Sunday, September 04, 2005

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While it’s true that New Orleans sits below sea level, and the Mississippi River’s natural flow has been replaced by a human-directed flow, these facts alone do not mean that New Orleans should not exist where it exists.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.


Steven Horwitz said...

One quick point Glen: I think the point about local responsibility for levees is correct. And your possible counter-argument ("don't they benefit those who consume the goods elsewhere in the country?") can also be refuted by a reductio. How much of what gets produced or transported through New Orleans is exported? Would we/should we somehow charge foreign consumers for part of the cost of the levees?

Glen Whitman said...

"Well, I have no objection at all to the producers of the seafood and the energy and the petrochemicals and the other agricultural and manufactured goods paying for reclamation and passing on the costs in the form of higher prices. The problem with this position is, WHAT IF THEY DON’T/WON’T DO IT?"

You mean, what if they lobby for subsidies? Then we ought to oppose them. But the whole question is whether you and I should support subsidies. Saying, "They'll get them anyway" doesn't refute the argument that they shouldn't.

"On this point, Glen notes that in this event it should be the job of local and state governments, not the federal government. I don’t understand this argument at all, since Louisiana and the other Gulf Coast states export most of their fish, energy, and petrochemicals to other states."

Hollywood produces movies watched by the rest of the country and, indeed, the world. Is this an argument for subsidizing Hollywood? No -- Hollywood has to pay to make movies, and the rest of us cover the cost through ticket prices. The fact that consumers benefit from a good is not an argument for making consumers subsidize it with tax dollars. If it were, then we'd have an argument for subsidizing *every* good (because consumers benefit from all the goods they buy).

"Personally, I don’t care whether I pay the costs in the form of taxes or in the form of higher prices, just so long as the resources and the people responsible for providing them to the rest of us are protected."

Well, I do care whether I pay through taxes or higher prices. Why? First, because higher prices target exactly the people who benefit, instead of forcing other people (e.g., someone who rides a bike or doesn't eat seafood) to pay. Second, because higher prices make consumers face the true cost of their economic choices. When the gov't subsidizes oil (or anything else for that matter), prices don't reflect the real cost of production, and consumers will tend to consume more of the product than makes economic sense.

With all that said, there's a difference between whether the gov't should help rebuild now (given past promises the gov't has made) and whether the gov't should continuing making promises to help rebuild in the future. My point in this post was to say that future promises should not be forthcoming. I still want the Katrina victims to get help, in large part because they were at least implicitly promised the help before the fact.

Glen Whitman said...

"The interruption of Hollywood movies would hardly qualify as a national catastrophe severely affecting the nations energy and food supply."

Hold on a minute -- you're shifting the argument. Remember your original argument was, in essence, "everyone who benefits from an activity should have to support it with taxes." My Hollywood example clearly refutes that point. You, as a moviegoer, pay for the cost of movies through your ticket price, so no subsidy is necessary.

But now you're shifting to a different argument, which is "these products are really important, and that's why government should be involved." As the present disaster shows, however, government involvement does not necessarily make the supply of these products any more secure. Indeed, subsidies encourage the placement of more industry in harm's way.

With the bike example, you're implicitly admitting my point by indicating that bike riders should pay their fair share for the roads (and that it's wrong for them to get a free ride). You're basically saying, "bike riders get a subsidy, so car drivers should, too." I'm saying no one should get a subsidy, and that way they'll face the true cost of their decisions. (And yes, I would like to see more pricing of road use, which would also help to deal with traffic congestion.)

Your response on seafood is a red herring. If non-seafood-eaters demand other foods, they also have to pay the costs of producing those other foods (through their prices). But if the production of seafood is subsidized, then seafood eaters don't face the full cost of their choices. Instead, they foist some of the cost of producing seafood onto those who don't eat it. (And if I'm willing to forgo the health benefits of seafood, that's my own business!)

Education is clearly a special case. I'd like to see much less gov't involvement there as well, but there's at least a case for subsidizing education on grounds that it produces positive external benefits for people not involved in the transaction -- specifically, those of us less likely to be victimized by future criminals. But the analogy to petroleum products just isn't there. There aren't any positive externalities; all of the benefits are experienced by the producers and the buyers of petroleum. (To anticipate your response: yes, petroleum products are used in the production of other goods and services, like transportation of food -- but then it's included in the price of those other goods and services, so the ultimate users still end up paying.) On the other hand, petroleum products arguably *do* create negative externalities in the form of pollution. There's a better case for heavily taxing oil and gas than subsidizing them.

"Again, I don’t care whether I pay for something through taxes or prices, as the money is fungible." Well, you *should* care, for exactly the reasons I said. The fungibility of money is irrelevant to the two arguments I made. First, when good X is subsidized with general tax revenues, that means money is being transferred from those who don't consume X to those who do. Fungibility doesn't alter that fact. Second, when faced with a lower price at the point of sale, people will tend to consume more of the product. The portion of the cost that they feel in their tax bill, on the other hand, does not affect their consumption of the good (because they have to pay the tax regardless). And that means subsidized goods will be over-consumed -- people will consume them even when the true costs are greater than the benefits. That's wasteful.

Dad, you've told me many times that petroleum is an industry that will eventually have to die as we switch from oil to other kinds of fuel. Well, how do you think that will happen? If you let the market work, prices for oil will keep rising, which will (a) give people an incentive to economize, and (b) give investors an incentive to invest in alternative products. When the government subsidizes the petroleum industry, it stymies both of those market incentives -- and then politicians blame the market for not producing alternative fuel sources! This is clearly nonsense. If the gov't wants people to economize on oil and develop fuel alternatives, it should STOP SUBSIDIZING OIL!