WHAT is the economic significance of Hurricane Katrina? Politically it may be the biggest event since 9/11 but its economic impact is likely to be smaller, at least in the US. Oddly, the economic effects will probably be worst outside America, especially in the eurozone.
In making this prediction, I know that I may be accused of an obsessive europhobia, so let me begin by saying that the events in New Orleans have epitomised everything most abhorrent about an American dream that has turned to nightmare since George W. Bush came to power. Let me add, for those who still believe I am prejudiced against the European social model, that the chaos, violence, greed and brutal social Darwinism we see broadcast from New Orleans remind us of the virtues of the post-war European social model that successfully instilled the virtues of social solidarity, equality, stability and orderly government into what had, until the 1950s, been the most violent and anarchic continent on earth.
Why, then, am I confident that Katrina will do very little damage to the US economy, while it poses a serious threat to Europe? Starting with the US, a powerful economy with annual output worth over $11 trillion (£6 trillion), growing at 3 to 4 per cent, locked through free trade and deregulated financial markets into a global economy that produces at a $50 trillion annual rate, will hardly miss a beat from the $50 billion losses estimated along the Gulf Coast.
Of course, there will be a modest slowdown this quarter, resulting from lost production and consumption in the region. But these losses will soon be recouped by faster growth. The possibility of slightly lower than expected interest rates combines with the certainty of a surge in spending on reconstruction, military preparedness and flood defences in other cities.
With tax increases out of the question to pay for what may be a $100 billion increase in public spending, the US budget deficit, which has been shrinking, will probably start expanding and there could be a substantial Keynesian stimulus to next year’s US growth, employment and consumption.
Higher oil prices are likely to have only a minimal impact on macroeconomic activity in the US. Experience suggests that the cost of higher oil prices will be largely offset by the benefit from ever-cheaper goods imported from China. Moreover, the Federal Reserve Board strips energy prices out of its calculations of core inflation. Thus there is no risk that US monetary policy might be damagingly tightened by over-zealous central bankers in a panic response to soaring oil prices.
The previous sentence suggests the first reason for greater concern about the prospects for the eurozone. Although the European Central Bank suggested last week that it did not see an inflationary threat from temporary shortages of oil, it continues to include energy prices in its main indicators of inflation, leaving its monetary policy hostage to shocks such as Hurricane Katrina, September 11 and the Iraq war. Unfortunately this is a euro-practice adopted by the Bank of England, to the detriment of the British economy, as explained on this page two weeks ago.
There are, however, much graver reasons for concern about the impact of Katrina on Europe, not only in the next few months but for years ahead. These stem from the fact that Katrina struck at the most sensitive possible moment in Europe’s political and economic cycles. Economically, the eurozone is balanced on a knife-edge between recovery and renewed recession. Politically it is teetering between pro-market transformation, especially if the conservatives win the election in Germany in a fortnight, and a return to protectionism and statism under the influence of the French and Italian political establishments represented by Jacques Chirac and Romano Prodi.
This first serious risk to Europe is that the shocking scenes from New Orleans will trigger a backlash in the German elections against the perceived anarchy and brutality of the “Anglo-Saxon social model”. Just as German voters unexpectedly rewarded Gerhard Schröder with an election victory three years ago because of his opposition to America and his efficient and energetic response to the North German flooding, it is conceivable that the electorate will turn against pro-market and pro-American politicians, because of the incompetence and lassitude of President Bush.
The second danger is that Europe will suffer a temporary economic setback due to higher oil prices and a loss of consumer confidence but, unlike the Fed and the Bush Administration, the ECB and European governments will refuse to offset this temporary setback with an easier monetary and fiscal policy. This is essentially what happened after previous temporary shocks emanating from America — the dot-com crash, terror attacks and corporate scandals on Wall Street — all of which ended up hurting Europe much more than the US.
A failure of European stabilisation policy in the next few months would then blight long-term hopes of structural improvements across Europe, even if a pro-market coalition did win the German election.
The fact is that structural reforms, especially in the labour market, tend initially to weaken growth and exacerbate unemployment and that makes them almost impossible to implement during a period of recession or low growth. This was the experience of Britain under Margaret Thatcher, who carefully waited until the economy was recovering strongly before attempting any of her most controversial reforms: the confrontation with the miners, the changes in labour legislation and the privatisation programme did not start until 1984, by which time the British economy was enjoying almost 4 per cent growth.
This lesson from British experience — that major structural reform is likelier to occur in a rapidly growing economy with active management of monetary demand — appears to be confirmed by a recent OECD study, which tried to assess the interaction between reform processes and the constraints of European monetary union. While the econometric research could not reach a firm conclusion, the balance of evidence indicated that “absence of monetary autonomy seems to be associated with lower reform activity”.
The symbiotic relationship between liberal economic reforms and US-style monetary stimulus is a point that nobody in Europe, and especially in Germany, seems to understand. From this point of view, the scariest economic news last week did not come from New Orleans but from Germany, where the conservative candidate for Finance Minister said: “Experience so far with the European Central Bank has been excellent. I would not change anything there.”
