Economic trends - Uneasy at the Big Easy

Hurricane Katrina's aftermath will test the US economy's resilience in several ways, writes Yorgos Papatheodorou.

At 6:15am, on Monday 29 August, Hurricane Katrina roared on shore.

Its 145mph winds were only marginally below the cutoff point for a category 5, the strongest possible. At the last moment, the eye of the storm jogged to the east, sparing the city of New Orleans a direct hit, inundating the shore of the state of Mississippi with 18ft waves instead. The destruction was horrific, and the immediate death toll rose to over 100. But the drama was far from over for New Orleans, a city surrounded by water on all sides and built largely below sea level.

First, storm surges from lakes Pontchartrain and Borgne overtopped the levees (floodwalls). Then a rogue barge and flood erosion massively breached two of them. By Tuesday morning almost the entire city was flooded with a foul stew of brackish water, raw sewage, oil and toxic chemicals. Tens of thousands of people who could not or would not evacuate before the hurricane found themselves marooned, without electricity, water, health and police services. The scenes of lawlessness and despair, rooftop rescues and evacuations played out on television screens all over the world.

Economic fallout

The political firestorm raging about what could have been done to prepare better and respond faster could provide fodder for many articles. Instead, this article will focus on the economic fallout from the disaster. The scale of destruction boggles the mind. An area about the size of Great Britain has been affected. A million people are displaced. Over $100bn (£55bn) worth of property has been destroyed or damaged. Incredibly, more than two weeks after the hurricane the number of dead is still unknown: numbers stand at about 500 at the time of writing, but could swell to several thousand. By now the levee breaches have been plugged, and New Orleans is being slowly pumped out, revealing layers of reeking mud, corpses and unimaginable amounts of debris.

How will all this affect the US economy? Will it even cause a recession?

The tentative answer to the last question, based on the consensus of economists from the National Association for Business Economics (of which I am a director) is 'probably not'. Natural disasters do cause large-scale destruction to property and disruption to economic activity. The former, however, affects net domestic product in national accounting terms, not GDP. The latter normally causes a smallish dip in GDP, which is then erased by reconstruction spending. Still, Katrina's aftermath will test the US economy's resilience in several ways, and it does increase the downside risks to the economy.

On the property destruction side, it is too early to arrive at accurate numbers, but estimates hover around $100bn. Roughly half of that is private homes, $30bn is businesses, and $20bn is government infrastructure. About $25bn (although at the time of going to press this was being revised upwards to $40bn) of the total is insured losses, making Katrina the most expensive natural disaster ever for the insurance and re-insurance industry, which was already hit by a very costly 2004. While the numbers are massive, accumulated profits and provisions are believed to be enough not to cause immediate trouble. Federal, state and local governments, plus charities are expected to pick up the tab for roughly another $35bn of destruction.

The other $40bn or so will probably burden the owners involved.

On the disruption to GDP side, the early estimates are for about $25bn in direct impact, with four-fifths of that in the affected states. The effect of higher fuel prices attributed to Katrina could be at least double that. Large-scale disruption of energy infrastructure, the immense port of New Orleans and vital Mississippi river shipping could add to the economic damage. And the knock-on effects on consumer confidence and spending are very hard to predict.

Early consensus estimates expect slower GDP growth (by 1.5% in Q3 and 1% in Q4). By the time these fade, the effect of reconstruction spending will stimulate GDP. Overall, GDP growth forecasts for 2005 are being revised down and those for 2006 are being revised up, with both below 3.5%.

Energy shock

The most significant downside risk to the US economy comes from the Katrina-induced energy shock. At a time of oil prices driven high by strong global demand, Katrina forced the shutdown of over 90% of oil production and about 50% of gas production in the Gulf of Mexico. Soon after, 26 platforms were missing and 20-odd damaged, and most were inoperable due to lack of workers. Eight of the largest refineries in the US were in the path of the hurricane, and were shut down.

Still, the oil industry proved itself impressively efficient, and much of the refining capacity was on line within two weeks, after power was restored and tent cities erected for the now homeless workers. The massive Louisiana Offshore Oil Port was up and running within days. Most on-shore pipelines likewise did not suffer too much damage and were operational quickly, easing fears of petrol shortages. The big unknown is the 33,000 miles of underwater pipelines that crisscross the sea floor just off the Mississippi delta, directly in Katrina's path: damage assessments are still being done.

The effect of Katrina on oil and petrol prices has so far been less than feared, and spikes have since moderated. Still, prices will stay high for several months. It is well known that the short-term price elasticity of fuel is low: it takes a long time for driving habits to change and gas-guzzling vehicles to be retired. High fuel prices are already affecting consumption, and will reduce private saving even further. High heating oil prices will hit north-eastern states hard this winter. Core inflation is starting to rise. At a time of massive indebtedness and a slowing housing market, risks are mounting.

Other risks have to do with disruptions in shipping. The Mississippi is clogged with debris. With the autumn grain harvest in the Great Plains drawing near, there are fears that American agriculture will be hurt.

However, it appears that the great commercial waterway may be close to handling normal traffic sooner rather than later, and the New Orleans port has already reopened one of its container terminals. As with energy, by all accounts the great commercial machine is swinging into motion faster than official disaster response.

Cost of reconstruction

What will happen to the devastated areas, and what will reconstruction cost? Those are the hardest questions. New Orleans needs to be there, to run the ports and oil terminals and refineries. But it has been a disaster waiting to happen for almost 300 years. Many displaced people are poor, underemployed and uninsured, and may not have much of an incentive to return and rebuild. Already, tens of thousands of them are renting apartments and taking jobs in other parts of Louisiana, Texas and beyond.

Perhaps much of the city will be razed, with new housing built above sea level, and with the historic centre restored. But perhaps not: Congress and the president may decide to rebuild and improve everything, including the levee and pumping system that failed to protect the city. Environmental cleanup promises to be a gargantuan job too. Whatever happens, $150bn or more may be added to the federal budget deficit. But that is another story.

Yorgos Papatheodorou is chief economist and manager of strategic and market development with Lockwood Greene, a US-based engineering and construction company. It is a wholly-owned subsidiary of CH2M HILL. The author's views are his own.

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