Just a brief message from the front of Hurricane Gustav today. Gustav did not strike a direct blow to New Orleans the same way that Katrina did, but the effects are similarly dramatic. While New Orleans did not flood with Gustav as with Katrina (only because the winds came from a slightly different direction), New Orleans is still without sewage and electricity services. Gustav sat on top of Baton Rouge as a category two storm, the worst in Baton Rouge history. The entire south-Louisiana region is essentially removed from the national electricity grid, with all but one of the regional high-tension transmission lines down due to the storm. Best estimates of restoring services have ranged from “three to four weeks.”
Estimates of economic losses due to business disruptions for tourism, chemicals, oil refining and extraction, and other industries are in the $35 billion range. Preliminary estimates of property insurance claims are about $10 billion. Estimates of personal outlays for refugee shelter in hotels and motels hundreds of miles outside New Orleans will only add to those figures. Adding Gustav to the losses incurred in the Midwestern floods earlier in the summer therefore adds to a growing list of real shocks that currently affect economic growth.
The reason I note the effects of Gustav is that they are what economists call “real shocks” to economic performance, that is, shocks that directly influence production or productivity and cannot be avoided. Real shocks stand in contrast to “financial shocks,” which – while seemingly costly – merely reflect speculative losses or, at best, follow real losses elsewhere in the economy. Unlike financial shocks (including the bubble in housing prices) there is no avoiding real shocks, i.e., oil production and the mouth of the massive Mississippi River transport system can’t be moved elsewhere. Hence, economic policy, including both fiscal and monetary policy is best focused on remedying the effects of real shocks while regulation is relied upon to maintain incentive compatible rules that discipline the speculative behavior that causes financial shocks.
The distinction between real and financial shocks leads to one other important conclusion in macroeconomics: financial shocks, alone, rarely create real output declines, i.e., economic recession. Financial shocks, however, exacerbate real shocks to create business cycle persistence. Indeed, that is the risk the economy faces today: the risk that financial shocks of the credit crisis will constrain our ability to rebound quickly from real shocks. For instance, there will be less credit available to rebuild New Orleans and the surrounding area this time, so recovery (which was still incomplete, nonetheless) will be even more difficult.
The point is, therefore, is that we have the capacity to fix the credit crisis financial shocks currently buttressing the economy. Fixing the credit crisis will serve to restore economic growth potential by removing the current substantial susceptibility to real shocks. The longer we wait to change regulation and recognize the behaviors and losses that contributed to the crisis, the longer economic performance remains inordinately sensitive to the effect of significant real shocks that can cause significant recession.