Wealth of Nations September 2005

Katrina and the Economy: a Toxic Combination

Katrina is causing the budget deficit to explode while also inflicting a supply-side shock on the economy. This is an especially toxic combination.

Are there are any fiscal conservatives left in the Republican Party? If so, Katrina confronts them with quite a problem. The costs of supporting hurricane victims and reconstructing shattered cities are going to be vast. There is no point in trying to be precise about it: The final addition to public spending can be no more than a guess at this point. Congress has already authorized new spending of $62 billion. For the eventual total, $200 billion and up is being talked about. The figure seems believable.

Such a price tag, needless to say, would be stupendous in its own right. It would exceed spending on the war in Iraq (whose cost is mounting faster than once seemed likely even to independent analysts, let alone to optimists in the Bush administration). Think of post-Katrina support and reconstruction as a single public project; even allowing for inflation, it may prove to be the biggest such initiative the United States has ever undertaken.

It is way bigger than the inflation-adjusted cost of the Apollo program, for instance. Even the total cost of building the interstate highway system seems comparatively economical at $130 billion, according to estimates made in the early 1990s (and those outlays were spread out over more than 20 years). Holding the federal agencies that will manage the new post-Katrina spending accountable—securing good value for money when sums as large as this are involved—is going to be next to impossible.

And this is to say nothing of the macroeconomic implications. The sheer scale of the extra spending is one issue. Unless taxes are raised and spending in other areas is cut, the fiscal costs of Katrina will seriously inflate an already enormous budget deficit. Then, compounding that difficulty, comes the fact that Katrina has worsened the outlook for oil prices. The immediate post-hurricane spike has subsided, but for a while prices will be higher because of the storm than they would have been otherwise. Costlier petroleum, in turn, undermines American industry's capacity to supply goods. Therefore, Katrina is causing the budget to explode at the same time it is inflicting a supply-side shock on the economy. That is an especially toxic combination.

Higher spending or lower taxes—a loosening of fiscal policy, however achieved—would often be an appropriate response to an event that temporarily depressed demand in the economy. The trouble with a supply-side shock like Katrina is that it does not respond well to this standard treatment.

Weak demand ordinarily eases pressure on inflation, making room for an expansionary dose of easier fiscal policy or lower interest rates. Costlier petroleum, in contrast, means higher prices. That makes the Fed nervous about lowering interest rates—witness this week's quarter-point rise, Katrina notwithstanding. In these circumstances, looser fiscal policy, rather than stimulating the economy to produce more output, might simply worsen the excess of demand over supply in the oil market that caused oil prices to rise in the first place. What was intended to be a boost to output might mainly leak away in the form of even more expensive oil.

As most economists will tell you, one way or another, a "real" (that is, supply-side) shock like Katrina is going to lower living standards, and that consequence cannot be easily or safely suppressed with fiscal or monetary policy. The Fed appears to understand this. But the Bush administration apparently intends to cover the costs of Katrina by borrowing more, rather than by raising taxes or cutting other spending to a correspondingly large degree. In other words, it continues to believe that deficit spending is a free lunch that imposes no costs on the economy—and that the government, maintaining other programs and keeping taxes low throughout, can simply spend its way out of trouble.

This sounds too good to be true, and it is. Yes, deficit spending is often a good way to stabilize a turbulent economy, or to spread the cost of large investments over time—but those valuable services do not come free. And remember that Katrina has further tightened an already restricted supply of energy; in those circumstances, the stabilizing role of fiscal policy is severely compromised anyway.

Admittedly, fiscal hawks of left and right, inside and outside the government, have long been predicting economic retribution. At some point, they have argued, the cost of all this will present itself, most likely in the form of a steep fall in the dollar, a spike in actual and expected inflation, higher interest rates, personal and corporate financial distress, and maybe an outright recession. To the extent that the White House has ever listened to such predictions, it has merely smiled condescendingly. This has been going on for years, officials point out. Why should it ever stop?

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