Once the immediate danger of a natural disaster subsides, and the loss of life, property damage, cost of rebuilding, and degree of insurance coverage can be assessed, attention generally turns to the economic effect. How will Hurricane Harvey affect the nation’s gross domestic product?
You will no doubt hear assertions that the rebuilding effort will provide a boost to contractors, manufacturers and GDP in general. But before these claims turn into predictable nonsense about all the good that comes from natural disasters, I thought it might be useful to provide some context for these sorts of events.
The destruction wrought by a hurricane and flooding qualifies as a negative supply shock. Normal production and distribution channels are destroyed or disrupted. Producers have to find less-efficient (i.e. more expensive) ways to transport their goods. The net effect is lost output and income, and higher prices.
Supply shocks reduce output and raise prices.
Over the years, I’ve observed a tendency among economists and traders to view such events through a demand-side prism. They see lost income translating into reduced spending on goods and services, which might even warrant some largesse from the central bank.
Of course, that is precisely the wrong medicine. Supply shocks reduce output and raise prices. The Federal Reserve’s interest-rate medicine affects demand. Lower interest rates will increase the demand for gasoline, among other goods and services, but they have no effect on supply. An easing of monetary policy under such circumstances would increase demand for already curtailed supply, raising prices even more.
But wait. What about all the new construction and investment necessitated by the devastation? Homeowners will have to rebuild. Businesses will have to replace destroyed or damaged plants and equipment. Pretty soon, we should start to hear about a boost to GDP growth.
If natural disasters are such a good deal for the economy, why wait for Acts of God to come along?
In the short run, yes. But focus on the prefix, “re,” as in re-building and re-placing. After a natural disaster, housing starts are bound to increase, but there will be no net addition to the supply of homes. Capital spending will increase as well, but it will not expand the nation’s capital stock.
Economics is about the allocation of scarce resources. A natural disaster commandeers those scarce resources in an effort to return to the status quo ante. Any boost to quarterly GDP from an increase in residential and non-residential fixed investment is an arithmetic expression of current activity, not a reflection of the wealth of a nation.
The one redeeming virtue of a natural disaster is that provides an opportunity to revisit a classic essay by the 19th century French political economist: “That Which Is Seen and That Which Is Unseen.”
In Chapter I, “The Broken Window,” Bastiat relates the story of a shopkeeper, whose son accidentally breaks a store window. The shopkeeper has to pay six francs to the glazier to replace it. The glazier now has six francs to spend on something else. And so on. Behold all the spending that emanates from a broken window!
What is unseen is what the shopkeeper would have done with the six francs if he didn’t have to replace the window. “In short, he would have employed his six francs in some way, which this accident has prevented,” Bastiat writes.
Discussions about the merits of fiscal stimulus are generally clouded by political bias.
The parable, or fallacy, of the broken window has applications elsewhere, even if no window has been broken. Take the belief that government spending stimulates the economy, based on the notion that $1 of government spending provides the resources for someone else’s spending: something known as the multiplier effect.
If the government borrows from A to give to B, it constitutes a transfer of resources, not stimulus. (Fiscal policy gets its bang for the buck from monetary policy, or an expansion in the money supply.) A dollar spent by the government can’t be spent by the private sector. During a severe downturn or depression, when the private sector isn’t spending, government spending as short-term stimulus may be justified. But, as per Bastiat, we can’t ignore that which is unseen, or what would have happened in the absence of government co-opting savings to spend.
Estimates of the effect of fiscal stimulus are all over the map, according to a review of the financial literature by Veronique de Rugy and Matthew Mitchell, senior research fellows at George Mason University’s Mercatus Center. The estimates of the government spending multiplier range from +3.7 to -2.88. In other words, a $1 increase in government spending produces $2.70 of private-sector growth, or displaces $3.88 of private growth, or anything in between, depending on economic conditions at the time and how the money is spent.
Discussions about the merits of fiscal stimulus are generally clouded by political bias, with some people finding huge benefits and others pointing to steep costs. The cost-benefit analysis of hurricanes, on the other hand, should pose no such hurdle.
I found enlightenment back in 1992, as Hurricane Andrew was sweeping the coast of Florida. I turned on the TV to hear a business news anchor proclaim that this Category 5 hurricane would be “great news for GDP” going forward. My reaction and response to his comment proved to be one of my more memorable laugh lines when I spoke to audiences on the subject of economic nonsense.
If natural disasters are such a good deal for the economy, I said, why wait for Acts of God to come along? Why not nuke our own cities so that we can rebuild and reap the benefits?
This column ran on Marketwatch and was published on FEE