Thursday 5 September 2013

Broken Windows, Part II: Will a Disaster Rebuild Increase Capacity Utilisation?

Following on from yesterday’s post on the broken-windows fallacy, Miguel’s second point is that the broken windows fallacy rests on an assumption of full utilisation of resources (so that resources devoted to repairing damage from a natural disaster have an opportunity cost somewhere else). He notes:
We're clearly not in full employment now, and we weren't before the quakes, so what basis do we have for claiming that "all the resources now devoted to cleaning up and rebuilding would have been employed elsewhere"? My point is that economists are too content to simply make this assertion without actually demonstrating it.
I will concede that it will be extremely difficult to provide evidence, but that is not a cop out. Note that market economies are very good at utilising their resources. We tend to look at unemployment and see the cup as being 5%-10% empty, but it is also 90%-95% full. Employment is less than 1/6th the size in New Zealand as it is in Australia, but that has nothing to do with the tendency for natural disasters there compared to here. They have more population and so the market economy creates more jobs. We understand pretty well how coordination through price signals achieves this matching of jobs to available workers. What we don’t understand well is why capacity utilisation consistently falls short of 100% and why the utilisation rates fluctuate. We have plenty of plausible stories involving frictions, asymmetric information, expectations, monopoly power, sticky prices, etc. but it is likely that the relative importance of these factors is very dependent on time and place.

So yes, we know that we employment was not at 100% before or since the earthquakes, and that following the GFC, unemployment rates have been higher than before; but we don’t know exactly what determines those rates. We also know that the Reserve Bank monitors economic activity and adjusts policy to try to keep activity at the level consistent with stable inflation; we further know that New Zealand is not close to being in a low-interest-rate liquidity trap, the story often advanced for why monetary policy might not be effective.

With this backdrop, we can’t be sure that the rebuild from a disaster wouldn't result in a greater utilisation rate of resources, but nor can we be sure that it wouldn't result in a lower rate. The best guess, however, would be that rebuilds would be unrelated to whatever it is that results in utilisation rates of less than 100%, and so would have no effect.


  1. the other element as offset is that it is unlikely we replace like for like - even if the building is the same, it is likely that the new building has benefits that the old building does not have (even if just unexpired expected lifetime)

  2. Hi Seamus - thanks for taking the time to elaborate on this stuff. This second post has more bearing on my original point, which was that the broken window fallacy - a closed economy story - need not necessarily apply at the level of a small open economy. We're talking about a global pool of resources that can cross borders with varying degrees of ease. Even if we allow for 100% utilisation at a global level, the fact is that there are resources being diverted to NZ that would not have been in the absence of the quakes.

  3. Hi Miguel--I don't think having an open economy changes things. If resources to rebuild capital destroyed by a disaster come from outside of the country, they are either paid for by diverting internal resources to additional exports from production for local use, diverting imports from other uses to a rebuild, or come in the form of an increased trade deficit which implies an obligation to divert future internal resources to paying back principal and interest. Only if the resources from outside are paid for by the insurance liability being held overseas or through foreign aid, is there not an opportunity cost of local resources being diverted to fund a rebuild.

  4. "Only if the resources from outside are paid for by the insurance liability being held overseas" - and there's a big element of that. So I'm not really hearing that I'm on the wrong track here.

  5. No, not on the wrong track. But the discussion is about the sign of the effect and the magnitude. The broken-windows-are-good side would argue that disasters are a good thing because the resulting rebuild generates economic activity. The BW fallacy side argues that the wealth of a nation is its resources and how well they are used, not the income generated from them and that a disaster is bad because it destroys resources. Having some of those lost resources replaced from outside the country (and possibly replaced with newer and hence better capital) reduces the magnitude of that loss but doesn't change it into a gain.