Underinvesting in resilience

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. He is also a member of the World Economic Forum’s Global Agenda Council on New Growth Models.

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.

The opinions expressed here are those of the author, not necessarily those of the World Economic Forum. Published in collaboration with Project Syndicate.

Image: A woman walks past the New York Stock Exchange through the wind and snow in New York’s financial district REUTERS/Brendan McDermid