Why prices rise after a disaster

I am a market-friendly liberal. Yet I found somewhat obscene the boom in stock markets after the December 26 tsunami. Anticipating a reconstruction boom, markets drove up the prices of companies engaged in construction, steel and cement.

In Indonesia, which has lost over 100,000 lives, the Jakarta Composite Index rose to an all-time peak of 1018, up from 939 in mid-December. The Bombay Sensex hit a record 6,679 on January 3, up from 6,498 before the tsunami.

The share price of a big construction company like Gammon shot up from Rs 630 to a peak of Rs 775, and of Hindustan Construction from Rs 300 to a peak of Rs 380. The price of Tata Steel rose from Rs 340 to Rs 386, of ACC from 330 to 355, of Gujarat Ambuja Cement from Rs 390 to Rs 425.

Let me not overdo the tsunami’s impact. The markets were rising even earlier, and kept rising in countries not hit by it (Hong Kong, Taiwan). The boom was brief and soon reversed: a US Federal Reserve Board report stoked fears of higher interest rates, and sent markets crashing across the globe. By January 6, the Sensex was actually lower than before the tsunami.

But the fact remains that victims hit by the tragedy will be hit again by higher prices during rehabilitation. This is the dark side of the market economy. In most conditions free markets are benefactors, but they can produce unfair outcomes when natural disasters strike.

The lynchpin of markets is price flexibility. In a socialist country, all prices are controlled, and so there is little knowledge of how much to produce of what. In the Soviet Union, the Planning Commission once set targets for glass factories in tonnes. Factories sought to meet targets by producing the thickest possible glass, so heavy that it shattered in handling. Wiser after the event, the Planning Commission next year set targets in square metres. Factories promptly produced the thinnest possible glass, which also broke in handling.

By contrast, the price mechanism in market economies is like a huge computer than processes information on demand and supply for different varieties from millions of customers and producers, matching them through price changes. If demand exceeds supply, prices rise, inducing an expansion of capacity. If supply exceeds demand, prices fall, inducing the mothballing of excess capacity. So a market system has inbuilt corrective mechanisms that effortlessly match supply and demand very efficiently. This is why market systems beat socialist planning hollow.

But what happens when a natural disaster strikes? A drought causes food prices to rise, precisely when incomes fall (farmers have less output, labourers have less jobs). The price mechanism exacerbates the problem instead of being self-correcting.

Needy families have to sell assets—land, animals, jewellery. Distress selling in distress conditions means they get the lowest prices. The buyers at low prices are the rich, who can withstand ravages of the drought. The next year, when the rains are good, poor people want to buy back their assets. But a good crop raises incomes, raises asset prices as everybody tries to buy, and so the poor are unable to buy back.

Similar problems accompany a tsunami. The price of fish rises exactly when fishermen have the least spare cash and least ability to catch fish themselves because their boats are destroyed. Because so many people suddenly need more boats, fishing nets, and building materials, their prices shoot up. The greater the damage, the higher the prices.

Technically speaking, the problem is one of missing markets rather than market failure. . If rural areas had sufficient insurance and credit mechanisms catering to the poor, these would provide safety nets in droughts. If all seashore-dwellers had tsunami insurance and options to buy materials in forward markets at fixed prices, they would be protected too. Since such markets do not exist, we need a major role for private donations, NGOs and governments for relief and rehabilitation (R&R).

Some of my fellow liberals are looking hard for alternatives to government R&R, given the corruption and waste in governments. I am less gung-ho. While private initiatives can achieve a few heart-warning successes, the organisational structures and efforts required for R&R are enormous, and well beyond the capacity of do-gooders. The government alone has the required capacity, warts and all.

For all those engaged in R&R, I will add a final warning. Estimates of sums required for R&R typically fall short of actual needs, since they fail to anticipate that disasters themselves will drive up prices of required materials and services. This is the iron law of supply and demand. The more the aid that flows in, the more it will push up prices. Make allowance for this sad behaviour of markets after disasters.

What do you think?