01 Sep 2008

Is Gustav Good for the Economy?

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In a previous post, I explained why the conventional GDP accounts–based on Keynesian macroeconomics–lead to all sorts of absurd analyses and policy recommendations, such as viewing a falling dollar and consumer spending as boosting growth. We see similar confusion whenever it comes to disasters such as earthquakes and hurricanes, when analysts say, “Although the loss of life and individual homes is a tragedy, nonetheless the event should provide a boost to GDP.”

Economists label this the “broken window fallacy,” after the great 19th century economist Frederic Bastiat who spelled out why it is, well, fallacious. Very briefly, the problem is that it just focuses on the workers rebuilding houses, replacing shattered panes of glass, etc. But in the absence of the disaster, those workers could have been deployed into creating additional wealth for the community; now, they are busting their behinds simply to get back to the starting point. There is nothing counterintuitive going from the micro to the macro; what is an individual tragedy for thousands of homeowners is a collective tragedy for the whole community.

Anyway, the latest example of this fallacy is on display in the press coverage over Gustav (h/t to Jeff Tucker):

Economists agree that in the long run, a major hurricane or other natural disaster can actually help lift economic activity because of insurance payments and federal assistance.

In the short-term, the destruction and the disruptions can be a hit to the economy.

If we could just forget for the moment that this is coming from a “senior writer” at CNNMoney, and imagined that it was penned by a 7th grader, its absurdities would be funny. Besides the broken window fallacy, the first paragraph is even worse because it says that it’s not the work of the construction crews etc. that is boosting economic activity, but rather the transfer payments from insurers and government. Does it really boost economic activity for one group of Americans to write checks to a different group of Americans?

Alas, since the financial press always talks about the benefits of holiday shopping, I don’t think this last question would strike them as goofy. If everyone would simply give $100 to the neighbor living to the right of his or her house, these writers would predict a massive boost in GDP, methinks.

One final point, which shows why GDP accounting is so pernicious: The broken window fallacy doesn’t actually disprove the point that a disaster might boost total “output,” but rather shows that “total output” is the wrong metric. During a war, for example, people might work double shifts for years at a time; GDP, even if measured correctly, might be much higher during the period. Yet this doesn’t mean individuals are better off than during peacetime when they lounged around more.

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