Underinvesting in Resilience
By Michael Spence
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.
Michael Spence, a Nobel laureate in economics, is Professor of Economics
at New York University’s Stern School of Business and Senior Fellow at the
Hoover Institution. His latest book is The Next Convergence – The Future of
Economic Growth in a Multispeed World (www.thenextconvergence.com).
