Irrational Economist_ Making Decisions in a Dangerous World - Erwann Michel-Kerjan [84]
A continuing behavioral question is why economic agents with huge stakes ignore the warning signs of forthcoming catastrophes and then suffer the consequences. In some instances, perhaps individuals believe “it will not happen to me” or they consider the events to be of too-low probability and then act as if the probability is actually zero. In others, government bailouts may be anticipated, leading some to take risks they would not otherwise take. And in still others, maybe economic agents underestimate the magnitude of the consequences, possibly because they have failed to recognize the externalities and systemic reactions the event will create, or otherwise have used an improper model to generate the loss distribution. This last factor seems particularly relevant to the subprime crisis, since the systemic effects have far exceeded the direct losses on subprime mortgages.2
Lesson 2: Government Intervention is Essential in the Aftermath of a Catastrophe
Following a catastrophe, “Who you gonna call?” The government, of course. The reality is that private markets regularly fail in the face of a catastrophe, and government or associated nonprofit entities are often the only available responders. This clearly applies to the emergency aid needed in the very short run, although the government response is not always effective, as was evident in New Orleans following Hurricane Katrina in 2005. In the medium run, government aid to reconstruct structures and infrastructure is often very limited, even if the conventional wisdom is to the contrary. By contrast, reconstruction aid following the 9/11 terrorist attacks and Katrina has been more substantial. Total federal assistance following 9/11 was approximately $30 billion, only slightly below the insured losses of about $35 billion. And government assistance following Katrina may well have exceeded the insured losses relating to that event. The subprime mortgage crisis has elicited strong calls for government aid, and it is fair to say that the government response so far has been disorganized, ineffective, and remarkably opaque in terms of its goals and strategies. This is all the more disturbing given the dollar costs of the subprime crisis, which far exceed those of past natural disasters or the terrorist attacks of 9/11. Due to regulatory “forbearance,” the response to the savings-and-loan crisis of the 1980s was also inefficient. One implication is that a greater role could be assigned to well-designed government insurance programs as “automatic stabilizers” to counter future financial crises.
Lesson 3: Government Catastrophe Insurance Responds to Private Market Failures
Over the last forty years, private insurance firms have withdrawn from providing primary coverage over the entire range of natural disaster and terrorism risks in the United States.3 The federal government started providing primary coverage against floods in 1968, following a decade of extremely heavy flooding. The state of Florida has provided primary reinsurance against hurricanes since Hurricane Andrew in 1992, and the state of California has sponsored the state’s primary earthquake coverage through a quasi-public entity since the Northridge quake of 1994. Most recently, the private market for terrorism insurance stopped functioning immediately after the 9/11 attacks, leading to the current system backed by free federal government reinsurance up to $100 billion.
To be sure, a fringe of private insurers remains in most of these markets, either by cherry-picking risks where the government’s premiums are too high or by providing special