By Steven Pearlstein
Friday, September 9, 2005
Allow me to dissent from the sanguine view of the economic impact of Hurricane Katrina embraced by the Wall Street herd, policymakers and most forecasters.
By any measure, Katrina is a shock to an economic ecosystem already seriously out of balance. It has reduced national wealth by several hundred billion dollars, displaced hundreds of thousands of citizens, aggravated bloated budget and trade deficits and reduced the political odds for permanent tax cuts on capital. And with so much still unknown, the risks, as they say at the Fed, are on the downside.
As always happens with disasters and financial crises, the early forecasts are based on tweaks to the standard forecasting models. These macro-analyses are invariably arithmetic and linear in nature (as in "a $100 billion loss is the equivalent of only a 0.6 percent drop in the S&P 500"). They assume rational behavior by consumers, investors and executives, and timely and effective intervention by the Fed.
But economic crises are by nature unpredictable. They are about the interplay of micro-events that have macroeconomic consequences. They involve irrational, herdlike behavior and tipping points in which the effects are nonlinear and geometric. And the Fed can rarely prevent them.
Pre-Katrina, the unpleasant scenarios all ended in the same place: stagflation, that '70s-era combo of inflation and stagnant economic growth, two conditions that were not supposed to coexist. Post-Katrina, the stagflation odds have greatly increased.
First, consider energy prices, which were up sharply before the hurricane and are likely to settle even higher because of storm-related damage. Today's crisis is gasoline; next week it could be jet fuel; and you can be fairly sure that a heating oil and natural gas spike will follow in the winter.
Higher fuel prices have begun to show up in taxicab surcharges, freight rates and airline tickets. Now that pricing power has been restored in much of the economy, prices across a range of manufactured goods are likely to jump, as well. And with barge traffic backed up, the extra cost of getting this fall's harvest to market translates into higher food costs.
Sharp price increases are also likely in the cost of construction materials and workers as the massive rebuilding begins on the Gulf Coast.
If you thought it difficult or expensive to get a roofing contractor or mason last month, you ain't seen nothing yet.
All of these increases might be relatively benign as long as they don't result in higher wages. But with labor markets tightening, productivity slowing and health benefit costs rising at double-digit rates, inflationary wage and benefits increases are a real possibility for the first time in years.
That's the "flation" part. Now let's consider the "stag."
Start with the lost output from an estimated 400,000 workers whose jobs or companies no longer exist. Add the drag on other consumption as households and firms pay higher prices for energy, transport, food and construction.
The auto industry, already on fumes, now warns of further troubles as higher gas prices drive down sales of gas guzzlers. Insurers can only guess the magnitude of the hit they will take. Airlines will take it on the chin once again. And farm income is almost sure to decline.
Some of that, of course, will be offset by federal spending for relief and reconstruction. But the fiscal stimulus could prove insufficient if many consumers respond to higher prices and pictures of destruction by saving more and consuming less.
Even before Katrina, U.S. economic growth was overly dependent on debt-driven consumption and the housing bubble that was so much a part of it. Now the hurricane could prove to be the long-expected shock that finally forces the economy onto a slower but more sustainable path. The transition would be a rocky one for households and businesses, but rockier still for financial and real estate markets that have overpriced assets and underpriced risk.
And that is where the greatest danger lies. The financial system is often described as the "lifeblood" of the economy, and once infected, it creates a self-reinforcing dynamic in which caution begets caution, weakness begets weakness and selling begets selling.
So far, markets of all sorts have blithely shrugged off Katrina. Given the magnitude of what has happened, and the uncertainty still ahead, that may be the most worrisome sign of all.
Steven Pearlstein can be reached firstname.lastname@example.org.