Natural disasters can strike anywhere, but the heart-wrenching tragedy unfolding in Japan may be unique for modern times, at least economically. In todayâ€™s post, we focus on what makes last weekâ€™s earthquake and tsunami so different from other natural disasters and why they have put Japanâ€™s economy at real risk. Later this week, we will lay out the implications for the rest of us, especially the economic aftershocks poised to hit the United States and China.
As a rule, natural disasters in advanced countries, like terrorist attacks, inflict enormous economic costs on the specific places where they occur, but with little if any serious damage to the nationâ€™s economy as a whole. When Katrina crippled New Orleans in August 2005 and exacted $81 billion in property damages on Louisiana and Mississippi, it didnâ€™t puncture investment or growth in the rest of the country. For a natural disaster to upend an economy, the damage has to touch most of the nation and endure for a considerable time. Those conditions normally occur only in small countries, especially small developing nations that depend heavily on foreign investment. What makes the terrible Japanese earthquake and tsunami uniquely destructive to that countryâ€™s large, advanced economy is that they could result in disabling a significant part of the nationâ€™s power grid for months and, even worse, spread dangerous radiation across many of the countryâ€™s agricultural, industrial and population centers.
To be sure, major natural disasters always have significant local and distributional effects. Katrina depressed parts of the Gulf state economies for several years, and tens of thousands of people fled Louisiana for nearby states, especially Texas. In addition, the temporary closure of the port at New Orleans reduced U.S. exports for several months. But the real losses were confined to the immediate region. And while the terrible human and property costs shook most Americans, their empathy didnâ€™t dampen investment or household spending anywhere else in the country. In fact, two months after Katrina struck, the fourth quarter of 2005 saw the strongest GDP gains of the entire decade.
The same dynamics were evident after the 9/11 attacks, which hit lower Manhattan like an earthquake. There were large, temporary distributional effects. For example, the attacks devastated real estate prices and rents in downtown Manhattan, but they boosted the real estate market for midtown. The attacks certainly shook most Americans psychologically; and when millions of people canceled planned trips for the coming months, it depressed airlines, hotels and other travel services. But the money that people saved by skipping their vacations went instead to buy large screen TVs and SUVs. And the Federal Reserve responded to the attacks by cutting interest rates, boosting interest-sensitive industries from capital equipment to housing. Just like Katrina, then, 9/11 had no adverse effects on the national economy. In fact, investment and consumer spending in the quarter following the attacks, October-November-December of 2001, were stronger than any quarter for two years before and after.
Unlike such localized catastrophes, the recent earthquake and tsunami will likely inflict enormous damages across Japan, and for some time to come. The issue here is not the terrible, immediate losses of life and property in the countryâ€™s northern shoreline towns and cities. The damage done to the countryâ€™s power grid will extend the economic costs far beyond the communities directly devastated by the disasters, slowing agricultural and industrial activity across up to one-third of the country. And for these losses, there will be no offsetting gains from reconstruction. Even more frightening, the radiation released by the ongoing meltdowns at nuclear power facilities could bring economic activity to a halt in much more of the country.
Other national economic effects are beginning to be felt across Japanâ€™s already fragile economy. Japanese investors are cashing out much of their large holdings of dollar and Euro-denominated financial assets, converting them to yen, and bringing those yen back home. The result has been a large boost for the yenâ€™s value, dealing an additional blow to Japanâ€™s export companies. Those same companies also are beginning to cut back their foreign production, because many of critical parts for Japanese automobiles and electronics are still made in factories closed down by the disaster and electricity problems.
The disaster and its aftermath also are quickly driving up Japanâ€™s budget deficit and national debt, which already were at dangerous levels following a decade of economic stagnation punctuated by the 2008 â€“ 2009 financial meltdown and subsequent deep recession. As Japanâ€™s economic outlook deteriorates, and its domestic savings fall with incomes and earnings, international investors will likely pull back. All of this could raise serious doubts about the viability of Japanese sovereign debt, pushing up interest rates and possibly triggering a run on the yen and a dangerous downward spiral.
As terrible as these dislocations will be for Japan, the worldâ€™s third largest economy, theyâ€™re not enough to derail the current global expansion. Even so, serious economic aftershocks will be felt soon beyond Japan, especially in the United States and China. Later this week, we will examine the potential damage to the American and Chinese economies from the horrific disaster in Japan.