A Lesson in Hurricane Economics

When it comes to evaluating the economic impact of hurricane Katrina, two errors are constantly repeated. The first is the free-lunch fallacy — believing that federally financed reconstruction and relief can be a net “stimulus” to the national economy. The second is the price-index blunder — confusing a one-time spike in the relative price of energy with a broad and lasting change in the rate of inflation.

The alleged “fiscal stimulus” of $62.3 billion of debt-financed federal funding in the hurricane-afflicted cities is pure illusion. The notion that replacing destroyed property will somehow boost the economy is, as economist Walter Williams reminds us, the old “broken window fallacy” exposed by Frederic Bastiat in 1848.

Breaking windows may create work for glaziers, but property owners whose windows were broken will then have less money left over to spend on something more enjoyable. Society then has to devote scarce real resources to this unfortunate task, rather than another. Meanwhile, interest expense on the extra $62.3 billion of national debt is a burden on taxpayers, not a free lunch.

There were about a million people potentially affected by the hurricane, so Congress plans to spend $62,300 for every man, woman and child who used to live in the affected area. In constant dollars, $62.3 billion far exceeds combined spending on the six biggest natural disasters since 1989. Yet some are talking about spending more.

It might be appropriate to add so much to the national debt if the funds were for rebuilding public infrastructure of national importance. But the $62.3 billion seems mainly targeted at short-term rescue, recovery and repair, rather than elevating the New Orleans levee or rebuilding Gulf ports, roads, hospitals and schools.

Most economically viable reconstruction efforts will be financed by insurance, which ensures the money is unlikely to be wasted. The congressional spending spigot, by contrast, is an open invitation to waste. Federal billions may even be used to reimburse the losses of households or firms who did not purchase the heavily subsidized flood insurance. That would set a disaster-prone precedent.

Anyone who anticipated wisdom and foresight from any level of government was once again disappointed. Yet those most critical of bungling bureaucrats for crisis mismanagement nonetheless expect such incompetents to rebuild New Orleans. The fact is that government agencies lack the knowledge and incentives to rebuild cities in an economically sensible way. Business owners and managers, real estate investors and insurance companies know best how to allocate scarce resources because they put their own money at risk.

The second error about Katrina’s economic fallout, the price index confusion, was illustrated by Washington Post writer Nell Henderson. “The Fed’s quandary,” she wrote, “is that the storm sent energy costs soaring, which both slows economic growth and fuels inflation.” Actually, any increase in the relative price of energy is definitely not inflationary. Yet the Fed may believe otherwise, as Henderson suggests.

This is an old mistake. Nearly 32 years ago, on Jan. 20, 1974, I wrote “Some Preliminary Effects of a Heavy Hand” in The New York Times. “An increase in one price,” I explained, “does not imply an increase in the average level of all prices (inflation). If consumers pay more for gasoline, they have less money left over to bid up the prices of other things.” Higher energy costs have a deflationary effect on non-energy prices. Transportation costs may be an exception, but transportation is included in price indexes that leave out direct energy expenses.

Aside from energy, the producer price index fell in August and was just 2.2 percent higher than a year ago. Aside from energy, the July CPI was also 2.2 percent higher than a year before (the August CPI has not been released as of my writing). Does anyone realize how low that 2.2 percent figure really is? Inflation in the non-energy CPI averaged 4.6 percent a year since 1967, and dipped below the 2004-2005 rate of 2.2 percent in only three of those 39 years — 1998, 2000 and 2001.

If energy is included, inflation in the CPI has been 1 percentage point higher than non-energy inflation since 2003. The only other times we have seen that wide a gap between CPI inflation and non-energy inflation were in 1974, 1979-80 and 1990-91. At those times, the Fed pushed the fed funds rate far above non-energy inflation — 2.5 percentage points higher in 1991; 1.8 in 1981. The economy suffered high real interest rates and high energy prices simultaneously. And recessions.

The Washington Post article says long-term interest rates “are lower than before the hurricane, providing additional stimulus.” On the contrary, if long-term interest rates remain low and the Fed keeps pushing short-term rates higher, then the yield curve will become flat (as in 1991) or inverted (as in 1974 and 1981). Eliminating any spread between short-term and long-term rates makes bank lending unprofitable, and almost always ends in recession.

The Fed has always flattened the yield curve whenever energy inflation was high relative to non-energy inflation. After the ensuing recessions, the Fed always cut short-term rates far below long-term rates, in 1975-76, 1984-85 and 2001-2003.

Many Fed watchers believe the Fed will lift the fed funds rate to 4.25 percent by year’s end — 2 percentage points higher than non-energy inflation and about the same as the yield on 10-year bonds. That same policy proved risky during past energy price spikes. Perhaps the Fed ought to pause and reflect, wait and see.

The U.S. economy can weather hurricanes and profligate federal spending. Whether or not the economy can weather high energy prices and rising interest rates at the same time remains to be seen. Unlike hurricanes, that risk is avoidable.