IMPACT OF INSTITUTIONS IN THE AFTERMATH OF NATURAL DISASTERS.

• Author: Diaz, Diego A.

The number and impact of natural disasters are increasing because of climate change and more people living in urban areas (Sanderson and Sharma 2016). The mechanism is simple, at least when considering climatic events: higher temperatures lead to higher rates of water evaporation, which increases the chance of flooding events (Wallace et al. 2014; IPCC 2001). The number of hot days has increased and the number of cold days has decreased in land areas, with model projections indicating that extreme precipitation events will continue to increase, resulting in more floods and landslides. At the same time, mid-continental areas will get dryer, which will increase the chance of droughts and wildfires (Van Aalst 2006). The course of action taken by humanity in the next decades will likely play a pivotal role since extreme differences in projections are expected if global temperatures rise 2 [degrees]C in comparison to 1.5 [degrees]C above pre-industrial levels (Allen et al. 2019). What are the economic impacts of natural disasters? This question has been addressed to a large extent in the literature, but it still does not have a conclusive response. The seemingly natural reasoning that destruction cannot lead to a net benefit for society was explained almost two centuries ago by Bastiat (1850) in his famous broken window fallacy. A shopkeeper's son, Bastiat relates, breaks a pane of glass in his father's store. The father, angry due to the boy's careless action, is offered consolation by the spectators, who claim that the event is positive for the economy since it provides labor to glaziers. While Bastiat acknowledges that the accident brings trade to the glazier since the shopkeeper has to replace the window, regarding the event as wealth-increasing conveys a narrow perspective. The shopkeeper ends up poorer since he cannot spend the same money elsewhere, and if the boy had not broken the window, then the labor and other materials that were used to repair the damage would have been used elsewhere, potentially milking the tangible wealth of the community grow.

As reasonable as Bastiat's argument might sound, it is not clear if natural disasters, or any destructive event for that matter, should affect economic growth and in which direction it might do so. There is a difference in the predictions that an economist would obtain with neoclassical growth models and certain endogenous growth models. While the former theorizes that a natural disaster--that is, a negative shock to capital or both to capital and labor--decreases output in the short ran, it does not affect the steady-state of the economy in the long run. Neoclassical models also predict that the destruction of the capital stock will temporarily accelerate growth immediately after the disaster by increasing the marginal return on capital. On the other hand, some endogenous growth models based on Schumpeterian creative destruction can predict an overall higher growth rate produced by an accelerated replacement of the capital stock with more productive capital, as is the case in vintage capital models (Hallegatte and Dumas 2009).

Given the extensive debate regarding natural disasters and economic growth, in an attempt to shed light on the mechanisms by which these destructive events affect the economy, we ask whether economic institutions and, in particular, economic freedom, is relevant for obtaining a higher rate of economic growth, independent of whether this growth is positive or negative. There are not many articles that have studied the relationship between institutions and economic growth after natural disasters. In our review of the literature, we found the following published articles: Felbermayr and Groschl (2014), Barone and Mocetti (2014), Raschky (2008), and Kahn (2005). Our objective is to expand on this literature by emphasizing the role of economic freedom ;is a relevant factor in explaining the economic recovery process in the aftermath of disasters, which is increasingly relevant today given the climate change projections for the next decades. As the frequency of natural disasters increases and their economic impact in society can be ameliorated with better institutions, it becomes imperative to find out, with as much precision as possible, which institutions are relevant and what policies can be put in place to lessen the destruction.

In the following section, we discuss the relevant literature regarding the impact of natural disasters on output and the role of institutional measures. Then we describe our methods and data, present the regression results, and offer some concluding comments.

Literature Review

Natural disasters are a topic that has been studied extensively in the scientific literature. Over 6,000 articles matching the topic "natural disasters" are registered in the Web of Science core collection. The body of literature that focuses on economic growth is much smaller, with 136 articles matching search results for "natural disasters" and "economic growth" at the same time. (1) Instead of attempting to provide a general perspective regarding this literature, we focus on the few articles that study the effects of institutions and their relationship with economic activity after a natural disaster (Felbermayr and Groschl 2014; Barone and Mocetti 2014; Raschky 2008; Kahn 2005) and discuss their findings.

Felbermayr and Groschl (2014), in a growth model that shows that disasters are negatively correlated with growth, included two institutional variables in their analysis: measures of democracy (polity index) and trade openness. They found that only the latter is significant in reducing the negative economic impact of natural disasters. Barone and Mocetti (2014) focused on whether the quality of institutions affect subsequent growth in GDP per capita after an earthquake by performing a case study of two Italian regions. They construct what they call an "overall institutional quality index," which they estimate through a principal component analysis based on four local variables: corruption levels, the share of politicians involved in scandals, electoral turnout...