The Gulf Coast's other disaster: moral hazard

The sheer magnitude of hurricane Katrina's destructive power dominated last week's anniversary coverage of the storm. But there's been little notice of another disaster that injured the Gulf Coast in Katrina's aftermath: the tragic incentives created by the federal government's recovery effort.

Even the simplest, most well-intentioned programs created problems. Take FEMA's debit-card program.

A year ago today, the Federal Emergency Management Agency (FEMA) began dispersing $2,000 debit cards to affected households. At the time, it was considered an innovative approach that offered flexibility and immediate cash assistance to those sorely in need.

But these debit cards proved to be a bit too flexible. A February study by the Government Accountability Office (GAO) found that some debit cards were used to buy guns, jewelry, tattoos, and lap dances. Surely policymakers did not intend to aid the sales of "Girls Gone Wild" DVDs. And mistakes and fraud in FEMA's broader effort to provide relief cost taxpayers at least $1 billion, the GAO later estimated.

Critics pounced on the reports as additional evidence of the government's incompetence – or the storm survivors' greed. But obscured in the scandal was the larger lesson of the deleterious effects of moral hazard in public policy.

In economics, moral hazard refers to people's tendency to make bad decisions when they do not bear the full cost of their decisions. We all face moral hazard: People with good health insurance are more likely to play extreme sports; rental-car drivers are more cavalier on the road than drivers who own their cars.

Structures with bad incentives cause good people to make harmful decisions. The Gulf Coast region had particularly bad incentive structures. Consider federally subsidized flood insurance. This program encourages people to live at or below sea level and near the coast. Thus many more people, responding rationally to the incentives established by public policy, live – and lose their homes – in these areas than otherwise would.

Moral hazard also occurs when people spend other people's money instead of their own. Take FEMA's debris removal and reconstruction spending. It uses federal tax dollars to reimburse state and local governments or other federal agencies for part or all of the cost they or their contractors incur removing debris. Given programs like that, it should be no surprise that eliminating FEMA disaster relief would reduce corruption more than 20 percent in the average state, according to "Weathering Corruption," a new study by West Virginia University economists Russell Sobel and Peter Leeson.

This is not a question of accountability. Messrs Sobel and Leeson show that stricter rules would do little to stem corruption. Rather, it is the predictable result of public policies that send the wrong signals. If the signals don't change, neither will the consequences of moral hazard.

That's partly why rebuilding has been so slow. Governments are sending mixed signals to Gulf Coast residents about where they can rebuild, what public services they will have, and whether their property rights will be respected.

But there's reason for hope. Constructive signals from individual initiative are stimulating successful rebuilding. In St. Bernard Parish, La., school chief Doris Voitier bypassed FEMA and reopened local schools just two months after Katrina, enrolling 703 students, according to a study by Emily Chamlee-Wright, a scholar at George Mason University's Mercatus Center in Arlington, Va.

Katrina's aftermath has driven home the point that the folly of mankind can compound the fury of nature. But if individual decision-making is unleashed and incentives are aligned, then small steps in the right direction can help rebuild lives and communities.

• Peter J. Boettke is a senior fellow at the Mercatus Center and professor of economics at George Mason University.