November 4, 2012 6:39 pm

Disaster theory thrown out of window

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When economists think about the effects of natural disasters, the idea they reach for first is the “broken window fallacy”: the observation that if a window is broken and then mended, it creates no net benefit to the economy.

It was coined in 1850 by the French economist Frédéric Bastiat, who pointed out that a householder who spends six francs mending a broken window will not then have that money to spend on something else.

It has become the standard explanation for why natural disasters or wars do not make an economy better off, in spite of appearances to the contrary.

Bastiat observed that the immediate benefit of spending on reconstruction is visible, but the lost opportunities to spend elsewhere are “what is not seen”.

Yet while that analysis is widely accepted by economists, there are several qualifications that will affect the impact of Sandy on the US economy.

The first is that, although Bastiat was right about the economic reality that “society loses the value of objects unnecessarily destroyed”, that is not properly reflected in national income accounting.

If a home is swept away by flooding or a power line brought down by a falling tree, that loss of value is not counted in gross domestic product. But rebuilding homes and manufacturing new cables creates an increase in reported GDP.

As Michael Gapen, senior US economist at Barclays, puts it: “Somewhat paradoxically, the direct destruction of the capital stock is not a GDP event, but the reconstruction effort is.”

That is why even if the US economy is not genuinely better off as a result of Sandy, it will make the GDP figures look stronger next year.

Another qualification, which has more to do with economic reality than mis-measurement, is that reconstruction is often not as straightforward as replacing a broken window.

Andrew Cuomo, governor of New York state, has been arguing that “we’re going to rebuild better than ever before”.

Where the investment delivers improved quality, such as more reliable electricity supplies or homes that are less at risk from flooding, those are real benefits that deserve to be recorded in GDP.

The other important qualification comes in an economy such as that of the US, which has high cyclical unemployment and spare capacity.

Keynesian economists argue that spending on reconstruction can create real economic growth by generating employment for people who would otherwise have been out of work. Post-Sandy reconstruction could be a small-scale version of President Barack Obama’s $787bn stimulus package in 2009.

Political disagreements over the efficacy of such stimulus, which has been strongly criticised by Republicans, set the scene for potential conflict in Congress over the financing of the reconstruction, once the elections are over.

Offsetting the potential benefits of rebuilding New York and New Jersey are the possible long-term costs.

The greatest economic damage a disaster can do is if it leads to structural changes that damage productivity.

The 9/11 terrorist attacks, for example, imposed a permanent cost on the US economy by compelling more extensive and intrusive security precautions.

New Orleans remains affected by Hurricane Katrina in 2005 because of the large number of people who decided to move out of the city to a safer location.

Similarly, New York city would be hit, with possible long-term costs to the finance, media and technology industries, if many businesses and individuals decided the threat of floods was too great and relocated.

A single storm may be unlikely to have that effect. But with three of the top 10 high-water marks in southern Manhattan since 1900 coming in the past two years, the long-term danger, influenced by a changing climate, is the greatest concern to emerge in Sandy’s wake.

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