Moral Hazard and City Location

Lynne Kiesling

One of the themes of post-Katrina punditry has been “why build a city below sea level and between three bodies of water?” Think about the history of the US, or for that matter, the Netherlands. The critical growth occurred at a time when waterways were the primary means of transportation (the 17th century in the Netherlands and the early 19th century in New Orleans). Location near waterways was the cost-minimizing strategy. As more people did so, agglomeration economies kick in, and it’s valuable to live where others are also living (both for work and for leisure), so growth naturally occurs. But as technological change happens and transportation evolves, relative values shift. Yet path dependence/initial conditions shape the dynamic; the city is there, it has a history, a culture, a heritage. So even though the economic reasons for its location have diminished, it persists.

At the time of New Orleans’ initial growth, levee investment was a local investment issue. Larry White importantly reminds us that levee construction and maintenance was initially funded locally, but then federalized:

…[T]he US Army Corps of Engineers became responsible for the levees during the War of 1812. Before that New Orleans levied its own taxes (on shippers who used the port) for levee maintenance. After that taxpayers all over the US would pay, and folks in DC rather than Louisiana would choose how much would be spent on levee maintenance.

Clearly most New Orleans or Louisiana taxpayers would have been willing to pay for levee maintenance if they knew they had to, but of course the city and state didn?t volunteer ? even though they knew the need for strengthening ? because they were counting on the federal taxpayers to pay for it. Live by the federal subsidy, die by the diversion of federal subsidies to other priorities. A tragedy of over-centralization.

The real moral hazard question comes, though, when you consider not “why build it there” in the first place, but when you consider a more nuanced question. Given the existence of the city in its location and its distinctive benefits (and costs), at the margin, were people more likely to live there because of the presence of and reliance on subsidized levee maintenance and subsidized federal flood insurance? That is the material point.

Often in the name of “public goods” or “internalizing externalities” public policy creates moral hazard incentives for people by expanding the distance and loosening the connection between what you get and how you pay for it. If I live in New Orleans and I think that my tax dollars (and my neighbors’, and all US taxpayers) are going toward maintaining levees and providing post-hurricane reconstruction resources, then I am more likely to rely on those others, as well as being more likely to live someplace I wouldn’t otherwise.

Thus I think the rampant blaming of federalism that is swirling around us this week is incorrect and misplaced, and too crude. Rather, the focus should be on the appropriate level at which to take action in order to align incentives and information. In this case, even if you believe that levee maintenance is a public good, aligning the incentives and information to get the best possible outcome means a more local approach.

If you are interested in thinking about how cities grow and change over time, I highly recommend Jane Jacobs’ The Death and Life of Great American Cities. This classic work analyzes the robust, resilient, interesting urban results of bottom-up emergent order as a growth process, versus the stultifying, static, sterile results that often arise from top-down centrally-planned urban orders.