Markets Work
What happens when governments suppress market forces
20 Feb 2007 in Regulatory Economics, Regulatory Policy, Legislation
Today's news brings a pair of interesting (and foreboding) lessons in what happens when government tries to suppress markets.
In Iran, government subsidies make the price of gasoline just 40 cents per gallon. In Florida, the state has decided to subsidize the cost of property insurance.
In Iran, there is massive overconsumption of energy that threatens both the economy and the polity. Its authoritarian, theocratic government is unwilling to endure the public reaction that would result from restoring market prices for energy.
In Florida, property owners in harm's way will overinsure and not bother taking otherwise cost-effective measures to reduce their losses from future hurricanes. When the hurricanes come, their losses will be covered by surcharges on other property owners (especially those out of harm's way) and taxpayers.
In Florida, the legislature and the governor collaborated on a new law that suppresses the market price of property insurance. The Washington Post's Peter Whoriskey says the government will accomplish this "by pledging tens of billions in public money to affected homeowners if a major hurricane or two strikes again." Because the State does not actually have this money on hand, "the measure is considered a gamble, even by proponents."
Whoriskey reports that Florida has about $1 billion available to fund losses arising from a major hurricane. The new law commits as much as $32 billion. These funds would have to come from unspecified new taxes:
Under the legislation, in the event of a major hurricane, the state will pay claims by taxing home, automobile and some other types of insurance policies sold in the state.
According to Whoriskey, a storm causing $40 billion in excess losses would require new taxes averaging "more than $5,000 for every Florida household." Apparently, Florida leaders also intend to try to shift much of these costs to taxpayers from other states. Whoriskey writes: "The federal government probably would be asked to pitch in to alleviate the burden."
The new law was adopted in January 2007 in response to pressure from Florida voters to lower the cost of property insurance -- that is, to avoid market prices This appears to be a longstanding practice in Florida, as property owners have avoided market prices for insurance for at least a decade. Citizens Property Insurance Corporation, Florida's largest insurer, was created by the legislature in 2002 in a merger of two other state-mandated joint underwriting associations that were created after previous hurricanes. Whoriskey reports that Citizens is technically insolvent:
The new legislation lowers Citizens premiums even though those premiums were already arguably too low to support the claims it has to make: The company ran out of money in 2004 and 2005, and it received $715 million from the state's general fund and imposed surcharges on insurance bills across the state to pay claims.
According to a Congressional Budget Office report, Citizen's precursors also were technically insolvent, having sold billions of dollars worth of coverage at below-market rates. They depended on the state-mandated Florida Hurricane Catastrophe Fund for reinsurance, and that product also was underpriced. (In 2001, 100- and 250-year losses were estimated at $21.6 and 31.9 billion, respectively. By August 2006, private insurance payouts for Katrina exceeded $40 billion.)
Having used regulation so many years to suppress the market price of property insurance, and thus distorted public perceptions about its true cost, it should not have been surprising that Florida voters now expect even greater suppression of market forces. When (not if) the next major hurricane strikes Florida, state leaders will be in an even greater political predicament. Apparently, they intend to try to shift these costs to taxpayers from other states. Whoriskey writes:
The federal government probably would be asked to pitch in to alleviate the burden.
The willingness of federal taxpayers to bail out Florida after such a disaster isn't clear, especially if Floridians' own culpability for their financial predicament becomes commonly known. But if Florida succeeds just once in shifting the costs of disaster recovery to other states, the chances are good that it can make that cost-shift permanent. Under that scenario, Floridians would lose all incentive to avoid overbuilding in hurricane-prone coastal areas and to take otherwise prudent steps to reduce losses.
The Wall Street Journal's Bill Spindle reports on Page One (temporarily accessible to non-subscribers) that Iran's government's decision many years ago to subsidize energy consumption now costs about $40 billion per year, "almost a quarter of the country's entire economic output." Spindle says Iran's domestic oil consumption is greater than all but 15 other nations, and that it uses domestically 40% of the 3.8 million barrels per day it produces. This year's $7 billion gasoline subsidy could become $9 billion next year.
Spindle reports that Iranian leaders have decided to resort to rationing rather than allow prices to return to market levels by reducing subsidies. The reason is that once consumer prices have become this far out of sync with the market, it's too difficult politically to correct the error even in an authoritarian state:
Iran's leaders are keenly aware of these problems. But in recent years, they've avoided making difficult choices as global oil prices climbed...
So plans to begin rationing fuel are being drawn up. But the government nixed a similar initiative last year for fear of a political backlash. This time, President Mahmoud Ahmadinejad says the government is serious about cutting back consumption, though he acknowledged recently it's politically impossible to get rid of subsidies and raise pump prices the 40% to 50% that would require anytime soon.
When consumption of a scarce resource has to be reduced, costs cannot be shifted to others, and government officials refuse to allow market prices to allocate, rationing is the only option left. In the story about Florida's property insurance woes, the Post's Whoriskey says state leaders could not think of any other alternative besides more suppression of market forces:
"We all need to pray to the hurricane gods," said state Sen. Steven Geller, who represents this beachfront condo city and negotiated a portion of the bill. "Yes, we're taking a risk. But what were our options?"
If federal taxpayers decline the opportunity to subsidize Floridians for the burdens of living in paradise, insurance rationing will be the only option left. Indeed, if Florida succeeds in cost-shifting it will invite the federal government to limit its exposure by indirectly regulating land use in Florida -- that is, by rationing Floridians' access to federal reinsurance.
