Monday, 5 November 2012

Are natural disasters good for the economy?

A classical Keynesian approach would suggest that they are. Consider the following example. According to the demand-side approach to kick-starting a recovery, getting governments and consumers to spend more will induce higher consumption, which will raise aggregate demand and ultimately result in higher short-run GDP growth, which will be the basis point for a longer-run restoration of the pre-crisis growth path. 

This theory implies that the government should step in and provide the jobs for those who lost it during the crisis in order to stimulate economic activity. In terms of pure logic, the government should attempt to provide even the most meaningless jobs like digging holes and filling them up in order to get more cash to consumers and incentivise their spending. 

But why is it better to pay the unemployed to dig up holes instead of simply sending them welfare checks every month? Well, since digging up holes adds to GDP as a newly produced government infrastructure investment. 

Hurricane Sandy "broke the windows"  

Bringing this to a more realistic level, let’s look at the applicability of this approach to the present situation in the United States. I’m referring to the hurricane Sandy of course, not the US Presidential election, although it’s hard to tell which event is likely to have a more adverse effect on the US economy. 

After the devastation caused by hurricane Sandy a lot of things need to be repaired, particularly in New York (see the gloomy outlook Arnold Kling predicts for NYC). The transport system and the electrical grid are priorities in restoring the city back to normal, in addition to cleaning up all the mess from the streets. All this requires hard work and more importantly more new jobs to help rebuild the shattered parts of the city and bring the people back to their homes. 

For demand-side economists this comes as a blessing in disguise, where the government is given an excuse to build or rebuild the existing infrastructure in a city as big as New York. Since there is a lot that needs to be repaired, many capital and human resources will now be reallocated into different productive activities and use resources in this fashion. This will create new jobs and redistribute a lot of income, which is supposed to incentivise more spending and give rise to aggregate demand. But the crucial point is that these resources could have been used in a much more efficient manner than rebuilding the economy if it hadn't been for the natural disaster in the first place. 

This sort of reasoning is typical of the broken window fallacy. But here’s what they miss:
The loss of key transportation infrastructure raises the cost of imports (food, construction materials, etc.), even as exports (financial services) go down. This drives down equilibrium real wages in many secondary industries (food service, for example), but the adjustment process is not at all smooth. Many small businesses fail and many jobs are lost.  
In order to remain ongoing concerns, many financial services firms will "temporarily" relocate to suburban offices and to virtual offices. These "temporary" adaptations will become so well entrenched that many of these businesses will not return to Manhattan. 
My favourite answer to all those who succumb to the broken window fallacy is: why don’t you let me smash all the windows on your house? This will create the job for the local glazier and you will redistribute your income to him. But perhaps you had different plans with your money. Now that you have to pay for your windows to be fixed, you won’t be able to, for example, take your family to a restaurant this weekend, meaning that you deprived the restaurant owner of his income. 
Source: Financial Times

By creating a job for one part of the economy you unwillingly deprive the other, perhaps more successful part of the economy of their income. You are sending a signal that the restaurant owner should go out of business as he won’t have any clients since they will all be spending their money on fixing their windows. 

This is a vast simplification but the point is clear. Destruction caused by a war or a natural disaster does not result in increasing wealth nor does it kick-start aggregate demand, primarily because most of the supply is destroyed. A war or a natural disaster is a type of an exogenous shock that also reallocates resources, but it is highly unlikely that this is the most efficient allocation. 

Natural disasters don't seem to increase GDP growth

In addition, so far the US experienced even worse and more costly hurricanes (see the graph above), and none of these seemed to have had a positive impact on raising GDP or increasing wealth, especially not in the local areas. Think of New Orleans after hurricane Katrina, or the BP oil spill, or even better, the Japanese earthquake and tsunami in 2011, and what they all meant for economic growth. 

Japan is particularly interesting as the destruction there was much worse than in the East Coast today. This exogenous shock translated itself across borders through trade linkages, and was blamed as one out of many causes of the double dip recession in the West. In addition, Japan did not experience a massive bounce back emerging after this event. (see graph below)

Source: Trading Economics
Neither will the United States. Don’t expect the Keynesian demand-side theories to work in this case. 

5 comments:

  1. Keynesian theories don't work in any case, not just this one.
    Good text, I can't stand people who think that things like wars or hurricanes tend to be good for economic growth. Isn't the US still engaged in a war of some sort? How did that help them in the recovery? Not much

    ReplyDelete
  2. It is foolish to think that a disaster or a war will cause any increase of wealth in the economy, but the case of Japan that you mention seems to show positive signs of temporary economic growth as an effect of the recovery from the disaster. This growth isn’t sustainable, nor will it initiate a recovery but perhaps this is what the proponents of this idea seem to mean. They’re just saying it wrong.

    ReplyDelete
    Replies
    1. You mean the initial, immediate effect after some repairments are made? Sure, that will by definition increase GDP, but it's senseless to think this will do any good for the economy afterwards. This is an example of a clear missallocation of resources. It's good since this missallocation isn't done artificially and persistently, but only as a reaction to an exogenous shock.

      Delete
  3. One cannot initially compare the broken window fallacy with natural disaster versus war, they are two completely different instances. During war we are more so force plummeting our economy in every section of the country to produce on a means that were grafted for the presence OF the war. Not for it.

    During the natural disaster, we are more so inclined to depressively hope and continue to do normal work for our country and band together knowing we are in danger.

    -Solomon Berkovitch

    ReplyDelete
    Replies
    1. Solomon,
      what I was referring to were the effects of labour and capital allocation after each of the events. While proponents of the broken window fallacy tend to claim that
      exogenous shocks like these will inevitably lead to an accumulation of growth, I think this reasoning is foolish due to the missallocation of these very resources in the first place.
      I don't see why should we need to destroy capital in order to make the economy grow. It is simply illogical.

      Delete