The Storm Windows Non-Fallacy

Paul Krugman makes the case that environmental regulation – in a liquidity trap – could actually by stimulative:

As some of us keep trying to point out, the United States is in a liquidity trap: private spending is inadequate to achieve full employment, and with short-term interest rates close to zero, conventional monetary policy is exhausted.

This puts us in a world of topsy-turvy, in which many of the usual rules of economics cease to hold. Thrift leads to lower investment; wage cuts reduce employment; even higher productivity can be a bad thing. And the broken windows fallacy ceases to be a fallacy: something that forces firms to replace capital, even if that something seemingly makes them poorer, can stimulate spending and raise employment. Indeed, in the absence of effective policy, that’s how recovery eventually happens: as Keynes put it, a slump goes on until “the shortage of capital through use, decay and obsolescence” gets firms spending again to replace their plant and equipment.

And now you can see why tighter ozone regulation would actually have created jobs: it would have forced firms to spend on upgrading or replacing equipment, helping to boost demand.

Alex Tabarrok replies that this is akin to saying that actively going around breaking windows would be stimulative – the regulation is effectively a tax, and the tax will be anti-stimulative even if the actual purchases of equipment are stimulative.

I think it’s unfortunate that Krugman refers to the broken windows fallacy, because this isn’t a “broken” windows situation at all, where you’re destroying something in order to force someone to spend money to repair it. This is what you might call a “storm windows” situation – you’re ordering people to spend money to make what amounts to a capital improvement with a positive return (assuming you believe the ozone regulations will lead to better health and a more pleasant environment). Moreover, since the regulations impose a one-time cost on businesses to retrofit to comply with the regulation, they don’t, in fact, interfere with profit maximization – they are not the equivalent to an increase in taxes; they are equivalent to a one-time assessment. Again: like a storm window installation, not an increase in the rate of window breaking.

Now, obviously, things aren’t that simple. Not all businesses are flush with cash; some businesses could find ways to avoid the regulation by moving operations offshore; etc. Depending on the circumstances, these effects could be very small or very large. If you were worried about these effects, you’d provide an offsetting tax credit, and allow the deficit to grow slightly. Now instead of mobilizing the cash on corporate balance sheets directly, you’d be doing so indirectly – laundering it through the Treasury.

But again, my point is: the long-term returns from improved air quality matter to the decision. They are not incidental. If the government decided to stimulate demand by hiring one group of people to go around breaking windows and hiring another group to go around installing new windows equivalent to the old, participants in the non-window-breaking sectors of the economy would conclude that the government had gone mad; with no plausible ideas of how to stimulate the economy, it was reduced to complete absurdity, obvious waste. This perception would result in lower expectations for future growth, and this would lead to less investment, less employment, etc. And on net, the economy would be worse off. On the other hand, if the long-term returns are plausibly material, and perceived as such, then there’s every reason to expect that the regulation would be stimulative on net in this situation, precisely because there’s a glut of investable dollars (which is another way of saying there’s a perceived shortage of attractive investment opportunities).