Saturday, November 3, 2012

Should the government help in case of natural catastrophes

With the recent calamity that descended on the Northeast coast of the United States, an old claim of presidential candidate Mitt Romney resurfaced: emergency operations in such cases should be left to the private sector. Now that it has happened, this statement is viewed as embarrassing. Is it really?

It is clear that there is a case of intertemporal inconsistency here. Imagine that as a government you assert you will not help people in a flood plain, but once there is a flood, you are compelled to help. The same holds for Romney, he now stands there as a politician without compassion. But he still has a point: why should the public sector take over something that the private sector could do as well?

Well, does it? A very significant part of the rescue and clean-up operations are already being performed by the private sector. Reconstruction of homes and rebuilding the electrical grid are tasks for private contractors. The public part in this is mostly the financing of it all, through grants, subsidies and preferred loans, which are of course financed from taxes. This looks very much like an insurance scheme, thus the question boils down to whether there would be a market for private insurance against natural events, and whether this market would do better than the current situation.

Most insurance policies actually have exclusions for natural events, and for a good reason. It becomes very difficult for an insurance company to credibly cover such costs, especially if it were to include transportation infrastructure. As, say, an earthquake causes widespread destruction, the insurance company cannot spread the risk. It is an aggregate risk, and there are very few counter-parties to absorb this type of risk. Especially now that natural events are becoming more frequent and more costly, re-insurance companies have themselves a hard time providing credible guarantees.

A government is in a better position here: it can leverage its power to tax in the future to obtain lots of resources. It can confiscate goods and time (through an army) to mobilize cheaply resources towards immediate relief that is of higher social than private value. It can change the rues of the game to provide help to everyone. All this the private sector cannot do.

And, finally, if private insurance were so much better, why is there no such insurance in place, especially for governments?

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