What exactly happens in an economic recession, and how much has Katrina increased the likelihood of one developing?
Cafe Hayek, William Polley, and
Division of Labor all noted with dismay the statement from an economist quoted in a recent Washington Post story, suggesting that Hurricane Katrina could prove to be a source of economic stimulus:
“There will be a lot of rebuilding that is going to need to occur. These things do spur GDP growth,” said Ken Mayland, president of ClearView Economics in Pepper Pike, Ohio.
It is an implication of Keynesian models that in some circumstances, additional spending on any activity, such as trying to fix or replace all the things that are now broken, would boost the level of GDP. But even the most committed Keynesian would not attempt to extrapolate this principle to any and all situations, as if it were possible for Bangladesh to make itself ten times as rich as the United States if its government were only to invent enough make-shift jobs for its citizens to perform.
The position of any responsible economist would be that the level of a country’s GDP is determined by the interaction between what the nation is physically capable of producing, given the size and quality of its workforce, capital stock, raw materials, and technology, and whether the economy is employing those resources efficiently. During an economic recession, we see the unemployment rate spike up and capacity utilization measures plummet, suggesting to many of us that economic recessions have largely to do with that second issue of effectively utilizing the economy’s basic resources. A spending stimulus has more ability to boost GDP in such circumstances than it would when the economy is already near full employment.
The level of prosperity in an advanced economy results from a high degree of specialization of labor, capital, and most importantly, the institutions (shops and firms) that coordinate their activities. What happens in an economic recession is that the market’s success at coordinating this specialization breaks down. Firms and workers suddenly find that the activity for which they are uniquely suited is no longer in demand, and the degree of specialization makes it infeasible to redirect these productive inputs immediately to other sectors. These sudden demand shifts can occur, for example, if sharp energy price changes and the uncertainty accompanying them produce dramatic changes in consumers’ purchases of items such as cars. A theoretical model of how this can occur was developed in a paper of mine published in the Journal of Political Economy in 1988.
Reductions in economic activity from these sectors can themselves be the cause of downturns in other sectors, with the possibility of a complete collapse of coordination such as the U.S. experienced in the Great Depression, in which nobody can work in part because, well, nobody else is working.
In a typical hurricane, there is some destruction of productive physical capital. But precisely because the physical trauma is relatively local, there is little impact on the ability to coordinate economic activity. Many people end up doing pretty much what they were doing before on the other side of town, with the rest of the nation able to serve as a buffer of available resources with which the rebuilding can be carried out. Macroblog documents that previous major hurricanes had very little macroeconomic impact.
Is Katrina any different? Although the effects on energy prices originally looked to be enormous, it now appears that we are already past the worst, with oil and gas prices falling again today. I am likewise hopeful that New Orleans’ hobbled port will not produce the insurmountable problems with getting goods to market that some had originally feared.
On the other hand, New Orleans itself looks to me like a coordination problem on the scale of an entire metropolitan area. Some of the people affected will get back to working quickly. But many who worked in schools, stores, or hotels seem quite unlikely to be performing a similar function on the other side of the river any time soon. Part of the sadness in looking at the great city under water is the realization that much of the magic that allowed it to function together as a cohesive unit has been destroyed.
How big is that effect economically? The estimate from the Congressional Budget Office of 400,000 lost jobs has been widely repeated by the press. I have looked at the CBO report, but did not see exactly where the 400,000 figure came from. The CBO did call attention to the facts that about 620,000 people worked in the New Orleans-Metairie-Kenner Metropolitan Statistical Area last year, of whom 250,000 worked in the Orleans Parish. It does seem a safe guess that at least 200,000 of those previously working in the MSA will not be employed again for a period of several months at a minimum.
How big a shock is that relative to the national economy? For comparison, U.S. nonfarm employment fell by over 400,000 jobs in the first three months of each of the last two recessions, and would normally be expected to grow by significantly more than 400,000 jobs over a typical 3-month period. Thus by this very crude reckoning, Katrina by itself represents less than a quarter of the size of a typical recession-inducing shock, or less than half, if you use the CBO estimate of 400,000 lost jobs.
The other reason that Macroblog found very little evidence of an economic slowdown from other historical hurricanes is that usually hurricanes are completely unrelated to anything that may be happening in other parts of the economy. In the present case, I am concerned that, even without Katrina, we could easily see additional layoffs in autos and
airlines. And sooner or later, the degree of Fed tightening that we’ve already seen is going to exert a substantial contractionary effect on the economy.
So where does all that leave us? The situation economically is not as bad as it could have been, and not as good as we would wish. A recession in 2006 remains a possibility, but not a certainty. Statements like this one from Federal Reserve officials remind me that the Fed still has the power to turn it from the former into the latter.