Why Hurricane Sandy May Not Be All That Stimulating

Invariably, every major disaster comes with the pundits who promise it brings a silver lining.

With a price tag of $50 to $70 billion, some economic forecasters are already rejoicing about the economic "stimulus" that rebuilding from Sandy will bring. If only it were so.

In fact, this paradox is well worn since it involves one of the central conflicts of economics itself. You may recognize it as a battle between Maynard Keynes vs. Frederic Bastiat.

It involves Bastiat's famous "Parable of the Broken Window".

You see, according to Bastiat (1801-50), the glazier who fixes the broken shop window earns money from it, and so he regards the broken window as economically beneficial. However, that's only half of the story.

It doesn't take into account what the shopkeeper might have done with the money he used to pay the glazier to fix the broken window.

As Bastiat points out there is a "hidden cost" within the broken window itself. The broken window made the shopkeeper that much poorer.

What's more, if the glazier secretly paid the boy who broke the window to generate the "new" business, he would be effectively engaging in theft from all the town's shopkeepers.

On a net basis, it's a no win ballgame.

Yet that is the effect of such misguided policies like the "cash for clunkers" scheme of 2009, which paid consumers to junk their still-usable automobiles long before their time.

Likewise, it's found in the same line of argument that somehow World War II rescued the United States from the Great Depression because it fails to properly account for the immense destruction of wealth (admittedly, mostly outside the U.S.) the war caused.

It seems easy enough—unless you're a Keynesian economist.

That's because Maynard Keynes (1883-1946) argued that if resources are not fully utilized, the multiplier effect of the shopkeeper paying the glazier does produce additional economic activity. So in a Keynesian world a broken window does indeed increase economic output.

But that's true only if the glazier was not fully occupied elsewhere. If fixing the shopkeeper's window forced him to neglect his other customers, overall economic output would not be increased.

Of course, Keynes also once suggested that the U.S. Treasury should fill old bottles with banknotes and bury them in abandoned coal mines, after which the private sector would labor mightily to mine the banknote-bearing strata, causing massive increases in employment and output.

Meanwhile, with Hurricane Sandy what we are left with is a stimulus fallacy since we are well below full employment and in a state in which resources are not fully utilized.

Here's the Fallacy Buried Beneath the Hope

One more interesting feature of the Hurricane Sandy episode is that the National Weather Center (NWC) and state governors seem to believe economic losses are eliminated when they are paid for by insurance companies.

In fact, I thought it was odd when the NWC downgraded Sandy from "Hurricane Sandy" to "Post-Tropical Storm Sandy" the second it crossed the New Jersey shore on Monday evening.

It now turns out that most insurance companies have much higher deductibles for hurricanes than for regular storms, so the authorities were trying to maximize the payout on voters' insurance claims.

The problem is that insurance companies are people too, even if a quirk of the Constitution fails to give them the right to vote. Conniving at insurance fraud by pretending Sandy wasn't really a hurricane is NOT the ethical behavior we should expect from those in authority.

And if you work for an insurance company, go picket the New Jersey State House in Trenton or New York's City Hall. Mayor Bloomberg, of all people, ought to know better!

So how big are the damages caused by so many "broken windows"?

The disaster modeling company Eqecat currently estimates the insured losses on Sandy at $20 billion, with an additional $50 billion in uninsured economic losses. (Those include the lost opportunities caused by most of New York not showing up to work for a week.)

Contrary to popular opinion, the $20 billion covered by insurance are real losses; they will be reflected in higher insurance premiums going forward, otherwise the insurance companies would go out of business.

As a result of the higher premiums, some projects in the future will be shelved because their cost is too high, some houses will not be built because homeowners can no longer afford them.

You see, Keynes is wrong. The $20 billion is a real loss to the economy, and in the long run it will not simply come out of insurance company profits, but be passed on throughout the economic system as higher costs-which equals less money.

Similarly, the $50 billion economic costs of the storm are real.

To take one example, if Goldman Sachs (NYSE: GS) averages $100 million every day in trading profits, then having the exchange closed for two days will reduce their fourth quarter profit by $200 million, with no chance of making that up.

This effect will also be reflected throughout the larger economy. Many New York and New Jersey businesses will go bankrupt, because the losses push them over the edge. And if the state decides to refund the costs, the additional taxes in future years will push other businesses over the edge as well.

Yes, the money spent on reconstruction is real, but it just substitutes for other money that won't get spent.

Maybe a restaurant is forced to rebuild using insurance money, and now has a larger, newer building. However, apart from the insurance premium increases discussed above, and any out-of-pocket cost to the restaurateurs, there may have been customers attracted by the old restaurant's charm, who will be repelled by the antiseptic new one.

Certainly if I were told I could rebuild my 1911 house with a 2013 one of equivalent size I would refuse; instead I would search high and low for another house with as much charm as my current residence.

As in most economic matters, I am on the side of Bastiat, not Keynes.

In this case, many of the costs of Hurricane Sandy are hidden, or postponed to future years, but they are nonetheless real.

That's true no matter what guys like New York Times columnist (and Nobel Prize winner – jeez –) Paul Krugman say.

You may remember what Paul Krugman said in August last year when he proposed that we could somehow rescue the economy by preparing for an imaginary alien invasion, building huge laser-guided defense systems, none of which would be needed unless aliens surprised us by actually invading on schedule.

Needless to say Bastiat would disagree. With cool nineteenth-century logic he would point out that whether it's an unnecessary window repair or an unnecessary atomic ray gun, if it's useless it's useless.

Our leaders should take Bastiat's lesson to heart, and not just when there's a hurricane.

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