COUNTERCOLUMN: All Your Bias Are Belong to Us

Those are the words from some old Rush tune.

I never much cared for Rush. But they were dead on about Hurricane preparedness, as this excellent column from Reason Magazine demonstrates:

The question, then, is not whether the failure to improve New Orleans's flood protection was a mistake in hindsight—obviously, it was—but whether it was a reasonable choice in foresight, based on the probable odds and costs as they appeared at the time.

Weighing low-probability, high-cost events is, as it happens, something economists and engineers know a bit about. W. Kip Viscusi, an economist at Harvard Law School and the editor of the Journal of Risk and Uncertainty, points out that the Corps of Engineers was among the first to develop and apply what has become a common cost-benefit template.

Using the more cautious of Strock's figures, assume the odds are that a storm surge would overtop or breach the existing New Orleans levees once every 200 years. This seems, if anything, optimistic, given that Category 4 storms hit the city in 1915 and 1947; that a Category 5 storm (Camille) narrowly missed in 1969; and that the devastating Katrina itself was not a direct hit. Still, assume it. Assume also that officials could reasonably expect the city's inundation, abandonment, and partial destruction to cost, ballpark, $200 billion in direct and indirect economic losses.

In any given year, then, figure that the expected economic cost of the swamping of New Orleans is $1 billion (divide the $200 billion cost over 200 years). A $2 billion levee project could be expected to pay for itself, probabilistically speaking, in two years; a $14 billion Delta restoration project, in 14 years.

But wait. New Orleans's 200-year flood might take place a century from now instead of right away (remember, this analysis is from a pre-Katrina standpoint), and money lost in the future matters less to us than money lost today. At an interest rate of 3 percent, Viscusi says, the present value of averting $1 billion in expected annual damage forever is $33 billion; at 5 percent, $20 billion; at 10 percent, $10 billion. Any of those numbers is higher than the estimated cost of hurricane-proofing the levees, and all but the smallest are higher than restoring the Delta.

Exactly. Even ignoring the tremendous nontangibal human costs of inadequate preparation (which the article goes on to note), this is exactly the sort of cost-benefit and risk analysis that public policy officials should have been doing years ago - and should continue to do with every other city and state (it's a local responsibility - not a Federal one. Local officials are inevitably more familiar with their own locale's risk budget and risk tolerance than any bureaucrat could possibly be in Washington.

Indeed, this is exactly the kind of risk discounting that insurance companies and reinsurance companies do every day, all the time. And the math is compelling: This was a no-brainer public investment, which went unmade for years because of a deadly combination of corruption, myopia, and inertia.

Meanwhile, someday, Florida will catch another Cat 5 storm. As will Louisiana and Mississippi. California will experience another major earthquake. Hawaii will, sooner or later, experience another tsunami, like the one that devastated Hilo in the 1940s. (One look at Hawaii's coasts would confirm that the devastation now would dwarf anything possible in the 1940s.)

The U.S. should not go crazy looking in the rear view mirror rebuilding New Orleans with Federal dollars. That's what the capital markets are for. We have several layers of insurance and reinsurance protection which exists for precisely that eventuality. And thanks to reinsurance companies like Swiss Re and General Re, and other global risk distribution companies, these risks are distributed on a GLOBAL scale, not a national one.

If the U.S. bails the city of New Orleans out, we would simply be transferring the absorbtion of risk from the widest risk pool possible (the global capital markets) to a comparatively narrow one (the American taxpayer).

The U.S. would also be setting a dangerous precedent: The removal of moral hazard. Once that precedent is set, all local governments, and the entire U.S. business community now have an incentive NOT to seek adequate insurance coverage.

The result will be a major distortion in risk markets. Either way, the premium will be paid. It can be made in advance by those who profit from the risk, and have the freedom to assess their own risk tolerance, and spread across the global capital markets, or it can be made in arrears by the American taxpayer who does not.

The best investment of federal dollars is not in bailing out those New Orleans residents and business owners who screwed everyone around them by not obtaining adequate insurance coverage (hoping for a sweet FEMA bailout if the worst should happen). That would simply be a massive gift from the taxpayers of the United States to the insurance industry at large, which supposedly exists for the very purpose of covering cities for the risk of disasters like Katrina.

Rather, the available federal money should be invested in real capital improvements to federal assets, such as highways and buildings, pipelines, levees, and other major interstate public works programs, to prepare them for the next disaster or terror strike. In the end, such preparations will enable insurance premiums to lower for everyone. Globally.

And that's a gift worth giving.

Splash, out

Jason