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After the Storm

In late October 2012, Hurricane Sandy hit the Caribbean and the East Coast of the United States causing wide-spread damage and scores of fatalities. In the US alone, some 130 people died and the economic damage is currently estimated at around $50 billion.IMGP02341

But what will the medium to long term impact of Sandy be in economic terms? Here the news is surprisingly not all that gloomy. Research has suggested that the long-term impact of natural disasters may in fact be positive, at least for developed countries such as the USA. Whilst the economic damage is clear, how can natural disasters actually have a positive impact on a city, region or nations economy?

Firstly, let us consider the immediate effects. Natural disasters, especially large ones such as Sandy, are followed by the necessary government relief and reconstruction. This can serve as a quasi-stimulus driving the recovery of the local economy. This effect of regeneration can then spill over even beyond the affected region offering further boosts to the economy. This is an aspect that I have considered with Sugata Ghosh and Weonho Yang, also of Brunel University (‘Government spending and the multiplier: New evidence from the US based on natural disasters’ a CESifo Working Paper No. 4005, November 2012, available to view and download at http://www.cesifo-group.de/ifoHome/publications/working-papers/CESifoWP/CESifoWPdetails?wp_id=19071550).

Using newly compiled detailed data on natural disasters and the associated emergency spending in the US between 1977 and 2009, we found that natural disasters tend to be followed by an upsurge of federal non-defense spending and higher GDP at the national (US-wide) level. We also noted a similar effect when investigating this issue at the state level: personal incomes and state fiscal spending goes up (the latter largely reflects increased transfers from the federal government). The evidence thus suggests that spending in the wake of natural disasters indeed displays stimulus-like effects.

Now what about the long-term effects? Here one view is to consider natural disasters as akin to Schumpeterian creative destruction. This refers to a process in which old physical assets and technologies are discarded or destroyed and replaced with new, more productive ones. Natural disasters are thought to act this way because old physical assets are more vulnerable to their destructive forces than new assets. A new building constructed using modern technologies and building materials is probably more robust than one built 80 years ago. At the same time a family with two cars fleeing an approaching hurricane is likely to drive away in the newer, more valuable, car. They are also likely to take their new i-Pads and laptops with them but leave the old desktop computer behind. As a result physical assets, whether they are whole buildings or individual items, are replaced before their time is up. These replacements are better, more modern and more effective.

As an added effect, experiencing a high frequency of natural disasters encourages substitution from investing in physical capital towards human capital. A high wind may blow away your roof but not your skills and education. I was reminded of this when visiting Japan where traditional buildings often consist of little more than wood, bamboo and paper. Such houses are bitterly cold in winter but tend to withstand earthquakes better. If they do not, they can be replaced relatively easily and cheaply. Living in an earthquake-prone region has limited the choice of construction technologies in Japan, and limited the amount of government money that is spent on expensive, large scale infrastructure development. Perhaps it is not a coincidence that Japanese students also consistently report some of the highest test scores among OECD countries.

Finally, natural disasters can also make an important intellectual contribution to economics. My aforementioned research with Ghosh and Yang was motivated by the desire to understand economic effects of government spending shocks. Much of the recent discussion on the virtues of fiscal stimulus spending evolved around the size of the so-called fiscal multiplier; a statistic that measures by how much the total GDP increases for every dollar of new government expenditure. Ideally this should be greater than one, although some studies suggest that it is lower than this benchmark or may even be negative.

The problem with estimating the fiscal multiplier is that one needs changes to government fiscal policy which were unannounced and unexpected. Increased spending or tax cuts that come into effect today would have a very different effect if they were implemented unexpectedly or if they were announced a year ago. In the latter case, much of their effect could have unfolded already following the announcement.
The previous literature used episodes of increased military spending to identify such changes in fiscal policy. Wars are not easy to predict and therefore the spending associated with them can be seen as unexpected fiscal shocks. Wars, however, also tend to be few and far between and therefore the results of that literature rest on a handful of large-scale events. Last but not least, the spending associated with military build-up tends to differ dramatically from that government spending in peace time.

This is where our interest in natural disasters comes in.
By their very nature natural disasters are unexpected. Importantly, for various reasons, the government response also varies; two disasters of similar size can be met by very different responses. The aftermath of Hurricane Katrina in 2005 for example was marked by controversy over insufficient precautions and slow subsequent response on behalf of both the state and especially the federal government.

The relief and recovery expenditure in the wake of natural disasters also is not too different from general government expenditure: rebuilding of roads and bridges is a better approximation of peace-time fiscal spending than purchasing tanks and missiles. Therefore, we can be confident that the multiplier that we estimate in this way is relevant for the multiplier associated with fiscal stimuli.

Using natural disasters to identify unexpected changes to government spending, we can therefore estimate a fiscal multiplier that is free from confounding anticipation effects and relevant for general government spending. Reassuringly, it is safely above one. Our estimate of the peak multiplier is around 1.4 regardless of whether we estimate it at the national or state level. In other words, fiscal stimuli are indeed effective at reinvigorating the economy.

Jan Fidrmuc
Senior Lecturer in Economics
Brunel University