Friday, November 28, 2014

Underinvesting in Resilience

NEW YORK – The hurricane on America’s eastern seaboard last week (which I experienced in lower Manhattan) adds to a growing collection of extreme weather events from which lessons should be drawn. Climate experts have long argued that the frequency and magnitude of such events are increasing, and evidence of this should certainly influence precautionary steps – and cause us to review such measures regularly.

There are two distinct and crucial components of disaster preparedness. The one that understandably gets the most attention is the capacity to mount a rapid and effective response. Such a capacity will always be necessary, and few doubt its importance. When it is absent or deficient, the loss of life and livelihoods can be horrific – witness Hurricane Katrina, which ravaged Haiti and New Orleans in 2005.

The second component comprises investments that minimize the expected damage to the economy. This aspect of preparedness typically receives far less attention.

Indeed, in the United States, lessons from the Katrina experience appear to have strengthened response capacity, as shown by the rapid and effective intervention following Hurricane Sandy. But investments designed to control the extent of damage seem to be persistently neglected.

Redressing this imbalance requires a focus on key infrastructure. Of course, one cannot at reasonable cost prevent all possible damage from calamities, which strike randomly and in locations that cannot always be predicted. But certain kinds of damage have large multiplier effects.

This includes damage to critical systems like the electricity grid and the information, communication, and transport networks that constitute the platform on which modern economies run. Relatively modest investments in the resilience, redundancy, and integrity of these systems pay high dividends, albeit at random intervals. Redundancy is the key. 

The case of New York City is instructive. The southern part of Manhattan was without power for almost a full workweek, apparently because a major substation hub in the electrical grid, located beside the East River, was knocked out in a fiery display when Hurricane Sandy and a tidal surge caused it to flood. There was no pre-built workaround to deliver power by an alternate route.

The cost of this power failure, though difficult to calculate, is surely huge. Unlike the economic boost that may occur from recovery spending to restore damaged physical assets, this is a deadweight loss. Local power outages may be unavoidable, but one can create grids that are less vulnerable – and less prone to bringing large parts of the economy to a halt – by building in redundancy.

Similar lessons were learned with respect to global supply chains, following the earthquake and tsunami that hit northeast Japan in 2011. Global supply chains are now becoming more resilient, owing to the duplication of singular bottlenecks that can bring much larger systems down.

Cyber security experts rightly worry about the possibility of bringing an entire economy to a halt by attacking and disabling the control systems in its electrical, communication, and transportation networks. Admittedly, the impact of natural disasters is less systemic; but if a calamity takes out key components of networks that lack redundancy and backup, the effects are similar. Even rapid response is more effective if key networks and systems – particularly the electricity grid – are resilient.

Why do we tend to underinvest in the resilience of our economies’ key systems?

One argument is that redundancy looks like waste in normal times, with cost-benefit calculations ruling out higher investment. That seems clearly wrong: Numerous expert estimates indicate that built-in redundancy pays off unless one assigns unrealistically low probabilities to disruptive events.

That leads to a second and more plausible explanation, which is psychological and behavioral in character. We have a tendency to underestimate both the probabilities and consequences of what in the investment world are called “left-tailed events.”

Compounding this pattern are poor incentives. Principals, be they investors or voters, determine the incentives of agents, be they asset managers or elected officials and policymakers. If principals misunderstand systemic risk, their agents, even if they do understand it, may not be able to respond without losing support, whether in the form of votes or assets under management.

Another line of reasoning is that businesses that depend heavily on continuity – for example, hospitals, outsourcing firms in India, and stock exchanges – will invest in their own backup systems. In fact, they do. But that ignores a host of issues concerning the mobility, safety, and housing of employees. A broad pattern of self-insurance caused by underinvestment in resilient infrastructure is an inefficient and distinctly inferior option.

Underinvestment in infrastructure (including deferred maintenance) is widespread where the consequences are uncertain and/or not immediate. In reality, underinvestment and investment with debt financing are equivalent in one crucial respect: they both transfer costs to a future cohort. But even debt financing would be better than no investment at all, given the deadweight losses.

Cities and countries that aspire to be hubs or critical components in national or global financial and economic systems need to be predictable, reliable, and resilient. That implies a transparent rule of law, and competent, conservative, and countercyclical macroeconomic management. But it also includes physical resilience and the ability to withstand shocks.

Hubs that lack resilience create cascades of collateral damage when they fail. Over time, they will be bypassed and replaced by more resilient alternatives.

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    1. CommentedProcyon Mukherjee

      Under-investment in resilient infrastructure that tends to defer costs to the future, is an inherent problem, not just due to lack of incentives, but because very few understand the concept of depreciation in physical infrastructure till the point is reached when investment must be made several times the physical depreciation in assets; Michael is so right when he talks about self-insurance and the bloated faith in it, the malaise that plagues many institutions, countries and administration who live in the short term world view.

      Procyon Mukherjee

    2. CommentedRichard Potter

      Why should taxpayers have to pay one cent in taxes to provide "resilience" to homeowners who never should have built homes on floodplains, barrier islands and oceanfronts in the first place, please? The economics of providing subsidized flood insurance, artificially depressed in price auto and home insurance, seawalls and dikes are just perverse. Like the TBTF banks, such residents enjoy their costly water views while they can, and then pass along the costs of a natural disaster to those of us who can not or will not live in such risky places. Let such homeowners pay the fully-loaded, risk-adjusted costs of their homes, and only then come to me with hands out for "resilience" investments.

    3. CommentedZsolt Hermann

      The article started in a promising way, mentioning the worsening climate events, hinting at human responsibility, also mentioning that besides effective crisis management we also need prevention, and then it just stopped connecting the two together.
      It does not matter what structural preparation humans do, how high walls we build, how deep we bury the electric lines, how the financial markets prepare, unless we actually try to get to the root problem.
      This root problem is humanity's total opposition to nature's system.
      While nature is based on the laws of general balance and homeostasis, when in nature each species is tightly interconnected within themselves and even with other species building a self sustaining and developing chain, human beings within their own species are each other's predators, killing each other, wiping out whole nations, cultures either physically or culturally, psychologically.
      And as a species they apply such a socio-economic system that is all about total exploitation of the human and natural resources around, basically behaving like a cancer within the body of nature.
      By the way latest research shows that even cancer cells have very sophisticated communication system with each other, so at least the cancer within itself is well organized and united, while the human cancer even within itself is self destructive, moreover each human being is destroying itself with the harmful lifestyle they pursue.
      In short it does not matter what we build or how we build it until we correct the only problem there is: the inherent self serving, subjective human nature.
      And this is where humans are superior to any other living creature, people are capable of self assessment and self adjustment provided they receive positive motivation to do so.
      The negative motivation is already upon us, either natural catastrophes, or the internal imbalance and explosion within human society is threatening our future.
      The positive motivation should come from an informed, transparent and scientific understanding of the global, fully integrated natural system we exist in and how humanity should adapt to this system in order to survive.