Disasters and development: natural disasters, credit constraints, and economic growth

Using a simple two-period model of the economy, we demonstrate the potential effects of natural 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 economy in which agents have unconstrained access to 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 disasters and economic underdevelopment, manifested through poorly developed financial markets. The predictions of our theoretical model are tested using a panel of data on natural disaster events at the country-year level, for the period 1979–2007. We find that for countries with low levels of financial sector development, natural disasters have persistent negative effects on economic growth over the medium term. These results are robust to various checks.