{"id":969,"date":"2011-08-30T08:29:07","date_gmt":"2011-08-30T12:29:07","guid":{"rendered":"http:\/\/www3.law.harvard.edu\/journals\/hlpr\/?p=969"},"modified":"2015-10-02T15:28:09","modified_gmt":"2015-10-02T15:28:09","slug":"hurricanes-and-moral-hazard","status":"publish","type":"post","link":"https:\/\/journals.law.harvard.edu\/lpr\/2011\/08\/30\/hurricanes-and-moral-hazard\/","title":{"rendered":"Hurricanes and Moral Hazard"},"content":{"rendered":"<p style=\"color: #505050\"><em>Yevgeny Shrago<\/em><\/p>\n<p style=\"color: #505050\">This weekend\u2019s highly hyped hurricane didn\u2019t materialize with the expected vengeance, but it did manage to do significant\u00a0<a style=\"font-style: inherit;color: #3f6dcf\" href=\"http:\/\/web.archive.org\/web\/20110907073957\/http:\/\/money.cnn.com\/2011\/08\/28\/news\/economy\/hurricane_damage_estimates\/\">damage<\/a>\u00a0to property across the Mid-Atlantic and Northeast.\u00a0 Flooded out homeowners find themselves in two very different categories: those with flood insurance and those without.\u00a0 Since most private insurers won\u2019t\u00a0<a style=\"font-style: inherit;color: #3f6dcf\" href=\"http:\/\/web.archive.org\/web\/20110907073957\/http:\/\/www.floodsmart.gov\/floodsmart\/pages\/about\/nfip_overview.jsp\">provide<\/a>\u00a0flood insurance, deeming it too risky, the government steps into the breach and provides the insurance.<\/p>\n<p style=\"color: #505050\">Flood insurance is an odd creature. In places where flooding is likely to happen, the government subsidizes the insurance in order to spur development.\u00a0 Suzy Khimm\u00a0<a style=\"font-style: inherit;color: #3f6dcf\" href=\"http:\/\/web.archive.org\/web\/20110907073957\/http:\/\/www.washingtonpost.com\/blogs\/ezra-klein\/post\/should-we-subsidize-flood-prone-homes\/2011\/08\/29\/gIQApl5pnJ_blog.html?wprss=ezra-klein\">argues<\/a>\u00a0that subsidized insurance creates an incentive for overdevelopment of flood-prone regions, since owners in those areas do not have to pay the full cost of the insurance.\u00a0 Khimm has several good points about problems with the way this insurance is handled, but the subsidy regime is even more perverse than Khimm recognizes.<!--more--><span id=\"more-6073\" style=\"font-style: inherit\"><\/span><\/p>\n<p style=\"color: #505050\">First, flood-prone property is often beach-front property, which makes it quite expensive. Subsidized flood insurance not only encourages development, but it props up the values of the already developed homes, since the owners don\u2019t have to worry about losing their investment. \u00a0 When floods happen, the insurance program payout includes the bump in house value from the subsidized insurance.\u00a0 Therefore, the government is paying for the benefit it bestows on the homeowners.\u00a0 Second, because the insurance is only subsidized in flood-prone areas, residents of other areas see something closer to market rates\u2014and given the low chances that they will be flooded out, probably won\u2019t buy flood insurance.\u00a0 When an extreme weather event like Irene causes\u00a0<a style=\"font-style: inherit;color: #3f6dcf\" href=\"http:\/\/web.archive.org\/web\/20110907073957\/http:\/\/www.nytimes.com\/2011\/08\/30\/us\/30vermont.html?pagewanted=3&amp;hp\">substantial inland flooding<\/a>, the people living outside of flood-prone areas lose their houses and their savings, while the ones who were living dangerously get a check for their troubles.<\/p>\n<p style=\"color: #505050\">The problem with Khimm\u2019s argument for eliminating the flood insurance subsidy is that it won\u2019t end the subsidy to people living in the flood-prone areas.\u00a0 Edward Prescott and Finn Kydland won a Nobel Prize in Economics in 2004 in part for their discussion of this problem in their 1977 paper, \u201c<a style=\"font-style: inherit;color: #3f6dcf\" href=\"http:\/\/web.archive.org\/web\/20110907073957\/http:\/\/tek.bke.hu\/files\/szovegek\/kydland_prescott_rules_rather_than_discretion.pdf\">Rules Rather than Discretion: The inconsistency of optimal planning<\/a>.\u201d In the paper, Prescott and Kydland point out that governments are not credible actors and use the example of homeowners building houses in a flood plain despite the government\u2019s stated refusal to provide flood-control measures.\u00a0 The authors point out that homeowners, as rational agents, will realize that once they have build the houses, the government will have no choice but to take the flood control measures, thereby subsidizing development in flood prone areas.\u00a0 Without subsidized flood insurance, we will only see increased pressure to provide costly flood protection in advance of every major storm or some other expensive flood countermeasure.<\/p>\n<p style=\"color: #505050\">Kydland and Prescott have an answer for this problem, and it\u2019s a blunt one.\u00a0 If an area is particularly flood prone, then the government should ban development.\u00a0 If that\u2019s not politically feasible, then a tax on development in the region can force homeowners to at least bear a larger share of the costs of development.<\/p>\n","protected":false},"excerpt":{"rendered":"<p>Yevgeny Shrago This weekend\u2019s highly hyped hurricane didn\u2019t materialize with the expected vengeance, but it did manage to do significant\u00a0damage\u00a0to 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