Endogenous Business Cycles and the Economic Response to Natural Disasters

1
Endogenous Business Cycles and theEconomic
Response to Natural Disasters

• Stéphane Hallegatte
• ENM, Toulouse and CIRED, Paris
• With M. Ghil, P. Dumas, J.-C. Hourcade

2
Business cycles and extreme events interactions

• Business cycles are interesting on their own
  
• For extreme events consequences, one have to take
  into account preexisting economic situation,
  including disequilibriums

3
Part IEndogenous business cycles
4
The  real cycle theory

• From Slutsky (1927) and Frisch (1933)?
• First proposed by Kydland and Prescott (1982)?
• Business cycles and economic fluctuations arise
  from exogenous shocks
• Changes in productivity
• Changes in energy prices
• Fiscal shocks
• Aside from these exogenous shocks, the economic
  system is stable

5
What does RBC theory assume ?

• Perfect markets questionable, especially for
  labor market over a few quarters
• No non-voluntary unemployment
• Rational expectations
• No role of quantities (e.g. aggregated demand)?
• (contrary to observations Gali, 1999, 2004)?
• Link with observable productivity shocks ?

6
Endogenous business cyclesan alternative to
real business cycles?

• In EBC models, cyclical behavior originates from
  endogenous instabilities in the economic system
  
• It does not mean that exogenous shocks do not
  play any role in economic fluctuations

7
NEDyM (Non-equilibrium Dynamic Model)

• Represents an economy with one producer, one
  consumer, one good to consume and invest.
• Developed from the Solow (1956) model, all
  equilibrium constraints are replaced by dynamic
  relationships with adjustment delays
• NEDyM equilibrium is neo-classical and identical
  to the Solow models one.
• Because of market adjustment delays, NEDyM
  dynamics exhibit keynesian features along
  transients trajectory in response to shocks.

8
(No Transcript)
9
(No Transcript)
10
(No Transcript)
11
Distribution between physical investments and
dividends

• Managerial regime (Berle and Means, 1932)
• the producer invests in all projects, up to a
  fixed level of profitability.
• The remaining part of available liquidities are
  redistributed.

12
?inv 1.7
?inv 2.5
13
?inv 10
?inv 20
14
Hopf bifurcation from stable equilibrium, to
limit cycle, to chaotic behavior
15
Endogenous dynamics an alternative explanation
for business cycles
16
Interpretation of the instability

• Business cycles originate from the
  profit-investment relationship. Oscillations
  with a 5.5-year period.
• higher profits gt more investment gt more demand gt
  higher profits
• Business cycles constrained by 3 processes
• Increase in labor costs when employment is high
• Constraints in production and inflation in goods
  prices when demand increases too rapidly
• Financial constraints on investment
• A small additional instability arises from the
  interaction of labor market and goods inventory
  (oscillations with a 300-day period)?

17
Endogenous dynamics an alternative explanation
for business cycles

• Harrod (1939) differences between population
  growth and labor demand causes unstability
• Solow (1956) capital/labor substitution makes
  economy stable
• even with capital/labor substitution
  (Cobb-Douglas production function),
• even with neoclassical equilibrium,
• adjustment delays in markets (goods, labor,
  capital) can cause endogenous economic
  fluctuations, without exogenous shocks
• Good ability to reproduce some stylized facts
  cycle period, cycle asymmetry, variable
  correlations (e.g. output and inflation)?

18
Main flaw in the model business cycle the
amplitude of price oscillations
19
Correction accounting for quantities in
behavioral equations (Gali, 1999, 2004)?
20
Part II The economic consequences ofextreme
events
21
Why to look at extreme eventsin the context of
climate change?

• Natural disasters are an important part of the
  climate change issue
• Because of natural variability, climate change
  might appear more through changes in the
  distribution of extremes than through changes in
  mean conditions.
• Because mild changes in means can lead to large
  changes in extremes and because the cost of
  extremes is strongly non-linear with respect to
  their intensity

22
Extreme events cannot be averaged

• Some economic models take natural disaster costs
  into account through decreases in mean
  productivity.
• But natural disasters are rather a series of
  shocks that destroy productive capital.
• This is equivalent only if the impact of
  disasters can be averaged over long periods,
  i.e., if impacts are linear, which is not the
  case.

23
How to look at extreme events?

• If disasters are modeled through capital
  destructions
• Using long-term growth model is impossible
  development of a disequilibrium model of economic
  growth (NEDyM model)?
• Using a classical production function leads to
  underestimated impacts on production (because of
  decreasing returns)?
• Accounting for financial and technical
  constraints on the reconstruction pace is
  necessary to reproduce the observed response to
  past disasters over the short-term.

24
Using a classical production function would
introduce a bias
Decreasing returns ? when labor is fixed, capital
is less and less efficient, because the most
efficient investments are realized first If x
of capital is destroyed, production is reduced by
less than x
25
A modified production function

• Investing less is not equivalent to having some
  productive capital destroyed by a disaster
• We introduce
• K0 potential capital (no disaster)?
• ?K portion of destroyed capital
• Effective capital K (1-?K) K0
• Modified production function
• Y (1-?K) AL?K0(1-?)?
• With this function, when x of productive capital
  is destroyed,
• production is reduced by x

26
Modeling short-term constraints

• Without taking into account short-term
  constraints reconstruction is carried out in a
  couple of month, even for large-scale events
• At odds with observations (1999 winter storm over
  France, 2002 floods in central Europe, Katrina)?
• Technical constraints
• availability of qualified workers, reconstruction
  organization, on-site accomodation of workers,
  material transportation and availability
• Financial constraints (mostly developing
  countries)
• We introduced a limitation of reconstruction
  investments at fmax percent of total investments
  (calibrated on the length of the reconstruction
  period)
• Ir lt fmax I

27
Long-term consequences on economic growth
Here also, the average loss depends on the event
characteristics and on reconstruction capacity
28
Long-term consequences on economic growth
Natural disasters and bifurcation in losses
From Hallegatte et al. (2007, Ecological
Economics)?
Index of disaster frequency and intensity
Index of reconstruction capacity
The impact of a series of events is not the sum
of the event impacts.
29
A macroeconomic feedback ?Interaction between
intrinsic dynamics and shocks
Recession
Expansion
From Hallegatte and Ghil (2007)?
30
A macroeconomic feedback ? Interaction between
intrinsic dynamics and shocks
Recession
Expansion
Limited losses if the disaster affects an economy
in recession
From Hallegatte and Ghil (2007)?
31
A macroeconomic feedback ? Interaction between
intrinsic dynamics and shocks
Recession
Expansion
Large losses if the disaster affects an economy
in expansion
A vulnerability paradox growing economies are
more vulnerable !
From Hallegatte and Ghil (2007)?
32
Variability and vulnerability
The cost of the current distribution of natural
disasters strongly depends on economic
characteristics.
33
Long-term consequences on economic growth
 positive feedback and poverty traps
Limited reconstruction capacity
Long reconstruction period after each disaster
 Positive  feedback
Limited economic development
Possibility of poverty trap
Large cost of natural disasters
Impossibility to increase the infrastructure and
capital stocks
Disasters can be a significant obstacle to
economic growth and development