Australia`s flood crisis - an economist`s summary

The newspapers are full of comment on the horrific floods and their consequences.

Some of the commentary is just plain wrong, and therefore deserves rebuttal. It seems that Henry's self-appointed role as coach to Australia's financial journalists must continue for a bit yet, though there seems no obvious way to benefit from this. (Students rarely thank their teachers, as I learned when one of my tasks as a central banker was to answer questions of journos.)

Any full-time, professional economist, or talented amateur for that matter, who has a different view is encouraged to contact Henry hereto provide him with some education, if that seems warranted.

Point one is that these floods are indeed horrific, and the full human and other costs will never be counted in any balance sheet of losses and benefit. The costs are obvious, and have been fully documented on national and even international television and in newspapers everywhere. There is loss of life, immense damage to crops, stock and property and as the floods recede there will be threat of disease. Furthermore, if this summer continues to produce further heavy rain (as seems likely) there may be further episodes of flooding. All this greatly reduces Australia's wealth, and the loss of life is unmeasurable but immensely important and tangible to those affected.

I discuss "benefits" also, not because I am a hard-hearted economist, but because the disaster itself, and people's often heroic efforts to help others, are entirely positive if also immeasurable side effects of the carnage. This is why bombing a city rarely succeeds in having the desired effect, Hiroshima and Nagasaki's nuclear destruction being an important exception to this rule. There are potentially measurable benefits also, restoring water in dams, aquifers and some environmental sites, important outcomes in a generally dry continent.

The press generally says the costs will amount to 1 % or so of GDP. I can readily believe that costs to Australia might amount to 1 % (or more) of national wealth. As with other disasters, however, the costs of repairing the damage will mostly be added to GDP. Wealth is a stock and GDP is a flow and, with no cute pun intended, this is the key point that gets lost in the general commentary.

Costs to GDP will mainly occur in the first quarter of 2011, including lost exports (some of which will be made up) and lost domestic economic activity. There will be offsets from early clean-up efforts, but these count as "useful activity" only because of national accounting conventions.

When the clean-up begins, the considerable costs of personal exertion will mostly be ignored, but new materials, work done that is paid for and other items measured in official statistics will be allowed for. This will boost GDP in the official estimate, rather than reducing it.

Readers may think the point I am making is a pedantic one, but this is far from the truth of the matter. The Australian economy is not too far from conventional estimates of full employment. There have been many indicators of wage inflation. The additional efforts required to clean up Northern Australia will add to overall demand, and will divert attention from more routine matters. This addition to economic activity will increase pressures on wages as well as the prices of materials needed for reconstruction and repair. In any case there is already a steep hike in the prices of fresh fruit and vegetables.

While in principle "temporary", the period may not be all that short as new crops need to be planted and harvested. Also, as noted earlier this week, the effects of the rain on Australia's wheat crops and thus on the global market for grain are already evident and will increase whilever the rain keeps falling. One of the biggest effects of the flood crisis will be to increase inflation, only some part of which is "temporary" in any real sense. To their credit, Scott Murdoch and Tracy Lee get the inflation point right.

There will be benefits also in the reconstruction efforts. The housing stock and that of other buildings repaired or rebuilt will be newer, and presumably better. The disaster may have persuaded people to build in safer areas and governments may further flood-proof key roads and train lines in flood-prone areas. Like most of the costs, these balance sheet effects will mostly not be measured, but are real.

Many press reports say the costs of the catastrophe will mean the Reserve Bank will delay further rate hikes, on the assumption that the board of the bank is composed of compassionate people who take largely unmeasured wealth effects into account. I have to say that the main effects the RBA will take into account are real effects pushing the economy closer to full employment and raising inflationary pressures. That is, after all, what taxpayers have asked the RBA to do.