Saturday, September 03, 2005

Should We Invest to Stop Mother Nature or Terrorists? Pre-emption of Low Probability Disasters

“More people than ever are living near hurricane prone coast lines, earthquake fault lines, forest fire prone areas and in flood plains, a trend that has created a landscape of expanding risk with more people, homes and communities in danger’s path. At the same time, disasters costs have risen, posing a growing problem for insurers, governments and communities in danger’s path.” (Quote from San Francisco Chronicle’s 9/1/2005 Disaster Planning focuses on Response not preparation by Walsh, Alpert and McQuaid)

I thought that most people are risk averse. When offered $100 for sure or a 50% chance of earning $200 and a 50% chance of earning $0, most people choose the $100 option. If this is true, how do we explain why more and more people are gambling with their most valuable assets (themselves and their family’s well being)? You might say that housing affordability is pushing people to live in more and more marginal areas. While in San Francisco this might be a pinch true, there are plenty of mid-west cities with quite affordable housing.

You might say that people are ignorant about the risks they are exposing their families to when they choose where to live. This logic suggests that only salient events such as hurricane “wake” people up. Behavioral economists would add that such events lead people to engage in a “law of small numbers” such that they now over-estimate the probability of future hurricanes. Post 9/11/2001, did you believe that flying was now much less safe? For months many people did.

Why do we need salient events such as this hurricane or 9/11 to focus us on allocating resources to mitigate risks? Do people really believe that the probability of a rare event is zero until it actually happens? Actuaries are paid to estimate such probabilities. Do government policy makers ever consult these guys to help them determine what are good investments to mitigate risk exposure?

In the case of New Orleans’ levees, it appears that both the local politicians and the federal government under-estimated the probability of disaster

What role did the wrestling over whether the Federal government or state and local government should pay for levee repair play in delaying this important investment?

The key “what-if” question I have is “If coastal states knew that they would not receive a dime from the federal government to protect themselves against natural disaster, how much of their own money would they have spent on such projects?”

An interesting local public finance issue arises. When do major cities use their own tax revenues to solve a problem versus when do they allow the problem to fester and continue to lobby the federal government for the money? Many newspapers are blaming the Bush Administration for not investing in the levee repair. Under what circumstance would the Governor of Louisiana have stepped in and used state resources to pay for this?

A point that I have not seen discussed in the role of for profit insurance companies in New Orleans. Suppose they charge home owners lower premiums if the levees were in better condition. This would have provided each home owner in the metro area with an incentive to lobby local politicians to address the issue perhaps even without federal money.

Finally, a point about the victims. The New York Times says that most of dead will most likely be poor blacks. In previous disasters such as the Chicago Heat Wave a couple of summers ago, the victims were poor blacks. This suggests that investments in natural disaster risk mitigation represent a type of “redistribution” because the poor are most likely to face mortality risk from such shocks.

Several recent economic studies have shown that the U.S is relative stingy as compared to other nations rather stingy See Alesina, Alberto and Edward Glaeser, Fighting Poverty in the U.S and Europe: A World of Difference, Oxford University Press 2004. Once a Tsunami or this hurricane takes place, we are much more willing to redistribute at least for a little while. Is this strange?

Homeland Security Department is investing a fortune attempting to reduce the realization of low probability terror attacks. Should there be a Department of Natural Disaster Security? At the margin, what are the marginal benefits of investing an extra dollar in the former versus the latter?