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Chidu's Union Budget 2013 embraces 'Broken Window Fallacy'

By Shanmuganathan Nagasundaram

Some of the outlandish economic ideas that are floated around these days, or for that matter for the last several decades, suffer from what Frederic Bastiat described in his work, That which is Seen, and That Which is Not Seen, as “The Broken Window Fallacy”.

Whether it is Paul Krugman’s calls for preparation for an alien invasion or the Indian economists’ call for budget allocations for food, education or infrastructure,they suffer from the same basic obliviousness - not foreseeing the second and third order consequences of proposed actions.

A brief explanation of “The Broken Window Fallacy” would probably be in order before proceeding (for readers interested in a more comprehensive explanation, check out this and this). Essentially, when economists say that a broken window leads to increased economic activity by virtue of the shopkeeper engaging a carpenter and increasing the sales of the glass producing company, they forget to ask the basic question: how would the shopkeeper have spent the money in the absence of the “broken window” (whether deliberately done as a consequence of central planning or otherwise).

Maybe he would have spent it on increasing his own business or purchasing a consumer good such as a shoe. In either scenario, the shopkeeper has something in addition to what he had previously and his net wealth would have increased, while in the case of the broken window he spends the additional money just to revert back to his previous standard of living.

So in not asking the basic questions about what is not seen, economists miss out on what would have happened if the government had not allocated resources to makework schemes such as NREGA or the Food Security Bill or any of the other innumerable schemes. Let’s say we did not have a scheme like NREGA. Then that amount (Rs 33,000 crore or whatever be the case) would have been available to private entrepreneurs for investments and/or would have resulted in lower consumer price increases, which would have given the benefit of higher purchasing power to the citizens.

he freebie culture and government schemes like social security and free healthcare are really retrograde even for a developed economy

he freebie culture and government schemes like social security and free healthcare are really retrograde even for a developed economy

What about the direct beneficiaries of the NRGEA scheme? (I am excluding the indirect beneficiaries of the scheme, i.e. the bureaucracy, for obvious reasons). Instead of working on a centrally-directed economically unviable project, they would have worked for a private entrepreneur who could have better utilised their labour for producing something that the society really needs.

While I have taken the very straight-forward case of NRGEA, the same explanation can be advanced for all government expenditures into education, food, health and subsidies of all kinds and infrastructure. Lest I be called uncaring, a brief explanation on the so-called “social infrastructure” spendings of the government needs further explanation.

It’s commonly assumed that unless government steps in to offer free food, health and education, the poor would suffer. The economic truth, as is usually the case with these “broken window” arguments, is the exact opposite. The main beneficiaries of government schools are not the students but the teachers and the bureaucrats who are paid far in excess of what they deliver. The market pricing mechanism is just absent in such a setup and if somebody manages to get a good education in a public school, it’s an accidental outcome.

What would have happened without these free public schools? In the absence of the government diverting massive resources to these schemes, society would have utilised this capital to produce and grow the economy. The increasing prosperity and standards of living would have automatically ensured that even the poor are able to afford a private school for their children’s education. It’s a situation that we are actually seeing with the urban poor or even a tier-II town labourer.

A housemaid who barely earns Rs 5,000 a month or a mason who earns Rs 10,000 in a small town is today sending his/her child to a private school in the hope of a better education rather than a “free public school”.

The essential point is that the job of allocating resources is best left to the market. If the powers that be are really spending sleepless nights about the absolutely poor and sick who cannot work and have no way out (which I presume should be not more than 5 percent of the population at the outside), then some kind of a targeted scheme would work instead of providing across the board facilities – which is just a drain of scarce capital.

Given global conditions, even developed economies cannot afford these misallocations of capital – let alone a developing country like India. Now it’s my contention that the market would take care of even the above scenario, i.e. the poor and the helpless, but I will leave that discussion for a later date. After all, we still seem to be debating the “Broken Window” fallacy within the country today.

So what role should the government play in a society? Perhaps that is at the crux of most of the debates that happen. If we look at the transitions of the developed economies of today from what were primarily agrarian societies, it would be clear that the role of government was limited to just two functions – protection of private property from internal and external aggressors and adjudication of contracts. These essentially mean the police, army and the courts/justice systems.

It is this limited role of governments that allowed societies to flourish and prosper. The freebie culture and government schemes like social security and free healthcare are really retrograde even for a developed economy. And it’s government corruption of free markets (not to leave out the core issue, which is the corruption of the monetary system) through these schemes that will ultimately bring developed economies like the US to their knees in the next few years.

So with this as a backdrop, let’s see what the Finance Minister P Chidambaram has proposed in his budget for next year. But for starters, I can safely say that it’s “Broken Windows Everywhere”.

Shanmuganathan “Shan” Nagasundaram is the founding director of Benchmark Advisory Services – an economic consulting firm. He is also the India Economist for the World Money Analyst, a monthly publication of International Man. He can be contacted at




Updated Date: Feb 28, 2013 15:29 PM

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