Ok, normally I’m writing about the disastrous effects of changes in GDP.  Today, though, I’m going to write about the effects of disasters on GDP. As I write this, it’s mid-day on Saturday, Aug 27.  Hurricane Irene has just hammered North Carolina and the Outer Banks. Irene is continuing in both it’s push up the Eastern seaboard toward New York City.  I have no idea at this moment how bad the damage will be.  What’s clear is that even if the storm weakens to a tropical storm strength, it will bring extensive flooding and wind damage across a very heavily populated area.

Major natural disasters generally do not have a major long-run effect on the economy and GDP.  This is largely because the U.S. is a really large nation and even the most severe natural disasters such as Hurricane Katrina only directly affect a small portion of the country.  So even if a hurricane or earthquake were to stop 40% of the economic activity in a region, as long as the region is only say 2-5% of the nation, the net effect is a short, temporary “blip” on the nation’s GDP.  Hurricane Irene could conceivably be different because the projected path includes over an estimated 65 million Americans – nearly 20% of the nation.

Asking what the effect of a natural disaster will be on GDP is probably the wrong question to ask.  What we’re really interested in is “what is the effect of the natural disaster on the economy and our living standards?”   It’s just that we are so accustomed to using GDP as a proxy measure for the size of the economy and our living standards.  Unfortunately, GDP as a measure of the economy and our welfare has some weaknesses.  These weaknesses are really important in the case of a natural disaster and interpreting it’s effects.  GDP measures economic production by counting the dollar value of all transactions where something new is produced and sold.  GDP doesn’t measure the value of what we own – our wealth. GDP doesn’t measure the value of services produced that aren’t sold (like charitable acts, household production, etc).  GDP doesn’t measure our capability to produce.  It only measures what we actually produce and sell.

The economic effects of a natural disaster are to change exactly these things that GDP does not measure. The primary economic effect of a major disaster such as an earthquake, hurricane, extensive flooding, or  a swath of destructive tornadoes is to destroy wealth and destroy our capacity to produce.  In macroeconomic terms, a natural disaster is a sudden reduction in our resources: capital equipment, buildings, and available labor. None of this is a good thing.  It reduces our ability to produce goods and services in the future and it reduces our welfare right now.  But that effect won’t show up in GDP measures.

What will show up in GDP measures after the natural disaster is a perverse reaction in the months after the disaster.  This comes because of the re-building activity that comes after the disaster.  Repairing buildings, cleaning up, rebuilding all require paid services, building supplies, labor, etc.  These transactions will show up in GDP measures in the months/quarters after the disaster as an slight increase in total GDP.  But it’s a deceptive increase in total GDP because we aren’t really significantly better off.  We’re just getting back to the condition before the disaster.  GDP counts the fixing, but not the damage done.  This is why we sometimes here commentators say that a “disaster is good for the economy”.  It isn’t really.  It’s good for GDP, but that’s not a perfect measure of the economy.  The mistaken idea that damage or disasters are good for the economy is what economists call the Fallacy of the Broken Window. It was first explained by Frederic Bastiat.

Normally the economic impact a natural disaster will be relatively short-lived so long as there is a mechanism to finance reconstruction and the real resources in the larger nation to do it.  Typically in a developed nation like the U.S., the financing for reconstruction comes from insurance company payouts and government, especially national government, loans and payments. In particular it is the responsibility of the national government to help rapidly restore infrastructure.  If adequate financing and national resources exist, then we rarely find a national impact on GDP or the economy lasting beyond perhaps a 6 months to a year.  The smaller the economy, the greater the potential for longer lasting damage and even a failure to rebuild at all.   That’s the problem in New Orleans five years after Katrina.  The city is now permanently smaller since large numbers of people chose not to return and rebuild.  At the U.S. level, though, it’s insignificant.

The lack of financing and resources can severely damage a very small or poor nation for a very long time.  That’s why Haiti, a small and poor nation, is so dependent upon outside help to rebuild. The other exception that can result in lasting damage and reduction of the economy is when the disaster brings permanent physical damage that cannot be repaired or rebuilt easily.  The nuclear disasters in Chernobyl and possibly Fukishima fall into this category.

So overall, a natural disaster is not likely to be a long-term significant