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Against the Hurri-Keynesians

Mises Daily: Thursday, November 01, 2012 by

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[This Mises Daily was originally published May 7, 2008. An MP3 version of this article, read by the author, is available for download.]

It seems that we may never rid ourselves of the broken-window fallacy.

Hurricane Katrina certainly did not stop economists from proclaiming the silver lining of natural disasters. On September 9, 2005, Labor Secretary Elaine Chao told USA Today that demand could create a labor shortage that could push up wage rates and that "We're going to see a tremendous boom in construction." On December 3rd, 2005, Nigel Gault, chief domestic economist at Global Insight, said, "We are now at the point where Hurricane Katrina's effects are adding to job creation rather than detracting from it."

And it's not only that disasters just have a silver lining: economists have long believed that natural disasters and wars are actually good for the economy! Until recently they have not made any attempt to empirically test their views. However, in 2002 Mark Skidmore and Hideki Toya published a paper where they found a positive correlation between disasters and human capital, productivity, and GDP growth.

Now the good news. A recently published paper in Economic Inquiry by Cuaresma, Hlouskova, and Obersteiner brings the positive benefits of disasters into question. Not only does it counter the silver lining of new construction jobs, it also finds that disasters actually subtract from economic performance. In addition the paper provides clues to the entire confusion over this issue.

Economists have generally rested their case for the benefits of disasters on "creative destruction," but our authors are quick to point out that Schumpeter's view of creative destruction is one that is driven by competition, where those associated with disasters are not; they are just destruction.

Their empirical test examines the amount of research and development goods that developing nations import after a natural disaster, ceteris paribus. The basic idea is that technology imported from highly developed economies should improve productivity and increase economic growth. So, do natural disasters really increase technology for developing countries?

Our authors find that, in general, catastrophic risk reduces the amount of technology imported into developing countries. This would clearly argue against the strength of the creative destruction argument. They also find that the frequency of catastrophic events also has an adverse impact on the economy.

Interestingly, this study (as well as earlier studies) has found little impact on GDP, positive or negative, from geological disasters. This is because earthquakes are random and only reoccur over long periods of time. The reason for the lack of impact is either that people prepare for earthquakes in advance (with earthquake-resistant structures) where they are likely to occur, or the likelihood is simply so small and remote that it has no impact on people's calculations of the present value of their investments. I would have thought that the exception of geological disasters to the "creative destruction" argument would have made economists more skeptical.

Only in the richest of the developing economies studied were there any positive effects and this might provide some clue or clarity to solving the puzzle of disasters. Wealthier countries tend to rebuild after a disaster with more advanced capital goods, while poorer nations do less rebuilding. This rebuilding then shows up in GDP statistics and is thus claimed as positive benefit.

However, an increase in GDP can be misleading. GDP rose significantly in the United States during World War II, but real consumption per capita remained at the same level as the Great Depression. The difference was all the tanks, bombs, and bullets that provided no improvement in economic well-being.

What makes wealthier economies able to rebuild is that they have access to savings, insurance, and borrowing, whereas poor nations do not. The resources made available from these sources make the people involved less wealthy in the case of savings, reduces the reserves of insurance companies and the value of insurance stocks, and creates a future liability for borrowers.

This means that wealthier countries have the ability to spread the economic pain of natural disasters over time, space, and the number of people involved (e.g., foreign owners of local insurance companies). They do not have the ability to magically make the pain go away — and certainly not to turn it into pleasure or prosperity.

The fact that the replacement buildings and equipment might be more modern does not make the disaster a boon either. What Henry Hazlitt said about war is just as true for natural disasters:

It is sometimes said that the Germans or the Japanese had a postwar advantage over the Americans because their old plants, having been destroyed completely by bombs during the war, they could replace them with the most modern plants and equipment and thus produce more efficiently and at lower costs than the Americans with their older and half-obsolete plants and equipment. But if this were really a clear net advantage, Americans could easily offset it by immediately wrecking their old plants, junking all the old equipment. In fact, all manufacturers in all countries could scrap all their old plants and equipment every year and erect new plants and install new equipment.

The simple truth is that there is an optimum rate of replacement, a best time for replacement. It would be an advantage for a manufacturer to have his factory and equipment destroyed by bombs only if the time had arrived when, through deterioration and obsolescence, his plant and equipment had already acquired a null or a negative value and the bombs fell just when he should have called in a wrecking crew or ordered new equipment anyway.[1] (emphasis added)

Yes, a few individuals might benefit from a disaster, but not the economy in general. Mises described the outcomes of war as similar to natural disasters:

War prosperity is like the prosperity that an earthquake or a plague brings. The earthquake means good business for construction workers, and cholera improves the business of physicians, pharmacists, and undertakers; but no one has for that reason yet sought to celebrate earthquakes and cholera as stimulators of the productive forces in the general interest.

Therefore we can rest the common-sense case that natural disasters are indeed bad. A nation that experiences natural disasters will be harmed directly and will be less preferred by investors to otherwise similar nations that are disaster free. More disasters do not improve the economy, and as with Bastiat's broken-window fallacy, we cannot achieve prosperity in any sense via destruction.

Notes

[1] Henry Hazlitt, Economics in One Lesson, 1978 edition.