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Wednesday, June 8, 2011

In the aftermath of earthquakes: The limits to creative destruction

By Andrés Ramírez and Nezih Altay

Though it is difficult to imagine anything positive arising from the devastation and loss of life caused by intense earthquakes in China, Haiti, Chile and now Japan, massive destruction caused by such natural disasters can lead to innovation.

Such a statement may seem counterintuitive in the wake of the human toll these disasters take. But our five-plus years of research on the topic has found support for creative destruction.

In 1942 Joseph Schumpeter argued that “the fundamental impulse that sets and keeps the capitalist engine in motion comes from the new consumers, goods, the new methods of production or transportation, the new markets, the new forms of industrial organization that capitalist enterprise creates.”

Businesses that by all measures appear to have lost everything – buildings, equipment, employees, customers – in fact have gained a unique opportunity to change or improve their assets and technology and adapt in ways that Schumpeter says keeps economic engines in motion.

Take businesses in Chile as an example, where an earthquake of magnitude 8.8 struck on February 2010. Before the quake, some businesses in this developing country employed basic technologies such as basin flood irrigation for farming or land lines for communications. In the aftermath, as they rebuild, Chilean businesses have an incentive to adopt the next level of technology -- perhaps drip irrigation and wifi. Chilean wineries could adopt new technologies – from bottling equipment to inventory software.  Such innovations induce a large jump in productivity. These increases are then reflected in higher stock market valuation.

So what about Japan? In the last months several experts have offered largely contradicting predictions about its future. For a developed country such as Japan, which already uses the latest technology to produce high-value-added products and services, the gains will be marginal. In fact firms Japanese firms are likely to experience a reduction in cash flows. Toyota can rebuild its damaged plants but it is unlikely that productivity will increase dramatically because they already had cutting edge technology before the earthquake. The same can be said about Fujitsu or Sony. For these companies, the costs (even after insurance payments) will greatly exceed the benefits. The only good news for a developed open economy such as Japan’s is that its multinational firms will fare better; they will experience a lower decrease in cash flows compared to domestic firms.

Our research is based on an analysis of 299 earthquakes between 1990 and 2004 and their impact on almost 150,000 companies in 50 countries. Among our findings:

-      A business will experience increases in market capitalizations even three years after an earthquake hits its country. A closer look, however, reveals that this result is valid only for companies in less developed countries, particularly those from non-G8 countries.

-      Regarding operational cash flows, businesses in Latin America and Asia – the two regions most prone to earthquakes – see an increase in cash flows; companies in other regions see a decline.

-      Earthquake damage generates a great deal of uncertainty about the future to which companies respond by increasing their cash holdings, even three years after the event. This cash hoarding can be detrimental to reconstruction efforts.

 Disaster damage is not a straightforward measure, and research on the impact of natural disasters on companies and corporations is in its infancy. We can focus on economic losses, lives lost, people affected. But in terms of creative destruction, what we do know is this: It is limited to the developing economies.

Andrés Ramírez is a professor in the Department of Finance at Bryant University, Smithfield, R.I. Nezih Altay is a professor in the Department of Management at DePaul University, Chicago.

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