fedgazette Roundup (2011-2015)

A wealth of flooding: A view from economics

Ronald A. Wirtz | Editor, fedgazette | @RonWirtz

Published June 8, 2011

Even if you don’t live in the Dakotas or Montana, you’re likely familiar with the vast flooding that has occurred over the past weeks, with still more to come as deep snowpack in Montana mountains melts and hits already-bloated rivers and streams, much of it eventually heading east via the Missouri River into the similarly soaked Dakotas.

The flooding is so widespread that it can be hard to get your hands around the economic impact of flooding. Over the coming months, the Federal Reserve Bank of Minneapolis will be attempting to do just that. In the meantime, it’s useful to tack up some theoretical background behind the immediacy of flooded communities and farmland across the western portion of the Ninth District.

Economists generally recognize four discrete economic stages related to flooding and other disasters; each has to do with either preparation for or recovery after a disaster. The first stage is the use of available but scarce resources to protect wealth. For example, public and private entities have created insurance products, and households and businesses buy these products to protect their assets.

Governments, businesses and households also spend resources to build temporary defenses against floods—river dikes, houses with raised living floors—and they expend additional funds planning for floods and keeping close tabs on the possibility of flood by monitoring and predicting water levels. Such expenses represent an opportunity cost because this money could have been spent on other needs, or saved. But the resources spent are perceived to be small in the context of potential damage and loss of wealth caused by a disaster. The efficacy of such spending (and for whom) depends on the frequency of disasters, as well as who pays for—and benefits from—the protection.

The second stage is the destruction of wealth. The opportunity cost of protecting all assets against disasters is extremely high—if that weren’t the case, there would be no such things as disasters. Instead we’d merely call them unique weather events because there would be no economic loss to justify the label of disaster. And when assets go unprotected, there is the prospect of loss from a variety of events, natural and otherwise.

The third stage is rebuilding wealth, which often has the look and feel of economic expansion as governments, businesses and households spend significant resources to rebuild. This new activity increases economic output, but it only replaces the wealth that has been destroyed. Economists call this the broken window fallacy because despite the buzz of activity, society's net wealth is lower after disasters. 

The final economic stage is the evaluation of past practices and the development of new strategies for protecting wealth—the lessons learned, if you will. This evaluation of past protection efforts extends to government, businesses and individuals.

These phases can be seen in any disaster. The current one unfolding in the Dakotas and Montana is only in the second phase in most places, as the floods are still exacting their toll on private and public buildings, farmland, infrastructure and other assets. The last epic flood disaster in the Ninth District was in the Red River Valley in 1997, which the fedgazette analyzed near its 10-year anniversary. Go here to read the analysis and see the various stages in play.