Endogenous Business Cycles and the Economic Response to Natural Disasters Stéphane Hallegatte ENM, Toulouse and CIRED, Paris With M. Ghil, P. Dumas, J.-C. Hourcade

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

Part I Endogenous business cycles

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

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 ?

Endogenous business cycles: an 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

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 model’s one. Because of market adjustment delays, NEDyM dynamics exhibit keynesian features along transients trajectory in response to shocks.

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.

 inv = 1.7  inv = 2.5

 inv = 10  inv = 20

Hopf bifurcation: from stable equilibrium, to limit cycle, to chaotic behavior

Endogenous dynamics: an alternative explanation for business cycles

Interpretation of the instability Business cycles originate from the profit-investment relationship. Oscillations with a 5.5-year period. higher profits > more investment > more demand > 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)‏

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)‏ Endogenous dynamics: an alternative explanation for business cycles

Main flaw in the model business cycle: the amplitude of price oscillations

Correction: accounting for quantities in behavioral equations (Gali, 1999, 2004)‏

Part II The economic consequences of extreme events

Why to look at extreme events in 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

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.

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.

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%

A modified production function Investing less is not equivalent to having some productive capital destroyed by a disaster We introduce: K 0 = potential capital (no disaster)‏  K = portion of destroyed capital Effective capital :K = (1-  K ) K 0 Modified production function: Y = (1-  K ) AL  K 0 (1-  )‏ With this function, when x% of productive capital is destroyed, production is reduced by x%

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 f max percent of total investments (calibrated on the length of the reconstruction period): I r < f max I

Long-term consequences on economic growth Here also, the average loss depends on the event characteristics and on reconstruction capacity

Long-term consequences on economic growth Natural disasters and bifurcation in losses 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. From Hallegatte et al. (2007, Ecological Economics)‏

A macroeconomic feedback ? Interaction between intrinsic dynamics and shocks Recession Expansion From Hallegatte and Ghil (2007)‏

A macroeconomic feedback ? Interaction between intrinsic dynamics and shocks Limited losses if the disaster affects an economy in recession Recession Expansion From Hallegatte and Ghil (2007)‏

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)‏

Variability and vulnerability The cost of the current distribution of natural disasters strongly depends on economic characteristics.

Long-term consequences on economic growth « positive » feedback and poverty traps Limited economic development Limited reconstruction capacity Large cost of natural disasters Impossibility to increase the infrastructure and capital stocks Long reconstruction period after each disaster « Positive » feedback Possibility of poverty trap Disasters can be a significant obstacle to economic growth and development