Hurricane Katrina: The Economics of Disaster

The Economics of Disaster:

Are Hurricanes Inflationary or Deflationary?

Insurance companies have estimated the damage from hurricane Katrina at $25 Billion Dollars. But the economic effect is much greater than that. That is just the loss of property.

Another consideration is the loss of revenue while things are being rebuilt. What about the loss of jobs from the companies who won’t be rebuilding because they didn’t have insurance? According to the “Financial Times” current estimates of “total economic losses” are closer to $100 Billion.

Those numbers are so large that it is almost impossible for us to get our minds around it. If you stacked 100 billion one dollar bills on top of each other. the stack would be about 5000 miles tall. Or roughly the distance from Washington, D.C. to Moscow. That is a lot of money!

So what will this $100 Billion loss do to the US economy? Will it cause inflation? Deflation? Stimulate the economy because it all has to be replaced? Or depress the economy because of all the loss of jobs? The answer is difficult because it will actually do all of the above. The question then becomes what is the net effect?

Let’s take a moment and look at some of the individual effects. We are looking strictly at the economic effects, although it has caused intense individual suffering, we are looking strictly at the “macro” or large scale effects on the economy.

Destruction of Assets

The first and most obvious effect is the destruction of assets. Any time you create anything (a building for instance) you increase the overall wealth of the world. A good example of this would be when you build a house. You start out with some raw farmland worth $1000/ acre. You add $49,000 worth of materials, $50,000 worth of labor and you have a house worth $150,000.

$100,000 in, $150,000 out. Where did the extra $50,000 come from? You created it out of thin air by combining labor and materials. And the world is actually $100,000 richer (because the labor didn’t exist before you built the house).

So what happens if you blow it up? The world is $150,000 poorer. Someone had a house worth $150,000 on their balance sheet now they don’t. This is the effect of wars and natural disasters. Some may argue that, “oh well, it was insured so the houses will be rebuilt” but the money still has to come from somewhere the insurance companies have to pay for it, so their balance sheets go down. Before the hurricane the insurance company had $150,000 on their balance sheet and someone owned a $150,000 house… after the hurricane there will only be one or the other (a net loss of $150,000).

What about all the wealth that is created when the new houses are built? You might ask, “Didn’t you just say that when houses are built wealth is created?” Yes, in the above example the net gain is $50,000 while the net loss was $150,000. The reason I say the gain is $50,000 rather than $100,000 is because the labor would have been spent anyway doing something else productive, if it didn’t have to be used to rebuild what was destroyed. So in the end if it hadn’t been destroyed there would have been two houses rather than just one. So the net effect of rebuilding is still a loss but not quite as big as before things are rebuilt. The loss is down to $100,000 rather than the initial $150,000.

The destruction of $25 billion in hard assets is inflationary. Here is why. Assume that you and nine other people are stranded on an island. Each of you has one dollar and each of you produces one product during your stay on the island. You then sell your products to each other. The average price of each product will be one dollar.

If someone finds ten one dollar bills buried in the sand before long the average price will go up to $2.00 for each item, since there is now $20.00 in circulation but only 10 items available. The money supply has increased but number of products stays the same so this is inflation (prices go up).

If on the other hand ten more items are built instead of finding the money. This time the average price of each item will drop to 50 cents because the number of items went up but the money supply stayed the same (20 items and $10.00). This is deflation; things get cheaper (producing things is deflationary). The opposite is also true destroying things is inflationary.

If someone destroyed half the items on your island you would end up with 5 items and 10 dollars or an average price of $2.00 again. Thus inflation can come from increasing the money supply or decreasing the number of goods available. So even though it seems counter-intuitive the destruction of thousands of houses is actually inflationary.

Economics of Disaster: Destruction of Paper Assets

On the other hand the destruction of paper assets like in a stock market crash is deflationary. Stocks prices aren’t really assets because they are just numbers on a piece of paper and so are simply another component in the money supply. Therefore if your stock goes from $10 to $1 you are poorer and it decreases the money supply. Thus it is deflationary. It has not affected the state of the actual company, it is still producing the same number of widgets as before the crash.

But back to hurricane Katrina, there is a very good chance that the FED will loosen the money supply to stimulate the economy to compensate for the loss of jobs. So we possibly have two inflationary factors. The destruction of assets and an increase in the money supply.

But what about all those lost jobs, because the companies won’t be reopening? I think it is quite possible that it will balance out with all the new work that will be necessary to rebuild. So the employment rate will be about the same, but the building trades will benefit while the factory workers suffer. The factory workers who are flexible and can work the building trades will do OK but those who are inflexible will suffer.

Economics of Disaster: Destruction of Factories

What about the destruction of factories? That is a problem. A factory is different from a house because it produces things. It is like a machine that creates wealth (or products). Imagine a factory cranking out the houses in the first example. Each product is worth more than the sum of its parts, so it is creating wealth. While they are spending time rebuilding the factory, these factories are not producing products. So, the downtime is lost production and less total wealth for the world.

But, what if the new factory is more modern and efficient and can produce more products than the old factory? In that case, in the long run the world is better off although it suffers in the short run. So it is possible, if modernization occurs, that New Orleans could be cleaner, safer, more productive and efficient (and thus wealthier) in the long run. Although, it will suffer in the short run.

In the same way, if the City of New Orleans was smart it would mandate that all new high rise buildings be built with mandatory garages on the first two levels and able to withstand flooding, so future flooding would be limited to washing the cars away. This could result in a revitalized downtown with more usable land area (the old parking lots) and the whole city has an opportunity to return as a completely modern rebuilt city.

Finally, what about the disruption in oil distribution and production? The Gulf is responsible for approximately 30% of US oil production and distribution. Extended outages could cause gas prices to skyrocket thus increasing costs (both production and to consumers) throughout the country. This would be another inflationary factor as costs are pushed up throughout the economy.

The FED almost has to increase liquidity to ease the transition period but then will have to clamp down on the money supply to prevent inflation. So we could see an initial lowering of interest rates followed by an increase several months later.

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