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Natural Disasters Don’t Increase Economic Growth – Article by Frank Hollenbeck

Natural Disasters Don’t Increase Economic Growth – Article by Frank Hollenbeck

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The New Renaissance Hat
Frank Hollenbeck
May 27, 2014
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Hurricane season is nearly upon us, and every time a hurricane strikes, television and radio commentators and would-be economists are quick to proclaim the growth-boosting consequences of the vicissitudes of nature. Of course, if this were true, why wait for the next calamity? Let’s create one by bulldozing New York City and marvel at the growth-boosting activity engendered. Destroying homes, buildings, and capital equipment will undoubtedly help parts of the construction industry and possibly regional economies, but it is a mistake to conclude it will boost overall growth.

Every year, this popular misconception is trotted out although Frédéric Bastiat in 1848 clearly put it to rest with his parable of the broken window. Suppose we break a window. We will call up the window repairman, and pay him $100 for the repair. People watching will say this is a good thing. What would happen to the repairman if no windows were broken? Also, the $100 will allow the repairman to buy other goods and services creating income for others. This is “what is seen.”

If instead, the window had not been broken, the $100 may have purchased a new pair of shoes. The shoemaker would have made a sale and spent the money differently. This is “what is not seen.”

Society (in this case these three members) is better off if the window had not been broken, since we are left with an intact window and a pair of shoes, instead of just a window. Destruction does not lead to more goods and services or growth. This is what should be foreseen.

One of the first attempts to quantify the economic impact of a catastrophe was a 1969 book, The Economics of Natural Disasters. The authors, Howard Kunreuther and Douglas Dacy, largely did a case study on the Alaskan earthquake of 1964, the most powerful ever recorded in North America. They, unsurprisingly, concluded that Alaskans were better off after the quake, since money flooded in from private sources and generous grants and loans from the federal government. Again, this was “what is seen.”

While construction companies benefit from the rebuilding after a disaster, we must always ask, where does the money come from? If the funds come from FEMA or the National Flood Insurance Program (NFIP), the federal government had to tax, borrow, or print the money. Taxpayers are left with less money to spend elsewhere.

The economics of disasters remains a small field of study. There have been a limited number of empirical studies examining the link between growth and natural disasters. They can be divided into studies examining the short-term and long-term impact of disasters. The short-term studies, in general, found a negative relationship between disasters and growth while a lesser number of long-run studies have had mixed results.

The most cited long-run study is “Do Natural Disasters Promote Long-Run Growth?” by Mark Skidmore and Hideki Toya who examined the frequency of disasters in 89 countries against their economic growth rates over a 30-year period. They tried to control for a variety of factors that might skew the findings, including country size, size of government, distance from the equator and openness to trade. They found a positive relationship between climate disasters (e.g., hurricanes and cyclones), and growth. The authors explain this finding by invoking what might be called Mother Nature’s contribution to what economist Joseph Schumpeter famously called capitalism’s “creative destruction.” By destroying old factories and roads, airports, and bridges, disasters allow new and more efficient infrastructure to be rebuilt, forcing the transition to a sleeker, more productive economy. Disasters perform the economic service of clearing out outdated infrastructure to make way for more efficient replacements.

There are three major problems with these empirical studies. The first is counterfactual. We cannot measure what growth would have been had the disaster never occurred. The second is association versus causation. We cannot say whether the disaster caused the growth or was simply associated with it.

The third problem is what economists call “ceteris paribus.” It is impossible to hold other factors constant and measure the exclusive impact of a disaster on growth. There are no laboratories to test macroeconomics concepts. This is the same limitation to Rogoff’s and Reinhart’s work on debt and growth, and many other bilateral relationships in economics. Using historical data from the early 1900s, researchers found that as the price of wheat increased, the consumption of wheat also increased. They triumphantly proclaimed that the demand curve was upward sloping. Of course, this relationship is not a demand curve, but the intersection points between supply and demand. The “holding everything else constant” assumption had been violated. In economics, empirical data can support a theoretical argument, but it cannot prove or disprove it.

So what do we do if the empirical studies have serious limitations? We go back to theory. We know a demand curve is downward sloping because of substitution and income effects. Wal-Mart does not run a clearance to sell less output! Theory also holds that natural disasters reduce growth (i.e., the more capital destroyed, the greater the negative impact on growth).

More capital means more growth. Robinson Crusoe will catch more fish if he sacrifices time fishing with his hands to build a net. Now, suppose a hurricane hits the island and destroys all of his nets. Robinson could go back to fishing with his bare hands and his output would have been permanently reduced. He could suffer an even greater decline in output by taking time to make new nets. The Skidmore-Toya explanation is to have him apply new methods and technologies to build even better nets, allowing him to catch more fish than before the hurricane. Of course, we may ask, if he had this knowledge, why didn’t Robinson build those better nets before the hurricane? This is where the Skidmore-Toya logic falls apart. Robinson did not build better nets before the hurricane because it was not optimal for him to do so.

If a company decides to replace an old machine with a new one, among the primary considerations are the initial price of the new machine, the applicable interest rate, and the reduced yearly costs of operation of the new machine. Using net present value analysis, the company determines the optimum time to make the switch (a real option). A hurricane forces a switch to occur earlier than would have been optimal under a price and profit motive. The hurricane therefore created a different path for growth. The creative destruction would have occurred, but on a different, more optimal, timeline.

The same conclusions can also be drawn from manmade disasters. Contrary to what many Keynesian economists would have you believe, WWII did not grow the US out of the great depression. Capitalism did!

Frank Hollenbeck teaches finance and economics at the International University of Geneva. He has previously held positions as a Senior Economist at the State Department, Chief Economist at Caterpillar Overseas, and as an Associate Director of a Swiss private bank. See Frank Hollenbeck’s article archives.

This article was published on Mises.org and may be freely distributed, subject to a Creative Commons Attribution United States License, which requires that credit be given to the author.

Hacking Law and Governance with Startup Cities: How Innovation Can Fix Our Social Tech – Article by Zachary Caceres

Hacking Law and Governance with Startup Cities: How Innovation Can Fix Our Social Tech – Article by Zachary Caceres

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The New Renaissance Hat
Zachary Caceres
July 16, 2013
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Outside of Stockholm, vandals and vines have taken over Eastman Kodak’s massive factories. The buildings are cold metal husks, slowly falling down and surrendering to nature.  The walls are covered in colorful (and sometimes vulgar) spray paint. In the words of one graffiti artist: It’s “a Kodak moment.”

After its founding in 1888, Eastman Kodak became the uncontested champion of photography for almost a century. But in early 2012, the once $30-billion company with over 140,000 employees filed for bankruptcy.

Kodak was the victim of innovation—a process that economist Joseph Schumpeter called “the gales of creative destruction.” Kodak could dominate the market only so long as a better, stable alternative to its services didn’t exist. Once that alternative—digital photography—had been created, Kodak’s fate was sealed. The camera giant slowly lost market share to upstarts like Sony and Nikon until suddenly “everyone” needed a digital camera and Kodaks were headed to antique shows.

How does this happen? Christian Sandström, a technologist from the Ratio Institute in Sweden, argues that most major innovation follows a common path.

From Fringe Markets to the Mainstream

Disruptive technologies start in “fringe markets,” and they’re usually worse in almost every way. Early digital cameras were bulky, expensive, heavy, and made low-quality pictures. But an innovation has some advantage over the dominant technology: for digital cameras it was the convenience of avoiding film. This advantage allows the innovation to serve a niche market. A tiny group of early adopters is mostly ignored by an established firm like Kodak because the dominant technology controls the mass market.

But the new technology doesn’t remain on the fringe forever. Eventually its performance improves and suddenly it rivals the leading technology. Digital cameras already dispensed with the need to hassle with film; in time, they became capable of higher resolution than film cameras, easier to use, and cheaper. Kodak pivoted and tried to enter the digital market, but it was too late. The innovation sweeps through the market and the dominant firm drowns beneath the waves of technological change.

Disruptive innovation makes the world better by challenging monopolies like Kodak. It churns through nearly every market except for one: law and governance.

Social Technology

British Common law, parliamentary democracy, the gold standard: It may seem strange to call these “technologies.” But W. Brian Arthur, a Santa Fe Institute economist and author of The Nature of Technology, suggests that they are. “Business organizations, legal systems, monetary systems, and contracts…” he writes, “… all share the properties of technology.”

Technologies harness some phenomenon toward a purpose. Although we may feel that technologies should harness something physical, like electrons or radio waves, law and governance systems harness behavioral and social phenomena instead. So one might call British common law or Parliamentary democracy “social technologies.”

Innovation in “social tech” might still seem like a stretch. But people also once took Kodak’s near-total control of photography for granted (in some countries, the word for “camera” is “Kodak”). But after disruptive innovation occurs, it seems obvious that Kodak was inferior and that the change was good. Our legal and political systems, as technologies, are just as open to disruptive innovation. It’s easy to take our social techs for granted because the market for law and governance is so rarely disrupted by innovations.

To understand how we might create disruptive innovation in law and governance, we first need to find, like Nikon did to Kodak, an area where the dominant technologies can be improved.

Where Today’s Social Techs Fail

Around the world, law and governance systems fail to provide their markets with countless services. In many developing countries, most of the population lives outside the law.

Their businesses cannot be registered. Their contracts can’t be taken to court. They cannot get permission to build a house. Many live in constant fear and danger since their governance systems cannot even provide basic security. The ability to start a legal business, to build a home, to go school, to live in safe community—all of these “functions” of social technologies are missing for billions of people.

These failures of social technology create widespread poverty and violence. Businesses that succeed do so because they’re run by cronies of the powerful and are protected from competition by the legal system. The networks of cooperation necessary for economic growth cannot form in such restrictive environments. The poor cannot become entrepreneurs without legal tools. Innovations never reach the market. Dominant firms and technologies go unchallenged by upstarts.

Here’s our niche market.

If we could find a better way to provide one or some of these services (even if we couldn’t provide everything better than the dominant political system), we might find ourselves in the position of Nikon before Kodak’s collapse. We could leverage our niche market into something much bigger.

Hacking Law and Governance with Startup Cities

A growing movement around the world to build new communities offers ways to hack our current social tech. A host nation creates multiple, small jurisdictions with new, independent law and governance. Citizens are free to immigrate to any jurisdiction of their choosing. Like any new technology, these startup cities compete to provide new and better functions—in this case, to provide citizens with services they want and need.

One new zone hosting a startup city might pioneer different environmental law or tax policy. Another may offer a custom-tailored regulatory environment for finance or universities. Still another may try a new model for funding social services.

Startup cities are a powerful alternative to risky, difficult, and politically improbable national reform. Startup cities are like low-cost prototypes for new social techs. Good social techs pioneered by startup cities can be brought into the national system.

But if bad social techs lead a zone to fail, we don’t gamble the entire nation’s livelihood. People can easily exit a startup city—effectively putting the project “out of business.” If a nation chooses to use private capital for infrastructure or other services, taxpayers can be protected from getting stuck with the bill for someone’s bad idea. Startup cities also enhance the democratic voice of citizens by giving them the power of exit.

Looking at our niche market, a startup city in a developing nation could offer streamlined incorporation laws and credible courts for poor citizens who want to become entrepreneurs. Another project could focus on building safe places for commerce and homes by piloting police and security reform. In reality, many of these functions could (and should) be combined into a single startup city project.

Like any good tech startup, startup cities would be small and agile at first. They will not be able to rival many things that dominant law and governance systems provide. But as long as people are free to enter and exit, startup cities will grow and improve over time. What began as a small, unimpressive idea to serve a niche market can blossom into a paradigm shift in social technologies.

Several countries have already begun developing startup city projects, and many others are considering them. The early stages of this movement will almost certainly be as unimpressive as the bulky, toy-like early digital cameras. Farsighted nations will invest wisely in developing their own disruptive social techs, pioneered in startup cities. Other nations—probably rich and established ones—will ignore these “niche market reforms” around the developing world. And they just might end up like Kodak—outcompeted by new social techs developed in poor and desperate nations.

The hacker finds vulnerabilities in dominant technology and uses them to create something new. In a sense, all disruptive innovation is hacking, since it relies on a niche—a crack in the armor—of the reigning tech. Our law and governance systems are no different. Startup cities are disruptive innovation in social tech. Their future is just beginning, but one need only remember the fate of Kodak—that monolithic, unstoppable monopolist—to see a world of possibility.

Those interested in learning more about the growing startup cities movement should visit startupcities.org or contact startupcities@ufm.edu.

Zachary Caceres is CIO of Startup Cities Institute and editor of Radical Social Entrepreneurs.

This article was originally published by The Foundation for Economic Education.