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Are disasters really good for the economy?

How can it be true that major disasters like Katrina often  end up boosting the economy? The answer lies in how we measure economic activity and illustrates the 'fallacy of the broken window.'  By's Martin Wolk
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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.

“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.

“What disasters do is they divert spending,” said McTeer, now chancellor of the Texas A&M University system. “The government is doing good for the affected region, but it’s pulling resources away from all other regions.”

The task is complicated by an economy that already was humming along at nearly full capacity before the hurricane hit, with a national unemployment rate under 5 percent. (The rate was slightly higher in the three states most affected by Katrina.)

With relatively few surplus workers available, and demand already high for building materials to support the booming housing industry, Katrina could add to inflationary pressures — even without the expected feed-through effect from higher energy prices.

And the federal spending required to restore the Gulf Coast region to some semblance of normality will deepen the federal deficit, making it more difficult for Congress to address long-term economic imbalances or costly problems like the high cost of health care.

A vast and wealthy economy
Still, economists can be confident because despite all the ripple effects from Katrina — including the destroyed refineries, broken pipelines and snarled shipping — the United States has an enormous, resilient economy that can withstand a severe blow, as it demonstrated after the 9/11 attacks, which were aimed at the heart of the nation’s banking and financial system.

Fariborz Ghadar, director of the Center for Global Business Studies at Penn State University, points out that disasters in poorer countries tend to be far more destructive economically because they do not have the available capital for rebuilding.

Stocks have rallied this week in part because Wall Street is assuming the money will be available for the massive reconstruction effort, he said.

“That’s probably a good assumption, but it doesn’t necessarily work around the world,” he said.

He and others also pointed out that the benefits of any recovery and rebuilding effort will flow unevenly, with lenders, general contractors and energy services providers among those likely to profit. Businesses like sugar refineries and textile mills that might have been only marginally profitable are likely to shut down for good, Ghadar said.

That may be good for the economy in the long run, but try telling that to thousands of Gulf Coast residents whose employers will never reopen for business. In any case many hurricane victims will be unemployed for the foreseeable future and may not recover financially for years.

In the end, the question of whether Katrina is a positive, negative or neutral economic event boils down to whether the nation is better off at the end of the rebuilding effort than it was before the hurricane hit, and to reach a conclusion on that issue requires looking at many intangibles, said Patrick Welch, an economist at St. Louis University.

“Peoples’ lives and their sense of well being has been destroyed,” he said. Families and friends who once formed cohesive units have been dispersed across the country, and people have been badly shaken by the civil unrest that took days to bring under control.

“They have lost their social capital — the networks that people have,” Welch said. “Some of these things  you can’t calculate.”

The total devastation of New Orleans reminded Welch of cities like Berlin, Dresden, Hiroshima and Nagasaki — all of which were rebuilt after they were destroyed in World War II.

“I don’t remember anyone ever saying that was a good thing,” he said.