Economics of Disaster-Prone Regions

Others have said most everything there is to say on the economics of building and rebuilding in disaster-prone regions, and I don’t have much to add. But since a debate has begun in my comments section, I might as well summarize my thinking on the matter.

I agree with Don Boudreaux that New Orleans’s precarious position does not, in itself, mean it’s irrational to build there.

While it’s true that New Orleans sits below sea level, and the Mississippi River’s natural flow has been replaced by a human-directed flow, these facts alone do not mean that New Orleans should not exist where it exists. The Netherlands, to pick one example, is one of the many other places that exist only because of human ingenuity at holding back the sea and replacing nature’s boundaries with man-made ones.

And I agree with my Dad (from a comment on a previous post) that the Gulf region in general is too important economically to write off as too risky to inhabit. Some risks are worth taking because the return is sufficiently high.

This geographic area and the people who inhabit it provide roughly a third of the nation’s seafood and probably 20-40% of the nation’s crude oil, natural gas, liquefied petroleum gases like propane, and petrochemicals that fuel the engine of our economy and our modern way of life. This region also contains a major portion of the refining and chemical processing plant capacity in the nation. It is also the origin or throughway for many vital pipelines that carry petroleum products, like gasoline, to the rest of the country. In addition, the Mississippi River accounts for huge amounts of waterborne freight transportation.

But these factors alone don’t justify having government support in the form of subsidized (or free) flood insurance, grants for rebuilding homes and businesses, etc. I agree with Amy that the existence of such subsidies creates a moral hazard problem: people will take excessive risks, locating too frequently and too extensively in dangerous areas.

One of the largest FEMA programs is the National Flood Insurance Program, which sells flood and other natural disaster insurance to Americans whose property lies in known weather hotspots. Sounds great, right? Except that by federal law, because the actual cost to insure property almost guaranteed to be destroyed by weather at some point would be astronomical, federal flood insurance is sold at well below the cost of replacing destroyed property. Yes, that means that some people living in hurricane and earthquake zones can afford to rebuild when they otherwise might be unable to. But it also removes natural economic incentives to not build in dangerous areas. That means that more people put themselves and their families in danger by living in known flood and hurricane zones because they can be sure that the government will provide the funds to rebuild their homes. Subsidized flood insurance allows property to be replaced, but it also raises the human toll of natural disasters because people are insufficiently afraid of the bad weather that can kill them.

So the issue is one of giving people the incentive to engage in the correct amount of risk-taking. As valuable as the goods and services provided by the Gulf region are, there’s only one way we can be sure they are worth the risk: by making sure that producers bear the full cost of doing business (including the cost of buying unsubsidized insurance or bearing risk directly), which will be passed on to consumers in the form of higher prices. If consumers continue to buy at higher prices, then the goods and services must be valuable enough to justify the hazards associated with producing them. This is true whether we’re talking about the price of gasoline, the price of seafood, or the price of drinks on Bourbon Street. And the same reasoning applies to homeowners and other residents – they need to bear the real costs of living in dangerous areas, or else we will end up with more people living and working in flood zones than makes economic sense.

I do, however, see a limited role for government. As Tyler notes, levees do possess the key features of a true public good. Once the levees have been built, they benefit everyone inside the protected area, whether they’ve contributed or not (so the benefits are non-excludable). And the cost of maintaining levees does not increase with the number of people in the area (so the benefits are non-rivalrous). As a result, there is good reason to think private enterprise might not provide levees even when they make economic sense, so government provision might be necessary. (Yes, I realize there exist private means of providing public goods, such as assurance contracts, but I doubt those solutions would work here.) However, the appropriate level of government to support the levees is local or state, not federal, because the direct beneficiaries are the residents and businesses in the protected area. True, the ultimate consumers of goods and services produced there, including many elsewhere in the country, will also benefit – but again, they will end up paying in the form of higher prices, as the taxes for building and maintaining the levees will tend to get passed through. (The pass-through argument relies on some assumptions about the kind of taxes imposed that I won’t get into here.)

Nonetheless, the federal government did assume responsibility for the New Orleans levees a long time ago, effectively precluding action by private enterprise or local/state governments, so I think the federal government should catch the blame for failing to upgrade the levees in anticipation of a disaster like Katrina (which experts have been predicting for years).

Here’s the dilemma we face now. On the one hand, the government has made lots of promises to the residents of the Gulf Region. The people there have come to expect massive assistance in the wake of natural disasters – and not without justification. The government has always bailed out disaster victims, and then it has always helped to rebuild. Without such promises, I think many fewer people would have placed themselves in harm’s way. Reneging on those (explicit and implicit) promises now would be unfair and cruel. But keeping the promises creates the expectation of future bail-outs, thereby perpetuating the problem. I don’t have any simple solution.