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?

It is a fair question. Actually, it will stop, it must stop: Present fiscal trends are literally incapable of continuing indefinitely. The question is whether the pattern will break gently and over an extended period, or violently and suddenly. Will it be a Category 1 economic adjustment, or a Category 5? Confronting a risk of this sort, as with hurricanes, it makes sense to follow the old advice to hope for the best and plan for the worst.

But why, you might ask, must there be any such adjustment? Why can't the trends just roll on perpetually? Mainly because of the implications for the country's external finances. This week, the Institute for International Economics published a detailed new study by William R. Cline, "The United States as a Debtor Nation." It is the most thorough and up-to-date look at the issue. Cline's analysis is alarming enough, even though Katrina came too late to be taken fully into account. It is to be hoped that somebody with influence in Washington is paying attention.

Cline shows that, even before Katrina, the United States was on an unsustainable track. Without reductions in the budget deficit and a further depreciation of the dollar, he estimates that the country's external deficit would rise to $1.2 trillion, or 7.5 percent of gross domestic product, by the end of this decade. By then, America's net liabilities to foreigners would be $8 trillion, equivalent to 50 percent of GDP. To make matters worse, this deficit is no longer, as it was in the 1990s, chiefly the counterpart of an inflow of private investment (which improves the economy's capacity to service overseas debt). Today, with the household savings rate at zero, the external deficit is mainly paying for personal consumption and the government's budget deficit—neither of which is making the economy stronger.

If this went on for another 20 years, by 2024 the country's current-account deficit would be 14 percent of GDP, and its net foreign debt would be 135 percent of GDP. Such numbers are unprecedented and virtually inconceivable: Long before those records were racked up, foreign investors would have begun to seek higher returns from their investments in America. And that would require either a fall in the dollar so steep that the currency is expected to appreciate henceforth, or higher interest rates, or both.

As a player in the global capital markets, Cline notes, the United States has some great advantages—earned and unearned—which have allowed the twin deficits to grow so large without significant penalty up to now.

First, America is able to borrow enormous sums in the world's favorite currency, its own. One consequence is that a devaluation does not increase the country's debts, as it would for most heavy borrowers overseas, because America also holds foreign-currency assets. Second, American investors abroad appear to get a consistently higher return than foreign investors in America. Since the stock of investment is about the same on both sides—roughly $3 trillion—America's net capital income is still in (modest and declining) surplus. These are reasons why the crunch has so far been avoided; they are not reasons to think it will never come.

Cline is no alarmist. He reckons that a hard landing is, even now, not the likeliest outcome—but the risk of a Category 5 event keeps growing as the deficits continue to widen, and they have certainly increased as a result of Katrina.

How to reduce that risk? First, says Cline, seek and encourage a further depreciation of the dollar, especially against Asian currencies (not just China, but also Hong Kong, Malaysia, Singapore, and Taiwan). Some kind of coordinated exchange-rate realignment, presumably organized around a big appreciation of China's renminbi, he argues, might be needed to overcome the reluctance of the governments concerned. Second—and this is for America itself to deal with—curb the federal budget deficit. Before Katrina, the deficit was on track to reach more than 3 percent of GDP for the rest of this decade and beyond. Cline calls for a program to eliminate it by 2010.

New Orleans could tell you that mitigating needless risks is good policy. Call it the wisdom of foresight.

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