Are Losses from Natural Disasters More Than Just Asset Losses?

Abstract

The welfare impact of a natural disaster depends on its effect on consumption, not only on the direct asset losses and human losses that are usually estimated and reported after disasters. This chapter proposes a framework to assess disaster-related consumption losses, starting from an estimate of the asset losses, and leading to the following findings. First, output losses after a disaster destroys part of the capital stock are better estimated by using the average—not the marginal—productivity of capital. A model that describes capital in the economy as a single homogeneous stock would systematically underestimate disaster output losses, compared with a model that tracks capital in different sectors with limited reallocation options. Second, the net present value of disaster-caused consumption losses decreases when reconstruction is accelerated. With standard parameters, discounted consumption losses are only 10% larger than asset losses if reconstruction is completed in 1 year, compared with 50% if reconstruction takes 10 years. Third, for disasters of similar magnitude, consumption losses are expected to be lower where the productivity of capital is higher, such as in capital-scarce developing countries. This mechanism may partly compensate for the many other factors that make poor countries and poor people more vulnerable to disasters.

Appendix: Price Impacts and the Cost of Reconstruction

The equality of asset value and output is valid only for marginal changes, i.e. for small shocks that do not affect the structure of the economy and the relative prices of different goods and services. The impact is different for large shocks. Such non-marginal shocks affect prices, while asset and output losses are often estimated assuming unchanged (pre-disaster) prices (e.g., assuming that if a house is destroyed, the family who owns the house can rent another house at the pre-disaster price). But this assumption is unrealistic if the disaster causes more than a small shock. In post-disaster situations, indeed, a significant fraction of houses may be destroyed, leading to changes in the relative price structure. In this case, the price of alternative housing can be much higher than the pre-disaster price, as a consequence of the disaster-related scarcity in the housing market.¹¹

For large shocks, estimating the value of lost output service should take into account the price change. Compared with an assessment based on the pre-disaster prices, it can lead to a significant increase in the assessed disaster cost.

Post-disaster price is especially sensible in the construction sector, which sees final demand soar after a disaster. For instance, Fig. 2.3 shows the large increase in wages for roofers and carpenters in two areas heavily affected by hurricane losses in Florida in 2004. This inflation affects the replacement cost of capital and is referred to as “demand surge” in the insurance industry.

Fig. 2.3

Wages for qualified workers involved in the reconstruction process (roofer and carpenter), in two areas where losses have been significant after the 2004 hurricane season in Florida. Data from the Bureau of Labor Statistics, Occupational Employment Surveys in May 03, Nov 03, May 04, Nov 04, May 05, May 06, May 07

Post-disaster price inflation is often considered as resulting from unethical behavior from businesses, justifying anti-gouging legislation (e.g., Rapp 2005). But it also has positive consequences by supporting the optimal allocation of the remaining capital (e.g., housing) and by incentivizing quick reconstruction. This inflation, indeed, helps attract qualified workers where they are most needed and creates an incentive for all workers to work longer hours, therefore compensating for damaged assets and accelerating reconstruction. It is likely, for instance, that higher prices after hurricane landfalls are useful to make roofers from neighboring unaffected regions move to the landfall region, therefore increasing the local production capacity and reducing the reconstruction duration. Demand surge, as a consequence, may also reduce the total economic cost of a disaster, even though it increases its financial burden on the affected population.

In extreme cases, or where price adjustment is constrained by ethical considerations or anti-gouging regulations, there may be rationing, i.e. the price cannot clear the market and supply is not equal to demand: there is no available house for rent at any price, there is no qualified worker to repair a roof. In these situations, even using the post-disaster price underestimates the losses.