Stephen King: Hurricane Katrina shows that America's free market does not have all the answers

There's a time for government to help establish the socially appropriate market price

Led Zep IV came out at the end of 1971, 34 years ago. If an English rock group back then knew about the risks associated with a breach of levees in the American Deep South, it makes you wonder why successive US governments, at both federal and state level, have seemingly done little about those risks. George W Bush may be getting a lot of stick at the moment for his perceived mishandling of the crisis but, longer-term, the recriminations will spread a lot further and a lot wider. Could the disasters that have befallen Louisiana, Mississippi and Alabama have been averted? And, even if they were somehow inevitable, why is it that the subsequent rescue operation appears, at least in the first few days, to have been so extraordinarily shambolic?

The risks of a disaster of this magnitude have been known about for years. Perhaps, though, this knowledge led to a perverse complacency. Other risks were somehow seen to be politically "sexier" precisely because of their lack of predictability. Take, for example, comments from the US Geographical Survey: "The States and the US territories are affected every year by recurring natural hazards. Earthquakes, although they happen infrequently in comparison with floods and hurricanes, are dangerous because of their unpredictability." The Geographical Survey doesn't quite spell it out but the inference from their statement is that predictable hazards are somehow less dangerous. Post-Katrina, that inference looks pretty foolish.

Then there's the approach of the Federal Emergency Management Agency. FEMA's origins can be traced back to 1803, but its accumulated wisdom over the last 200 years appears to have been of only limited help in this latest disaster. In March 2003, FEMA, formerly independent, was subsumed into the Department of Homeland Security. Even before then, according to FEMA's own history, "Billions of dollars of new funding were directed to FEMA to help communities face the threat of terrorism". On its own admission, "FEMA was actively directing its 'all-hazards' approach to disasters toward homeland security issues".

FEMA also states that its "mission remains: to lead America to prepare for, prevent, respond to and recover from disasters with a vision of 'A Nation Prepared'. At no time in its history has this vision been more important to the country than in the aftermath of September 11th." The reference to 9/11 is revealing: even if hurricanes were a risk, and even if the levees might have been breached, political priorities were focused elsewhere. The US chose to fight terrorism. Although that choice was - and is - understandable, America's rejigging of priorities may have left it vulnerable in other areas.

Beyond these observations, though, there are other issues which will increasingly be difficult to sweep under the carpet. Of the 50 states that make up the United States, Alabama, Louisiana and Mississippi are three of the poorest coming, respectively, fortieth, forty-first and fiftieth in per capita income levels in 2004. And, as the table shows, the proportion of the population that is made up of black people is significantly higher than for the US as a whole (and, by way of contrast, I've included the data for Massachusetts as well). When television images show that the majority of people trapped in the hellholes that now make up the Mississippi basin are black, it's not difficult to work out that, in these poor states, the poorest of the poor are mostly from one ethnic background: they're the ones who couldn't escape, who already had no job and could not heed Robert Plant's recommendation to go to Chicago.

Then there's the issue of market failure. America is a country that strongly believes in the free market, and the freedom of the individual to operate within that free market. Yet everyone knows that not everything in life can easily have a market price, whether it's pollution, over-fishing, or hurricane risk. The suffering we're now seeing in the Deep South evokes John Kenneth Galbraith's famous reference to "private affluence, public squalor". If a nation becomes too reliant on the market, and market failures are therefore ignored, the nation's longer-term economic health is potentially compromised.

This is not to say that we should be heading towards some sort of socialist utopia (think Chernobyl) but, rather, that some mechanism should be found to ensure that businesses and individuals pay for the social costs of their private actions. If stronger flood defences are a requirement for cities like New Orleans, then those that profit from activity in the region should be made to bear some of the costs. After all, property developers who are given a free rein to invest without making a proper contribution to flood defences are typically long gone before disaster strikes: their profit all too easily comes at the detriment of those who, later on, have to pick up the pieces. There's a need to understand when government has to be involved to help establish the socially-appropriate market price.

And issues of market failure extend into areas that, hitherto, the United States has steered away from. At this stage, it's difficult to know whether climate change has had any influence on the hurricane season: the season is nothing new, the frequency of hurricanes is no greater although, possibly, the severity of the storms may have increased. It may simply be that New Orleans was destined to be hit one day, whether or not global warming had occurred. Nevertheless, the US is by far the world's biggest consumer of energy and so long as the heavily-indebted US consumer remains committed to driving a fleet of SUVs, no change is likely. If a blessing ever comes from this disaster, it may be that America will finally recognise that its dependency on oil is damaging not just to the global environment but also, as the President might put it, "to the folks back home".

Finally, there's the short-term issue of the economic fallout associated with the disaster. Estimates of the scale of destruction are inevitably tentative: insurance companies are talking about total costs of $25bn. This seems low: the Mississippi river flood of 1993 caused $15bn-$20bn of damage and 48 deaths, and the latest disaster seems to be on a rather different scale. Knowing how much a disaster costs is not, though, the same as knowing what the impact on the overall economy will be. Where will the funding come from? What is the opportunity cost of the extra spending? How successful have economists been at working out the economic consequences of previous disasters? (A look at the record post-9/11 or in the aftermath of Japan's Kobe earthquake suggests that any attempt to calculate the overall impact on the economy should be taken with a large pinch of salt.) And, whether or not Katrina itself has a lasting impact, how will the US cope with oil prices that have taken oil consumption as a share of GDP back to levels seen just after the first oil price shock? After all, although most disasters seem to have little lasting effect on economic activity, the evidence from higher oil prices is a lot less encouraging. Katrina's aftermath is unlikely, on its own, to be the trigger for a US economic downturn but it's just possible that Katrina's arrival may signal the high water mark of America's economic recovery.

Stephen King is managing director of economics at HSBC

stephenking@hsbcib.com