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Economy

Flooded

Even after a financial calamity, America’s economic risk runneth over.

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Danger: People have a tendency to undervalue risk, whether it’s with floods or the economy.(Eric Thayer/Getty Images)

The windows of heaven opened over the Mississippi River basin in early April 1965, and rain was upon the land for half a month. It fell on soil hardened by an unusually deep winter frost and streams swollen with the melt from a heavy, late snow. On April 5, the Mississippi began rising rapidly in Minnesota, Wisconsin, and Iowa. Governors deployed the National Guard to build and patch dikes.

The river swept away houses or beat them to sticks, according to witness reports compiled by the National Weather Service. On April 16, Good Friday, surging waters broke through railroad tracks in Bluff Siding, Wis., and raced over thousands of acres of farmland, flinging dazed livestock across the countryside.

 

From north of Minneapolis down to Hannibal, Mo., the waters climbed to heights that still stand as records. The raging Mississippi inflicted what would be $1.5 billion in damages in today’s dollars, a tab largely picked up by the federal government, because most of the farmers lacked flood insurance. It was a level of destruction that few townsfolk along the river had thought possible.

As Charlie Hale, a photographer who snapped hundreds of rolls of flood photos for the Post-Bulletin in Rochester, Minn., later recalled to the Weather Service, “Old-timers couldn’t remember any floods big enough to flood a city—why should 1965 be different?” His camera told Hale it was different. Flying over the Mississippi in early April, he likened the river to “a time bomb,” and said he wondered “if it was going to get the right elements and explode someplace.”

People build houses on floodplains because they expect that someone will rescue them if things go bad. That’s the classic economic parable of “moral hazard,” the tendency of individuals and institutions to take on too much risk whenever they don’t have to pay for it. It’s also one of the simplest ways to explain how the U.S. economy tanked three years ago and why it remains in danger of collapsing again, even more catastrophically.

 

The river-dwellers in the 1960s, who undervalued risk, presaged the investment bankers and subprime-mortgage borrowers in the run-up to the financial crisis. After all, what kind of society turns its back on families left homeless by a flood, or lets its system of borrowing and lending disintegrate overnight?

When a monster flood strikes, the government typically passes laws designed to prevent a repeat of the destruction. Fairly quickly, though, houses start popping up on the floodplain again. That was true along the Mississippi River basin. After the 1965 floods, President Johnson pushed through a set of reforms that included the first federal flood-insurance program. In 1993, the river spilled over its banks again. Damages topped $22 billion in today’s dollars, about 15 times the real-dollar amount from 1965. Once again, the government bore much of the cost. Few locals had bought what was supposed to be mandatory insurance.

The U.S. economy is in danger of a much more devastating déjà vu event today—unless regulators, lawmakers, businesses, and consumers adjust their actions to account for new risks and the nation’s increased vulnerability to them. Protecting ourselves starts with admitting that the next big storm could hit soon and that, if it does, rescue could be a long time coming.

(Watch Jim Tankersley talk about the five vulnerabilities that the U.S. economy faces.)

 

The waters are just now receding from the financial flood of 2008. But the river remains, as photographer Hale said, filled with time bombs. The increasingly connected international economy, the rapidly changing global ecology, and the world’s dizzyingly complex and distressed financial system all carry risks that could explode and wipe out the U.S. recovery. Meanwhile, the lingering effects of the last crisis have weakened wealthy nations’ ability to respond to the next one if it comes soon.

It’s difficult to pin down the total burden of risk that the economy is bearing, or to say with any certainty whether Americans are taking more inadvisable risks today than in the past. But what’s indisputable is that the American economy is highly vulnerable, perhaps more so than at any point in recent history, to the threat of risky behavior blowing a hole in its fragile recovery. It’s also true that the underpriced risks taken today by an overconfident few—highly leveraged foreign banks, say, or fossil-fuel gluttons in industrial countries—could rain economic misery on the masses in the United States and around the world.

In other words, whether we choose to or not, we all live on a floodplain now.

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A PERILOUS ECONOMY

Economic risk isn’t inherently bad—nations couldn’t grow and prosper if people never took chances with their money. In a free and functioning market, problems start when risk is priced too low, forcing every­one unwittingly to share in the resulting vulnerability.

If Jane wants to buy a house with money borrowed from her bank, the bank estimates Jane’s risk of default and charges her appropriately to cover that risk. But what if the lender gave Jane a discount, assuming that her neighbors would step in to help make payments if she faced losing the house? So, what if Jane got a loan she really shouldn’t have qualified for? And what if Jane and all her neighbors, who also borrowed from the bank at discount rates, defaulted at the same time? What if the bank then fails, and no one in town can borrow money, and the local economy collapses? A lot of people with no connection to Jane or her loan suffer the consequences.

Clifford Marks contributed contributed to this article.

This article appears in the March 12, 2011 edition of National Journal Magazine.

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