What a difference a few weeks make. At the beginning of the year, I thought the economy would pick up momentum, inflation would soon come down, and polling trends would continue, possibly leading to a change of government come election time. I also thought that, after talking about inflation in my past columns, it was time to shift the conversation to a different topic, like New Zealand’s notoriously low productivity ranking and that businesses spend more time on regulation compliance than doing their job.
However, a series of natural disasters for the North Island and a change of Prime Minister has mixed things up. The economy will take a little longer to recover after the destruction of productive resources, the shortage of supplies puts upward pressure on prices, we have seen a resurrection of the Labour party in the polls and I am back talking about the state of our economy and inflation.
The assessment of damages caused by the January flooding, Cyclone Hale, and Cyclone Gabrielle is still in the early stages. Nevertheless, international research of comparable natural disasters points to a figure of $10 billion to $20b (the Christchurch earthquake is estimated to have cost about $40b).
In addition to the cost of repairing and rebuilding homes, businesses, infrastructure, assets, and capital stock, recent events have affected the overall health of our economy, which is what I want to explore in today’s column.
Natural disasters’ effects on GDP
Natural disasters have a negative and positive effect on GDP. The destruction of production factors shrinks GDP, but the demand associated with the recovery stimulates economic activity.
The affected regions contribute nearly 59% to our GDP: Auckland contributes around 37%; Waikato 9%; Bay of Plenty 6%; Northland 3%; Hawke’s Bay 3%; and Gisborne 1%. Even a slight reduction in output of these regions, say by 5%, could shave about $12b off our GDP.
Furthermore, Northland, the Bay of Plenty, and Hawke’s Bay play critical roles in the agricultural and horticultural sectors. The primary sector only contributes about 12% to our national GDP, but these sectors make up 70% of our export earnings.
But the news is not all bad, as the rebuild will add to our GDP.
Academic studies suggest the overall impact of a major natural disaster on a country’s annual GDP growth rate is a reduction of 0.5% to 7%, depending on the severity of the event. Cyclone Gabrielle was categorised as two out of a possible five. So, let’s cautiously consider the impact on our annual GDP growth rate to be somewhere in the middle of the spectrum. If we reduce our current rate of 2.7% by 3% for the affected regions, we will end up with an annual GDP growth rate of 2.65%. I am sure any prime minister would take that.
Inflationary impact
The recent events also have had an inflationary impact on our economy. Additional demand in an already capacity-constrained economy will undoubtedly push prices up, especially for goods such as fruit and vegetables or construction materials. Transportation costs will also rise as trucks take longer routes to bypass road closures. Businesses are likely to push these additional fuel and wage costs onto prices.
Our Treasury estimated that the January floods would increase the CPI by 0.4 percentage points. Cyclone Gabrielle certainly added to this. But, again, there is good news. Inflationary pressure caused by natural disasters tends to be transitory and diminishes after six months.
To respond to the inflationary pressure, the Reserve Bank recently increased the OCR from 4.25% to 4.75%. Last year, the initial expectations were that the OCR would peak at 5%, a value revised in the bank’s November forecast to 5.5%. We are inching closer to this target and, hopefully, the Reserve Bank won’t have to adjust this value again in light of recent events.
Ask an economist what the highest economic cost of recent events is, and the answer might be: lost opportunity. Opportunity cost is an essential concept of microeconomics and represents the potential benefits someone misses out on when choosing one alternative over another. If you have $100,000 spare cash and buy yourself a new boat, you give up the opportunity to replace your ageing four-wheel drive with a new EV.
Also, opportunity costs are considered in economic decision-making but not in accounting. Imagine you give up an annual wage of $60k to start your own business, where you make a profit of $100k. Your accountant will tell you that you must pay tax on the entire profit. An economist would deduct your opportunity cost, which reduces your profit to $40k.
New Zealand must spend considerable resources, including time and brainpower, to repair and rebuild large parts of the North Island. This will divert capital, and we will miss out on improving or creating new wealth. When considering the actual cost of the recent events, we also need to consider opportunity costs.
A series of natural disasters have rocked our country. While the repair costs are high, the damage to our GDP growth rate will likely be small, and inflationary pressure might ease in this year’s second half.
If New Zealand switches to a future-proof ‘build-better’ approach instead of simply rebuilding production factors and infrastructure, we will seize rather than lose opportunities.