Sunday, May 27, 2012

Tsunamis, Growth, Stocks and Flows, and the Broken Window Fallacy

Just a great piece by Ryan Young in The American Spectator entitled “A Tsunami of Bad Economics”:

Japan was hit by a tsunami last year on March 11. …  What’s the upside to this natural disaster? I’ll be blunt. There isn’t one. But some economists think there is.

To come to such an inhumane conclusion is to forget the economic discipline’s most fundamental lessons. … As it turns out, Japan’s GDP is growing twice as fast as America’s. 

This is a simple mistake to make if the Keynesian model is the basis for your thinking about macroeconomics: higher employment is always good.

But, this goes back to Bastiat’s broken window fallacy: you shouldn’t conclude that breaking a window is a good thing because it creates work when it is fixed.

The reason people get to this point is that they are only thinking about flow variables (current work) not stock variables (past work embodied in current capital). Accountants are very careful about this: that’s why they use balance sheets and income statements. Public policymakers … not so much.

Think about it: we run our macroeconomies based on GDP. This is a flow variable. Where’s the stock variable? We simply don’t think about it much in macroeconomics. Mostly we do this because national wealth is difficult to measure. That’s a reason for being careful, not a reason for ignoring stock variables.

Imagine for a minute that the tsunami never happened. Japan’s GDP growth would probably be slower; Krugman is almost certainly correct on that. And yet, a tsunami-less Japan would be better off. …

As far as the economy goes, all that reconstruction spending would instead go to creating brand new wealth, as opposed to merely replacing what people already had to begin with. It is better to build than to rebuild.

This sort of mistake simply doesn’t happen if you’re using a growth model as the basis for your thinking. In that model, 1) a reduction in capital (from, say, a tsunami) clearly makes you worse off because it leads to lower output and per capita income, and 2) it also will lead to a higher growth rate because it takes you further away from the steady state. But, there isn’t any way you’d view that as a good thing because # 1 clearly causes # 2 in the growth model.

Via Cafe Hayek.

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