Fred Foldvary

Civil Society Institute lecture

April 26, 2006

"What New Orleans could learn from the San Francisco earthquake’s 100th Anniversary: and what we can learn for recovery after the next big one!"

Good evening!

Welcome to the first Civil Society Lecture for Spring 2006!

The “Civil Society” is the voluntary sector of our economy and culture.

The Civil Society Institute at Santa Clara University explores how civil society functions and could function, and its comparison to that other sector, the government.

My topic tonight is San Francisco’s great earthquake of 1906, whose 100th anniversary was commemorated last week on April 18.

There have been lots of programs and articles on the destruction of the earthquake and fire,

but very little on the recovery from the earthquake.

San Francisco sprang back very quickly.

Within a few years, the city was rebuilt,

the population was growing,

and commerce was back in full swing.

And all this was done with little federal or state aid.

There was no FEMA, no federal emergency management agency.

San Francisco recovered almost all on its own.

How was San Francisco able to do it?

And why is the recovery of New Orleans,

with billions of dollars of federal aid,

not going as well?

This is also an economics story.

Thomas Schelling,

professor at the University of Maryland

and winner of the 2005 Nobel Memorial Prize in Economics,

has said,

"There is no market solution to New Orleans.”

The problem, he says, is that the free market has a coordination problem.

The market by itself cannot coordinate the expectations of individuals in New Orleans,

since a person who wants to rebuild does not know whether others will also do so.

If you are the only person in your neighborhood who rebuilds,

or if only a few landowners rebuild,

then the neighborhood won’t be viable,

and you will have made a bad investment.

Since nobody can know what everybody else will do,

the market will fail, according to Professor Schelling.

If this market-failure doctrine is true,

then the recovery of New Orleans requires government,

especially the federal government,

to coordinate all the reconstruction.

Well, let’s take a look at how well federal coordination is working in New Orleans.

The April 14 issue of the Contra Costa Times had an article on the FEMA aid.

It said, “Katrina aid full of waste.”

Audits have revealed that the hastily improvised $10 billion recovery effort

has generated vast sums of waste and misspent funds.

The article says that FEMA’s trailer housing program

suffers from inadequate planning and poor coordination.

It says government’s response has been too slow, too bureaucratic, too inefficient.

Many of the manufactures homes acquired by FEMA can’t be used because they are too big or unsafe.

FEMA put many people in hotels and cruise ships instead of much less expensive apartments.

Local governments in Louisiana have also been blamed for lack of coordination.

For example, according to the article,

New Orleans mayor Nagin failed to take action on 108 approved trailer sites.

The conclusion to be drawn here is that if markets fail to coordinate a recovery,

government agencies in fact have not coordinated well either.

But - the question is, do markets really fail?

The private sector is in fact managing to come back in New Orleans.

A report in the Los Angeles Times (Dec. 4, 2005) has the headline,

"On Their Own in Battered New Orleans"

Despite all the federal aid,

the Los Angeles Times story stated that the recovery was "grindingly slow."

Moreover, the Times stated that the only real actors in rebuilding

have been private homeowners and businesses.

That’s not me saying this, it is the Los Angeles Times.

Did markets fail in San Francisco after 1906?

What is missing from professor Schelling’s dis-coordination model?

The devastation in San Francisco was at least as bad as that of New Orleans after Katrina.

Gas pipers were fractured.

Fires burned for three days and could not be extinguished because the water pipes were broken also.

28,000 buildings were destroyed.

The property loss was over $500 million in the dollars of those years.

Insured losses from fire were $235 million,

equivalent to $4.9 billion in 2005 dollars

Some 3000 persons were killed.

I don’t think it helped any that the mayor issued a “shoot to kill”

order to stop looting. There was actually very little looting.

But the government did play an important role providing order and relief,

but the reconstruction was done almost all with private initiative.

San Francisco bounced back so fast its population grew by 22% from 1900 to 1910,

in the very wake of its destruction;

it grew another 22% from 1910 to 1920

and another 25% from 1920 to 1930,

becoming the tenth largest American city.

It did this without expanding its land base,

as rival Los Angeles did,

and without stinting its parks.

On its steep gradients it housed a denser population

than any city except the Manhattan borough of New York.

San Francisco had the economic power later

to bridge the Bay and the Golden Gate,

grab water from the High Sierra,

finance the fabulous growth of intensive irrigated farming in the Central Valley,

and become the financial, cultural, and tourism center of the Pacific coast.

What was the catalyst that sparked this renewal?

Four elements enabled San Francisco to spring back.

First, private insurance compensated many for damages.

Secondly, private banks, especially the Bank of Italy (later the Bank of America), provided loans for reconstruction.

The head of the bank, A.P. Giannini,

saved his bank by filling a horse-drawn wagon

with $2 million in gold and securities,

covering the valuables with vegetables,

and rescuing the resources.

The next morning,

he opened for business on a wharf on San Francisco Bay.

Many of the loans that were used to rebuild San Francisco came from these funds.

Third, city authorities recognized that they had not lost their public-finance base:

the buildings were gone, but the land was still there,

and land could be the economic as well as the physical foundation for reconstruction.

Fourth, citizens provided one another with mutual aid.

In terms of economic game theory,

they played a repeated, cooperative, positive-sum game.

Also, there was explicit coordination in the business community,

which formed the “Committee of 50” to guide the rebuilding.

They quickly organized, while the fire was still burning,

a system of food relief, administered by volunteers.

Now let’s focus on the key element of coordination:

the public finances of San Francisco.

In 1906, there were no federal or state income taxes, and not even a sales tax!

The city depended on the real property tax for its public revenues,

and with the buildings demolished,

the property tax was now mainly a land-value tax.

Tapping the land value, along with bank loans, insurance, and mutual aid,

become the means for the coordination of expectations.

Landowners had to pay an assessment

based on the value of their site

as though it were developed.

To pay this charge, an owner had to put up a building quickly;

otherwise there was a tax expense with no revenue.

Here’s the kicker:

The neighbors were in the same boat, so they all rebuilt.

And the fact that they knew

that everybody else was under the same pressure

solved the expectations problem.

So here is a challenge to economics game theorists.

Put that in your model, and see whether markets still fail.

Schelling’s work emphasize focal points,

things which the players can focus on,

and so coordinate their activity.

So I suggest putting the focal point of a land tax

in the game theory models,

and see if the market would still fail to coordinate.

The property tax was levied by government,

but it was policy that operated through the market,

not against the market.

Another example is a pollution charge.

It takes the form of a tax, but

it is really compensation to society for polluting,

a cost that would be paid to a private owner

if the resource such as a lake were privately owned.

Indeed, if the government does not levy a pollution charge,

and there is no private owner for a resource such as a lake,

then in effect the polluter is subsidized,

by not bearing the full costs of the pollution.

Likewise, if the government provides the infrastructure,

but does not charge the landowners for it,

the public works pump up the land rental and land value,

subsidizing the landowner,

and therefore distorting the real estate market,

thus creating financial pollution,

as the tax is imposed instead on the earnings of labor

and speculators cash in on values generated by government.

In San Francisco after earthquake 1906,

if a landowner could not rebuild,

his incentive was to sell to someone else

who was willing and able to do so.

Tapping the site value for public revenue

pushed everybody to rebuild quickly,

and the insurance money and bank loans

provided the financial means.

New Orleans has a fantastic location

as a port at the mouth of the Mississippi River,

which creates huge land values.

Tapping these land values would push folks to quickly rebuild,

as in San Francisco of 1906.

But it is not being done.

Louisiana's property taxes are very low.

Is that good?

Well, if the private sector provided the public goods,

it would be fine,

because homeowners would pay private assessments

instead of taxes.

But what the residents of Louisiana save on property taxes,

they pay in higher taxes on incomes and sales.

Louisiana has a homestead exemption law that

for many homeowners, reduces its property tax to little or nothing.

It is a tax exemption on the first $75,000 of the value of a person's home,

the biggest exemption in the US.

If your house worth $100,000, you are exempt on the first $75,000 of value;

and you pay taxes only on the remaining $25,000 of value.

The median price of a house in New Orleans is $140,000

and it would pay a property tax only on $65,000, $1100

on the property tax rate of 1.7%.

If the building is destroyed, then the lot is tax free.

That is why the mayor of New Orleans stated that

the city had lost its tax base.

The land is still there, but it can’t be tapped,

and the city can’t harness the market

by pushing landowners to develop,

like San Francisco did in 1906.

New Orleans could let the residents of neighborhoods create

homeowner associations,

and substitute their services for those of the city,

replacing taxes with assessments on the land value,

based on expected rebuilding.

Like in San Francisco of 1906,

the incentive would be to rebuild quickly.

The free market can indeed coordinate the recovery

with voluntary associations

motivating all their members to rebuild quickly.

The San Francisco Bay Area also

could not repeat today

what the city did after 1906

unless it converts to homeowner associations.

Under Proposition 13, the property tax is limited to

1 percent of the market value when purchased.

California’s property tax looks to the past,

not to the future,

as is it did in 1906.

The market coordinates looking forward,

not looking backward.

Another problem in San Francisco is that 65 percent of the residents are renters,

and 71 percent of those residents live in rent-controlled housing units.

With rentals below market, the owners have not had an incentive

to upgrade their buildings to withstand an earthquake.

So, how would the pure free market handle a disaster such as an earthquake?

The Red Cross and other charities would come in to heal the injured.

There would be insurance against damages for those willing to pay the price.

Banks would offer loans for reconstruction.

Civic associations would provide contractual governance

and they would provide infrastructure and services

financed by assessments based on site values.

After an earthquake,

the assessments would remain the same.

To pay the assessment, the homeowner would rebuild quickly.

Insurance and loans would provide the financial means.

The focal point of coordination would be the knowledge

that your neighbors have the same push to rebuild as you do.

In conclusion, if we harness the market,

we can quickly recover from the next disaster,

and much more effectively

than if the federal or state governments

try to coordinate the recovery.

Thank you,

and I’ll be pleased to answer any questions.