Pecuniary and Technological Externalities, and EQC

Recall that in standard micro, a pecuniary externality is one that affects you through your budget constraint, if you follow the standard Buchanan and Stubblebine definition, or one that is mediated through the market process, if you follow other texts. A technological externality is one that affects you through your utility function (Buchanan & Stubblebine) or operates outside the market process (others).

And standard theory says that pecuniary externalities are of no efficiency consequence. They don't result in sub-optimal decisions being made; further, we usually expect that they're offset elsewhere. If my bidding at auction forces you to pay more for your house, that's a loss to you but a gain to the seller and the house still goes to its most valued use. Technological externalities generate inefficiency. So we say that policy should generally ignore pecuniary externalities and focus on technological ones.

And in Friday's paper we read that New Zealand's Earthquake Commission withheld from neighbours information about dangers posed by neighbouring buildings. Why? Because of the potential pecuniary effects:

The Earthquake Commission (EQC) withheld information on a dangerous and ultimately deadly Christchurch building to protect privacy and property prices, a royal commission has been told.

Two women were killed in Wicks fish and chip shop in Worcester St after a brick wall from the neighbouring two-storey building collapsed into the shop during the February earthquake.

Natasha Hadfield, who owned the shop with husband Geoffrey, was serving Betty Dickson when they were both crushed by falling bricks.

The Canterbury earthquakes royal commission was told yesterday that on February 1 a commission inspection of the two-storey building found two walls were unstable and "in danger of collapse".

The EQC inspector urgently requested an engineering inspection of the building, but the request appears to have gone nowhere.

EQC chief executive Ian Simpson said yesterday the file had "gone into a hole", blaming a paper filing system that had since been replaced.

"I can't answer why an engineer was not contacted," he said.

After the September 2010 quake, the building sustained substantial damage. It had its eastern wall propped, and a hole in the roof was covered by a tarpaulin. It was cleared by at least one engineer as safe.

The western wall, which fell on to Wicks on February 22, was not braced.

EQC inspectors identified the western wall as dangerous, but the information was never passed on to neighbouring building owners or the Christchurch City Council.

Simpson said the policy had been to not release any information on inspections to third parties to preserve property prices and privacy.

"It was about bricks and mortar and property prices," he said.

The policy had reflected many residents' concerns that if information on quake damage was attached to their property, it could affect values, he said.

The policy was changed in October this year, largely because of the deaths at Wicks, he said.

The pecuniary effect is troubling enough; let's take that one first.

Let's start with the best case for EQC's information withholding being efficient. Suppose that a property's earthquake damage gets listed on the Land Information Memorandum (LIM) but the damage is fixed by the owner. If the subsequent repairs don't get noted on the LIM, or if buyers are irrationally risk averse, the owner may suffer a real loss despite having fixed all the damage. If buyers are rational, this only happens where property damage is a good indicator of likely damage in subsequent events despite the property's being repaired; in that case, we impose a cost on buyers if we fail to disclose. But if they're irrational, then we could perhaps view LIM listing as being akin to noting on the LIM that somebody was murdered on the property a few decades ago if everybody in town believes in ghosts. If ghosts don't exist, then both buyer and seller are better off by that the buyer never finds out that the property might have ghost-risk.

But earthquakes are real and ghosts aren't. Even if there aren't any technological effects, policy then effects a transfer that may not be desirable: buyers can't tell which properties are subject to greater earthquake risk and so we get a transfer to the owners of risky buildings from buyers and from the sellers of relatively safer buildings who then are pooled with the owners of risky buildings.

Bringing back the potential for technological externalities, things look worse. In order to avoid a pure transfer, EQC induced a technological externality.

It's not likely that different policy would have affected outcomes in the case noted in the paper; unless the inspector finding problems immediately went next door to warn people, the information would have been lost in the system until after the 22 February earthquake anyway. So it's wrong to blame this EQC policy for these two deaths. But that sure doesn't make it good policy to trade a pecuniary externality for a technological one.

Get out of the way

Bomber Bradbury wasn't exactly kind in his review of the LibertariaNZ's opening broadcast ad. He wrote:

Libertarianz PartyWeird video outside the war zone that is Christchurch. Trying to claim Christchurch as an example of bad regulation is intellectually skanky. 

Here's Vicki Anderson on the current state of play in Christchurch.

Over eight months I have vicariously shared their rollercoaster ride with bureaucracy.

For example, one was told his venue had been demolished, then that he had been told it had been demolished in error and that it was going to be repaired.

He was upset, ecstatic and then upset again when four months later he phoned me from inside the red zone, having been allowed in after much red tape to retrieve valuable equipment from the building, saying "you're not going to believe this".

Yes, turns out the building had been demolished after all.

However, when he phoned Cera "exploding with rage", they denied that the building had been demolished, despite his offer through gritted teeth to send them photographic evidence to the contrary. They then placed him on hold for 2 hours before cutting him off.

He's a big bloke. That day I saw him cry through sheer frustration. We talked for a long time that day.

Another venue owner tried to discover what was happening with his building. He has a family member who works for the council. This family member was told to pass on the message that he should not ask any more questions.

He took the inference to be "rightly or wrongly" that her employment could be in jeopardy if he "rocked the boat". 

... On behalf of everyone who has taken the time to lob their ball into my court and share their personal stories and struggles with me over the past eight months I ask: Dear beaurucrats, our heart's gone over your fence, can we have it back now please?

Bomber, please go and read the whole thing and take off the partisan blinders for a minute.

RBNZ on seismic risk

Here's RBNZ Governor Alan Bollard on the Reserve Bank's activity during the Canterbury earthquake:

One of our most pressing concerns immediately following the earthquakes was the maintenance of payments systems. In the aftermath of events such as natural disasters, there is strong demand for food, water, petrol and other necessities. And with damage to power and telecommunications systems, access to cash is a key concern. Only two hours after the  February earthquake the Reserve Bank started receiving orders from banks for more cash for delivery to Christchurch. Ensuring cash was available required us to work closely with banks and Cash in Transit companies to meet the spike in demand. This task was complicated by damage to roads that meant travel, where possible in Christchurch, was taking about three times as long as normal.

The public also needed information about where cash was available. To ensure this, Bank staff used Google maps to provide a live feed of operational and accessible ATMs. Overall about $150 million of extra cash was sent to Christchurch in the week of the earthquake, representing about $350 per resident.  There was a big drop in electronic payments and increased demand for cash, initially in the form of $20 and $50 notes through the surviving ATM machines. We learned a lot about ATM configuration to ensure operability, and the internet was very useful to provide up to date information on ATM availability.

I saw a lot of non-functioning bank machines, but I didn't see any not working in places where the power was on and the phones were working. After the February quake, there wasn't really anything on my side of town on which money could be spent. But the precautionary motive for cash balance holding certainly has affected how much I keep on hand.

Bollard goes on to talk about balancing medium-term inflation risks coming from eventual Canterbury reconstruction against short term declines in economic activity. The costs in Wellington of a similar event would be far worse: more roading chokepoints through hills, dependence on the Cook Strait Cable, and an airport built on land that didn't exist prior to an earlier earthquake.

RBNZ is ready in case Wellington goes down:

But even though our building could be standing after an earthquake, there is a risk that damage to surrounding buildings could make the Wellington office  inaccessible. To ensure that the Bank's core functions can be maintained in such circumstances, an Auckland office has been set up that houses a dozen staff on a day-to-day basis. These staff are engaged in a number of business critical roles (including foreign reserves management, domestic liquidity, and payments and settlement systems) to ensure the economy of New Zealand would continue to function with some stability in the event of a major disaster. Furthermore,  provisions in the Reserve Bank Act provide for the delegation of key aspects of the Governor's role to the Auckland Office Manager, with appropriate safeguards.

They warn against over-reaction: guarding against downside risk imposes cost in states of the world where the risk doesn't obtain, and it's possible to overinsure against earthquake risk with building regulation. But they also warn about our potential isolation in the case of a big hit to Wellington. It's because of this latter risk that I've worried about EQC's being heavily invested in domestic government securities. Hopefully any future rebuilding of the fund will have more diversified asset holdings.

There will have to be a serious rethinking of EQC's role once the current disaster has played out; it will be interesting to see what changes RBNZ and Treasury recommend. The interplay between EQC and private insurers have been a complete mess. Whatever losses might obtain due to agency problems in a world where EQC simply covered the first $100k of property damage as assessed by the private insurer are likely less than the costs that we're currently seeing due to coordination failures between insurers and EQC.

Insurance problems

Christchurch is going to have to face higher insurance costs for a while. Earthquake risk here is now revealed to be higher than we had previously expected. We're now less likely to get major quakes than we were a year and a half ago, but we're probably more likely to get them than we had expected we were as of a year and a half ago. And so the risk payment goes up not because the actual risk has increased but because we have better expectations of the real risk.

John Pagani argues for the nationalisation of AMI, the big Canterbury insurer that had to be bailed out when it was revealed to have insufficient re-insurance for the series of major Christchurch earthquakes. And he makes some reasonable arguments: if the government's going to be liable for bad outcomes, it ought to have some hand in making sure it doesn't happen again. And, he's right that there are moral hazard problems with the big private insurers perhaps banking on the potential for bailout; I know that I didn't worry about checking into AMI's asset and risk structure because they had so substantial a Canterbury presence that, even if they tanked in an earthquake, there was no way the government would fail to bail them out.

But I'm not sure what problem nationalization solves. You can make a good case for that companies with exposure to concentrated correlated risks buy more reinsurance than those having a diversified customer base, and that regulations could be tighter around that. But whether AMI is private or public, it will still have to buy reinsurance on the global reinsurance market. And if that market has seized up, I'm not sure how changes in AMI's public or private status affects things.

I remain a bit perplexed about why people can't get new policies. You can't insure against a certain risk, but if the risk of another February hitting Christchurch is around 5%, you'd think reinsurers would be happy enough to issue cover at a fairly high premium. Some potential explanations:

• Reinsurers fear being saddled with the costs of prior quakes in any new event if a full assessment of a property's prior damage hasn't been completed
• But then, why is there difficulty in getting coverage for new builds?
• Uncertainty over what portion of future claims will be covered by EQC if the EQC fund is exhausted,
• But then, wouldn't we expect solution through better insurance contracts? 
• Reputational costs of actuarially fair pricing would swamp potential returns
• But reputation accrues mostly to the local agent, not the big reinsurer; for those, reputation is determined, I would have thought, by track record in paying out.

I think we need a fair bit better understanding of what's going on before we start nationalizing insurance companies. 

Killing downtown

Regulatory uncertainty, delays in building approval, the central city cordon, lack of information about future building codes, and insurance delays really aren't helping prospects for a downtown recovery in Christchurch. Recall that somewhere around 60% of downtown buildings are being torn down and nobody in Christchurch gets any access to downtown while the demolitions continue; the cordon's not expected to come down entirely for rather a while. In yesterday's Press:

On Friday, the 14-storey Westpac building on Cashel St was approved for demolition, the last of Miles Middleton's four central Christchurch high-rises to be be pulled down because of quake damage. Middleton said he wanted to rebuild in central Christchurch, but without changes to the seven-storey height restrictions in the draft central city plan, he would be forced to take his insurance money to Auckland or even Brisbane.

"A lot of people that were keen to rebuild here have gone cold," he said. "I would love to rebuild here but at the end of the day I don't want to go broke."
...
Christchurch developer Ernest Duval, who fronts the CBD property group Core, said insurance money was already draining out of the central city, with owners who had been without tenants since the September 4 quake the first to look elsewhere to invest. "The simple solution for many property owners is to take their money elsewhere to restore their income stream," he said.

Most central Christchurch property owners were not developers and would rather buy a building in Auckland than grapple with a consents hearing, tougher building standards and the ongoing shadow of possible Government intervention in Christchurch, he said. Others simply could not afford to wait until the central city reopened in April next year, Duval said.

I don't entirely buy that delays of a up to a year wind up being the critical issue; if Christchurch's downtown is likely to be viable, I would have thought that developers could have thrown insurance money into bonds or term deposits while waiting to rebuild. But more plausible is that the set of restrictions and uncertainty just makes Christchurch a less attractive investment option; the added delays then help tip folks to take their investment elsewhere.

One bit of slightly good news:

Christchurch City Council has moved to douse concerns about the draft plan. At a meeting with property owners this month, council strategy and planning general manager Mike Theelen said owners of multi-storey building would retain the rights to rebuild to the same height. Theelen was unavailable for comment at time of print.

Two problems with this though.

First, if the grandfathered right is restricted to the location of the former building, we have the somewhat perverse result that you can only build really tall buildings in the places where really tall buildings did really poorly during the earthquake. Sure, we can fix some of that with better site compaction and stronger and deeper foundations. But if tall buildings are a bad thing due to earthquake risk, requiring that they be built in the place where old ones fell over seems a bit odd.

Second, if the right stays with the owner but isn't site-specific, why oughtn't we just let anybody who wants to risk his own money building a tall building that meets code go ahead and do it? I can get that we want to compensate those from whom Council has confiscated wealth through regulations barring that they replace a building with one of like quality, but if we're doing that by letting folks rebuild rather than giving them cash, it kinda suggests that there isn't any great reason for the six story building limit (or seven if you're green enough!).

Meanwhile, Labour's proposed an earthquake recovery policy [unconstrained by any prospect of forming government] that includes this bit:

"Under Labour's plan to acquire 1500 sections, the cost of buying and readying the land for rebuilding will be recovered when it is on-sold to Red Zone residents who have been paid out from the Canterbury Recovery Fund.

"We will do this at cost to keep the price low so as many residents as possible can make a fresh start without suffering extreme financial hardship.

"It is expected our plan will act as a signal to the market and help keep property prices reasonable in other areas.

"We will not rule out using the Canterbury Earthquake Recovery Act to purchase land in the face of any evidence of price gouging by developers if that is needed to ensure a fair price is sought and paid."

Ok. The main constraint keeping land prices up is the supply constraint stopping people on the edge of town from subdividing. There's plenty of land within reasonable driving distance of downtown that could be opened up for Red Zone residents if only the land were zoned for denser residential use. Wouldn't it make more sense to get rid of a regulatory barrier to building than to have government purchases help to bid up the price of inelastically supplied sections? And I can't see how it's helpful to threaten losses on developers working to build new houses for folks in the Red Zone by promising to intervene in property markets if prices don't meet Labour's standard of fairness.

Labour also promises that the insurance standoff would be resolved: insurers won't take on new policies in Christchurch, partially because, as I understand things, the reinsurers won't touch new policies until the aftershocks ease off. I really wish I knew more about what's breaking insurance markets currently. I can believe that an actuarily fair premium right now would be very high for the next few months and that some reinsurers would sooner delay than be viewed as profiteers. I'd expected that some uncertainty had been resolved by the recent court decision finding that EQC takes the first $100k of all earthquake claims on a property rather than of the cumulative total damage to the property. But that's not yet seemed to open up the insurance markets.

Earthquakes and monetary policy

From today's Monetary Policy Statement, in which the RBNZ (as entirely expected, and as entirely reasonable) did not change the interest rate:

Repairs and rebuilding in Canterbury will have a substantial influence on the New Zealand economy.  Construction sector activity will be boosted for several years, creating resource shortages in the building industry and other parts of the economy more generally.

The eventual volume of repairs and rebuilding is highly uncertain. Since the March Statement, the Bank has based its projections on a working assumption of $15 billion of reconstruction in 2011 dollars. Recent assessments from the EQC and additional damage from aftershocks have highlighted upside risk to this working assumption. As a result the Bank has revised up its working assumption to $20 billion. The Bank will continue to update this assumption as more information becomes available.

While some properties have been repaired, so far only limited rebuilding has occurred. Continuing aftershocks have hindered planning and building, and made it very difficult to secure insurance for new buildings. It seems unlikely that construction sector activity will pick up as soon as was projected in the June Statement. The updated projections assume major aftershocks soon cease, allowing EQC contractors to step up repairs on moderately damaged properties from early next year. Furthermore, seismic stability would be expected to help free up the private insurance market. It is assumed that rebuilding of severely damaged properties gets under way from the middle of next year.

In terms of the influence on monetary policy, it is the pace of reconstruction and the resultant degree of pressure on resources, rather than the eventual magnitude of reconstruction, that will have the greatest influence on interest rate settings. It is unclear how rapid reconstruction will be.

Earthquakes do bring spending. But only with long and variable lags. Even leaving aside wealth and capital destruction, the unavoidable uncertainty induced by ongoing aftershocks imposes large costs. Nobody knows when they'll be able to rebuild. Add on top of the natural and unavoidable uncertainty the regulatory uncertainty induced by that Council's still deciding who will be allowed to rebuild where and subject to what building codes. Earthquakes just don't seem that great a Keynesian policy prescription.

There's a limit to the extent to which resource shortages in building will wind up generating resource shortages; at least some of the supply pressures in construction will likely be handled by importing workers from a flagging Australian construction sector. Wages will be bid up to the point at which Kiwi construction workers in Oz come back home.

I would like to revise one prior post where I had things partially wrong. I'd not been pleased that the Earthquake Commission's asset base consisted largely of New Zealand government securities and suggested foreign investments as preferable, or at least a portfolio the value of which ought to be higher after an earthquake: construction companies and the like. An earthquake large enough to require EQC's portfolio liquidation would, I'd thought, cause the Kiwi dollar to tank with an NZ credit downgrade. I'd missed that reinsurance inflows would push the dollar higher. So I'd retract the part where I suggested a strong foreign-bias in the EQC investment portfolio; reinsurance inflows for anything big are going to dwarf the currency effects of EQC portfolio liquidation. But it still seems a bad idea to have EQC having to sell off a couple billion dollars worth of NZ government securities at the same time as the government has to go to the debt markets to cover the parts of earthquake cost for which government has assumed responsibility.

Minimising liabilities

What's an earthquake event, for insurance purposes?

New Zealand's Earthquake Commission, EQC, is funded by a check-off on property insurance and covers the first $100k of property damage subsequent to an event. September, Boxing Day, February, and this past week's earthquakes all counted as separate events for EQC purposes, each with its own three month deadline for filing claims.

But what happens if EQC's assessor is slow in checking up on your property so the assessor can't tell how much damage was due to each of the events? EQC argues that the assessment then becomes the event: the first $100k of property damage on an assessment falls on EQC, with the rest going to the private insurer. EQC and the insurance companies are seeking a declaratory judgment.

And there is some sense to this. Our place was inspected post-September but we never received a quote from EQC on their estimate of the damage cost, and so we were never able to book in with a builder to get things fixed. Once EQC's assessors get around to us, hopefully before this coming September, there's no way they'll be able to tell how much damage is due separately to Boxing Day, February, or this weekend's major earthquake (for folks abroad: the city just keeps rocking). But there have been 12 separate events. If private insurers argued that damage were spread evenly across all twelve events, EQC would be on the hook for all damages - $1.2 million per home, well in excess of the "bowl it over and build new" cost for the vast majority.

On the other side, if EQC can minimise its liabilities by lumping a whole pile of separately damaging earthquakes into one event, EQC's foot-dragging in getting assessments out makes more sense. Again, using our place as example: damages from September's quake were pretty minor as we're over on the east side of town; Boxing Day provided no new damage; February was far worse for us. Our housesitter (who was also our housesitter for the Boxing Day quake) informs me that the house is currently a mess of broken glass and that the cracks in the internal wall plaster are rather worse than they've been since February. EQC footdragging then lets them count all the earthquakes against the same $100k cap, with any excess costs then falling on AMI.

Meanwhile, nothing gets rebuilt. In some cases, that's efficient; fixing cosmetic damage like plaster cracking probably doesn't make sense if the next damned earthquake will just undo everything. But each bit of structural damage that doesn't get fixed because of foot-dragging makes the next quake's damage worse. Will be interesting to see what's waiting for us on our return.