SERIOUS MONEY:A DEVASTATING earthquake with a magnitude of 9.0 on the Richter scale struck the northeastern coast of Japan on March 11th at 2.46pm local time.

The Sendai earthquake was unprecedented in Japanese official history and its strength greatly exceeded both the Great Hanshin earthquake of 1995 and the Great Kanto earthquake of 1923.

The scale of the humanitarian tragedy continues to unfold, with more than 20,000 dead or still unaccounted for, a number far greater than the nearly 6,500 lives lost in 1995 though substantially less than the death toll of more than 140,000 in 1923.

The extent of the devastation wrought by the earthquake and the ensuing tsunami, combined with the loss of human life, may lead to the conclusion that the tragedy will weigh heavily on the Japanese economy for years to come.

However, the historical evidence from previous natural disasters suggests the disruption to economic activity in advanced economies is typically short-lived.

The initial hit to growth is always significant but the boost that follows once reconstruction gets under way often sees the local economy recover more quickly than even the most optimistic predictions.

Indeed, the British philosopher and economist John Stuart Mill in Principles of Political Economy, published in 1848, observed "the great rapidity with which countries recover from a state of devastation . . . the disappearance in a short time of all traces of mischief done by earthquakes, floods, hurricanes and the ravages of war".

The economist noted that though “all the inhabitants are ruined . . . in a few years after, everything is much as it was before”.

Mill's observations are corroborated by the work of the late George Horwich of Purdue University who penned Economic Lessons of the Kobe Earthquakein 2000, the definitive account of Japan's Great Hanshin earthquake, which struck the city of Kobe in early 1995.

The city was home to the world’s sixth-largest container port, accounting for almost 40 per cent of Kobe’s gross industrial output, and the extensive damage wrought by the natural disaster led many commentators to conclude that it would take at least a decade for the local economy to recover.

The predictions made in the earthquake’s immediate aftermath proved to be embarrassingly wide of the mark as import trade fully recovered within a year, manufacturing activity was just 2 per cent below its pre-earthquake trend after 15 months, and all department stores were open after 18 months.

Horwich writes: “Two years after the quake, all debris had been removed . . . lifeline utility services had been restored within three months, electric power in a few days or less; all rail systems and roads, other than the major expressway, had become operational within five and seven months, respectively; the Hanshin expressway, the major artery, was rebuilt in 21 months . . . and complete reconstruction of the port was celebrated after 26 months.”

The late economist’s observations are also applicable on a national level.

Industrial production and export trade both dropped as expected once the Great Hanshin earthquake struck, with the latter registering a decline of almost 10 per cent due to the extensive damage to Kobe’s port facilities.

However, both indicators quickly recovered and surpassed their pre-earthquake peak within a month as production was switched from the affected region to prefectures with idle capacity.

Although the economic lessons of the Kobe earthquake give cause for optimism, there are reasons to believe that the negative impact resulting from the Sendai tragedy will be greater in magnitude and longer-lasting.

First, though the nominal output of the three regions most affected by the natural disaster – Fukushima, Iwate and Miyagi – at roughly 4 per cent of gross domestic product (GDP) is comparable to the product attributable to the Hyogo region in 1995, significant disruptions to economic activity are apparent in the adjacent prefectures of Tohoku and Hokkaido, which account for a further 8 per cent of GDP.

Second, the ensuing tsunami contributed to relatively greater damage over a broader area, with significant destruction of infrastructure including roads and power generation capacity.

Roughly 4 per cent of the power supply has been shut down and the ability to resolve the shortage is constrained by the fact that the grids in the eastern and western half of the country are not compatible. This could prove particularly troubling as the country approaches peak summer demand.

Finally, and perhaps most importantly, the damage to nuclear power stations at Fukushima poses a substantial risk to confidence and private consumption. It appears that the situation is worse than the Three Mile Island accident that occurred near Harrisburg, Pennsylvania, in 1979, though far removed from the Chernobyl disaster of 1986.

The economic impact could well resemble the severe acute respiratory (Sars) scare that struck Hong Kong during the first quarter of 2003 and precipitated a double-digit percentage point decline in private consumption.

The Japanese have been struck by a threefold catastrophe including devastating earthquake, tsunami and potential nuclear meltdown. The historical evidence suggests the economy will recover from the natural disasters far more quickly than most anticipate, though the nuclear situation continues to fuel uncertainty.

Nevertheless, the Japanese stock market may prove attractive to the opportunistic investor at current levels.

charliefell.com