Sunday, June 13, 2010

Stocks, Flows, and Bastiat

Jonathan Catalan defends Austrians on Bastiat in the comment section here. I want to clarify my concern with how Bastiat is handled. I think most people familiar with him (Austrian, libertarian, or "mainstream") understand and agree with Bastiat. It's a fairly obvious and unremarkable point he makes, after all. I think a lot of the problems come in when people try to apply him. Here are a few basic problems that I see crop up over and over again, even with professional economists:

1. Gross vs. Net benefits: Lot's of gross benefits can result from a crisis, but Bastiat's point is simply that there is never any net benefit to destruction. Jonathan insists that Austrians know the difference between gross and net. I agree - of course they do. The problem isn't in understanding the concept - the problem usually comes in inappropriately applying the concept when you're trying to catch someone in committing a fallacy. Russ Roberts recently put up a post that didn't exactly criticize articles remarking on the "green jobs" created by the oil spill. He didn't criticize those articles because they hadn't even been written yet! He was anticipating them and asked people to "keep him posted" on any such fallacious articles. Roberts, like a lot of Bastiat fans, was just itching to play "gotcha". Here's the problem with that - there are gross benefits to the spill and the creation of green jobs and the invigoration of the environmental management industry are two of them. Russ can't call foul on an article that simply points out a gross benefit unless it suggests there is no greater gross cost. And I think I'm safe in saying that no article on the spill is going to suggest there isn't a greater gross cost to the spill. If they don't say it explicitly, it is clearly implicit. Do Russ and do others understand the difference between gross and net. Without a doubt they do! But understanding something and applying your understanding with fidelity in a given situation are two entirely different things.

2. Stocks and Flows: Economists care deeply about the distinction between a stock variable and a flow variable: a given, existing quantity of something and a new addition of that something. We often talk about "flows" - namely, GDP. Every year, the American economy produces several trillion dollars worth of stuff. That's GDP and that's a flow. But a lot of that stuff is durable. I just moved into a new apartment and spent yesterday carrying lots of very heavy furniture, none of which was produced this year. So that is an existing stock of "wealth" that remained from a previous flow of "production". Sorry to belabor the point, but it's important for readers unfamiliar with the distinction. So economists talk a lot about "flows" (you never hear annual wealth stock statistics, but you hear annual GDP, consumption, and investment statistics all the time). So how does this relate to Bastiat? Well, when destruction occurs - when there is a war or a flood or an earthquake - usually what gets destroyed is stock. Buildings, cars, etc. The gross negative that contributes to the inevitable net negative largely falls on stock. Now, human action changes in response to massive destruction like that - production (a flow) can shoot through the roof to replace the destroyed stock. As we produce more and more we bring in more labor and capital. This is how destruction can actually lead to a period of sharp growth and low unemployment. None of this contradicts Bastiat because there is still a net loss. But if the gross loss falls on stock and the net loss falls on flows and flows are important to you (say, if you care about something like employment - which I do), it's fine to comment on the impact that destruction has on flows.

The modern canonical example of the broken window fallacy for Bastiat aficionados is Paul Krugman's claim that 9-11 would increase investment. Krugman was absolutely right. Investment is a flow variable, and a lot of destroyed capital did need to be replaced after the attack. In the article where Krugman wrote this he went to great lengths to explain that there certainly was a broader tragedy - he wasn't denying that - but that this was one (gross) economic product of the attack. Krugman wasn't misunderstanding the broken window fallacy - his critics were. (A caveat, of course, is that if enough capital gets destroyed it can impede growth and growth can actually be lower... but whether this is the case in any given crisis is ultimately an empirical, rather than a theoretical question).

Wilhelm Ropke, a German economist who is highly regarded by the Austrians, made very similar points about the differential effect of destruction on stocks and flows in his book Crises and Cycles. I quote the relevant section and provide brief comments here. Ropke gets it. A lot of modern libertarians and Austrians don't, I fear. And it's not because they don't understand basic concepts - it's because they are so obsessed with playing "gotcha" with people they're convinced they have to embarrass and disprove that they don't take the time to think through these issues carefully, the way Ropke does. Wayne William Anderson has a blog dedicated to arguing against Krugman for God's sake! That's the kind of climate that many of these sorts of people operate in. With that kind of attitude you're going to take simple concepts like gross and net and stock and flow and confuse them instead of applying them accurately.

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