Posted by: Dirk | March 4, 2013

The implications of the parable of broken window for Spain

Here is the latest video from Xavier Sala-i-Martin (in Spanish):

Once again I find that Sala-i-Martin does not understand economic theory. The parable of the broken window, which he explains in the video, says the following. A child smashes a window, and the window is being repaired for 1,000 euros. The new window has to be created, which creates a job and an income. That income is then spent by the person that produced the window, which creates another job and income and so on and so on. Question: why not smash all windows if this seems to create lots of jobs and lots of income?

Thinking about the problem applying microeconomic theory you will understand that people have budget constraints. If the boy has no income, the window will not be repaired. If his father is made to pay, like Sala-i-Martin says (I would have preferred the family to pay since the idea of the man as the only wage earner is long past), he will spend 1,000 euros on the window but 1,000 euros less on something else. This explanation by Sala-i-Martin is correct. The parable of the broken glass, says Sala-i-Martin, therefore exposes a logical fallacy: you cannot create more jobs and more income by spending more, therefore you should not break the windows.

Nevertheless there is a problem with this argument. It is based on microeconomic thinking where participants in the economy face budget constraints. The government, however, might not face such a budget constraint. (In the eurozone it does, by the way.) How does a government spend money then?

A sovereign  government with its own currency creates money through an interaction with the central bank which more or less goes like this. The government creates a sovereign bond, which is basically a piece of paper saying that at some future date I will pay you some amount of money in the local currency plus an interest rate which is fixed on the paper. The central bank receives this sovereign bond and in return creates money (from nothing, just by keystroke). The government can then spend that money.

The introduction of the government into the parable of the broken windows makes the whole thing more interesting. Now we have a participant with no budget constraint! If the government would spend 1,000 euros more, it would indeed create additional jobs and income of more than 1,000 euros since the money is spend again and again. Here is what Keynes wrote in the General Theory:

If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coalmines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again (the right to do so being obtained, of course, by tendering for leases of the note-bearing territory), there need be no more unemployment and, with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is. It would, indeed, be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing.

But: would this not lead to inflation?

That depends on whether there is already full employment in the economy or not. In the former case, it surely would create inflation (in the short run) as more money is chasing the same amount of things. However, in case there is significant unemployment there will not be a rise of inflation since the additional demand for goods is filled by an increase in supply at the existing wage and price levels. The unemployed are in no position to negotiate higher wages.

Now the question for Sala-i-Martin was how to connect this story – which he did not invent – to the economic situation in Spain. Does Spain have something like full employment or is there significant unemployment? Of course, the latter is the case. That means, that the Spanish government could create more jobs and more incomes by spending more. You might have noticed that the opposite has been true in the last couple of years. The Spanish government cut spending and it destroyed incomes and jobs.

The only problem is that the way the euro is set up the Spanish government cannot create money by interaction with the central bank. Spain has actually ceased to be a sovereign state since its government is depending on finance from the outside, which is the private sector. Only if more euros were invested in Spanish government bonds could the Spanish government spend more. The interest rates it pays on its existing sovereign bonds is already quite high, so this will be very difficult to accomplish.

In order for Spain to move forward it must either introduce a sovereign currency (the new peseta) or the institutions of the euro zone must be changed so that someone in Spain is allowed to spend more money. What will not bring forward is to listen to the economists that do not understand that models have assumptions and that you have to choose your model carefully. One model does not fit all – sometimes you are in a Keynesian world with low interest rates weakness of demand, sometimes you are in a neo-classical world with (almost) full employment and supply problems.

The Spanish newspaper should carefully handpick the economists that they provide a platform for. Xavier Sala-i-Martin and Hans-Werner Sinn (in EL PAIS today) are economists that said nothing when the crisis built up. For some reason, they do not seem to make a lot of sense. On the other hand, some economists said pretty useful things before the crisis, during and after. To find out who makes sense and who doesn’t I propose that newspaper journalist question economists more rigorously and also try to understand what they say. They should get second opinions, too.

The crisis that we are in is the result of intellectual failure. By this I mean that we have abandoned science and philosophy as the principles that guide us and replaced it with neo-classical economics – which is based on a deterministic world of the view – and profit-striving – which is nihilistic – as the personal way of live. Economists like Sala-i-Martin and Sinn, whether they recognize it or not, have played a large part in this.


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