Your Personal Finances and “The Broken Window” Theory

Managing my family’s finances and investment portfolio, I enjoy applying abstract economic theories to everyday decision-making. I came across renowned economist, Henry Hazlitt, twenty years ago. In his seminal book, Economics in One Lesson, he lays out a theory that I encounter in my personal finances every day.

The Broken Window Theory looks at every economic transaction in three steps instead of two. There’s the seller and the buyer, of course, engaging in trade. But there is also the third person, the one who wasn’t there, the trader whose goods the buyer didn’t buy because he bought something else.

In my personal finances I make buying decisions every day. Will I buy organic milk or regular milk? Apples or oranges? Meat or chicken? I make these financial decisions because I need these products and because I have a limited amount of money to spend on food. Every time I buy organic milk, the regular milk vendor loses a potential sale.

In a free market environment, The Broken Window theory is even more interesting because competition offers you a range of vendors and products to choose from in the same field. In that case, The Broken Window Theory relates both to the item you buy and the person you buy it from.

The Broken Window theory becomes even more relevant to your personal finances when you consider financial decisions that are forced on you. To use Hazlitt’s example, if someone throws a rock through your window and breaks it, you find yourself suddenly forced to spend money on a new window. You gain nothing that you didn’t already have, and yet you spend money in the transaction. If the window hadn’t been broken, you might have bought a new coat or gone out to dinner instead.

In my personal finances I come across the Broken Window theory in several ways. When I make a bad financial decision, for example buy a beautiful dress even though I have several in the closet, I end up with less money to spend on the things I truly need.

If I buy the dress on a credit card because I don’t really have the money anyway, I not only wipe out the potential for buying something useful, but I commit my future earnings to paying off both the dress and the interest on the loan.

Thinking of my financial decisions with the three-layered perspective of The Broken Window theory keeps me from getting tempted to buy things I shouldn’t. This is especially helpful when I see items on sale, which increases the temptation to buy even more.

The Broken Window theory also applies to my personal income. My salary takes me a fixed number of hours to earn. I could be spending these hours doing something else. This leads me to question whether my lifestyle is too expensive, whether earning the livelihood I need is consuming too much of my free time.

In short, The Broken Window theory keeps me on my toes when it comes to my personal finances. That something else, the unidentified commodity that I lose when I choose one path over another, always reminds me that every decision wipes out a slew of alternative options. I have to make sure that I don’t break windows in my life. In other words, that I don’t end up spending my limited resources on things I already have and don’t really need.