The Earthquake and the Global Economy

By Stephen Smith

April 6th, 2011

The tragic earthquake and subsequent tsunami has caused a significant disruption in the Japanese economy. In the most affected areas, transportation and production interruptions have caused economic weakness in the near term. The damage to electric power facilities, including two nuclear power plants, has created power shortages throughout the country. The drama at the Fukushima Dai-Ichi nuclear power plant has unfolded with explosions and radiation scares. Damage totals could amount to over $300 billion, putting the Japanese earthquake and its aftermath as the most expensive natural disaster on record.

Japan is the third largest economy and a significant link in the global manufacturing supply chain. As a result, lost output in Japan and disruption to industrial production will have a negative short term impact. Japan is not considered to be a major driver of the current expectations for the global growth in 2011. Global growth is expected to come from developing economies and the United States. Japan is expected to contribute one-tenth of one percent of the expected 4.2% global Gross Domestic Product. The Bank of Japan will inject a record amount of cash into the financial system and will double the size of its program to buy financial assets from approximately $60 billion to over $120 billion. This large supply of cash to banks is temporary and can be withdrawn when no longer needed. The decision to step up its quantitative easing program is more permanent. This program will continue until June, 2012. These moves largely follow the blueprint of what the Federal Reserve did after 9/11, except that the Federal Reserve cut short term interest rates instead of quantitative easing because United States interest rates were well above zero.

Natural disasters in developed countries have typically put into motion a series of policy and other actions that begin to create a positive counter effect. Specifically, the initial fall in production and consumption often gives way to a pickup in economic activity. Historically, government spending, monetary stimulus, and insurance payouts lay the foundation for a surge in economic activity over the medium term. An initial sell off in the aftermath of a natural disaster is a common historical pattern in stock markets. Global stock exchanges traded down 6% on average after the natural disaster but have since recovered most of those losses. Japanese equities are still down 10% but the disaster in and of itself should not be enough to derail the global economy. The world economy should be able to withstand the near term deceleration in Japan, though the uncertainty creates the potential for additional volatility in the global financial markets.