Ebook: Disasters and Economic Damage : Macro, Meso and Micro Approaches

Tsunamis, droughts, earthquakes, hurricanes and floods are a constant threat to society. Where in the past the population at risk had to react on the consequences of disasters, at present society wants to be more in control. Due to the high costs of restoration, of the stress and of the loss of family and friends a proactive policy in order to prevent disasters or at least to minimize the impact is required. Such a policy asks for a framework to decide on the risk society wants to take. Moreover, it is mandatory to agree on the way instruments preventing disasters are evaluated on their effectiveness. Economists play a special role because of their ability to compute costs and benefits to society of different instruments. The European Union in collaboration with the University of Twente in The Netherlands has taken the initiative to discuss the framework and the way proactive instruments are evaluated via costs and benefits. On a workshop in Delft, The Netherlands, May 23 and 24, 2003 country experts discussed experiences with recent floods and lessons learnt in handling the consequences of floods. Moreover, expert economists discussed the methodology of computing the cost of disasters, that is to say the benefits of preventing disasters. This special issue accounts for the contributions on the methodology of damage estimation by leading European and American economists. In the following we introduce the subject and present an overview of all papers. Disasters There is an increasing awareness of the impact of disasters on society. The establishment of the UN International Strategy for Disaster Reduction “Enabling all societies to become resilient to the effects of natural hazards and related technological and environmental disasters, in order to reduce human, economic and social losses” (www.unisdr.org/unisdr), proves to be an efficient worldwide discussion platform. The publication of Living with Risk (ISDR, 2002) is the consequent milestone. Other world organisations already published a vast amount of reports and publications on the management of disasters, inter alia (Kreimer and Arnold, 2000; Freeman et al., 2002; ECLAC, 1991; Colombo and Vetere Arellano, 2002). As Benson and Clay (2000) points out, there is indeed a change in attitude towards disasters: In the past, society showed a more passive attitude, which means a government reacting on the consequences of disasters, whereas at present governments want to be in control. This change in attitude is accompanied by a change in the role civil engineers adopt. For The Netherlands for instance protection against flooding by raising dikes moves from an engineering risk based design to a societal risk based design of dikes. Otherwise stated, the question becomes relevant “what is it we are protecting”? Moreover, “how do we decide on differences in risks?” Finally, “what is the benefit of preventing a disaster?” The role of economists Parallel to the UN international strategy for disaster reduction is an interest by economists in the methodology of estimating the consequences on welfare of disasters and an interest in the effects of recovery plans for the economy. Disasters prevent developing countries to take part in the world economy because of the high costs of recovery. But also for developed countries there are high values at stake. Clearly, the building of the Thames Barrier near London had precisely this meaning. Here Living with Risk asks for clear concepts and cost estimation methodologies in order to help governments in designing instruments to prevent and to overcome disasters. Fortunately, there is already a certain literature on earthquakes, flooding and hurricanes. However, this literature is rather scattered and there is no uniform approach towards concepts of costs. Moreover, there is almost no attention for the structural economic effects of large-scale disasters. Methodology For economists there are thus major challenges in researching the changing role governments take towards disasters. The aim of the EU/University of Twente workshop firstly was to concentrate on different cost concepts that are in circulation and secondly to investigate the methodology of cost estimation in relation to the scale of the problem. In the following, we will focus on these two topics. Cost concepts It is an amazing observation that in the economic literature of disasters different cost concepts are used. In what follows, we will show that these differences may be linked to differences in economic points of departure. Cost concepts: welfare economics. The main point of the discussion in the literature refers to the idea that to assess the value of the loss, one can measure its value by either taking the stock value or the flow value. It is argued that these values, in theory, represent the same. In the “colored” manuals of Flood Hazard Research Center Parker et al. (1987) develop a clear set of definitions of damage. Based on the difference between stocks and flows the authors distinguish between direct costs and primary and secondary indirect costs: Direct costs relate to loss of land, capital and machinery, thus to stocks, and primary indirect costs to business interruption, which means a flow. Moreover, secondary indirect effects relate to multipliers in the economy. The authors warn that it is not allowed to sum direct and primary indirect costs, unless production is lost to foreign countries. Note that the above applies to firms. For households loss is of course defined as the stock value of property. In the flooding literature there is a long lasting tradition to include also non-monetary impacts on households (MAFF, 2000). To households, impacts of flooding such as increased stress, health damage and loss of memorabilia can be far more important than the direct material damage to homes and their content. Finally, there are approaches to include recreational and environmental benefits in flood and coastal defence schemes. In a CBA these benefits show up as avoided losses. The line of reasoning Flood Hazard Research Center takes is based on cost-benefit analysis: flood and coastal defense project appraisal helps governments to decide on new projects. Welfare economics is the language to compute costs and benefits. Cost concepts: an accounting framework. American authors take a somewhat different position in defining direct and indirect costs. Rose and Lim (2002) initially argues along the same line as FHRC. In his view the stock of capital and machinery gives rise to a flow of production and income in the future, which means that business interruptions and capital stock affected measure the same thing. However, he consequently defines business interruption as a direct cost instead of an indirect one. Rose states that an estimate based on flows may be a better proxy for estimating damage. His reasons are the following: (1) An estimate based on flows makes up a better proxy of the lost value since it also accounts for damage due to business disruptions. (2) Flow measures are more compatible with macro-economic parameters. A stock based concept may result in an over-exaggeration of damage since only a portion of the property value may translate into service flows in any time. (3) Estimates based on a flow concept are more compatible and more consistent with the distinction between direct and indirect damage. (4) Flow measures have an explicit time dimension, which makes modelling better to do. A main point of Rose’s idea is that when it comes down to estimate economic damage, stock-based damage models are related to a different timingperiod compared to flow-based damage models. The stock-based damage models do not reflect the true cost to society. When taking the stock value of the loss, this stock value does not take account of the fact that there are also flows produced with the stock outside the time span of the flood. The criticism on using the stock value to measure economic costs comes down to the idea that the effective disruption period (comprising of both the duration of the flood and the time necessary to turn back to normal) of the flood is a shorter time period as the depreciation period of the stock. It is only in the disruption period that society is faced with the loss of consumption due to a production disruption, given that resiliency or transfer of production does not take place. We come back to this point later. Cochrane (1997) extends the definition of direct costs by not only including the physical damage to land, plants and houses, but also induced physical effects, which are the consequence of the disaster. Whereas Parker et al. (1987) defined indirect costs as business interruptions and multiplier effects in the economy, Cochrane (1997, p. 225) defines indirect economic effects more precise as “a result of dislocations suffered by economic sectors not sustaining direct damage. Activities that are either forward-linked (rely on regional markets for their output) or backward-linked (rely on regional sources of supply) could experience interruptions in their operations”. He thus refrains from business interruptions. Indirect economic effects are due to relations within an economy. If factory B is damaged by a disaster the production of sectors A and C is affected, but also the production of final products (consumption, investment, export and consumption of government) might be hit. From Figure 1 it can be seen that other factories of type B in non-flooded areas may take over the production of the damaged factory B. The magnitude of these indirect effects depend on: . the availability of alternative sources of supply and demand; . the duration of the disruption; and . the possibility to extend production. The main advantage of applying the concepts of Rose and Cochrane is that there is a perfect match with the System of National Accounts (SNA) adopted by all countries in the world. All world Bureaus of Statistics use an accounting principle that computes production and Value Added on basis of surveys of individual firms. All statistical material necessary to compute direct and indirect costs of damage on a national or regional scale is thus available. Moreover, input-output (IO) analysis as a tool to compute effects for the economy as a whole is standard in economics. Economic cluster analysis and the computation of multipliers can easily be connected to IO analysis, while extending the scope of economic analysis of the consequences of disasters. Compared to the principles of FHRC the USA cost approach seems to be embedded in an accounting framework. Cost concepts and macro-economics: IIASA, the World Bank and the UN. In reports of the United Nations and the World Bank a somewhat different position is taken in defining damage (Benson and Clay, 2000). The concepts of direct and indirect costs are extended with the concept of secondary effects. Direct costs relate to the physical damage to capital assets, including buildings, infrastructure, industrial plants, and inventories of finished, intermediate and raw materials destroyed or damaged by the actual impact of a disaster. Direct losses can therefore be roughly equated with stock losses. Indirect costs refer to the damage to the flow of goods and services. Indirect costs include lower output from damaged or destroyed assets and infrastructure and loss of earnings due to damage to marketing infrastructure such as roads and ports. Indirect costs may also include costs such as those associated with the use of more expensive inputs following the destruction of cheaper sources of supply. Secondary or macroeconomic effects concern both the short and long-term impacts of a disaster on aggregate economic variables (ECLAC, 1991). Secondary effects thus relate to the performance of the overall economy. ECLAC (1991, part one, p. 14) then concludes: “[c]ombining direct and indirect categories gives an idea of the overall material losses attributable to the disaster”. Given the discussions above on stocks and flows we judge this statement as inconsistent. In a World Bank report Freeman et al. (2002, p. 3) tinges this statement: Expressing total loss as the sum of direct, indirect and secondary effects involves double counting. Also (Benson and Clay, 2000) warn for double counting. The World Bank, the International Institute of Applied Systems Analysis (IIASA), and the Swiss Reinsurance Company (Swiss Re) developed a methodology to incorporate future probabilistic losses from natural disasters into macroeconomic projection models (Freeman et al., 2002). Swiss Re estimated capital stock at risk. IIASA then incorporated the estimates provided by Swiss Re into the World Bank’s standard macroeconomic projection model: the revised minimum standard model (RMSM). Freeman et al. (2002) suggest that by combining direct loss estimates and secondary effects there is now another approach for designing strategies to flow disasters through an economy. This kind of work links response strategies to the disasters themselves. The latter statement is interesting because it suggests that secondary effects are especially insightful because of evaluating rehabilitation strategies. The discussion on secondary effects by the World Bank and the UN thus suggests a third kind of approach of computing the costs of disasters directed at macro-economics. Scale There simply is very little research on the structural economic effects of disasters. In the water disaster literature main attention is on smallscale effects. In (Parker et al., 1987) one even concentrates explicitly on direct effects and ignores indirect effects. However, in the literature on earthquakes there is a focus on structural effects be it mainly through damage to life lines (Rose and Benavides, 1998; Shinozuka et al., 1998). General attention to damage and economic structure has been given by (Okuyama et al., 2002). Some first observations Economists direct more and more their attention to the effects of disasters on society. It is however an interesting observation that there seem to be strong demarcations between the literature on floods, hurricanes and earthquakes. There are very little cross-references between different types of literature. An exception is the disaster handbook by Hewitt (1997) who centers his ideas on the concept of risk. Very little attention is paid to the structural economic effects of large-scale disasters. Regarding the definition of cost there seem to be at least, three approaches towards costs. A distinction can be made between: . welfare economics; . an accounting framework related to the System of National Accounts; and . macro-economics. The three types of definitions vary in the way they are embedded in economics: (1) In the approach based on welfare-economics a central concept is a change in consumer surplus. Apart from property costs to firms and households consumers face changes in welfare due to changes in the availability of certain market products, changes in environmental quality, changes in the availability of recreational sites, and stress. A lot of effort is devoted to incorporate nonmonetary aspects of disasters in a CBA. (2) By computing costs on basis of an accounting framework economists rely completely on the System of National Accounts. IO analysis and computable general equilibrium (CGE) models provide the researcher with tools to deal with ripple effects in the regional and national economy. (3) Macro-economists who deal with disasters are interested in the process of recovery. Governmental money for investment in rebuilding houses, infrastructure and machinery and equipment diverts federal money away from other potential spending. How does the economy deal with this shock? What is the net effect on unemployment, government deficit, and inflation? The three types do not exclude each other; new research towards the effects of disasters might try to achieve sort of integration between the approaches. However, the little attention for the structural effects within an economy due to largescale disasters seems to be one of the niches in economic research towards disasters. It is here where the focus on the workshop was directed to: micro-, meso- and macro-economic approaches in damage estimation. Disasters and economic damage: micro, meso and macro approaches Hal Cochrane discusses myths around the measurement of damage. The paper discusses pitfalls in the development of a methodology for estimating flood damage. Those pitfalls include double counting of value added and direct damage to buildings, ignoring post-disaster liabilities and questions how indirect losses might be modeled. Cochrane categorises techniques for calculating and estimating indirect damage abound in one of six categories: linear programming models, surveys, econometric models, IO models, general equilibrium models, and hybrid models. He is critical on the use of CGE models: looking at actual events relative price changes are conspicuously absent, which robs CGE of one of its chief advantages. Cochrane then presents a brief description of the Hazus model, the software developed by the Federal Emergency Management Agency. Hazus appears to be a subtle algorithm to calculate indirect losses. The research of Cochrane thus is a good example of a regional (meso) accounting stance. Cochrane discusses new issues in loss estimation asking attention for forms of indirect losses often neglected: non-market losses. Here, he relates to the European research on non-market losses by Flood Hazard Research Center in Middlesex, UK. Finally, as an empirical case he assesses the attack on the World Trade Center. He formulates the following critics: . baselines for estimating loss are inconsistent and misleading; . failure to account for the reconstruction stimulus; . failure to distinguish between losses sustained from the attack vs. the cost of adjusting to the terrorist threat; and . the existence of post attack systemic loss is still an open question. Colin Green takes a macro and a micro point of view in evaluating vulnerability to flooding. He argues that vulnerability has to be discussed in its entire systems context. Scale issues are central to the assessment of vulnerability. Floods may be a negligible hazard when compared to other hazards that consist. And, at the other hand, a household may be vulnerable to an event when neither the local community nor the country as a whole is vulnerable. He then designs a systems view for households in allocating resources between different hazards. Green concludes that a systems’ approach in defining vulnerability have far reaching implications: . vulnerability is path dependent; . vulnerability thus is time dependent; and . vulnerability has to be understood as being constructed rather than being innate. Reinhard Mechler takes a different stance: he stresses the macro economic consequences of a disaster. Especially he, and his co-authors calculate the macro-economic effects of diverted funds and foreign funds for relief and reconstruction. Direct stock losses due to a disaster are an input in a macro model that uses a flow-of funds accounting methodology to ensure consistency between the sources and uses of funds in a national accounting framework. He distinguishes between the public sector, the monetary sector, the foreign sector and the private sector. In an empirical study, Mechler applies the model to Honduras, computing the effects of a catastrophe on GDP. He concludes that it is important to understand the probable size of losses compared to resources available to meet reconstruction and relief needs. Adam Rose starts with a discussion on resiliency with respect to its scope: micro-economic, mesoeconomic and macro-economic. According to Rose, resiliency has a behavioral emphasis: individuals and firms do not simply react passively in the face of a disaster. He distinguishes three difficulties: firstly, on the conceptual level, where actions may violate established norms, such as rational behavior; secondly, the operational level, where it is difficult to model individual and community behavior in one single framework; and thirdly, the empirical level where it is difficult to gather data. He then turns to the resiliency of markets: prices do act as invisible hands that guide resources to their best allocation. CGE models are state of the art in regional economic modeling, but he acknowledges the fact that CGE models emphasize equilibrium, whereas after a disaster, disequilibrium ensues. These disequilibria can be researched by analyzing the underlying closure rules. Rose applies this type of disequilibrium model to simulate the impacts of water disruption in a regional economy. Finally, Rose is able to make a distinction between inherent resiliency and adaptive resiliency within a CGE model; inherent resiliency is the ability or capacity of a system to absorb or cushion against damage, and adaptive resiliency is the ability to cope due to ingenuity or extra effort. In the papers by Bockarjova, Steenge and van der Veen, by Cole and by Okuyama effort is made to structure resiliency within an IO accounting framework. Cole extends the IO system with a social accounting matrix in order to capture adaptations of societies to lifeline disruptions. Societies are structured and adapt over time to balance performance and its protection. The question Cole raises is how society deals with the balance between the level of protection and accompanying costs, based on output losses. Moreover, how are these losses divided over all actors in the system? He illustrates his theoretical model with empirical material for a sub-regional economy in the US. The Niagara Power Project is the example for a life-line disruption of power supply that hits a regional economy. Cole shows in his work how costs of protection vary with the size and frequency of events over time and the relative importance of direct and knock-on effects for the well-being of economic actors. Yasuhide Okuyama also applies an IO framework to model damage due to earthquakes. He illustrates his work with the Great Hanshin Earthquake in Japan. Okuyama bases his model on Miyazawa’s Extended Framework of conventional IO models. This extension has the advantage of structuring production generation and income distribution and linking location of production and location of consumption. Temporal impacts of a disaster are captured in a sequential interindustry model. Okuyama distinguishes between a just-intime production mode, an anticipatory production mode and a responsive production mode. Each economic sector is then assigned to one of the three modes. A simulation of the sequential interindustry model produces a production chronology that reveals how an economic structure deals with a disaster. Okuyama concludes that recovery and reconstruction activities after a disaster need to be planned and phased so that no significant supply constraints occur; secondly, detection of temporal key sectors are crucial for economy-wide recovery. Bockarjova, Steenge and van der Veen formulate a new view on structural changes in a regional economy after a disaster. Starting from IO analysis their basic question is “where to start from”. The reason being, that a catastrophe by definition affects the existing networks and connections in a fundamental way. Certain elements in the structure may be lost, some possibly forever, while others may survive. From the literature, they apply the concept of an “event matrix”. It traces the development of the situation at selected intervals after the catastrophe and during reconstruction. The problem with the concept, however is, that it is still in the developing phase. By introducing the notion of a “basic equation” that structures the insight in production capacities that remain active, they make an important step forward. Mark Thisse investigates the effects of a life-line transport infrastructure disruption on a regional economy. He formulates a spatial applied general equilibrium model where a transport disruption affects production and labour allocation between regions. The effect on labour markets is seen as a major improvement towards previous models where commuting and migration patterns were omitted. Search behavior of commuters and migrants is such that in the end utility is equal for laborers among regions taking local price differences such as housing prices into account. Secondly, an important element of the model is that the effect of transport infrastructure takes agglomeration effects is considered. Conclusion We presented nine papers that reflect current methodology in damage estimation. The field is now covering the full range of micro, meso, and macroeconomics. This issue focused on structural economic changes as consequences of large-scale disasters. Here we will see much progress in the coming years. Previously published in: Disaster Prevention and Management, Volume 13, Number 4, 2004