BP's Broken Window

By Andrew Beattie | July 15, 2010 AAA
BP's Broken Window

Many people see economics as an idealistic science that applies to the world in only the most broad and tangential ways. This may be true of some economic theories, but it certainly doesn't hold for all. While the BP (NYSE:BP) oil spill disaster is just that - a disaster - it does offer an opportunity to look at one important economic fallacy: the broken window. (For background reading, see What is the broken window fallacy?)
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The Tale in Brief
Frederic Bastiat, the man who came up with "The Petition of the Candle Makers", a 19th-century satire about protectionsim, created a similar parable about a broken window. In Bastiat's tale, a man's son breaks a pane of glass, meaning the man will have to pay to replace it. The onlookers consider the situation and decide that the boy has actually done the community a service because his father will have to pay the glazier to replace the broken pane. The glazier will then presumably spend the extra money on something else, jump-starting the local economy. (Read Understanding Supply-Side Economics to for another attempted method of economic recovery.)

The onlookers come to believe that breaking windows stimulates the economy, but, as Bastiat points out, a further analysis exposes the fallacy. By breaking the window, the man's son has reduced his father's disposable income, meaning his father will not purchase new shoes or some other commodity. Thus, the broken window might help the glazier but it robs other industries and reduces the amount being spent other goods. Moreover, replacing something already purchased is a maintenance cost, rather than a purchase of truly new goods - maintenance doesn't stimulate production in the same way as pure demand. In short, Bastiat shows that destruction doesn't pay.

BP and GDP
In the case of the BP disaster, we have millions upon millions being spent on attempts to clean up and stop a constant stream of economic destruction on many levels. Although the clean-up spending is calculated as a gain by the standards of GDP, the overall losses are overwhelmingly obvious in this case. With every barrel of oil lost to the sea, there are several levels of aftershocks. One, a barrel of oil is lost; this is an opportunity cost for BP and also a reduction in potential oil reserves. Two, the lost barrel of oil becomes an agent of destruction, breaking windows in fisheries, tourism and many other affected industries. Three, the ongoing spill dislocates the capital needed to stop it.

These overall reductions in supply, both of capital and oil, make the cost of both go up - albeit imperceptibly because the worldwide supplies are so large. For every dollar that BP and the government spends on clean up, a dollar is not spent elsewhere. (When most people think about asset classes, things like stocks, bonds, real estate and commodities come to mind. Read more, in Human Capital: The Most Overlooked Asset Class.)

Beyond BP
There are many broken windows that have masqueraded as beneficial events. One is the assertion that war is an economic stimulus. Destroying buildings and lives drains the overall economic wealth of the world, even if a few companies manufacturing military equipment see a boon. Another is the idea that wasteful public spending can serve as a stimulus. While some may benefit from an over-priced public work, and jobs may be created because of it, the overall effect is a net loss by all those whose money has been taken involuntarily through taxes and spent on the few - just as the broken window resulted in an involuntary loss for the father and the other retailers who may have received his custom, and a benefit to the glazier.

If dislocations of capital were desirable, we would be cheering BP for causing billions in damage. The truth is that the economy works best when capital flows according to people's free choice. When this flow is interrupted by either emergency or government taxation and spending, there are unintended consequences.

The Bottom Line
Although the line of reasoning connecting Bastiat to BP to government spending may be disturbing, it is sound. To borrow from Bastiat, every event or decision must be judged by the effects that are seen as well as those that are unseen. For every dollar spent on clean up or even agricultural subsidies, there is one less dollar in the world for you to spend as you choose. In BP's case, and often in the case of war, these losses are unavoidable because an emergency has already occurred. Thankfully, these unavoidable cases are rare. The constant dislocation of capital through government spending, however, may prove to be the bigger and longer lasting in the end.

Catch up on your financial news; read Water Cooler Finance: I-Spy, IPOs And iPhones.

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