Discussion on Katrina

I have a had a very interesting discussion with David Miller, a fellow contributor to Minyanville.com, on Federal government’s role in hurricane Katrina. David publishes Biotech Monthly and knows biotech industry inside and out. I wrote the following:

I think the Federal government is to blame in part for the level of destruction caused by the hurricane. This is not a political statement but rather an economical one; remember I am a capitalist pig (not a political one)!

There is a very good reason why insurance companies did not want to underwrite flood insurance in New Orleans. The probability of a city residing below sea level being flooded is very high, and thus private insurance companies would have had to charge premiums that would make living in New Orleans unaffordable. The Federal government was selling flood insurance below its true market cost, thus tax payers have subsidized the true cost of living in New Orleans.

In the absence of Federal government intervention, people would have thought twice about building houses in a high risk flood area, as the "market" cost of insurance would have entered into economic equation of that decision.

This unfortunately is catch up time financially, as taxpayers across the United States will be rebuilding New Orleans, and yes, this $2000 is coming from their pockets. Is it the right thing to do? Yes, we have to help our own in such an unbelievably terrible time of disaster. However, we should be mindful of what impact government actions (even those which are driven by good intentions) will have on the human behavior and the resulting externalities.

According to the WSJ, Allstate (ALL) is gradually pulling out from Florida, as local insurance bureaucrats don't allow the company to raise rates to charge local residents enough for the risk of non-recurring events - hurricanes - which “non-recur” every August and September. Allstate is a not a government entity thus it makes decisions that are arguably economically sound. David Miller responded:

If the federal government doesn't underwrite insurance in the hurricane areas, then it would also have to ignore the consequences of not being insured. Our society is simply not capable of that. If we "merely" assume the lack of subsidy would cause people to move, then the additional concentration of population in "non-at risk areas" (wherever the heck that is) has a significant (and almost always unintended or ignored) cost that also must be factored in.

I saw such unintended consequences occur in coastal Washington state when reliance on flawed science eliminated immense tracts of productive farm land from active production. Populations streamed to the cities to flee the resulting economic destruction, causing significant financial burdens. Education which, by State constitutional mandate, was funded by the proceeds from this farming has been chronically underfunded ever since (creating a downward economic spiral).

Those who make the pure capitalist/economic/whatever argument it makes no sense to rebuild New Orleans or other areas demolished by recurring natural disasters (Northridge, CA; tornado alley, nearly all river basins; etc.) naively assume it isn't a zero-sum game. Those displaced folks have to go somewhere and there is a hard dollar and economic cost to that. I replied:

David - great counter argument! Of course the lack of Federal government intervention would have changed human behavior, but then it would have been a rational decision made without outside interference. Let me run this exaggerated, but realistic example by you.

The Federal government started underwriting volcano destruction insurance and selling it at a small fraction of the cost. Towns built on the top of active volcanoes could enjoy a spectacular view of the ocean, and have become a huge tourist attraction. The land is cheap, so why not build a house? The bank will give a loan, but will require volcano destruction insurance. By this action the government has augmented human behavior transferring the cost of the insurance to tax payers, who have not reaped the full benefits of enjoying a spectacular ocean view, and at the most visited the volcano town once in awhile while staying in an overpriced bed and breakfast.

Next time you go to Florida and see a multi million-dollar villa built on the side of the ocean, remember you are paying for that with your hard earned taxes.

Oh, and one more thing...

I read in the Economist a couple days ago that recent reforms in Germany called Agenda 2010, which are pushing Germany from Socialism towards Capitalism, appear to be paying off.

All Germany had to do was remove the incentive instituted by the government for unemployed people not to look for a job. And yes, there was a side effect: it has lowered consumer confidence. But I'd rather live in the country with higher employment and less confident than other way around. David Miller responded:

OK, Vitaliy. I love the illogical extreme example so let's run with that... I'll grant you the government screwed up. With that in hand, we have a decision about those volcano dwellers. Do we let them suffer and figure it out themselves? How about prohibiting them from rebuilding there? If we prohibit them from rebuilding there, where exactly do they build that is immune from natural disaster and still allows them to economically prosper? Where could we move these hospitality industry workers that would have the appeal of volcano-top resorts?

The beach? Oops, hurricanes (or earthquakes). The river? Oops, flooding. The city? Oops, who want to get away from it all ten block up town? A "hill" in Kansas? Not exactly the same experience (and tornados).

My point is decisions repealing the "moral hazard" have a dollar cost and an opportunity cost. I am unconvinced those costs are less than what we are doing right now.

I replied: Dave this is what we do. We save them, help them and than let them decide what they want to do. However, if they want to move to the volcano land they'd have to buy insurance from the private companies that would insure a true risk. Why should you and I pay for their love of ocean views and volcanoes?

You are right! Nothing (except Colorado - that is what I keep telling my wife) is safe from natural disasters. But let people subjecting themselves to the risk of those disasters pay a true cost of those disasters. Private (as opposed to government) insurance companies will do their best to gage the risk and they'll price insurance polices accordingly.

Vitaliy N. Katsenelson, CFA Copyright Minyanville.com

This article is written for educational purposes only. It is not intended as a recommendation to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.