Hurricane Sandy And The Broken Window Fallacy

 @moranzhang on November 10 2012 10:00 AM

Superstorm Sandy, which shut down Wall Street and disrupted business activity throughout the populous U.S. Northeast, will likely be a drag on economic activity in the fourth quarter, but rebuilding efforts will provide a modest boost to the country's economic growth next year.

However, the widespread misery Sandy left in its wake is a straight loss to society.

Although the actual scale of the damage caused by the monster storm will not be known until much later -- after many months or even years – early estimates by Eqecat put Sandy’s cost in a range between $30 billion and $50 billion.

These losses have gradually been trending higher as the full extent of the storm’s impact is revealed. They would put the costs of Superstorm Sandy above those of many of the hurricanes to strike the U.S. in recent years and on par with Hurricane Andrew in 1992 and the cumulative costs from the four large hurricanes of 2004. However, damage estimates from Sandy are well below those of Hurricane Katrina in 2005 at this time.

The possible benefits of destruction is a topic that has been debated by economists for years.

“One of the most common refrains heard after a natural disaster is that the rebuilding efforts will boost economic activity,” Mark Vitner, a managing director and senior economist at Wells Fargo, wrote in a note to clients. “Measured [gross domestic product] does benefit from rebuilding efforts, but the effect takes time and does not necessarily boost economic well-being.”

The famous “broken window fallacy,” coined by the 19th-century French economist Frederic Bastiat and described at Wikipedia, in his 1850 piece “That Which is Seen, and That Which is Not Seen,” explained why natural disasters or wars do not make an economy better off, in spite of appearances to the contrary.

In Bastiat's tale, a man's son breaks a pane of glass, meaning the man will have to pay to replace it. That adds to GDP, but this man personally is not better off for the experience. More importantly, Bastiat observed that while the immediate benefit of spending on reconstruction is visible, the lost opportunities to spend elsewhere are “what is not seen.”

As Bastiat explained: “It is not seen that as our shopkeeper has spent six francs upon one thing, he cannot spend them upon another. It is not seen that if he had not had a window to replace, he would, perhaps, have replaced his old shoes, or added another book to his library. In short, he would have employed his six francs in some way, which this accident has prevented.”

Bastiat concluded that spending from a destruction event can never help an economy because it merely diverts money that already would have been spent in other ways.

Keynesian economists would argue that Bastiat’s analysis holds only if the householder would have spent the money on something else and not put it away in a shoebox. To bring the discussion back to Sandy, Keynesians would argue that debt-financed reconstruction spending can have a strong effect on growth at a time when there is cyclical unemployment and spare capacity in the economy.

How GDP Is Calculated

Damages are not the same as economic costs. Accordingly, it is important to know how the U.S. Bureau of Economic Analysis translates damages into their ultimate economic impact.

Property damages do not subtract from economic activity. The homes, buildings, and automobiles damaged or destroyed by Superstorm Sandy were produced some time ago, and they contributed to GDP in earlier periods. The cleanup, repair, and reconstruction of these damaged properties will add to GDP, as noted by Vitner.

Barclays Capital economists led by Michael Gapen pointed out in a note that it appeared reasonable to use the example of Hurricane Katrina as a benchmark for Sandy’s economic impact, given its size: “Although it may be too early to know where Hurricane Sandy will rank in terms of estimated damages, it appears safe to conclude that it will be smaller than Hurricane Katrina’s. Understanding Katrina’s impact on the broader economy should provide an accurate benchmark to assess Hurricane Sandy from an economic perspective.”

Growth fell markedly after Katrina in 2005, but no significant hit followed the smaller hurricanes of 1992, 2004, and 2011. The Congressional Budget Office estimated that Katrina subtracted about 0.5 percent from real growth in the second half of 2005.

Gapen said he expects Sandy to pose a modest drag on the fourth quarter on the order of about 0.2 percent to 0.3 percent, with negative effects in October and early November partially offset by a rebound later in the quarter. Barclays maintained its forecast of real GDP growth at 2.5 percent for the quarter, but warned of Sandy downside risks to that call.

Meanwhile, Vitner estimated reconstruction could add about 0.2 percent to GDP growth in the first half of next year.

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