March 11, 2002
From the desk of Jane Galt:Craig Biggerstaff has an interesting
Craig Biggerstaff has an interesting post on Social Security, in which he makes this observation:
Since Social Security is the retirement plan of last resort, it must be made immune to individual stupidity or chance. This is due to Biggerstaff's Law: it will not become acceptable in the future to let a voting bloc of elderly grasshoppers starve, so any grasshoppers will inevitably be funded (again) by responsible taxpaying ants.A purely private investment scheme, like a mandatory 401(k), would give individuals the most control. It would also be subject to Enron-like investor madness, followed by the application of Biggerstaff's Law above.
Fans will be surprised to find that I agree with Mr. Biggerstaff, and this is because of a phenomenon economists call Moral Hazard.
The premise of Moral Hazard is simple: when you buy fire insurance, you suddenly don't care as much whether your house burns down. (No, I'm not talking about people who burn the house down to collect the insurance; economists call that Insurance Fraud, just like everyone else does). Oh, you still care -- there's all those pictures of the wedding, and little Timmy with his first goldfish, and that precious light-up plastic statue of James Joyce you bought the night you won your first scrabble tournament. But you don't care as much as you would if you were going to have to scrape up the 200K to buy and furnish a new house on your own. You're not as careful about smoking in bed. When you use up the fire extinguisher on the Portieres du Salon au Cherries Jubilee, you forget to buy a new one. After little Timmy gets bronchitis from staying out in the garage for hours during the winter, you agree to let him practice his fire-eating in the house.
This is what's known as moral hazard: the act of taking a large precaution (insurance) has caused you to stop taking small precautions. Fraud aside, one of the most reliable predictors of accidents is the size of the insurance coverage against those accidents. Think of HIV. When treatment became available, unprotected sex became more popular.
Regulations intended to protect people from catastophe work the same way. People build houses in areas prone to regular flooding because they know that FEMA will swoop in and bail them out. Farmers plant crops that generate the highest yield, rather than those that are appropriate to local conditions, because the DOA will bail them out of any crop failures based on -- you guessed it -- yield per acre. Savings and Loans executives take off on a massive jackalope-ranch-buying-and-junk-bond-trading spree and the investors at those institutions don't bother to look up from their Bingo cards, because they know the government will cover any losses.
Even most hard-core libertarians aren't going to let some poor schmuck who bet on the wrong horse in the market starve to death when he's too old to work. People know this, which makes them more likely to take outsized risks with their portfolios.
Imagine two retirement investments. One has a 100% chance of paying off $60 for every hundred you put in. The other has a 50% chance of getting a $100 payoff, and a 50% chance of getting nothing. In a laissez-faire economy, risk-neutral or risk-averse investors (there's no such thing as a risk loving investor, not even your idiot cousin Bob who bought the jackalope ranch. Risk-loving investors, in theory, are people who, given the choice between a 50% chance of $40, and a 100% chance of $60, would take the 50% chance at $40 just for the thrill of it) will choose the sure thing, rather than the 50% chance of a higher return, because the Expected Value, or the probability wieghted value of a choice, is $60 for the first, but only $50 ($100 x .5 + $0 x .5 = $50) for the second. With me so far?
All right, now imagine social insurance. Let's say that you know that if you lose everything, your fellow taxpayers will kick in some amount -- let's call it $25 -- to keep you alive. Let's look at that expected value again:
Expected value of the sure thing: $60Expected value of the risky investment:
Upside: $100 x .5 = $50
Downside: $25 x .5 = $12.50 (I lost, but my fellow suckers. . . excuse me, citizens, are keeping me in Geritol)
So my expected value for the risky investment is $62.50. The rational choice is to gamble, and count on the taxpayers to make up my losses, at least in part. Note that in order for me to choose the sure thing, social insurance has to be less than or equal to just 1/5 of my potential high return.
This is a vastly simplified scenario, of course, and it leaves out the question of whether most people can actually make qualified investment choices, but you see my point. Even in a world of rational, informed actors, the moral hazard of the implied social promise could lead people to take on a lot more risk than they should. And a lot of that risk will be taken on on behalf of the future taxpayers they're expecting to cushion the downside, which could severely undermine the stability of a private system. So government will have to take some sort of measures to mitigate this. What those measures might be, I shall leave for brighter minds and another day. Posted by Jane Galt at March 11, 2002 09:55 PM | TrackBack | Technorati inbound links