One of the many layers of the evolving tragedy in Japan is that it illustrates how an exogenous shock can hit a nation’s economy.
The physical damage already is severe. Until the ongoing nuclear plant emergency is fully played out, however, it will be difficult even to speculate exactly how recent events will affect Japan’s economy and the world’s.
An exogenous shock refers to an event that can change the course of economic activity but that comes from outside the economic system itself, not the result of any economic system or policy.
For a half-century after John Maynard Keynes published his “General Theory of Employment, Interest and Money,” in 1936, many economists fixated on how government policies might counteract the business cycle of booms and busts or of inflation and unemployment. But a group of dissidents eventually argued such Keynesian policies were doomed to failure. Moreover, they argued, the important questions were why some economies grow faster than others and why booms and busts occur in the first place.
That gave rise to “real business cycle theory” for which Edward Prescott, a University of Minnesota professor for many years, received the 2004 Nobel Prize along with Finn Kydland, his former colleague at Carnegie Mellon. One finding was that “exogenous shocks” were a major force driving fluctuations in output and employment. Such shocks include events like wars, political disruptions, droughts, floods and earthquakes. They also include technological breakthroughs like railroads, electric motors, computers and the Internet.
It is hard to think of a more dramatic exogenous shock than the triple whammy of a 9.0 earthquake, a tsunami and a nuclear emergency. These are the sorts of events that can oscillate a major economy like Japan and, perhaps, the entire global economy. The problem is that industrial economies are so complex and interlinked that it is impossible to foretell exactly how a shock like this will play out over coming months.
Not all negative exogenous shocks harm economies. World Wars I and II were devastating to many countries. But loss of life aside, the two wars gave tremendous boosts to overall U.S. output and household incomes. The value of total output, adjusted for inflation, nearly doubled from 1939 to 1945.
These wars also facilitated New York and the U.S. dollar supplanting London and the British pound sterling as the axes around which global finance revolved.
World War II in particular involved large government spending on the development of new technology. Two investments stood out: the Manhattan Project to develop the atomic bomb and the Radiation Laboratory at MIT that took radar from fixed facilities of large consoles full of vacuum tubes to a proximity fuse that could fit on the end of a 5-inch antiaircraft shell. This research had great benefits to the subsequent postwar economy.
The same war that doubled U.S. output and incomes was a tremendous blow to Russia, Japan, France, Italy, Germany and the United Kingdom. But economic recovery in some of these countries, particularly Japan and Germany, was remarkable.
Shocks from natural disasters have varying effects. Some historians cite the 1906 San Francisco earthquake as a contributing factor to the Panic of 1907 and the ensuing harsh recession. The unprecedented property losses forced insurance companies to liquidate stocks and bonds to pay out claims, causing a disturbance in the force of financial markets. Although we did not measure gross domestic product back then, California boomed with rebuilding activity.
In many cases of natural disaster, wealth is destroyed by quakes, storms or floods, but output is stimulated. That was true in the 1997 Red River Valley flooding. Homes and businesses in Grand Forks, N.D., suffered large hits to their net worth because of flood damage, even after insurance. But the economy of Grand Forks hummed that summer as hundreds of furnaces and appliances were replaced and acres of drywall and insulation were ripped out and replaced.
The same was true after Japan’s 1995 Kobe earthquake. The nation was five years into what became a 20-year slump, but Kobe largely was rebuilt, and Japanese GDP did not dip.
There are, however, other cases where adverse shocks severely harmed output, employment and incomes. As I write this, the nuclear plant emergency in Japan is still unfolding. Political events in the Arab world and Europe’s smoldering sovereign debt problems don’t help. Japanese stocks have fallen sharply despite the largest three-day liquidity injection in history. Japan’s natural disasters may well put it into a severe recession that will spill over to the world economy. We just don’t know yet.
© 2011 Edward Lotterman
Chanarambie Consulting, Inc.