Op-Ed: Disaster Relief and Flood Insurance by David Montgomery

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President Trump’s economic, political, and moral instincts are right when he calls for $6 Billion in Federal aid for Houston. To take the last first, giving aid to those who have lost much or everything is right for civil society and government as well. The problem both face is how to do it effectively. That requires planning and rebuilding far beyond the scale of clothing drives or even what effective, community based relief organizations like Catholic Charities (a plug for my favorite charity) can do. Hence the role for government and the moral obligation to support that funding.

Offering aid with no strings attached is politically wise, especially because it is not political payback. As another columnist pointed out, Houston was one of the few regions in Texas that Hillary won, so that everyone should understand that this is not generosity motivated by Red-state favoritism. President Trump has not had much time to promote his program of infrastructure spending, which is the one part of his platform with bipartisan support. His unconcern with the budgetary consequences of this relief effort should reassure Democrats that he is sincere in his desire to spend. At the same time, his deference to the governor of Texas and the good things the Governor said about him will please his base and other Republicans. Rarely does a politician get to make both sides happy.

It is on the economic side that questions might be raised about the implications of such an increase in spending, starting with how it will be fit into the Federal budget. Will the increase in Federal spending to rebuild the area of Texas ravaged by Harvey derail plans to reduce taxes? Will it have to come out of defense or other high priority spending? Or will it be added to the already enormous Federal debt?

I will argue that the correct economic answer is to let the additional spending ride directly into the Federal deficit and debt. This is also the most likely procedural outcome. Both these conclusions rest on the unexpected and extreme nature of the event. The whole point of saving and borrowing is to make it possible to minimize unnecessary economic harm from unexpected events. True, we have done a lousy job of saving as nation, but that does not mean that we should not tap into our continuing ability to borrow when an extraordinary need arises.

The problem with the rising national debt is that it is driven by the intended and predictable growth of spending on entitlement programs – a classic case of living beyond our means and passing the problem onto our children and their children. Nevertheless, the United States government remains able to borrow additional funds, and an occasional unexpected expenditure need not alter the timing of policies intended to deal with longer-term problems of national security, economic growth and debt reduction.

The alternatives to additional borrowing are reducing planned spending on other programs or increasing tax revenues. Both alternatives are political minefields, and would forego the long-term benefits that restoring military strength and tax reform are expected to provide. Politically, further cuts in domestic programs would strengthen Democrats opposition to the Trump budget and increase Republican defections, and taking away from increases in defense spending would outrage Trump’s base (and me, to make my preferences clear). Tax reform is already stalled because of lack of ways to offset revenue loss from rate reductions and increases in investment incentives. Its problems would just be made worse if revenue must be raised for Houston as well as offsetting tax reductions.

The most worrisome consequence of this additional borrowing is very arcane: how it will affect the Federal Reserve System’s plan to correct its balance sheet. A great deal of the recent increase in Federal debt was acquired directly by the Fed and put on its balance sheet as an asset, and the Fed has announced a schedule for selling off that debt. A new increase in borrowing by the Federal government could upset the Fed’s delicate calculation of how its selloff will affect interest rates and as a result slow its progress toward a normal balance sheet which puts it less at risk.

Procedurally, there is no obstacle to increasing the Federal deficit to accommodate disaster spending. Anticipation that disasters requiring added Federal spending will on occasion occur is the reason why the Congressional Budget Act allows the budget to be revised through Reconciliation Instructions.

The paramount procedural question is how to deal with the Federal flood insurance program. Economists (including me) have long criticized that program for subsidizing flood insurance in a way that encourages development in vulnerable areas – and even my friends in the Intergovernmental Panel on Climate Change have concluded that the increased economic damage done by tropical storms is due to increased development rather than increased storm activity.

Now it is pretty clear that the extent of subsidization will become politically relevant – when the reserves of the flood insurance program are deleted by claims for damage by Harvey. Since flooding from Harvey is characterized as a 500 year event, it is likely that the reserves of the flood insurance program would have been deleted even if premiums were much higher. That is why additional Federal aid to Texas is justified. At the same time, the magnitude of the loss should signal policymakers that rates for Federal flood insurance should be increased to levels based on an actuarially sound calculation of expected payouts. After all, the definition of “insurance” is pooling of funds to share risks not a free payout for damage.

That premium is still likely to be less than the rate that a private insurer would require, for reasons also made clear by Harvey. Whereas the Federal government can use its borrowing capacity to cover claims in excess of reserves, the ability of even large insurance companies to do the same is limited. Therefore private insurers must include a risk premium to build reserves against the possibility of the “gamblers ruin” while the government does not need to do so. That is why there has to be cap on the amount of coverage provided by the Federal government to avoid driving private insurers out of the market.
Extraordinary disaster relief is another form of risk spreading that is appropriate for unforeseen events, and government insurance spreads that risk over the largest possible pool. But that does not excuse subsidies in the form of premiums that do not generate enough revenue to pay foreseeable claims.

Unfortunately, the political calculus for this most needed reform leads to the opposite conclusion from the economic one. But if predictions of sea level rise and increased storm activity with climate change do turn out to be even partially correct, ending flood insurance subsidies will become more and more necessary and extraordinary relief after the fact will be less justified. There is little reason to believe that the growth of the Houston area was driven by subsidized flood insurance, but that is not true of many other areas that could become increasingly vulnerable to flooding. Including the Eastern Shore.

Therefore, I anticipate comments similar to those made in response to an earlier column in which I defended reduction of Federal funding for Bay cleanup in favor of an interstate compact. My answer is the same, though I will be less colorful. We cannot move toward national policies designed to promote the common good unless some of us are willing to stop taking Federal money for things we could do for ourselves. Because of where I live, I would surely pay a great deal more for flood insurance if I could not get some from the Federal program. My choices of where to live and how to build would likely change if I did bear those costs. That would be a good thing for the economy as a whole, even if it changed the amenities that some of us could afford.

David Montgomery was formerly Senior Vice President of NERA Economic Consulting. He also served as assistant director of the US Congressional Budget Office and deputy assistant secretary for policy in the US Department of Energy. He taught economics at the California Institute of Technology and Stanford University and was a senior fellow at Resources for the Future.

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