In the aftermath of last week’s earthquake and tsunami, Japan faces its most serious crisis in a generation. The terrible human toll is still being assessed; even as relief efforts accelerate, the estimate of lives lost have climbed from a few hundred in the hours after the flooding to projections surpassing 10,000. And while the humanitarian scale of the disaster is coming into focus, the ultimate scope of the crises at the Fukushima Daiichi, Fukushima Daini, and Onagawa nuclear power plants remains unclear, as does the extent of damage to critical infrastructure along the country’s North Pacific coast.
In the midst of the disaster, economists and policy makers are faced with the delicate task of assessing the implications of current events for Japan’s already-tenuous economic recovery. The analysis is far-reaching in its relevance, not least because of Japan’s position as the world’s third-largest economy, the challenges it already faces in moving toward fiscal sustainability and its role in supporting global financial markets, including currency markets and the market for U.S. treasuries.
In advance of the earthquake, the economic outlook for Japan was already fairly dim. The economy was projected to grow at just 1.7 percent in 2011, according to consensus estimates, roughly half the pace of the United States. Significant new fiscal stimulus to support the economy was largely ruled out given the country’s already substantial budget deficit. At nearly 200 percent, the country’s gross debt-to-G.D.P. ratio is second only to Zimbabwe’s, though its net debt is roughly half that level and servicing costs remain low.
Reframing the Budgetary Debate
Faced with competing policy priorities from lackluster growth and unsustainable growth in its debt load, the Diet was deadlocked over the budget for the coming fiscal year before last Friday’s earthquake. A spending bill was passed on March 1, but the parties seemed hopelessly at odds over companion legislation to finance that spending. Prime Minister Naoto Kan’s government appeared to be nearing collapse over the budget impasse, deeply unpopular in the polls and losing its foreign minister in a fund-raising scandal earlier in the week.
Japan’s budgetary debate has been entirely reframed in the past few days, with policy makers now poised to engage in a new and substantial round of fiscal stimulus. Apart from the expected spending measures, monetary policy interventions are being undertaken on a scale intended to match the crisis. The Bank of Japan acted almost immediately following the earthquake to bolster investor and consumer confidence, stating that it “will do its utmost to continue ensuring stability in the financial markets and securing smooth settlement of funds, including providing liquidity.”
Following the market’s open on Monday-the Nikkei fell by roughly 5.2 percent in early trading-the central bank announced market operations that would inject an unprecedented $220 billion into the financial system.
After Immediate Shock, a Qualified Rebound
As with any substantial negative shock, the immediate impact of the earthquake and tsunami is almost certainly a decline in economic activity and private capital inflows. In the short and medium term, however, activity may rebound as capital and labor resources are quickly deployed in the rebuilding effort.
There is substantial evidence to support this contention. In the aftermath of Hurricane Hugo, which struck the Caribbean and South Carolina at a cost of billions of dollars in September 1989, Paulo Guimaraes, Frank Hefner and Douglass Woodward described the reconstruction phenomenon as follows (1):
An irony of natural disasters is that although they destroy physical wealth, they often dramatically raise economic activity during reconstruction. Many urban and regional economies suffer immediate wealth losses from physical catastrophes. … However, some sectors of the economy experience temporary surges in income and employment that can be difficult to disentangle from other cyclical changes.
We must be careful in developing expectations of a post-disaster rebound. In particular, any meaningfully positive impact from reconstruction spending must be disentangled from the broken-window fallacy, where activity increases simply to replace productive resources that have been lost.
The devastation and replacement of infrastructure following a disaster–whether that disaster is natural or a combination of natural and follow-on events–does not necessarily imply a process of creative destruction, even if capital goods are upgraded as a result. If it did, we would observe efficient governments tearing down those factories on their own.
In Joseph Schumpeter’s seminal analysis, creative destruction describes how radical innovation can reduce or destroy the value of established technologies and business models. There is a branch of the academic literature that applies this model to our understanding of how economies recover from exogenous shocks.
But a shock such as a natural disaster may deviate from the implicit assumptions of Mr. Schumpeter’s model, especially if valuable and highly productive assets are destroyed alongside the obsolete. Debate on this question has not yet reached a satisfying conclusion. In fact, recent research suggests that climatic disasters, such as hurricanes, have beneficial long-run effects, while geologic events, such as earthquakes, have negative effects.
While data to support the analysis is becoming more available, the academic literature is still relatively sparse in its empirical assessment of the long-run economic effects of disasters. Nonetheless, the findings are sufficiently consistent that we might generally agree upon a relationship between a country’s institutional and market structures, level of economic development and the growth impact of disasters.
The research shows that more developed economies and countries with larger landmasses tend to experience fewer human losses and recover more quickly from disasters. Decomposing individual disaster recoveries and controlling for variation in country development, increases in economic activity are neither even nor unambiguous, but tend to favor certain sectors of the economy.
The broad finding that more developed countries recover more quickly and more completely may result from their higher ex ante investments in disaster mitigation. In the case of Japan, the infrastructure that alerted coastal residents to the imminent tsunami has been credited with saving an untold number of lives, even if seawalls failed under the sheer size of the wave.
Nuclear Crisis Will Prove Determinative
On balance, the available research suggests that the Japanese economy should bounce back from the current crisis, even though it may take several years. As for whether the disaster supports a net increase in long-run economic growth, the research is inconclusive.
Structural and institutional factors dominate the growth outlook. Not least among those factors, there are risks in delaying efforts to address enormous budgetary imbalances. These are risks that policy makers will deem necessary under the circumstances. Provided that the domestic market for Japanese government bonds remains strong, a debt crisis can be averted.
In assessing the growth outlook, the most pressing questions now relate to the ultimate scope of the nuclear crisis a
nd Japan’s energy production capacity. Both of these bear on the economy’s productive capacity across industries and the scale and breadth of the disaster’s impact relative to the size of the Japanese economy.
One finding of the research that seems to hold across otherwise contradictory analyses shows that scale matters for the economy’s capacity to rebound (2): “… If a natural disaster is large enough to dislocate economic activity, all the mechanisms that could potentially make it positive for growth would be weakened. Consequently, the data ought to show that severe disasters of any type lower economic growth.”
(1) Paulo Guimaraes, Frank Hefner and Douglas Woodward, “Wealth and Income Effects of Natural Disasters: An Econometric Analysis of Hurricane Hugo,” The Review of Regional Studies, 1993.
(2) Norman Loayza, Eduardo Olaberria, Jamele Rigolini and Luc Christiansen, “Natural Disasters and Medium-Term Economic Growth: The Contrasting Effects of Different Events on Disaggregated Output,” Working Paper, 2009.
Sam Chandan, Ph.D., is global chief economist of Real Capital Analytics and an adjunct professor at the Wharton School.