Monday, August 29, 2005

Katrina and the Economy - I

I have held up publicly commenting on Hurricane Katrina for the last two days because it did not seem right to me to be talking money when so many lives have been lost or dislocated. However, I have spoken to many of you, and I think it is appropriate that I pass on to everyone my thoughts of the short and long-term implications of Katrina. The history of natural disasters has followed a fairly regular course. There is a short-term dip in economic activity followed by a strong uptick 3 months to 12 months later. It may seem impossible that anything good can come out of such a destructive storm, but from a pure economic perspective, once the rebuilding begins there is a significant economic stimulus. I think the best way to understand this is to think of the economic implications of one family. For our purposes here, let's call them Mr. and Mrs. America. The Americans lived in a 30-year old home on a side street in a pleasant middle-class neighborhood. Their children are gone, and they both work outside the home. The storm's winds have completely wrecked their home, and they are living with friends in another part of town. We will assume that they will continue to receive their salaries from their places of employment. They have been in contact with their insurance broker and they have been told that they will be receiving a full settlement of $240,000 for their house and $50,000 for contents. They will also be receiving some bridge type support for living expenses while they rebuild. They have already talked with a contractor friend, and he has agreed to rebuild a home with approximately the same square footage and improvement as their old home. Some additional improvement they would like will add another $25,000. The biggest problem they have is that their street is still covered with water, and it will take weeks to clear the damaged trees and houses in their neighborhood. They could begin work much sooner if they rebuilt in a more suburban area farther from the center of the city. Thus even though they have a check waiting for them at their insurance office and a contractor ready to go, they must wait. The only thing they can do to get their lives back to some semblance of normalcy is to begin the process of shopping for the essentials that they know they will need, such as sheets, towels, and everyday clothes. They have leased a storage unit, and they plan to go shopping at a nearby Walmart that is powering its facility with a generator. To get at the implications of the storm's effect on the economy of the area, we have to make two estimates of the American's annual spending. The first is the amount they spend annually on the contents of their home. and the second is the annual maintenance cost on their home. Because they will still be eating and brushing their teeth at about the same rate as before the storm, the biggest change in their family expenditures is the money they would ordinarily be spending on their total living expenses that is now in suspension. Let's assume that the $50,000 they received from the insurance company for the contents of their home has an average life of 5 years. That means that the American's spend an average of about $10,000 per year on clothes, furniture, decorating, electronics, and appliances. That is an average of about $800 per month. To keep things simple, let's assume they have no mortgage on their house. The $240,000 they received for their home would have had an average life of 40 years, meaning maintenance and improvement on their home would have been about $6,000 per year, or about $500 per month. Finally, they spend about $700 per month on utilities, telecommunications, cable, and insurance. The items total about $2000 per month. This represents about 50% of the American's take-home pay. With some possible exceptions, the remainder of the American's expenditures will continue as before. If this 50% hit to spending were wide spread across the area, the economic implications for the New Orleans area would be devastating. Economically speaking, Mr. And Mrs. America would be fine: they have the insurance proceeds to replace their home and belonging, and they still have jobs. But the storm has essentially cut their spending by half for as long as the damage takes to clean up, and thus, the economy in the area will suffer. The ironic thing about the American's situation, however, is their current shortfall in spending will be more than made up over the next 12-18 months. At some point over the next 18 months, they will be spending the insurance proceeds of $240,000 plus the additional $25,000 for the improvements on their new home. In addition they will be spending the greater part of the $50,000 they received for the contents of their home. Looking at it from another perspective had the storm not occurred, they would have spent about $24,000 on items related to their home. Now, because the storm has destroyed their home, they will be spending $315,000. Multiply this times thousands of people and the Delta region will resemble a boomtown. In essence, it is hard to believe, but these natural disasters can actually spur economic activity on a delayed basis. For this reason, I do not believe the economic impact of the situation will be anywhere near as bad as some are now warning. The real risk to Katrina is the damage she did to the oil infrastructure in the area. I will not cite statistics that you can easily find elsewhere, but there is heavy damage to the offshore oil rigs as well as the refineries. I can not speculate on how much damage there is, or how long it will take to repair it, but I do know that the refineries in this country were already running near capacity. Thus, even if one refinery is severely damaged, the supply of oil will be cut and prices will rise. But even here, in my judgment, the situation is not catastrophic; repairs will eventually be made, and the supply will be back on line in time. In the meantime, the higher oil prices (they may go as high as $4 a gallon) and the awe that all of us feel at the incredible destruction that Katrina has wrought will act to dampen our animal spirits a bit and cause a general slowing of the economy. I cannot emphasize enough, however, that the slowdown will be temporary. The rebuilding will give a big lift in the coming months. The hypothetical situation above is neither a best case or a worst case scenario. The issues are far more complex for those people without insurance or are not able to maintain their jobs. In these cases, the burden falls to the state and federal governments. The costs will be terrific, but I believe all parties realize the magnitude of the problems and the consequences if any of them shirks their responsibilities. I am heartened that the state of Texas has not only offered the use of the Astro-Dome for the 25,000 refugees who were trapped in the Super-Dome, but has also opened their schools for the fall term to the school-age children who will living in the Dome. I will report more on the rebuilding in time. The key thing for the economy is how long it takes to pump out the water and how long it takes to clean up the damage. From that point on, the economic benefits of the rebuilding will be substantial. Rebuilding the Delta region will take years, but the economy will be stronger than many commentators now believe. The stock market is a discounting machine. It knows everything I have said here and more. I believe it will be able to look through Katrina's devastation and see that, in effect, she has slugged us, but our nation has proved over and over that we are resilient. Addendum: Many are now saying that Katrina is the worst natural disaster in US history. The "Big Easy" has fallen, and she needs our help. I would encourage anyone reading this to contribute whatever you can to help those who have lost everything. Check with your local Red Cross. It is my understanding that they can take your contribution and get it to the Katrina relief effort.