What’s Good for the GDP Isn’t Always Good

The people of Southeast Texas are enduring a natural disaster of biblical proportions.  Hurricane Harvey has brought misery to our country’s fourth largest city and the surrounding area.  We’ve all seen the images on TV of unfathomable flooding in and around Houston, and, as I write the waters are still rising in many spots.  Beaumont, Texas is forecast to receive up to five inches more rain.  Tragically, at least 30 people have lost their lives, and the human cost will likely rise.  Our thoughts and prayers are with the great folks of Texas.
Today I’d like to discuss some of the possible economic implications of Hurricane Harvey.  I’ve written in several recent commentaries about the most commonly used gauge for the overall size of the economy, Gross Domestic Product (GDP).  Most people might assume that the grinding halt in economic activity in and around our fourth largest city would lead to negative implications for the US GDP at large.  But while that’s true in the immediate aftermath, the intermediate- to long-term impact is much more ambiguous.

The storm certainly has an obvious and immediate economic impact: as you fill up your car this week, you’ll see higher prices at the pump as at least 13% of the US refining capacity has been shut down.  Some of those refineries will re-open at full capacity in short order; others may have some damage that will require significant repairs.  At the same time, oil prices have, perhaps counter-intuitively, declined.  The reason for this is that off-shore oil rigs were largely undamaged by the storm, resulting in more oil than refining capacity at the moment.
Apart from the impact on the energy markets, the flooding will cause massive property losses.  We have all seen stunning footage of cars and homes flooded, many of which will be a complete loss. As the storm is ongoing, there are no solid estimates of damage, but we’ve heard figures as big as $100 billion.  The losses could reach levels seen only during Hurricane Katrina.

But losses sustained from disasters such as Harvey are not necessarily a big negative for the economy as a whole.  In fact, the rebuilding that is bound to ensue will likely lead to a net increase in GDP.  That’s right – by our standard yardstick, the economy will grow.  How can massive destruction produce a positive for the economy?  It is a lesson in why raw numbers don’t tell a whole story.  GDP is a measure of the size of the economy, not necessarily its health.

It is true that the storm has created a loss of productivity as the country’s fourth largest city in America has, effectively, no economic activity at the moment.  However, over the coming weeks and months, as both commercial and consumer property is repaired or replaced, the region will receive a hefty boost.  Construction workers will arrive for work from other parts of the country, while in the process increasing service demand in the Houston area as they stay in motels and dine in restaurants.  Manufacturers of building materials will add overtime to produce the plywood, drywall, nails, shingles and all else required.  Retailers will, when they re-open, replace inventory at a rapid pace.  Many of the cars that are destroyed will be replaced by new cars rolling off assembly lines, and those that are damaged will require repair.  But a natural disaster can’t be good for the economy, can it?

Well, no. And yes. It’s complicated. Yes, the net effect on GDP is likely positive, but size of the economy doesn’t necessarily indicate health or well-being.  The resources that will be employed to repair and rebuild in Texas are resources that could have been utilized elsewhere.  Money provided by insurers and the federal government for rebuilding might have ultimately found its way back to shareholders and taxpayers.  Federal funds earmarked for infrastructure spending elsewhere might instead be diverted to Texas. Insurers will have to rebuild their capital bases through premium increases. Charitable contributions toward rebuilding Texas may come at the expense of charitable giving elsewhere. And the rebuilding contribution from various government entities will increase their respective debt loads.

All that said, disasters are ultimately stimulative for the economy.  A disaster forces an economic response, and economic activity begets more economic activity.  The classic example is the effect of World War II on the American economy.  While the economy had been in recovery since 1933, with the exception of a downturn in 1937-38, the contraction of 1929-32 was so deep that per capita GDP only returned to pre-depression levels in 1940 after war had broken out in Europe.  When the US entered the war, the country was at full employment, and factories were running at full capacity for several years.  The economic activity of the war ended the Depression for good.

But while disasters (man-made or otherwise) have a stimulating effect on the economy, destruction, obviously, can’t be a good thing. The effect is called the “broken window fallacy”, first explained by an early 19th century French economist named Frederic Bastiat.  If a boy breaks a window, his father pays the glazier to repair the window.  The glazier then spends his extra income on something else, in the process jump-starting the local economy.  While on the face of it, the boy breaking the window stimulates the economy, the destruction takes resources (his father’s disposable income) that could have been spent elsewhere.  Though as a measure of GDP, the newly installed glass is a finished product that counts toward GDP, in a broader sense it is a maintenance cost as it replaces something rather than creating something new (such as a window in a new building).  Bastiat suggests that destruction, while it does create economic activity, ultimately doesn’t pay in an economic sense as it diverts production from growth to maintenance. It’s a long-winded way of explaining what common sense tells us. Otherwise, society would pay for window smashing.

So what does a natural disaster mean for an investor?  For those of you who are regular readers, you know I always say we take the “Farr View” with our investments.  We don’t get too excited about short-term fluctuations triggered by natural disasters or anything else.  While Harvey is a one-in-500-year event on the Texas coast, that means there is a 0.2% chance of that magnitude of event happening in any given year.  In a country the size of the United States, several one in 500 year events happen every year.  We look at companies that have the financial strength and management resources to cope with extraordinary events.  Over time, and we always look to invest over long periods of time, extraordinary events will happen.  Thus, as an investor, natural disasters should be no cause for alarm.  Perhaps a company will have a down quarter due to large amounts of business in Texas.  Perhaps another in your portfolio will do well selling building materials.

On a non-business note, it is good to see people coming together to help those in need in Texas.  This morning, I saw footage of a line of trucks pulling boats headed to the worst-hit areas.  These were regular working people, taking time off work to come to the aid and rescue of those who need it.  We salute these folks, and we encourage all to do what they can to help those in need.