By Doug Carey

Redstone Review

BOULDER – The powerful earthquake that occurred off the coast of Japan this past March caused a massive tsunami that wreaked havoc on the island. Damage estimates are over $300 billion (6 percent of overall GDP) and the number of dead is at least 15,000 people.

Yet in this tragedy, there are many who see a bright side. More than a few economists, pundits, and government officials both here and in Japan have already stated that they believe the spending needed to rebuild the coastal areas of Japan will help boost economic growth. Jobs will be created and this in turn will increase consumer spending. This is just what Japan needed to propel it out of its 20-year economic slump they say. Former White House economics adviser Larry Summers said after the earthquake, “It may lead to some temporary increments in GDP as a process of rebuilding takes place. In the wake of the earlier Kobe earthquake, Japan actually gained some economic strength.”

The idea that the destruction of property leads to economic growth is not a new one. It has been cast about for decades and rears its head again with each large natural disaster. This idea is not only wrong-headed, but dangerous, for it can encourage destruction for the sake of economic growth. It is also difficult to believe that people still subscribe to this theory today given that the French philosopher Frederic Bastiat so roundly discredited this notion over 160 years ago. In 1850 Bastiat wrote an essay called That Which is Seen and Unseen. In this essay he included a parable which eventually came to be known as the broken window fallacy. This parable is as follows:

“Have you ever witnessed the anger of the good shopkeeper, James Goodfellow, when his careless son happened to break a pane of glass? If you have been present at such a scene, you will most

assuredly bear witness to the fact that every one of the spectators, were there even 30 of them, by common consent apparently, offered the unfortunate owner this invariable consolation: ‘It is an ill wind that blows nobody good. Everybody must live, and what would become of the glaziers if panes of glass were never broken?’

“Now, this form of condolence contains an entire theory, which it will be well to show up in this simple case, seeing that it is precisely the same as that which, unhappily, regulates the greater part of our economical institutions.

“Suppose it cost six francs to repair the damage, and you say that the accident brings six francs to the glazier’s trade—that it encourages that trade to the amount of six francs—I grant it; I have not a word to say against it; you reason justly. The glazier comes, performs his task, receives his six francs, rubs his hands, and, in his heart, blesses the careless child. All this is that which is seen.

“But if, on the other hand, you come to the conclusion, as is too often the case, that it is a good thing to break windows, that it causes money to circulate, and that the encouragement of industry in general will be the result of it, you will oblige me to call out, ‘Stop there! Your theory is confined to that which is seen; it takes no account of that which is not seen.’

“It is not seen that as our shopkeeper has spent six francs upon one thing, he cannot spend them upon another. It is not seen that if he had not had a window to replace, he would, perhaps, have replaced his old shoes, or added another book to his library. In short, he would have employed his six francs in some way, which this accident has prevented.”

Bastiat wrote this before economics was even a science. He understood in 1850 what many do not understand today: Destruction does not create economic growth. If destruction did create economic growth, then why do we punish those who spray paint graffiti or break into cars? Why don’t we hire kids to go to downtrodden cities like Detroit and tell them to start throwing rocks through windows? Think of all the jobs that will be created!

Sadly this is an idea that won’t seem to go away. The broken window fallacy has been used to justify all sorts of spending ideas as well as wars. Many people today still believe that the production of tanks and war material in World War II is what led the United States out of the Great Depression. If that were true, then why don’t we just start building even more tanks and more guns today to snap our economy out of the doldrums? We have spent over $1 trillion on our wars in Iraq and Afghanistan. Why isn’t the economy booming now?

The bottom line is this: We live in a world of finite resources. Most of those resources can only be used one time. If we take resources and manpower to build tanks, those resources and laborers cannot be used to build bridges or new businesses that we need. If we ask the window maker to build a new window for the one that was broken, then he cannot build a window for the person down the street. On a more grand scale, the resources that will to rebuild Japan’s coast will not be available for things the Japanese people needed before the earthquake, such as more homes, roads, cars, etc. The broken window fallacy may help some people feel better about natural disasters by looking on the bright side of things. But this is one theory that should be laid to rest once and for all.

Doug Carey lives in Boulder and has been working in the finance industry for over 16 years. He has had jobs ranging from portfolio manager, overseeing nearly $11 billion in assets, to being part owner of a financial analytics software company. Carey has a master’s degree in Economics. Carey is a Chartered Financial Analyst and owner of Atlas Capital Management, a fee-only registered investment advisor firm based in Boulder. His company provides investment management, retirement planning, financial planning, and employee stock options advisory services. Visit www.atlascapitalmgt.com or email him at dcarey@atlascapitalmgt.com.

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