Political Economist

September 6, 2005

Honorable William H. Frist, M.D.

Senate Majority Leader

United States Senate

S-230 Capitol

Washington, DC 20515

Dear Senator Frist,

The Congressional Budget Office (CBO) has received numerous inquiries regarding the

likely consequences of Hurricane Katrina for the national economy, federal receipts, and federal

outlays. While the primary consideration is the human cost of the disaster, it will also likely

spawn economic impacts, some of which will spread throughout the economy.

Those impacts will arise from the disruption of production (especially of oil and oil

products) and spending in the affected areas, from the loss of wealth of those most directly

affected, and from the loss of life. In addition, the disaster is also likely to have budgetary impacts

beyond the recently enacted supplemental. Some of those will flow directly from federal

involvement in the cleanup from disaster; others will come from the disruption to production and

private spending.

While it is not possible at this time to provide a clear picture of the impacts, CBO staff

have put together some initial thoughts about those economic and budgetary effects in the

attachment to this letter. To provide context, recall that the overall economy was growing steadily

at the time the disaster. (CBO’s summer forecast called for 3.7 percent real growth in 2005 and

3.4 percent in 2006.) The devastation in the Gulf Coast region is unlikely to knock the economy

far from that course. While making specific estimates is fraught with uncertainty, evidence to date

suggests that overall economic effects will be significant but not overwhelming. Because they are

concentrated in this year, there is the potential to reduce growth by between one-half and one

percentage point at an annual rate in the second half of 2005. (On a year-to-year basis, the impact

may be as small as a few tenths of a percent of GDP). Last week, it appeared that larger economic

impacts might occur, but despite continued uncertainty, progress in opening refineries and

restarting pipelines now makes those larger impacts less likely.

Page 2. Honorable William H. Frist, M.D.

While Katrina has devastated ordinary business, it will also likely lead to a boom in

clearing and reconstruction activity, first in the areas along the coast that escaped persistent

flooding, and then in New Orleans. This follows a pattern familiar from past natural disasters

(such as Hurricane Andrew in 2002), but with the caveat that such reconstruction may begin a bit

less rapidly.

At this point the ultimate impact of Hurricane Katrina on the federal budget is unclear, but

it will be dominated by legislative actions of the Congress. The President has already requested

and Congress has appropriated $10.5 billion in emergency assistance. In addition to that

legislation, substantially more funding is likely to be provided for assistance to businesses and for

long-term reconstruction efforts. There may be other changes in spending—both increases and

decreases—associated with the disaster, in part because the disruption of payments systems in the

Gulf Coast region may affect the timing of several kinds of federal payments and of tax receipts.

I hope that you find the attachment useful. CBO would be pleased to address any further

questions that you may have.

Sincerely,

Douglas Holtz-Eakin

Director

Attachment

Identical Letters sent to: Honorable Harry Reid, Honorable J. Dennis Hastert, and Honorable

Nancy Pelosi.

September 6, 2005

Katrina could dampen real gross domestic product (GDP) growth in the second half of the year

by ½ to 1 percentage point and reduce employment through the end of this year by about

400,000. Most economic forecasters had expected 3 percent to 4 percent growth during the

second half, and employment growth of 150,000 to 200,000 per month. Economic growth and

employment are likely to rebound during the first half of 2006 as rebuilding accelerates.

The Congress has appropriated $10.5 billion for spending on emergency relief, and many

analysts expect more to be provided in the near future. Katrina will affect the budget in a number

of ways in addition to the emergency spending—outlays may be affected by disruptions in the

submission or processing of claims for federal payments, reductions in royalty payments from oil

and gas drilling, and the sale of oil from the Strategic Petroleum Reserve; and tax receipts will be

affected by immediate reductions in national income and gasoline consumption, along with

temporary tax relief provided by the Internal Revenue Service—but it is still too soon to estimate

what the net effects on the budget might be.

Katrina’s macroeconomic effects will be greater than those of previous major hurricanes such as

Andrew and Hugo, which caused a great deal of devastation but which had a small effect on the

macroeconomy. Katrina’s effects will be greater because of the greater devastation, the long-term

flooding of New Orleans (which will preclude immediate rebuilding), and the destruction of

energy and port infrastructure.

The supply of petroleum products and natural gas will be lower than it otherwise would have

been, but the reduction in supply will not necessarily hurt economic activity nationwide

significantly. If most of the refineries come back online during the next two weeks and there are

no significant periods of total unavailability of product—that is, if rationing is done through the

price mechanism alone—energy use will tend to be put to its highest-value uses, and economic

activity will not be seriously affected.

Spot prices for energy products have begun to fall from last week’s highs.

The pipelines for refined product have been largely restored, but three of the major refineries that

were shut down may not reopen for more than a month, and petroleum production from some oil

rigs in the Gulf will be curtailed for many months. The supply of crude oil from the Strategic

Petroleum Reserve (which is already being sent to refineries), the reallocation of petroleum

product within the United States, and the likelihood of more petroleum product from overseas

(which may take three or four weeks to get here) will dampen the adverse effects of the reduction

in supply.

Natural gas markets have been affected by the storm in four main areas: production, processing,

electricity generation, and local distribution. First, production from the Outer Continental Shelf

was shut down before the storm and cannot fully resume until production platforms in the Gulf

are all inspected and restaffed (and repaired, where necessary). Half the original loss of natural

gas supply—which totaled nearly 15 percent of the nation’s supply—has been restored. Second,

four natural gas processing plants that help produce pipeline-quality gas were closed. The

Congressional Budget Office (CBO) cannot confirm the status of those gas plants—any lingering

problems could impede pipeline deliveries. Third, the Louisiana electric utility, Entergy, has had

some problems delivering gas to its generating plants, although current reports indicate that gas is

being received. And fourth, local distribution of natural gas to customers throughout the region is

disrupted because of broken lines.

Production of electricity, oil, refined products, port services, housing services, manufacturing,

retailing, tourism, and other consumer services will be sharply curtailed for at least a few months

in the affected areas. The gross state product of Louisiana is about 1.2 percent of U.S. GDP, and

that for Mississippi is about 0.7 percent. If half of that product were lost for three months

(September to November), the level of real GDP would be lowered by about 1 percent from what

it otherwise would be, cutting about 1.3 percentage points from the annualized growth rate for

the third quarter and about 2.7 percentage points from the fourth quarter. It is unlikely that

production would be hurt that much for that long, however. Presumably some people in New

Orleans and other parts of the coast will be able to return to work in one or two months, and

construction employment will be picking up during the fourth quarter. Therefore, it is more likely

that economic activity in the affected area would directly reduce the growth of GDP by less than

1 percent for both the third and fourth quarters.

The main areas likely to experience prolonged and substantial disruption of economic activity

and employment are the New Orleans-Metairie-Kenner metropolitan statistical area (MSA) of

Louisiana and the Gulfport-Biloxi and Pascagoula MSAs of Mississippi. Other areas were

affected by the storm but are likely to experience little if any sustained disruption of activity.

Employment for September will decline significantly—estimates of the impact range from

150,000 to half a million—as a direct consequence of the hurricane. The Bureau of Labor

Statistics (BLS) may or may not be able to estimate the size of this effect when it releases the

September data on October 7. Employment will increase in subsequent months, as workers return

home and businesses reopen and as reconstruction activity gathers steam. The large-scale

relocation will generate additional demand for workers in receiving communities; some of those

jobs will be filled by the evacuees themselves. Once New Orleans residents are able to return

home, the net effect on the level of employment will be positive, as reconstruction activity

continues.

considerable time before basic services are restored and most residents are able to return. Total

employment (based on the BLS’s Establishment Survey) in the New Orleans-Metairie-Kenner

MSA was 616,000 in 2004, including 510,000 private-sector workers. Data from the BLS

unemployment insurance within that MSA, 248,000 were employed in Orleans Parish (City of

New Orleans), 213,000 in Jefferson Parish, and the remaining 135,000 in the other five parishes

making up the MSA. Not all of the suburban areas experienced flooding to the same degree as

New Orleans itself, so some workers and residents of those areas may be able to return sooner.

Some of those workers, especially those whose jobs involve the provision or restoration of

essential services and those involved in reconstruction, are likely to return to work soon and

remain on payrolls. Some others, including federal and state government workers and employees

of large multiestablishment corporations, may be able to work from alternate locations until they

are able to return home. But it is reasonable to expect that the majority will be off payrolls at

least through September, with only a gradual rebound. That effect will be partially offset by

large-scale hiring of construction workers.

surges than from flooding. Thus, residents should be able to return much sooner than in the New

Orleans case. Total employment last year stood at 113,000 in the Gulfport-Biloxi MSA. That

includes roughly 14,000 employed by casinos, which were severely damaged or destroyed.

Another 54,000 were employed in the Pascagoula MSA. Aside from the effect on casino

workers, many of whom are reportedly still being paid, the effect on employment should be

smaller and of shorter duration than in Louisiana (and will again be offset to a considerable

degree by reconstruction activity).

There are few reported problems related to the inability of people to make payments. Apparently,

the Federal Reserve’s contingency plans are intact. Although the New Orleans branch of the

Atlanta Federal Reserve Bank remains closed, other branches of the Atlanta Fed are covering

currency demands and check-processing needs.

• News anecdotes indicate that many financial companies are relaxing their payment

requirements and waiving late fees for contractual obligations (loan and insurance

payments, for example) of those affected by Katrina. Some banks are waiving ATM

(automated teller machine) fees for cash withdrawals by nondepositors.

• By last weekend, about 80 percent of the roughly 240 Federal Deposit Insurance

Corporation-regulated banks in the Katrina-affected area had been reached by regulators.

Most were open for business in some fashion.

• Social Security recipients can go to any Social Security office to pick up their monthly

check.

• Although the lack of electricity makes credit card payments difficult, people are making

do. For example, one news report indicates that one business is recording payments with

paper and pencil for future debiting.

• Some Blue Cross/Blue Shield plans in the affected areas were not making payments to

medical providers last week.

• The Texas Workforce Commission is assisting the Louisiana Department of Labor in

processing Louisiana disaster unemployment assistance claims.

Rebuilding will take place along several dimensions—rebuilding of residences, businesses,

infrastructure, and stocks of consumer durables. Nationwide, each housing start adds over

$200,000 to GDP. So, each block of 100,000 housing units (homes and apartments) that needs to

be completely rebuilt raises GDP by over $20 billion, or about 0.2 percent. Repairs and major

replacements of structures not completely destroyed would add to that figure. To estimate the

amount of eventual rebuilding, CBO will need information on the number of housing units lost

or the dollar value of housing losses (both insured and uninsured). Replacements of destroyed

residences will be needed whether the former residents rebuild in the same place or elsewhere.

Nonresidential structures—shops, factories, streets, bridges—will also need to be rebuilt. CBO

has no information on the value of such structures destroyed by Katrina, but it is likely to be

substantial. Nationwide, the stock of private nonresidential fixed assets is about 90 percent as

large as the stock of residential fixed assets, in dollar terms, while the stock of government fixed

assets (for example, roads and schools) is about half as large as the stock of residential fixed

assets.

5 The timing of such rebuilding is highly uncertain. Presumably, clearance and rebuilding will start

almost immediately in the areas of the coast that have not suffered persistent flooding but will be

delayed up to several months in New Orleans. Nonresidential structures typically take longer to

build than residential structures, so one might expect this rebuilding to proceed more slowly than

the rebuilding of lost residences.

Reconstruction activity will employ a large number of construction workers and will increase the

demand for construction materials such as cement and plywood. The demand for those resources

is likely to cause a slight increase in the cost of construction elsewhere in the country.

Preliminary estimates suggest that privately insured losses from Hurricane Katrina could exceed

$30 billion. (By comparison, insurers paid about $32.5 billion after 9/11.) Undoubtedly, some

businesses have business interruption coverage which will allow them to continue to meet their

payrolls, but other businesses likely did not purchase that coverage. (A significant portion of the

insured losses after 9/11 were for business interruption insurance.)

Although no estimates have been published, federal flood insurance payments are also likely to

be substantial. Those payments could exceed the program’s reserves and thus necessitate

Congressional action. Additional payouts on federal crop insurance are also possible. Finally, the

Congress may enact additional supplemental relief.

Economic activity in the rest of the United States will be adversely affected through higher

energy prices, which will temporarily reduce other consumption (and reduce saving), and through

any reduction in port activity, which may keep energy supplies and raw materials from getting to

producers and consumer goods from getting to retailers.

The supply of petroleum products, as indicated above, does not appear to be a major

macroeconomic problem, but higher gasoline prices will temporarily reduce both gasoline

consumption and consumption of other goods and services. The increase in gasoline prices is

basically a temporary redistribution of income from consumers of gasoline to the stockholders of

refiners. As a ballpark estimate, assume a 40 percent average rise in gasoline prices in September

and that consumers, on average, reduce nongasoline spending by 40 cents for each dollar increase

in gasoline prices. Since gasoline accounts for 2.7 percent of consumption (without the price

increase), the rise in prices would reduce consumption (net of the rise in gasoline prices) by 0.4

percent (40 percent x 40 percent x 2.7 percent), or about $38 billion at an annual rate. If

sustained, that would reduce annualized GDP growth for the third quarter by 0.4 percent and for

the fourth quarter by 0.9 percent. That effect is temporary: as gasoline prices return to pre-

Katrina levels, consumption would bounce back, meaning higher GDP growth.

6 The damage to the Port of Southern Louisiana is significant, but most shipping will be able to

resume in a few weeks or be diverted from the New Orleans facilities to other facilities on the

Mississippi (such as Baton Rouge) or to Houston. Vessels drafting more than 39 feet cannot

currently use the river. Only one grain elevator appeared to be severely damaged, and the others

are coming back into operation as power is restored.

At this point, it is unclear what the ultimate impact of Hurricane Katrina will be on federal

spending. Thus far, the President has requested and the Congress has appropriated $10.5 billion

in emergency assistance, with $10 billion of that total going to the Federal Emergency

Management Agency’s (FEMA’s) disaster relief account. (The remaining $500 million was

appropriated for operation and maintenance for costs incurred by the Department of Defense for

evacuation, deployment of personnel, and related efforts.) CBO expects that most of the outlays

from that supplemental appropriation will occur in fiscal year 2006. Much of the new funding

may be obligated in this month (that is, within fiscal year 2005), but most of the checks are likely

to be written in subsequent months. In addition, FEMA may spend at least a few hundred million

dollars more in September—from funds previously appropriated—than it would have expended

otherwise.

That initial funding is likely to be used mostly for short-term emergency assistance for

individuals adversely affected by the hurricane. It is likely that more funding will be provided for

assistance to businesses and for long-term reconstruction efforts.

The hurricane will affect federal spending in September and the months beyond in a number of

other ways. Some of those effects may simply be a shift in the timing of spending or in the

collection of offsetting receipts. In the near term, some programs may experience lower outlays

because federal agencies or their agents may not be able to process payments as rapidly as usual

or because recipients of payments may be delayed in submitting claims. Offsetting receipts from

royalty payments for leases on the Outer Continental Shelf are likely to be lower—by at least a

few hundred million dollars—for one month or more this fall. However, the Department of

Energy will collect receipts for the sale of oil from the Strategic Petroleum Reserve, possibly in

the neighborhood of $2 billion (for the announced sale of 30 million barrels). In addition, federal

flood and crop insurance payments could increase, and the government may experience an

increasing number of defaults in some of its loan and loan guarantee programs. Most of the

outlay effects of those near-term changes are likely to occur after September (that is, in fiscal

year 2006). It is still too soon to tell what the net effects for either fiscal year 2005 or fiscal year

2006 might be—though the effects in 2005 are likely to be small, since there is so little time left

in the fiscal year.

The effects of Hurricane Katrina on tax receipts are also unclear at this point. Federal receipts

will be affected not only because of the immediate reductions in national income and gasoline

consumption, but also because of temporary tax relief provided by the Internal Revenue Service.

7 Victims of Hurricane Katrina in Louisiana and designated areas of Mississippi, Alabama, and

Florida can delay their estimated payments of individual and corporate income taxes beyond the

normal September 15 due date. Those tax payments instead will not be due until at least October

31, therefore delaying some tax receipts into fiscal year 2006. Taxpayers who reside outside of

the affected areas but have their financial records or tax practitioners within the areas also can

qualify for the delay in payments. Other payment delays applying to withheld income and

employment and excise taxes do not currently last into fiscal year 2006. Also, through September

15 penalties will not be assessed on taxpayers who sell for highway use certain dyed diesel fuel

(which is normally available only for tax-exempt purposes). All of the payment delays may be

extended at a later date for certain taxpayers.