To begin, our guiding philosophy should reinforce our immutable constitutional principles of freedom and democratic justice. These principles establish that the rights of life, liberty, and the pursuit of happiness are lodged within the individual. It is important to remember this. Economics, politics, and social policy serve a greater good beyond economic and physical security. Cuba claims to provide equality and economic security to all its citizens through income support and free health care, for instance. But it does so at the greater cost of a loss of liberty and basic freedoms that we in the U.S. take for granted. So, our first principle for policy is:
1. Economic policy and politics should serve the principles of freedom; in the realm of public policy this translates into maximizing freedom of choice and freedom of action.[54]
We have discussed how the economy sustains itself over time by constantly reallocating resources between consuming, saving, investing, and borrowing. Our second principle for policy flows from this understanding:
2. Policies should facilitate the flexibility of the economy, its adaptability to unpredictable change, and the fluid reallocation of resources. This requires accurate price signals provided by competitive, functioning markets.[55]
Among the programs we have instituted in the past, a policy anomaly exists that reveals something important about our priorities. While the proposals of politicians and policy experts try to expand economic growth at all costs, the programs that have actually been delivered are designed to manage risk with social insurance and welfare transfers. This leads me to conclude that our political demands reflect the dominance of loss aversion in our policy preferences. Social Security (a retirement income program), Medicare (a retirement healthcare program), Medicaid (a healthcare safety net), and assorted insurance-based compensation programs for unemployment and disability consume the bulk of our government expenditures. Direct spending on these programs constitutes roughly 57% of the Federal budget. When we include military spending, which defends us from risks to our national security, plus interest on the debt, the share comes to roughly 80%. Most of the remaining 20% is spent on the bureaucratic administration of these various programs. This spending pattern is mirrored in the fifty state budgets.
This would appear to confirm what evolutionary and behavioral psychology tells us: What citizens really want is life, liberty, and the pursuit of happiness subject to an acceptable level of risk that ensures our survival and well-being. When we feel we cannot manage these risks ourselves, we have overwhelmingly voted to have them managed through public programs. What we have really created with our democracy is not a free market, capitalist society supporting a small welfare state, but a social insurance state in its entirety.[56]
Politicians and policymakers single-mindedly pursuing economic growth do not have things wrong. The accumulation of wealth through economic growth is one of the best self-insurance policies, and the ultimate source, through taxes and redistribution, of any social provision. But with respect to policies, the goal of maximizing material welfare through economic growth is not the same as insuring society against loss. Economic growth requires increasing risk-taking investment; insuring against loss demands better collective and individual risk management. These two policy goals should complement each other, as better risk management empowers greater risk-taking. Our quest for economic growth can serve our desire to be secure, but it should not violate the more important desire of freedom of choice. Our survival instinct demands that we manage our private risks prudently (an amusing reference to the Darwin Awards comes to mind), but the logic of democratic politics will often lead to perverse results with the public management of risk. Systemic risk in our financial sector and impending budgetary crises in Social Security and Medicare are two cases in point. To save these programs, we need to change them.
Let us also consider the context of the world in which we live. It is uncertain and constantly changing. Our economic and political policies and institutions must enable us to adapt and manage this change in whatever form it comes. Rigidity and inflexibility is a recipe for disaster, as the experience of any fossilized dinosaur might attest. To restate Charles Darwin’s quote cited at the beginning of this book: "It is not the strongest of the species that survive, nor the most intelligent, but the one most responsive to change." Universal social insurance policies are, necessarily, of a one-size-fits-all variety. They sacrifice individual freedom of choice and preference in favor of centralized efficiency, an efficiency that usually never materializes. We chose these programs in the past, but as technology and social organization evolve, new possibilities for managing these risks have arisen. How many people had 401(k)s in 1945? Or invested in foreign currency funds? The point is that our risk-management tools have evolved—our political and social institutions must evolve as well.
We should only resort to social insurance if there is no better option. Instead, our economic markets should to be fluid and responsive in their allocation of resources over time and our public policies should reinforce nature's imperative to adapt to change. This yields the next policy principle:
3. To facilitate the management of change, public policies should primarily focus on managing risk; first by helping citizens manage their own risks; second by insuring functioning private insurance markets; and lastly, by providing social insurance.
4.2.1 Private and Social Insurance
As we discussed in Chapter Two, in a closed system there is really only one way to manage the risk and uncertainty associated with change: diversification. While nature diversifies with biological species that randomly adapt over long periods of time, we must diversify financially by accumulating capital and distributing it across broad classes of financial assets. This is the logic underlying any and every insurance and retirement plan. For example, pension funds or 401(k)s accumulate payroll savings that are pooled and reinvested into diversified portfolios of financial and real assets. The same applies to our accident, homeowners, or automobile insurance, except these only pay out if we suffer a loss.
On the public side, Social Security is a diversified income security insurance pool that collects contributions from almost all working members of society and is paid out to current retirees according to set formulas.[57] Social Security insurance is different than a pure insurance model in that the funds are not saved and reinvested over time to achieve additional returns. Transferring funds from young to old makes Social Security highly dependent on demographics and the overall growth potential of the economy.
All insurance pools, public and private, suffer from moral hazard and adverse selection. Adverse selection occurs when low-risk participants opt out of a pool because they feel the premium cost is too high given their individual risk profile. As these low-risk participants opt out, premiums must rise to reflect the higher risk profile of the remaining pool, causing even more low-risks to opt out. In the end, only high-risk participants will remain in the pool with prohibitive premiums. The concentration of bad risks defeats the goal of diversification. An example is when good drivers opt out of auto insurance pools, leaving only an undiversified pool of bad drivers who raise the cost of insurance. The problem posed by adverse selection is often solved by compulsory participation or mandates, but there is still a self-sorting problem of low-cost, low-risk vs. high-cost, high-risk pools. This problem afflicts our health insurance industry for patients with pre-existing conditions.
We defined moral hazard briefly in Chapter Two, but let us reexamine the concept here. Moral hazard describes a situation of information asymmetry where the insured changes his/her behavior because they have insurance, but the insurer is unaware. An example of moral hazard is a person who drives more recklessly because he/she's insured. This increases the possibility of unexpected losses to the insurer. The only way to reduce moral hazard is to monitor the insured’s behavior, which is why auto insurers raise or lower premiums based on one’s driving records and accidents. Implicit in the notion of moral hazard is the idea that
incentives between the two parties are misaligned. If their incentives were perfectly aligned, the information asymmetry and the monitoring would be superfluous. (Self-insurance through personal savings is a case where incentives are perfectly aligned, thus, there is no moral hazard.)
Like private insurance pools, social insurance programs like Social Security and Medicare also suffer the costs of moral hazard (because of adverse selection, participation is compulsory for most citizens). For example, people expecting Social Security often reduce their private savings for retirement. Since the government also is not 'saving' Social Security payroll taxes, there is a net loss of savings to the economy. A smaller supply of savings means interest rates must rise, reducing investment returns in economic production and growth. This reduces national wealth and tax revenues, which Social Security depends upon to meet its obligations. Indirectly, we see the magnitude of this moral hazard cost in the unfunded liabilities of the Social Security system, now at a level of $15 trillion.[58]
The problem is more egregious with Medicare, as the provision of free healthcare in old age encourages people to indulge unhealthy habits and overuse healthcare services, which increases the total costs of care. The main problem with social insurance is that there is no agent, or agency, able to monitor the behavior of pool participants, as is done with private insurance pooling. We each pay the same level of taxes, whether we are good risks or bad risks. Good risks are thus penalized for good behavior and bad risks are subsidized for bad behavior. What can we expect except an increase in bad risk behavior and exploding costs?
With self-insurance there are no moral hazard or adverse selection costs—the inherent informational costs associated with insurance pools and their misaligned incentives are eliminated when we internalize them to the individual. Most people do self-insure to a certain extent against the contingencies of old-age or health. We call it saving. This propensity to manage unforeseen contingent risk is summed up in the iconic phrase: "Save for a rainy day." It seems unlikely that public policies encouraging us to do otherwise (i.e., no need to save, the government will take care of you) will give us the results (security) we desire. The more important non-economic benefit of self-insurance is that it empowers individual freedom and choice. We own our savings, we can invest them as we see fit, and upon our death, we can leave the remainder to anyone we choose. We enjoy none of these freedoms with social insurance.
The main point of this section is to demonstrate how private insurance is superior to social insurance in almost every way. Why, then, do we even have social insurance? The reason is because of the incompleteness or failures of private insurance markets. There is no easy way to insure against the loss of a job, so we have socialized unemployment insurance. Insurance pooling is also inadequate if loss events are not independent or if their probability of occurring approaches unity, or one. Think of a company insuring against a natural disaster, such as an earthquake, hurricane, or flood. All the insured parties within the path of this disaster suffer losses together. The losses are related, or dependent. The insurance pool that includes all these parties is unable to cover the losses and the insurer goes bankrupt.[59] Because insurance is difficult to obtain for these losses, federal programs, such as FEMA, are often the only way to receive compensation. A person with a pre-existing health condition is a case where the probability of that loss event occurring is one—a sure thing. A universal catastrophic social insurance plan based on the incidence or probability of such illnesses or diseases is one proffered solution to the case of pre-existing conditions. We should not disavow the need for social insurance, as democratic justice demands that we protect citizens from the vagaries of chance. It is most efficient, however, when it is used as a complement, not as a substitute, for private insurance markets.
Some advocates justify social insurance by arguing that it can contribute to a sense of communal interdependence and solidarity in the face of risk or disaster. With universal social insurance, all citizens receive the same protection and share the same fate, so there is little conflict between winners and losers. There is considerable value to political solidarity within a democratic polity, but this can be achieved without the onerous financial cost incurred by runaway liabilities associated with moral hazard. We should consider private-public solutions to risk management that involve narrower, loss-based, catastrophic social insurance pools in conjunction with wider, private, self-insurance methods. Think of how we combine 401(k)s and IRAs with Social Security. The more successful private self-insurance is, the less dependent we are on social insurance and uncontrolled public liabilities. It is an error to believe that social insurance provides the only viable solution to our risk management needs. The bottom line is that we need policies that encourage us all to produce and save throughout our lives for contingent risks. The following corollaries should be added to policy principle #3 on risk management:
i. The preferred policy for risk management is self-insurance through increased savings and diversified asset holdings;
ii. The next policy priority should be to insure functioning and competitive private insurance markets;
iii. In cases of insurance market incompleteness or failure, policy should resort to universal social insurance systems funded by taxed contributions; ideally these contributions can be based on the actuarial experience of losses so that the insurance system is financially sound. Social insurance essentially provides a minimum safety net.
4.2.2 Distributional Issues
One of the most persistent criticisms against market economies is the problem of economic inequality, in terms of both income and wealth. I will define this as a distributional issue that is rooted in risk-bearing and in the political or economic power that determines who bears the risk and who controls the returns. Proponents of market outcomes often cite evidence of the mobility of incomes and wealth, in that poor people often become richer in absolute terms and inequality is just a temporary artifact of a fluid society. The more important issue for them is national wealth and the belief that a rising tide lifts all boats. But this argument is unconvincing by itself.
First, relative wealth matters in a world of scarce resources. Think of the successful Stanford professor who earns a good salary, but must compete with Silicon Valley neighbors to buy a house. It is of little benefit to know he could live rather well in Oklahoma on the same salary.
Second, wealth can confer political power that can influence the formulation of policies that reinforce that wealth and power. This exposes democratic society to the risk of plutocracy, whereby the winners of a winner-take-all society get to make the rules under which that society operates. This can only lead to a banana republic in which the wealthy political class makes all the laws and reinterprets the constitution to favor their particular interests.
Third, when markets function well and economic growth is positive, the returns to capital concentrate to the successful, at least initially. The more successful a business is in maximizing its profits (often by reducing labor costs), the more residual profit of production is returned to the owners of the business. In other words, those who successfully bear the risks get richer and those who do not either receive the same, or less, compensation. We can observe this in the immediate results of outsourcing production to cheap labor countries. Labor costs drop, leading to higher profits for existing owners. (My point is not to condemn outsourcing or the rationalization of production, as these both can add to national wealth, but only to recognize the real distributional effects.) Successful adjustment can occur only if the domestic resources that have been idled (such as skilled workers) are redeployed to more profitable uses. That's a big "if," as any middle manager now knows, and in the meantime the distributional costs are borne unevenly by those who are displaced.
Fourth, I will make a controversial claim that inequality imposes economic, as much as political and social, costs upon a democratic capitalist society by depressing economic growth. Think back to our earlier discussion of trad
e and exchange: The basis of exchange depends upon the ability of both parties to offer something of value to one another. If one party holds all the wealth, there is no basis of exchange beyond subsistence labor, as existed with feudalism. What happens in our simple model if the rich keep getting richer and the poor get poorer? Total aggregate demand must decline and excess investment capital, in the hands of the rich, will chase decreasing returns as the value of idle capital dissipates. This causes investment capital to fuel asset price bubbles, first in the stock and commodity markets and then in real asset classes like precious metals, collectibles and real estate.[60] Imagine also that government policymakers, seeing the decline in demand, step in to stimulate consumption with deficit spending and loose credit? This merely fans the flames of resource misallocation with more asset booms that lead to busts. This should all sound familiar.
4.2.3 Capitalism For All
Whether one accepts the propositions in the previous paragraph or not, there is a set of solutions that can address the problems of inequality and also serve the objectives of good economic policy. The main idea behind this set of solutions is the promotion of widespread capital accumulation across the population and its subsequent reinvestment in diversified asset portfolios. Individual portfolios of capital assets would not only grow in value as the economy grew, they would be available to mitigate the risks we face in an uncertain world. In other words, we would solve our needs for security in the only tried and true method possible: through savings for self-insurance and through diversification of wealth. This yields the following policy principle:
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