Katrina and Psychology

Several people have asked me in recent days whether I think Katrina will have any measurable economic impacts on the national US economy. In general, I think it’s hard for localized events such as a hurricane (or even a large terrorist attack) to have effects on the US economy as a whole, simply because the US economy is so vast and so diversified. Sure, massive rebuilding after a big storm (e.g. after Hurricane Andrew) could add a couple of tenths of a percent to GDP for a quarter or two due to increased construction and replacement of damaged assets, but I would still discount that as a relatively minor impact on the US economy.

However, there’s one way in which I think that a purely local event can have a significant and lasting effect on a national economy: by changing the psychology of individuals across the country. And as far as that goes, I wonder if Katrina may have been just the wrong storm at just the wrong place and wrong time.

A lot of economic behavior is driven by psychology. After all, many economic decisions that people and firms must make every day depend crucially on their expectations for the future. And those expectations are often not measurable or knowable in any concrete way, but rather depend in large part on speculation, estimates, presumptions, guesses, conjectures, and gut feelings. That’s why many economists believe that simple optimism and pessimism can play huge roles in the course of the business cycle. That’s what Keynes’ famous notion of “animal spirits” was all about, after all.

And lately I’ve been a bit worried about which way animal spirits were heading in the US.

  • The economic expansion has almost certainly peaked (in terms of growth rates) and growth seems to be slowing, if anything.
  • There is much debate about the health of the labor market right now (see our very own PGL for much more on this), but nearly all economists agree it is not nearly as strong as we would like it to be, particularly for the mature phase of an economic expansion.
  • The signs that the real estate market is at or very near its peak in many hot markets are slowly becoming more abundant (see Calculated Risk for much more on this), and the unwinding of regional housing market bubbles will almost certainly bring at least moderate discomfort (financial and psychological) to many individuals.
  • But the most important contributor to a growing sense of economic angst, I think, is simply this: people are really getting tired of paying $40 or $50 to fill their car with gas, and are tired of finding that gas prices continue to rise month after month, and are starting to think about how much their heating bills are going to be this winter.

Now add Katrina. If it turns out, as seems increasingly likely, that Katrina will cause some supply disruptions in the gasoline and oil markets in the US – whether due to lost refinery capacity, damaged port and transportation infrastructure, or damaged petroleum infrastructure – then the resulting spikes in oil and gas prices in the US could really put individuals and firms in a bad mood.

Even temporary problems can get magnified if they contribute to a broader change in psychology. And I think that the current situation contains the seeds for such a shift in sentiment. My personal odds for a recession in 2006 have just gone up, thanks to Katrina.