Hamish McRae: Economic damage of floods may be minor, but the future will be different

Natural disasters have inevitable economic effects and the flooding is no exception. It is hard to put a price on the human misery and disruption, and everyone should be sensitive to the horrid slog a lot of people face in getting their lives back to normal. We also have to hope that there are no serious long-term health or other issues that may occur later as a result.

Nevertheless, as far as can be gauged, the long-term economic damage seems as though it may be quite small - quite small, that is, in terms of the overall size of the economy.

This is partly a quirk of the conventional way that we measure economic activity. If someone has to spend a weekend mopping up their home, throwing out carpets, sorting out insurance and so on, this time comes out of their normal leisure time. In other words it is costed at zero, the same rate that it would were they walking in the country or fishing. And the expense of fixing a house appears as greater economic activity - resulting in a higher GDP - a perverse result if ever there were one.

But it is also a sign of just how big a modern developed economy is. Take a £5bn figure for the cost of this disaster. That is a bit higher than the £3bn currently quoted but I suspect the numbers will creep up further. If that is right it will turn out to be a similar order of magnitude as the "mad cow" disease disaster.

Some numbers make this clearer. UK GDP this year will be about £1.25 trillion and it will have grown by about £40bn. So £5bn is equivalent to five or six weeks' growth. Looked at another way, it is the difference between growth of 2.75 per cent and 3 per cent.

The greater potential danger (in economic terms, that is, rather than human terms) comes were there to be a lasting disruption, or a disruption that damages the underlying potential of an economy or a region to recover. There have been plenty of examples of these differential effects. San Francisco recovered swiftly from the 1906 earthquake but Galveston, the port of Houston in Texas, never recovered its economic significance after its destruction by a hurricane six years earlier.

I think in this instance there will be no lasting damage to the regional economy, in the sense that economic activity is not going to move away from the Severn or Thames valleys.

The most recent experience of similar disasters - the flooding in Prague in 2002 for example - is that economies do bounce back. Only if there is some fundamental underlying weakness in the economic position, as in New Orleans, does damage prove lasting. The economic losses to New Orleans post-Hurricane Katrina, incidently, have been estimated at $125bn (about £65 billion), which puts these floods in context.

In the coming weeks there will be a huge amount of anguish about the need for better flood defences, as well as the wisdom of building on flood plains. That leads into an intriguing discussion of the best way to prepare for events that mercifully are rare but would be very destructive if they do occur. The table shows some calculations published earlier this year by the insurance company, Swiss Re, and quoted in a new paper by Goldman Sachs. I have added some rough numbers for the present floods to set these in context.

Some key points emerge. One is that for most countries earthquakes are the most serious natural disasters, more so than hurricanes, and of course it is hard to protect from them. Another is that if events are likely to occur only about every 1,000 years or more, it is hard to persuade people that they need to take such a remote possibility into account.

On the other hand, where there is an obvious and continuing danger it makes a lot of sense to spend money to avert it. The London flood barrier is designed to protect the capital from a surge of water, sucked up by very low pressure in the North Atlantic and driven down the North Sea by a shift in the winds and then compressed by the Straits of Dover.

That particular combination of events was calculated as likely to occur only once every 100 years or more - Samuel Pepys describes the great flood of 1663, when the Thames burst into the Palace of Westminster. As it has turned out the barrier has been very useful to protect against the more general problem of rising sea levels. Its cost, in today's money of some £1.5bn, seems good value when set against the damage that a London flood might cost.

The country with the greatest experience of flood protection is the Netherlands, which spends nearly £2bn a year on flood defences - you might think cheap at the price, since 70 per cent of the country's GDP is generated on land below sea-level.

More generally, a World Bank and US government study calculated that spending $40bn in mitigation and protection could have reduced the losses from natural disasters in the 1990s by some $280bn.

All this gives a guide as to how we should proceed once the waters subside. One obvious decision will be where we allow building to take place. It is fascinating looking at the aerial pictures to see how the medieval core of cities such as Tewkesbury remain above water, whereas the new developments are flooded. They knew what happened to rivers when they founded the place. On the other hand, it may be economically sensible to build on a flood plain provided you accept that your buildings will be flooded every 100 years. Most new commercial buildings have a projected life of 60 years or less. Better to use the cheap and convenient land and take the risk of periodic losses.

The really important thing, though, is that the risks should be properly assessed and the costs properly attributed. If the state is going to pay for disaster relief, and whatever the costs carried by the insurance companies and the people who have lost goods or earnings, the state has to properly fund the emergency services. It also has a responsibility for hardship relief. And it has an overriding responsibility for infrastructure, including flood defences. If it has to pay for these, it therefore has a right to regulate where buildings are placed.

As for insurance, this will be self-policing. It may well be, looking ahead, that insurance of certain types of property will become very expensive. So be it. People have a choice as to whether to self-insure or whether to find property in less exposed positions.

The big point here, surely, is that we need to apply the lessons of this disaster to other potential catastrophes. We need to do this coolly and rationally: what is the risk, how should it be mitigated and how should the costs of covering it be allocated?

For one thing is sure: sadly, there will be much greater disasters ahead.