Disasters and Development: Natural Disasters, Credit Constraints and Economic Growth

Abstract

We demonstrate, using a simple two-period equilibrium model of the economy, the potential effects of extreme event occurrences – such as natural or humanitarian disasters – on economic growth over the medium- to long-term. In particular, we focus on the effect of such shocks on investment. We examine two polar cases; an unconstrained economy where agents have access to perfect capital markets, versus a credit-constrained version, where the economy is assumed to operate in financial autarky. Considering these extreme cases allows us to highlight the interaction of extreme events and economic under-development, manifested through poorly developed financial markets. The theoretical analysis shows that, where agents face borrowing constraints, the shock of an extreme event occurrence could have lasting effects on economic growth. The predictions of our theoretical model are then tested using a panel of data on natural disaster events at the country-year level, covering the period 1979-2007. In line with recent literature, we find that natural disaster events exert a significant negative impact on economic growth over the short-term. These effects appear to be compounded by a lack of access to credit. Looking at the medium-term dynamics of the interaction between disasters, credit constraints and economic growth, we find evidence in support of the hypothesis that credit constraints cause disaster events to have more persistent effects on economic growth.