Examining the EPA Cave-in: Does the Broken Window Fallacy Apply?

(Stockbyte)

Did President Obama get the economics wrong earlier this month when he abandoned stricter air-quality rules, wagering environmentalist loyalty in a bid to avoid job losses from strict new ozone standards? Paul Krugman thinks so, calling the decision to wave off the EPA a “lousy decision all around.” But is Krugman right?

The short-run job-creating move, Krugman contends, would have been for Obama to promulgate the new ozone regulations, which would have forced firms in hundreds of counties across the country to replace and upgrade capital in order to comply with new, stringent pollution abatement requirements. He asserts that because the U.S. economy is in a liquidity trap, wherein conventional monetary policy is insufficient to induce firms to spend, the regulations could have accomplished what the Fed cannot. In such a “world of topsy-turvy,” as Krugman says, the usual rules of economics are thrown out, and even the “Broken Window Fallacy” ceases to hold.

The 19th century French theorist Frederic Bastiat cautioned against concluding that a shopkeeper’s broken window is a good thing because it induces him to employ a glazier to repair the window. Such a conclusion ignores that which is unseen: that the shopkeeper would have employed the shoemaker to replace his worn out shoes had the window not been broken. Hence, the broken window doesn’t increase employment or grow wealth. In fact, it shrinks wealth, leaving the shopkeeper worse off than if he had been able to replace his worn out shoes for the cost of the new window. The deliberate destruction of windows, then, would assuredly be poor economic policy in normal times because it trades wealth-creating spending for wealth-replacing spending.

But what happens in unusual times, like those of a liquidity trap? Krugman contends that shopkeepers are sitting on stockpiles of cash and not spending. So the shopkeeper’s expenditures to replace broken windows won’t crowd out expenditures on shoes since he wasn’t going to purchase shoes in the short run anyway. So, too, Krugman reasons, forced investments on pollution abatement won’t crowd out other investments since they’re not happening anyway. Thus a policy of capital destruction to spur economic activity, like breaking windows or using regulatory fiat to mothball functional equipment, may never make more sense than during a liquidity trap. But that doesn’t mean it makes sense even then.

Let us consider the employment and wealth impacts of new pollution abatement requirements on three classes of businesses: those with savings, those without savings, and those who are considering new entry or expansion. Let us assume, as a liquidity trap story does, that absent new pollution abatement requirements, businesses with savings would not spend down their savings in the short run to buy new equipment or hire new workers. In order to comply with the new regulations, these businesses draw down their savings and make expenditures to meet the new standards. There is seemingly no crowding out of other investments in the short run, though future spending would decline.

But, cash reserves are not “idle” for most businesses; they are providing a hedge during uncertain economic times. If owners of such businesses have decided that their current reserve is optimal, then surely they will seek to maintain that hedge even with the requirement of new pollution-abatement expenditures. In that case, they must reduce other expenditures today in order to retain the hedge. The new expenditures and jobs for pollution abatement, then, are partially or fully offset by reduced expenditures and job losses elsewhere.

What about the business that does not have savings but must spend to comply with the new regulations? Unless these businesses can take on debt, which is doubtful if they are cash constrained, then the new regulations force them to either shutter their businesses or make one-for-one reductions in other expenditures. Among those without savings, then, the broken window fallacy holds strong. In essence, creating a job for a pollution “abater” comes at the cost of a job for a shoemaker or for the shopkeeper, himself.

Finally, what do the pollution abatement requirements do to the shopkeeper who was planning to open a new shop? The compliance costs lower his return on investment from opening a new shop and may cause him to forego opening the shop altogether.

When one considers that which is unseen—the loss of expenditures and jobs by businesses without substantial cash reserves and the loss of jobs among potential entrants—it becomes clear that Krugman’s prescription for job growth may not be the antidote to an ailing economy. And even among those businesses sitting on cash reserves, it is likely that regulatory compliance costs would crowd out other expenditures (and thus other employment) as those firms sought to maintain the cash reserves they deemed optimal in the first place as a hedge against an uncertain economic future.

Even in a world of topsy-turvy, the laws of economics still hold: shopkeepers, glaziers and shoemakers are still utility maximizing agents. And imposing higher regulatory costs on firms still deters job creation and growth. President Obama may not succeed in creating enough jobs to save his job, but, a priori, it’s certainly not clear that his decision to walk back costly new ozone regulations in uncertain economic times was a bad idea.

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  1. Will says:

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  2. jonathan says:

    The argument would be more persuasive if you were able to discuss the current situation without resorting to standard model arguments.

    I don’t agree with Krugman on this particular case but his point is not as simplistic as you present. His point is that the regulations are good, that they thus have benefits over time and that putting them off because they have current costs misses the point of the situation we’re in. He starts from that position. He even says, ” if you’re going to do environmental investments — things that are worth doing even in flush times,” meaning he sees this as a deferral of what should be done.

    I understand that economists aren’t very good at listening to other economists, that they’re more interested in making their own points, but read what he says: these are investments that should be made, so putting them off only feeds the current mess. You focus on his use of the broken windows fallacy as though this were an actual example of that. You are entitled to feel that way – I feel that way about these particular regulations – but that’s not what he said.

    As for these regulations, I’m not convinced they’re the right ones. That then makes this a question of good versus bad regulation and here I’d prefer to hold off. This isn’t, for example, restricting emissions to curb acid rain.

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    • Joshua Northey says:

      This is just what I was going to say. If these are worthwhile investments then issuing some regulations which forces companies to get off their stacks of cash and make them is possibly a good thing, if they are it is not.

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      • Deflation? says:

        Isn’t it a tautology to say that if something is “worthwhile” then it is “possibly a good thing”?

        Corporations don’t actually hoard dollars bills, having stashed them in some corporate mattress back at headquarters. They have them in treasuries, or interest rate swaps (ala Eddie Lampert at Sears), waiting to pay out dividends, buy back stock, purchase other assets, etc. Corporate officers make investment choices.

        Being forced to spend on something is being forced to not spend on something else. Even if they decide that complying with certain regulations benefits the company, there are sometimes reasons to wait.

        For example, if the currency is being inflated, faster than the economy is producing, then maybe they should spend the money now when things are cheap, not later when the costs will be that much higher. Or, are we in a deflationary world, where money circulation is slowing much, much faster than any increase in money supply? In which case, purchasing power is growing and those who hold cash will be in a much stronger buying postion later, as more and more people, companies, and countries deleverage and sell off assets, driving down prices, and creating bargains for the patient.

        These are the kind of decisions best made on the corporate level and not at a governmental (force) level. So, yes, the “broken window fallacy” still applies.

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  3. rlumban says:

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  4. Roger Sinclair says:

    But what about the rest of what is going unseen, namely the windows that are being broken by these firms in the first place? I feel the author leaves out an entire class of businesses – those that are not creating employment now, nor in the future, due to past and present pollution. An extreme example would be the entrepreneur who died an untimely death from carcinogens – but a more realistic one is the drag on the economy that comes from productivity loss due to illnesses stemming from the very pollution that the EPA is seeking to regulate.

    I concede that in the end, it is possible that the overall gains from allowing businesses to continue their current practices may be larger than the benefits of abatement – but don’t we need some numbers to look at before we assume so? Is it too costly to even get said numbers?

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    • William Merrick says:

      This is the function of a court system. If I leave trash on your lawn, you have a claim against me. The case is no different for pollution, only more complicated. This is where environmental forensics comes into play, an industry whose growth has been stunted by the regulatory structure in this country. Due to the socialization of our environmental protection, pollution has been turned into a social problem when in reality it is a property rights issue.

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    • Jeff Sullivan says:

      Roger makes a good point. Think of the drag on the economy that pollution has due to loss of productivity and increase in illnesses. Often times these illnesses need to be supplemented with medication which, is paid for by the government.

      For example; pollution causes an increase in the rate of asthmatics. Pollution is most concentrated in urban areas and therefore so are asthmatics. People located in urban areas often have low incomes, without personal medical insurance.

      Due to the liberal society we currently live in; these low-income individuals are provided with medication through government programs and subsidies which are funded by hard-working tax payers.

      Instead of tax payers consuming normal or luxury goods, their dollars are funding the perpetuation and continuity of low-income individuals.

      If strict environmental regulations were put in place, less dollars would be spent to mitigate the problems associated with asthma. In the long-run the United States would see a decrease in the rate of asthmatics, a decrease in taxes which fund medicare and medicaid. With those decreases; you would see an increase in the consumption of pollution abatement materials, and an increase in the general populations disposable income. An increase in general consumption combined with the multiplier effect would have far more benefits that the short-term costs which are incurred by companies to meet pollution abatement standards.

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  5. Mike B says:

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  6. Greg says:

    I suspect you don’t really get the fact that pollution *is* capital destruction. Just because it’s not (wholly) your corporation’s capital doesn’t change that fact.

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  7. Dan Santo says:

    A lot of the comments here are completely ignoring what the article says, not with a counter investigation showing that the Sexton’s view is faulty, but merely by saying it’s wrong and that it really is a good idea to force companies to “get off their stacks of cash”.

    Read the article. Those “stacks of cash” are doing something, and new regulations aren’t going to affect those “stacks of cash”.

    It’s a valid argument to say the societal benefits that might be seen through the implementation of these regulations might be worth the negative impact the regulations will have on job creation, but that’s a very different topic than what Krugman and Sexton are talking about.

    It was a newspaper article, and I doubt Krugman put the serious thought into it he would have an economics paper. If he had, I’m pretty sure that he would have seen Sexton’s point — the Broken Window Fallacy is still in effect even in the “liquidity trap” that Krugman is talking about.

    A purely theoretical liquidity trap is indeed something that might break down the Broken Window Fallacy, but in the real world, the liquidity trap Krugman suggests has actual reasons behind it that keep it from being purely theoretical and also keep the Broken Window Fallacy in effect.

    Putting the regulations in place might be a good environmental move, but there’s no wriggling around the fact that they would have a negative impact on jobs. If one wants to say the chilling effect on jobs is worth it, then bring up the estimates on how many jobs the regulations would cost and the estimates of the health costs over time and start doing a solid analysis.

    Don’t just simply claim basic economic principles are no longer in effect.

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    • Joshua Northey says:

      “Putting the regulations in place might be a good environmental move, but there’s no wriggling around the fact that they would have a negative impact on jobs. If one wants to say the chilling effect on jobs is worth it, then bring up the estimates on how many jobs the regulations would cost and the estimates of the health costs over time and start doing a solid analysis.

      Don’t just simply claim basic economic principles are no longer in effect.”

      “Regulations destroy jobs” is not a basic economic principle. To say so is to just completely misunderstand economics. The regulations are just as important as everything else because without the regulations everything would break down.

      Whether the regulations destroy jobs depends on a ton of factors, nearly all of which are debatable. What is the capital vs labor breakdown of the industry, what is it for the regulatory expenditures, is their an opportunity cost or not, et cetera.

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      • Austin says:

        “The regulations are just as important as everything else because without the regulations everything would break down.”

        This is a heroic assumption you make here about the importance of government regulation. City police and health officials had hitherto not regulated the elementary school lemonade stand industry, yet I could hardly drive through a neighborhood in the summer without running into one. As regulation is applied, and the cost of selling lemonade rises by either the cost of the permit or the expected cost of fines, you’ll see fewer lemonade stands. It’s been around the news recently.

        Those familiar with the strictly dominant strategy of Defect in a prisoner’s dilemma may say that regulation is necessary to stop companies from defecting on their customers resulting in higher profits for the company and only an acrid taste in the customer’s mouth. Tired of being cheated, the customers will similarly defect, not engage in trades, and society will be the worse off. Everything would break down, as you say.

        In game theory terms, this analysis ignores the repeat play aspect of life: ours is not a one-shot game. Even in instances of patronizing a restaurant a single time, our willingness to do so may hinge on the recommendation of a friend; our own experience may influence someone else to dine there or not. The repeated interaction of companies and customers is essential to harmony instead of regulatory interference.

        This is not to say that regulation has no place, but rather than it is not the fundament of economic transaction.

        As regards your “Regulations destroy Jobs”, may we agree that regulations impose higher costs than would otherwise exist? Regulation for lemonade stands forces them to purchase a permit as well as lemons, sugar, and water. The decision for the child is: “Is it worth the time and effort if up-front fixed costs erode my expected net gain?” (Because all children think in these terms.) Likely she will not purchase the permit (liquidity constraint?), and the world will be poorer 2 gallons of lemonade.

        “Ah,” you may say, “But this permit costs nothing, and only requires the use of the LemAde-2000, which will drastically reduce the marginal cost of lemonade production, leading to fewer wasted resources, more efficient lemon-squeezing, and a reduced strain on the environment!” In which case you’ve forced the little girl to sacrifice current wealth for future profit margins.

        I’d like to point out that if the girl is patient enough with a low time preference, she will purchase the LemAde-2000 regardless of the existence of regulation forcing her to do so. The only effect the regulation will have is in discouraging girls with higher time preferences who wish to spend in the present from entering the market for lemonade.

        As this regulation only ever discourages parts of the market from entering (and this is not to say that you never want to do this!), regulation will, in a very real and tangible way, destroy jobs, if only destroy the jobs of people who might have entered.

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  8. John B says:

    Contrary to commenters who disagree with the author, his arguments are far from simplistic. He goes into a thorough analysis and treats Krugman’s theories much more kndly than he deserves.

    What is simplistic is the stated assumption that the governmental regulations will be good, necessary and helpful. Examples of bad regulations and government policy on “anti-pollutants”:
    1. MBTE – government forced the industry to use MBTE in gasoline as an oxygenate. Turned out it caused a lot of problems with the water supply. The same politicians and regulators who pushed this then blamed industry, which had to cover billions in cleanup damages. More “broken windows”?

    2. Ethanol – 40% of US corn production is used to make an inefficient fuel for cars, thus increasing the cost of driving and forcing up food prices for poorer Americans and many foreign countries, leading to malnutrition and starvation overseas. “Shattered windows”?

    So the elimination of these latest regulations may well be good in two ways:
    1. sound economics; (2) good environmental policy.

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