions and stuff like that, what concerns me more than how fast and in what volumes goods are flying all over the place, is how prosperous people are, and with that in mind I think the broader definition is better.

    Maybe you see things differently? Maybe you would say "well in the real world there is a very strong correlation between prosperity and the amount of goods flying around, and its much easier to get other people on the same page when talking about goods flying around, not to mention easier to analyze, so that's what we economists do"

    Which I guess is fair enough, but I am anticipating that response and not too happy with it.

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  17. But Gene: what were the poor inhabitants doing before the hurricane came? You said they were subsistence farmers. That means that if they worked any less, they wouldn't produce enough to be able to survive. So, when the hurricane destroys the rich man's estate, they aren't able to work on it, unless the rich man has a store of goods that enable them to survive while they work at it (another alternative is that the rich man works too, but produces more than he consumes so that he is able to support the poor people while they repair his estate). If the rich man doesn't have such a store, then he won't be able to repair his estate, unless he works too and produces more than he consumes in a quantity that is enough to support a number of poor people so that they repair his estate.

    Whatever happens, things that have value to people have been destroyed. If the hurricane hadn't come, the rich man's store of goods wouldn't have been used at the same rate, or he wouldn't have employed his surplus in repairing it. Wealth is lost. The poor people are better off, because the rich man probably must offer them more than what they can produce by themselves to convince them to work on repairing his estate. The rich man is worse off. I don't think that makes the example fundamentally different from Bastiat's. In Bastiat's example, the glassmaker is better off, but the rest of the people is worse off. The difference is the number of people that are better off and the number of people that are worse off.

    The point, I think, is that wealth is lost. A glass window serves a purpose and is valued by someone. A broken glass window serves no purpose, so when someone breaks a window, wealth is lost. Where there was something that was valuable to someone, now there is something that is valuable to no one. I don't mean by that that people are worse off in general. Like you said, this would require interpersonal comparisons in utility.

    The only case in which economic activity increases is if the rich man didn't work, lived from his store and now has to start working in order to hire poor people to rebuild his estate. That "economic activity" goes up doesn't mean that conditions are improved.

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  18. "You said they were subsistence farmers. That means that if they worked any less, they wouldn't produce enough to be able to survive."

    No it doesn't. It means they only have enough land to feed themselves. They may be able to do so in a few hours per week.

    "Wealth is lost."

    Yes, I know.

    "That "economic activity" goes up doesn't mean that conditions are improved."

    Of course not. I didn't say it did!

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  19. "But it stands to reason that if you use the broader definition of economic activity, and not the more narrow one, that in the end you will draw very different conclusions."

    Only if you mistake your definition for reality!

    Look, Avram, when someone says "The economy is in a recession" it would be foolish to reply, "No it isn't -- people are still economizing full time!"

    And when we talk about whether or not stimulus might work, that is the kind of situation at which we are looking. The praxeological definition is not the appropriate definition to use in the case of a downturn, because the very concept of "downturn" is meaningless under that definition.

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  20. If interpersonal utility comparisons are impossible, what does it mean wealth is lost?

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  21. "Of course not. I didn't say it did!"

    Well, I didn't say you said it did :D

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  22. Well, I didn't say you said I said it did!

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  23. Just so, scineram, there is a lot of wobbling back and forth between incompatible frameworks in Rothbardian economics.

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  24. Yes, Ryan, I know many economists have used wealth maximization as a welfare criterion. That does not mean it is a good one.

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  25. Gene,

    You said "when someone says "The economy is in a recession" it would be foolish to reply, "No it isn't -- people are still economizing full time!"

    I agree, that would be a foolish thing to say. But to my unerstanding Economies go into recession cause prices go out of wack and people can't economize properly, not because they stop economizing. i.e. economizing in the usual way leads to unintended results such as clusters of businesses making huge losses and all the consequences of this (misallocated capital, people needing to reskill and so on).

    I think this is consistent, and to my plebian mind a great explanation. Makes far more sense from an economy-as-the-measure-of-prosperity stand point than "goods aren't flying around fast enough".

    Am I misrepresenting you in saying that your position is that economic hardship for real people occurs when goods don't fly around fast enough and in the right volume? If I am please advise.

    You also said:

    "in the case of a downturn, because the very concept of "downturn" is meaningless under that definition."

    Yeah sure cause downturn implies some kind of curve heading down, like a GDP curve or something.

    But it does make sense to talk about recessions in terms of say the quanitity of noise in price signals, the costs of denoising the signals and so on. Replace "downturn" with "increased noise".

    So the pundits would say as the economy heads into a recession: "There are signs of increased noise in the economy" intead of "There are signs of a downturn in the economy".

    Seems to me that talking about downturns is adressing the wrong problem, albeit a strongly correlated one.

    I mean it explains why when economists talk on TV they appear so clueless as to explaining *anything*. Its a very cartoon view of the world to see the economy as some kind of sine wave that needs to be modulated with cash influxes or whatever as stimulus.

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  26. "I agree, that would be a foolish thing to say. But to my unerstanding Economies go into recession cause prices go out of wack and people can't economize properly..."

    So you find the market to be extremely fragile, and unable to adjust to minor price distortions? You make a very good case for Keynesianism, Avram! I am glad to see that you are so open-minded.

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  27. I don't mind making a case for Keynesianism if that is what I do. I do not think I am but if I am that is cool with me.

    But I will say that I dunno how fragile or not fragile markets are to price distoritions.

    I imagine modern markets using money wouldn't be the most robust institution for economizing, and that they would scale poorly.

    i.e. the more the market grows the more fragile it becomes to even minor price distoritions

    I mean I'm prolly wrong about that but its my intuitive hunch.

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  28. Just to give you fair warning, Gene, I linked to this post for a Mises article coming out on Monday. Live it up this weekend, you will be ashamed to show your face in public when my article runs.

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  29. Hey I posted a comment but it didn't seem to make it through. It went something like this:

    Gene,

    Sure if Keynesianism is what you categorize as the things I am saying then that is what I am saying.

    Also yes I think market based economies are fragile and sensitive to price signals. I think the larger, and more intertwined a market based economy, the even more fragile it becomes in this regard. So it's a system that scales poorly.

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  30. Of course that the "broken window fallacy" is an a priory truth. I will "prove" you this in the shortest possible way:

    Imagine a guy who before a destructive event X has the capacity (because of a given stock of accumulated goods ready to be used) to satisfy 4 of his 4 subjective ordinally ranked wants:

    1. something h
    2. something j
    3. something k
    4. something l

    Unfortunately a destructive event happens and destroys one of his accumulated and ready-for-use means. For example, the means for satisfying end 2. (I forgot to mention that the means are specific and can not be used for the satisfaction of more than one end.) Now, he, thanks to the destruction, can not satisfy one of his wants (end 2), which otherwise he could have satisfied. HIS both OBJECTIVE AND TANGIBLE (the destroyed mean) and his SUBJECTIVE WEALTH (his satisfaction) are DIMINISHED.
    If the means were not specific, then, he would use some of the means that he first had arranged for the satisfaction of end 4 for the satisfaction of end 2. This "transfer" or re-allocation of means from the satisfaction of end 4 to the satisfaction of end 2 in order to counter-act the destructive act of the event that destroyed the means devoted for end 2 results in the NON-satisfaction of end 4. This is THE ALTERNATIVE COST of the destructive event. This is what he could have been consumed TOO, if the event did not happen.
    This example uses means as stock of goods. But the same is true when we use flows, that is, income available for allocation to different ends. The individual IS ALWAYS BETTER OFF if his NET WEALTH increases, i.e., when he ADDS to his stock of goods, and he is ALWAYS WORSE OFF when he REPAIRS (re-add what he had before the event - no net increase) what he already had before the disastrous event.


    This is an a priori "proof" of Basitat's "broken window fallacy". I say proof with "" because you know that praxeology is not provable (in the logically-positive sense).

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  31. I. Georgiev, very well:
    "The individual IS ALWAYS BETTER OFF if his NET WEALTH increases, i.e., when he ADDS to his stock of goods, and he is ALWAYS WORSE OFF when he REPAIRS (re-add what he had before the event - no net increase) what he already had before the disastrous event."

    I quite agree. But you have sid nothing that addresses my example!

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  32. "Live it up this weekend, you will be ashamed to show your face in public when my article runs."

    Bob, I must say, I don't see how your article even disputes what I was saying! My face will appear as before.

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  33. Gene, I believe you think that I have not addressed what you have written, because I have not considered the increased employment of the construction workers? The other thing is that you think there is no way we can assess or evaluate whether "the valley" collectively/aggregately is better off or worse off (since some individuals are worse off - the rich guy, and some individuals are better off - the construction workers). It is true that the wealth that is located "in the valley" is not collectively owned but rather individually and when a disaster happens and destroys only individual's A wealth than we can with certainty claim that (A) he is worse off and (B) all those other individuals with whom he would have exchanged are too worse off. This implies these two IRREFUTABLE points:
    (1) society is always better off with more accumulated goods ready for consumption/production than with less accumulated goods
    (2) in your example you miss to see "the unseen". The unseen is that if the disastrous event did not happen he would employ the means he now has to employ for re-construction for the attainment of an ADDITIONAL END. This would have made him better off; this implies that he would have ANYWAY exchanged with someone, which would have made that someone better off.

    The irony in your posting is this: First you claim that when a disaster happens we can not assess how it has influenced "the valley's" aggregate condition. But later when "economic activity happens", that is, re-construction, as a result of the disaster, you claim that "the economy picks up", with which you IMPLY that after all we can evaluate the aggregate wealth condition of "the valley".

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  34. I. Georgiev, your last post is evidence of one who has been driven insane by praxeology. Your "irrefutable" claims are both nonsense.

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  35. (1) First, you discuss the possibility - or lack there of - to evaluate the economic consequences of a disastrous event. That is, you discuss whether we can make a statement regarding the condition of "the valley's wealth". Then you say that we can not compare interpersonal utility. Then, though, you write that the disaster is a cause for more economic activity "than there was before".

    Let me first note that you are correct in writing that we can not compare inter-subjective utilities.
    From here on I will try to proceed as coherently as I can.
    Your first mistake is your perception of
    the valley as something that can be better or worse off. This implies that you think there exists an aggregated mass of wealth that belongs collectively to "the valley".
    First of all the valley is not an entity that can own things, it is a geographical territory. There IS wealth on this territory and it is owned individually. These individual property owners are integrated parts of the system of division of labor developed on the valley. This system forms and shapes community (society) that lives on the valley. There are three implications:

    (i) Every individual is better off when the available for him stock of goods is higher than lower.
    (ii) Every individual voluntarily decided to become part of the division of labor framework because he thought he would be worse off in case he stayed in self-sufficient isolation.
    (iii) The community as a whole is better off when each individual's wealth is higher than lower. More accumulated goods makes the system of division of labor relatively more beneficial to each of the community's members.

    Second, I do not know what exactly mean with "economic activity" and whether it is always or sometimes a good or a bad thing. Please specify. What I know, though, is this: you compare this "Activity" in the present with the "Activity" in the past. This comparison is wrong and it reveals one of the reasons why you can not comprehend Bastiat's "unseen". Bastiat makes the following comparison: what is the wealth in the present and WHAT THE WEALTH COULD HAVE BEEN AGAIN IN THE PRESENT, if a disastrous event X did not occur.

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  36. "From here on I will try to proceed as coherently as I can."

    Hey, you gave it your best shot.

    "Your first mistake is your perception of the valley as something that can be better or worse off."

    Ah, I see, when I say that economists CAN'T say if the valley is better or worse off, I actually secretly mean CAN!

    "society is always better off with more accumulated goods ready for consumption/production than with less accumulated goods"

    So here you make the mistake you just falsely accused me of making.

    "this implies that he would have ANYWAY exchanged with someone"

    I can't believe anyone could even say this! I can't make myself better off, by, say, going for a walk, which involves no exchange with anyone else?!

    Like I said, both of your "irrefutable" propositions are utter nonsense.

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  37. Oh, yeah, all three of these are nonsense as well:

    "(i) Every individual is better off when the available for him stock of goods is higher than lower."

    You've never heard of anyone killed by their new-found riches?!

    "(ii) Every individual voluntarily decided to become part of the division of labor framework because he thought he would be worse off in case he stayed in self-sufficient isolation."

    What rubbish. Individuals are part of the division of labor because that's our nature as social animals, and that's where they were born. People aren't born from acorns out in the woods, then grow up, and then "decide" to join society!

    "(iii) The community as a whole is better off when each individual's wealth is higher than lower. More accumulated goods makes the system of division of labor relatively more beneficial to each of the community's members."

    See point 1 -- maybe "society" is better off, and maybe it isn't.

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  38. OK, I. Georgiev, I can't even bring myself to post your last load of codswallop. But you are clever -- I'm sure you could prove "irrefutably" that the sun is not really in the sky, if you put your mind to it.

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  39. The point of the broken window fallacy is to show that it is important to look not just on the immediate effect (e.g. rise in economic activity, which is good for the farmers in Callahan's example), but also on those effects which are not seen immediately. Read the beginning to the essay What Is Seen and What Is Not Seen (BWF is mentioned in that essay).

    Quote from Bastiat: "If the window had not been broken, the shoe industry (or some other) would have received six francs' worth of encouragement; that is what is not seen.

    And if we were to take into consideration what is not seen, because it is a negative factor, as well as what is seen, because it is a positive factor, we should understand that there is no benefit to industry in general or to national employment as a whole, whether windows are broken or not broken."

    What would the "wealthy loner" do with his money if his house wasn't damaged?

    I must repeat. The point of BWF is to show that we must look also at those effects, which are not seen immediately.

    Mr. Callahan, in your discussion of BWF in this post, you completly ignored that part of BWF. So in your post you said nothing regarding the question whether the BWF is a priori truth or not, since you completly omitted the main and only point of the BWF, that is, the negative factor - that what is not seen immediately.

    (See also Mr. Wenzel's post, http://www.economicpolicyjournal.com/2011/08/bad-economic-modeling-failing-to.html)

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  40. "I must repeat. The point of BWF is to show that we must look also at those effects, which are not seen immediately."

    You *must* repeat, must you? Well, you know, I wrote a whole book making use of Bastiat extensively, so I did not "completly ignored that part of BWF" -- I postulated that the guy is a "loner" who is living in autarchy. What he is doing with his resources is consuming them.

    Now, this is a very artificial example, I grant you... it is set up to show a *possibility*, and not a likelihood. But at his blog Bob Murphy also agreed that my example showed exactly what I intended it to show.

    I must repeat: You should really read things more carefully before you set out to criticize them.

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  41. Ok, I see now, you didn't ignore it.

    "Now, economic science has nothing to say about whether the valley is better off after the hurricane than it was before -- doing so would require interpersonal comparisons of utility. But it is clear that there is now more economic activity than there was before.
    The point of this? Bastiat's "broken window fallacy" is not an a priori truth."

    Bastiat assumes that if the window isn't broken, the shopkeeper will use his money on something else, so the broken window doesn't increase economic activity. But you have different assumptions then the BWF, so in your case it doesn't apply, but you don't prove that it is not an a priori truth - to prove it, you must start from the same assumptions as Bastiat. Or am I still missing something?

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  42. "But you have different assumptions then the BWF, so in your case it doesn't apply, but you don't prove that it is not an a priori truth - to prove it, you must start from the same assumptions as Bastiat. Or am I still missing something?"

    Well, what I was pointing out was that the truth of the assumptions is an empirical matter. I suppose it's a matter of definition whether one wants to say "It's a priori true given the assumptions" or "It's not a priori true because it makes empirical assumptions."

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  43. I think the question of what is not seen is more subtle than what the rich guy is otherwise doing with his resources, it is why is there no mutually beneficial exchange available? If you assume that there isn't and that a hurricane makes it so that there is then I agree you get more economic activity but while the blogosphere is on fire debating Bastiat's broken window fallacy, nobody seems to be talking about how we could get into such a situation to begin with. For my part here is a more detailed attempt to steer the conversation in that direction.

    http://realfreeradical.wordpress.com/2011/09/06/still-more-broken-window-economics/

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  44. "I think the question of what is not seen is more subtle than what the rich guy is otherwise doing with his resources, it is why is there no mutually beneficial exchange available?"

    That is because it is a thought experiment, Free Radical, and I set up the conditions to illustrate a possibility.

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