Monday, March 19, 2007

The Parable of the Broken Window - My View

I thought I'd take a break from the latest depressing news about our corrupt government, and also from posting about other such depression-inducing subjects such as rape, and discuss economics, specifically, the fallacy of the parable of the broken window.

You can follow the link, but in short, it is the idea that if a shop keeper's window breaks, it is really a "stimulus" to the community because it gives work to all sorts of people who then have to fix it. And the fallacy is that it really doesn't stimulate anything, because the shop keeper is out money on the window he would have otherwise spent elsewhere. And I think it is true as far as that goes. But there is one thing that is not taken into consideration here, and that is insurance.

I think the existence of insurance takes this out of fallacy land back into a real stimulus, and I'll briefly explain why. Any smart shop keeper is going to have insurance that covers such things as broken windows. That is only good business. Leaving aside the issue of deductibles and such (we can assume he does not have one for the sake of illustration), when that proverbial window breaks, all the stimulus mentioned in the fallacy happens AND the money does NOT come out of the shop keeper's pocket, so it is, in fact, a net stimulus to the local community. So what seems like a fallacy, with insurance, is not a fallacy at all.

Ah-ha! says the libertarian (that being me) there still is only a break-even here because now the insurance company is out that money. But not so fast, says the libertarian back (still me), paying claims is part of the cost of doing business for an insurance company. The fact that they will be paying them is already factored into their business. In fact, if they did not pay any claims, they would not exist, for no one would buy any insurance. (In point of fact, they are very good at calculating just how many claims they should expect to pay, i.e. how many windows are likely to break, and this is already factored in to their business model). Thus, when that window breaks, there really is a stimulus to the local economy, one that does not take away from anyone, because the shop keeper does not pay out of pocket, and the insurance company is just paying for what it already expected to pay (just as the shop keeper, a baker, expects to pay for the dough for his bread and the electricity for his ovens).

Now, this can break down if there is a huge disaster that the insurance company did not count on - now the insurance company is out more money than it anticipated and then rates go up for everyone - but on a non-disaster scale, I think it holds true.

Now, one could argue and quibble about details such as deductibles, but unless the deductible is so high that the shop keeper pays the whole cost for the window himself (as if he had no insurance), you still have a net stimulus to the community because the amount of stimulus (the cost of the window replacement) still exceeds the loss to the shop keeper (who pays less than that cost, up to the amount of the deductible).

That's just something I had to get off of my chest. I've seen this fallacy come up on various libertarian sites and now it is even on wikipedia, but something always missing is the mention of insurance, which is a core part of how our economy and the world operates - in other words, the parable really is unrealistic without consideration of insurance.


The Barefoot Bum said...

I don't think your view is correct: You're conflating trade with wealth creation.

One economist says to the other, "I'll give you $20,000 if you hit yourself on the head with a brick." The second economist agrees and hits himself—hard—with the brick.

The first says, "Well... I'm not so sure I want to cough up the dough. How about you give
me $20K if I hit my head with a brick?" The second economist agrees, and the first hits himself on the head.

The second economist says, "Well, that was an exercise in futility: We're both exactly where we started and we both have sore heads."

The first economist retorts, "Nonsense! We've just generated $40,000 in trade!"

It really doesn't matter where the money comes from to fix the broken window. The controlling issue is that no new wealth has been generated by breaking and repairing the window.

Wealth is generated in only two ways: Making stuff and delivering stuff to where it can be used. That's economics; everything else is just accounting.

DBB said...

I would agree with you, except that's not the economics behind the concept of insurance.

There is economic activity generated and the money for doing so does not come out of anyone's pocket any more so than there would have been otherwise.

And there is more to generating wealth than just "stuff" - there are services as well.

The Barefoot Bum said...

I understand about services.

My point is that breaking a window intentionally does not stimulate the economy, insurance or no insurance. All you're doing is losing the wealth the unbroken window would have had. All insurance does is move window-fixing services efficiently to where they're naturally needed; intentionally breaking more windows does not increase the wealth-creation of that service.

DBB said...

This was not so much about intentional breaking of windows as it was addressing a specific non-fallacy fallacy regarding costs to an economy when a window breaks.

It isn't about wealth creation or non-creation. It is about economic stimulus. If money is spent in that community fixing that window, money that does not come out of the local merchant's pocket, that is a net plus to that economy.

David M. said...

Very bad reasoning. The author is merely repeating the fallacy as if net destruction really were the equivalent of net creation. Ask the shopkeeper if he wouldn't mind having his window broken every day--or his wall bombed out--so long as insurance covers the cost of repair.

Even under the ludicrous terms of the "refutation," there is only a net "gain" for the local economy if the insurance company is treated as being outside of that economy. The fact that an insurance company expects to make payouts doesn't make any particular payout less of a payout. Suppose, because of a reduction in vandalism, insurance companies only have to expend $10 million in payouts in a city instead of $12 million. The two million just goes under a mattress for all eternity?

When productive goods and services in any form are destroyed, they are simply destroyed. They aren't magically now greater than they were simply in virtue of the fact that productive energy must now be expended in reconstituting them. Had they not been destroyed, that same productive energy could have been used to create something new.

Perhaps the author will understand the fallacy better if he reduces the local economy of his example to ten persons on a desert island, with one of them functioning as an insurance agent because he happens to be better at storing goods long-term than the others, and one of them functioning as a vandal. When the vandal throws somebody's store of apples into the sea, the insurance agent is able to restore an equal supply to the victim. Great. But there are now fewer stored apples on the island for everybody to eat. No worries, though, since more apples can now be picked, right? Um, wait a minute, though.... The time spent picking apples could have been used instead to reinforce a hut against the rainy season...or to sharpen sticks to create spears for fishing...or....

DBB said...

The deserted island analogy fails because we are not dealing with a deserted island, we are dealing with a huge, modern economy, one in which insurance companies are an integral part of it.

As I think I already stated, insurance companies have no reason to exist and no one would pay premiums to them if they did not also pay out claims. Assuming there is not a natural disaster that requires massive payouts all at once, but instead just an isolated window incident, you do have a local, net increase in economic activity that you would not otherwise have had. We are not dealing with apples, we do not have a barter economy. We have currency. The island example is not insurance - it is more akin to a neighbor with extra helping out.

Doug said...

This is wrong for precisely the reason you stated: if insurance never had to make payouts, it wouldn't have to exist. This is the main point of the fallacy of the broken window. If insurance did not exist, then the money people would have spent on premiums could be spent in other ways, and the people who would have worked for the insurance company could do other work, such as construction or farming. You forget that insurance works by paying premiums, which must be adjusted to be at least equal to what the insurance company pays out. The more payouts, the higher the premiums go, and vice-versa. The fact that the cost of the window is diffused among everyone who uses that insurance company doesn't change the fact that they have all just lost the cost of the window.

DBB said...

My point is they lose the cost of the window in advance by paying premiums. Everyone does. What changes when a window actually breaks is that money then flows back into that local economy.

It is not the case of comparing a situation where either no one pays out for the cost of the window or everyone pays by a fraction of their premiums - that money is already spent, already gone. Instead it is a comparison between a situation where everyone pays their money and the insurance company does not pay money to fix the window and one where everyone pays money and the insurance company DOES pay.

Finally, a single broken window does NOT increase premiums. In fact, if not for that broken window, there's no reason to pay premiums. In fact, that windows break and people insure against it also creates jobs in the insurance industry.