A morally hazardous conversation with my mother-in-law

A note from my mother-in-law in my inbox:

If you have time, I would love to know if you feel it is economically smart to rebuild the parts of Galveston that are so vulnerable to weather. This goes for the parts of New Orleans that would be under water if not for the levies also.

Frequent readers can probably predict my response (edited):

I’ll give you the short version: I don’t mind one way or the other if they rebuild or not. My concern is whether they are properly insured or not. To me the problem isn’t whether people choose to build in dangerous areas, but rather should the government explicitly (or implicitly) insure the homes? As long as people bear the full cost of their own decisions, then they can rebuild if they want. But I don’t think that’s the way it works anymore. Disaster insurance is underpriced because companies know they will be reinsured by the government in the case of widespread losses, homeowners build in places they shouldn’t because they can get underpriced insurance, and builders fail to meet local building standards because they know the government will act as the insurer of last resort. I’ve seen some recent stories on New Orleans where only small fraction of the houses being rebuilt meet new stricter building codes. Why? Because the builders and the homeowners know the government will pay them to rebuild if it happens again, just as they did this time. The economic term for this is ‘moral hazard’—where people behave differently if they are insured against risk. In the case of natural disasters, you get moral hazard when people choose to (re)build in disaster prone areas because they don’t have to take on the full cost of their decisions. So you get too much building in those areas and the potential for higher damages.

OK, maybe that wasn't the short version.

UPDATE:  A response from my very liberal mother-in-law:

• So how do we get the government to stop paying to rebuild in hazardous areas?
• What happened to people accepting the consequences of their actions?

Comments

[Gabe]

Aren't places like New Orleans, with it's port, and Galveston with it's oil, important places for the country's economy as a whole? If there are significant benefits to the rest of the country when folks build and live in risky areas, then it makes sense for the government to subsidize it, because there is no mechanism for private individuals to do so.

[Scott]

Tim,

Do you know why the building codes are not being enforced? I can understand why builders and homeowners are trying to skirt the codes, but why are they being allowed to do so? Here in CA houses have had to be torn down or construction halted for not following codes.

On a related note, does the concept of Moral Hazard extend to situations where a person is protected from responsibility by things other than insurance?

It seems to me that in the case of the mortgage meltdown, there was a Moral Hazard like situation that develops when someone who rights a mortgage can sell it to someone else, who then must bare the consequences of the way the mortgage was written. In fact exactly that ability to escape the consequences of poorly written mortgages by bundling and selling to others and thus through a moral hazard like mechanism, remove the incentive to underwrite loans on a sound financial basis.

Would not one simple way of eliminating this problem be to disallow the selling of loans? Thus if you write the loan you have to live with the consequences of your underwriting practices. Is there any other practical way to deal with this moral hazard?