Are disasters really good for the economy?

Martin Wolk Chief economics correspondent • Profile • E-mail

Economists have been living up to their reputation as “dismal” scientists in recent days, predicting that despite the devastating human tragedy, Hurricane Katrina ultimately could have a positive impact on the economy.

To be sure, economists are human beings who lament the loss of life and recognize that tens of thousands of hurricane victims have been left with shattered lives and incalculable losses. Some dissenting voices also warn that it is still too soon to assess the full economic impact and that Katrina might be different from past disasters, in part because the storm exacerbated an energy price shock, raising the risk of recession.

But in general forecasters have been remarkably sanguine, saying the loss of production from the Gulf Coast region this year likely will be more than offset next year by a massive infusion of government and private funds for reconstruction.

Already the federal government has allocated $62 billion for disaster relief, and insurance companies are expected to pay out tens of billions more, much of which will go toward rebuilding destroyed property.

“When you are rebuilding on a grand scale like that generally that’s a very good thing for the economy,” said John Silvia, chief economist for Wachovia Corp.

Silvia’s comment reflects a consensus view that Katrina will be similar in impact to past disasters like Hurricane Andrew in 1992, the Northridge, Calif., earthquake in 1994 and the 9/11 terrorist attacks of 2001. In all these events, the initial negative impact was more than offset by reconstruction and government policy responses that ended up boosted the national economy.

How can it be true that such major disasters often end up boosting growth?

Part of the answer has to do with the way we measure economic activity. Gross domestic product may rise next year as a result of goods and services purchased to rebuild the affected region, but that does not take into account the $100 billion or more in housing and other infrastructure destroyed by the storm and its aftermath.

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“We measure gross economic activity instead of net economic activity, so everything tends to look like incremental activity over time,” said David Joy, vice president of RiverSource Investments, the asset management arm of Ameriprise Financial.

The broken window fallacy
The basic flaw in the logic behind such accounting was attacked a century and a half ago by French thinker Frederic Bastiat who referred to the “fallacy of the broken window.”

Imagine a boy who has broken a window, he said in his 1850 essay “That Which is Seen and That Which is Not Seen.” Onlookers inevitably find a silver lining in the added work for the window repairman: “What would become of the glaziers if no one ever broke a window?"

Yet this thinking fails to take into account that the boy’s family, which will be paying to replace the window, will have to divert funds that could have been used to buy new shoes or a book instead.

“Everybody falls into that same fallacy all the time on just about everything,” said Bob McTeer, former president of the Dallas branch of the Federal Reserve and a fan of Bastiat’s work. “They look at what is happening without looking what would have happened.”

Simply take the broken window example to its logical extreme: If every window in town were broken there would be plenty of work for glaziers but few resources for other projects like building new houses or shops.

Similarly Katrina will suck away workers, materials and funds that otherwise could have been gone to other, potentially more productive uses elsewhere in the country.

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