Simple Logic is Enough

Filed Under (Finance, U.S. Fiscal Policy) by Don Fullerton on Jun 15, 2012

Despite being in a Department of Finance, my own background and research is in economics and public policy (hence the “Center for Business and Public Policy” in our department).  I don’t claim expertise in finance, per se.   On the other hand, it seems that both sides of the JP Morgan debate are using discussion of the Volcker Rule and their other financial expertise to obscure the basic logic of government bank regulation.  It is a basic logic of incentives, which does not require expertise in finance!

JP Morgan wants to make money; we can hardly blame them for that.  In economics generally, we let companies try to make money, as they have the expertise in their own line of business to determine the risk-reward tradeoff.  If they lose money, then they lose money.  They might even be able to buy various kinds of insurance – that’s between the company and their insurer.  A person or company with insurance might have incentive to undertake riskier activities, since any gains are retained, while losses go to the insurer.  But the insurance company might enter the deal willingly, to charge premiums, especially if it can require the company or person to limit some of their riskier activities.  Your auto insurance has co-insurance and deductibles, to make you pay at least part of a loss and to restore some of your incentive for precaution.  

But when a bank becomes “too big to fail”, the U.S. government is thrown into the role of insurer, without being able to collect premiums, co-insurance, or deductibles.  It is not a “deal” between the bank and their insurer, because the government has no choice.  Because of financial contagion, a single major bank failure could bring down the whole system and cause horrific recession.

Given that the bank’s biggest losses must be covered by their insurer (the U.S. government), the bank has more incentive to undertake even riskier activities: they get any profits, and they don’t suffer the worst losses.   Any private insurer would require the bank to limit their riskiest activities, in order to be willing to sell that insurance.  But the government is the insurer by default, with no private “deal” allowing the government to require limits on the riskiest activities in order to be willing to offer that insurance.

To be sure, the bank still must be careful about some risks, as many different kinds of losses would reduce their profits without requiring government bailout.  The recent JP Morgan case did not create danger of bankruptcy or bailout, because their $2 billion loss on that one operation only offset part of their positive profits!  But any bank that is “too big to fail” has less incentive to avoid the really big losses that could cause bankruptcy, because that would require the government to bail them out.

The government could pass laws and regulations to limit the banks’ riskiest activities, and that is the purpose of the much discussed Volcker Rule.  I will leave the discussion of the details to the experts in finance.  For example, the Volcker Rule may or may not be the best way to regulate banks.  The effects depend a lot on the rule’s design, implementation, and enforcement!  Maybe some other rule or incentive-management would be better.  I will leave those details to the experts.  Instead, the point here is just the simple logic that the government is not a private insurer who would require limitations on risky activity to be willing to sell insurance.  The government must provide insurance, so they must have some kind of regulation to limit banks’ risky activities: higher capitalization requirement, Volcker rule, or other regulations.   

I did in fact talk to some of the finance department’s experts, like Jeff Brown and George Pennacchi.  George notes that “the incentive to take big risks declines as a bank finances itself with more shareholders’ equity (capital), and in JPMorgan’s defense they are one of the most highly capitalized banks, which helped them survive the crisis.”  He adds that “If banks carry government deposit insurance, whether explicit or implicit due to Too-Big-to-Fail, then the government should limit their activities to protect taxpayers from losses.”  Moreover, “it is noteworthy that, prior to the establishment of deposit insurance in 1933, banks had much greater capital (financing via shareholders’ equity) and made much less risky loans. … Indeed, there are several recent “narrow bank” proposals to greatly limit the activities of banks that issue insured deposits.”  He has a review of the topic on his website (forthcoming in the Annual Review of Financial Economics).

The bottom line is that in a private deal between a bank and its insurance company, the bank would have to agree to limit risky activity in exchange for being able to buy this insurance.  With government as insurer, they get the insurance regardless.  So just look at their incentives!  The banks have incentive to make money, and so they have incentive to take more risks since they can keep any profits and not cover the biggest losses.  AND they have incentive to lobby Congress to avoid government regulations.  We switch from a private market “deal” to the world of politics!  If they can get Congress to limit regulation of banks, they can make riskier investments, make more money, and not have to cover the biggest losses.

So just think about those incentives, next time you hear a bank executive use the jargon of financial expertise to make the case against “unfair interference by government regulators into the private market”.

Why YOU may LIKE Government “Theft”

Filed Under (Finance, Retirement Policy, U.S. Fiscal Policy) by Don Fullerton on May 18, 2012

Or, alternatively, “Why I Love Teaching”!  First, teaching lets me grandstand a bit, if that help students really think about the world around us.  Second, it lets me pretend to be an expert in fields other than economics, even fields such as philosophy (see below).  Third, trying to teach about a topic forces me to think hard about that topic myself!  A case in point is the standard lecture on “Justifications for Government Policy to Redistribute Income”, otherwise known as “Robin Hood”, otherwise known as government “theft” from the rich to give to the poor.   

One thing currently happening in the world around us is a heightened political debate about whether the top income tax rate is too low or too high.  See the diagram below.  So this “lecture topic” is not just textbook irrelevance.  It might even help YOU to think about what you read in the newspaper!  Then please decide for yourself.

I see four possible justifications, any one of which may or may not ring true to you.  If one or more justification is unconvincing, however, then perhaps a different justification is more appealing. 

1.)    As described below, some in the field of “moral philosophy” have found ethical justifications for extra help to the poor.

2.)    Even if the poor are not deemed special in that way, and all individuals receive equal weight, it may still be that a dollar from a rich person is relatively unimportant to that rich person, while a dollar to a poor person is very important to that poor person (higher marginal utility).  If so, then equal weights on everybody would still mean that total welfare could increase by taking from the rich in order to help the poor. 

3.)    If incomes are generally uncertain, so that any individual might do well in some years and not in other years, then government might actually make all of us happier by the provision of implicit “insurance” – taking premiums in good times in order to help any person who suffers bad times.

4.)    A reduction in income equality could be a “public good”, like the classic example of a lighthouse that benefits all ships whether they have helped to pay for it or not.  Everybody’s individual incentive is therefore not to pay (to “free ride”).  The private market never exists.  But government can raise welfare for all shippers by taxing all ships and using the funds to build and operate the lighthouse.  Similarly, if many people would LIKE to have more income equality in society, they could “free ride” on others who do give voluntarily to help the underprivileged. If so, then government could fix that market failure by taxing everybody and using the funds to improve income equality.

Having used up several paragraphs already, I will miss the chance to explain all four of these important points adequately in this one blog, and so I’ll save a few for the next blog.  Let’s just start with the first one.

In the field of moral philosophy, some libertarians such as Robert Nozick believe that theft itself is ethically wrong, that each person is morally entitled to the fruits of their own labor.  No person is allowed to steal from a rich neighbor, even to give to the poor, so why would government be allowed to do so?  If theft is morally wrong in itself, then government should not be redistributing from rich to poor, no matter how needy the poor nor how worthy the cause.  On the other hand, by the way, government steals from individuals through taxes in order to build highways and provide for national defense, and so one may wonder why theft is justified for some purposes and not others.  One way out of that problem is to decide that a tax for public purposes is not in fact “theft”.

In contrast, John Rawls argues that the moral choice is to help the poor.  Actually he has two important ideas.  One is that those who are already rich have no moral justification to argue for reducing taxes on the rich, just as those who are poor have no moral justification to argue for raising taxes on the rich.  Such positions are merely self-interested.  Therefore, a useful thought experiment is to put yourself in what Rawls calls the “Original Position”, at the beginning of the World, before places have been assigned in the wide distribution of incomes and well-being.  That is, suppose resources are limited, and that the world will inevitably have a distribution of different human abilities and disabilities.  You don’t yet know your IQ, or whether you will have any particular talents in music, sports, the arts, or management.  Our job in this “original position” is to write a constitution, a set of rules for government and human interaction.

The purpose of this thought experiment is to try to strip away self-interest and think about how rules “ought” to be designed.  And then, Rawls’ second idea is about what any of us would likely decide to do in such a position.  He argues that the only natural choice, indeed the only logical choice, is to be extremely risk averse.  We are not talking about twenty bucks you might lose at the Casino, where risk is fun.  Instead, we are talking about your entire life’s prospects, where risk is not fun.  It must be great to be Brad Pitt, but what if you end up with little talent or ability.  You could end up homeless, or worse.   Given that risk, he argues, one should design the rules such that society would take good care of those who are disadvantaged, unlucky, or disabled.  You might well be the person on the bottom of the totem pole.

His treatise, called “A Theory of Justice” is 600 pages, so I haven’t even read it all!  So I won’t try to explain all the reasoning, but the interesting point is the connection between risk aversion and redistribution.  Rawls himself is extremely risk averse, saying we ought to maximize the welfare of the poorest person with the minimum income – the “maximin” strategy.  That does not mean perfect equality, as he points out that the poorest person’s welfare might be improved by giving the most talented individuals plenty of incentive to work hard and invent new technology that generates plenty of profits, market success, and economic growth.  But cutting the tax rate on the rich is only justified for Rawls if that really does improve the welfare of the poorest.

Well, out of space for today, so I’ll save the other justifications for next time.  But in case you don’t like the justifications of Rawls, those other justifications (#2 through #4) are completely different!

A Look at Herman Cain’s 999 Tax Plan

Filed Under (Finance, Other Topics, U.S. Fiscal Policy) by Don Fullerton on Oct 21, 2011

The point of this blog is to inject some substance into discussion of Presidential candidates. To see the problem, consider what I wrote on my facebook page: “In an airport for an hour yesterday, we could not avoid hearing CNN talk about the upcoming presidential debate. For the entire hour, we heard only comments like: Perry needs to come out swinging; or, ‘Is Cain a viable candidate?’; or, Bachmann has really fallen in the polls; or, ‘This now boils down to a two-man race’, followed immediately by the wisdom that ‘Yes, but we don’t know yet who the two men are.’  What inanity! It is JUST a horse race! Not a single comment during the entire hour had anything whatever to do with any substantial issue of policy. Is this all we get?”

There must be more to consider, in this important decision.  So, I started by looking at Herman Cain’s 999 tax reform plan.  See more at his website, with the key bullets in the insert below. 

Bear in mind that I’m a former Deputy Assistant Secretary of the U.S. Treasury (1985-87), so I worked hard on President Reagan’s successful “Tax Reform Act of 1986” to lower the rates and broaden the base.  Since 1986, however, Congress has managed to reintroduce plenty of new deductions and tax breaks, while raising the rate.  Maybe it’s time to do something again!

Cain’s proposal has a lot of similarities to the 1986 reform, if perhaps more extreme.  It is meant to be revenue neutral, raising the same total tax.  It would eliminate virtually ALL deductions, like mortgage interest paid, and it would cut rates drastically.  It would eliminate the income tax as we know it, and introduce a national sales tax (or value added tax).   What about the accuracy of Cain’s claims below?  By reducing rates drastically, this proposal probably WOULD reduce the distorting effects of taxation by reducing the interference of taxes in the productive activities of workers and business – what economists call “deadweight loss”.  For similar reasons, it probably would provide greater incentive for work and investment, and therefore probably provide some stimulus to growth.  That’s all for the good.

However, ANY tax reform plan of ANY politician EVER, no matter what motivation, will always have two effects to watch out for.  First, any tax reform will always raise taxes on some taxpayers and reduce taxes for others.  It will have distributional effects worth analyzing.  Second, it will therefore create disruptions and reallocations.  Activities to pay additional tax may shrink – laying off workers who may remain unemployed for some time until they can re-train and find work in other activities that now face lower tax rates and hope to expand.  That is, for only one example, the Cain plan might hurt homeowners and homeownership by eliminating the mortgage interest deduction.  With such pervasive changes, however, the disruptions will be widespread and costly in themselves.

Finally, for now, note the point about distributional effects.  Nothing in any of Cain’s bullets says anything whatever about distributional effects.   I’m afraid this point is the Achilles heel of Cain’s 999 plan.  According to the non-partisan Tax Policy Center, Cain’s plan will greatly reduce taxes of those with the highest incomes and raise total taxes on those with low incomes.  It is ‘regressive’.  And you don’t even need to read the TPC analysis to know this is true.  Cain’s plan cuts the top personal rate from 35% to 9%.  There is no amount of tax-base broadening for those high income taxpayers that can get back the same tax revenue from them.  And currently those with the least income pay no Federal tax at all.   Under Cain’s plan, everybody will pay the 9% sales tax, on everything they buy.  Moreover, if those low-income individuals are working, they will probably bear some additional burden of the 9% business tax that applies to all profits AND wages paid: it applies to all sales revenue minus purchases and capital investment, not subtracting wages paid to workers.

I’d personally favor another revenue-neutral reform like the TRA of 1986, one that lowers the rates and broadens the base.  Such a reform would undoubtedly cause some disruptions and adjustments costs.  And it would help some while hurting others.  But perhaps it could be designed in a way that also tries to be distributionally neutral, not adding tax burdens on those least fortunate while cutting taxes on those already doing well.

A Global Problem with No Solution

Filed Under (Environmental Policy, Finance, U.S. Fiscal Policy) by Don Fullerton on Sep 25, 2011

If one town’s water pollution flows into another town, the two towns can negotiate a solution with no need for the state to intervene.  But if all towns are polluting all neighboring towns, the lines of communication are too complex to negotiate – requiring the state to pass a law to solve the problem.

If one state’s water pollution flows into another state, the two states can negotiate a solution with no need for Federal intervention.  But if all states are polluting all neighboring states, the lines of communication are too complex to negotiate – and it takes a national government to solve the problem.

In other words, those problems have solutions.  If one nation’s water pollution flows into another nation, then (potentially, at least) the two nations can negotiate a solution with no need for a global government to intervene.  But if all nations are polluting all neighboring nations, the lines of communication are too complex to negotiate – and no global government exists to solve the problem.

I’m currently pessimistic about two of the worst problems the world has faced: global climate change, and global financial contagion.  Both are “externalities” in the classic sense.  Each nation’s greenhouse gas emissions pollute the whole world, and the only really effective solution is a worldwide global agreement to reduce emissions.  In fact, we don’t really “need” all nations to reduce emissions; all we really need is an agreement among all nations saying that if SOME countries reduce emissions then the other countries won’t increase emissions to steal their business.  But the lines of communication are too complex to negotiate – and no global government exists to solve the problem.

Environmental policy is my usual bailiwick.  At the moment, however, I’m even more worried about global financial contagion.  It seems that one small country can have lax financial regulations that allow banks or investment companies to take on too much risk.  Or a small country can overspend, taking on too much debt.  In the olden days, that country could go down in flames, with no big problem for the rest of the world.  With tremendously increased globalization, however, all financial markets are highly integrated.  One country’s borrowing may come from any or all other countries of the world, and one nation’s problem become the world’s problem.  If banks in other countries loan to that small country, then a financial crisis in that small country may create fear about the financial well-being of the banks that lent to them, causing a run on the banks in all those other countries.  Moreover, globalization means much more trade in commodities.  If one small country faces severe financial difficulties and must cut back all spending, that reduces aggregate demand worldwide, and can spread a recession worldwide.

A strong global government could rein in the poorly managed countries by requiring larger capital requirements, careful financial scrutiny, and only tax-financed spending.  But we don’t have any such global government.  As a result, even a small country like Greece can over-spend for years without oversight.  The situation in Greece may be made worse when banks in other countries raise the rate at which Greece can turn over its debt and borrow again, making the financial situation in Greece even worse.

The problem may be caused by Greece or not.  Regardless of “fault”, if Greece any small country were to go into default in years past, then the cost would be primarily on that small country.  Now Greece could go bankrupt and impose horrible costs on the entire World?!?

Closing the Barn Door after the Horses Escape

Filed Under (Finance, Other Topics, U.S. Fiscal Policy) by Don Fullerton on Sep 2, 2011

The New York Times today says that the Federal Housing Finance Agency is set to sue major U.S. banks such as Bank of America, JPMorgan Chase, Goldman Sachs, and Deutsche Bank, among others.  The U.S. government argues that the banks sold packaged mortgages as securities to investors while ignoring evidence that the homeowners’ incomes were inflated or falsified.  That is, the banks failed to perform the due diligence required under securities law.  When many of those homeowners were unable to pay their mortgages, the securities backed by the mortgages tanked.  Housing and financial crises ensued.

Kinda late, isn’t it?  Well, certainly it’s too late this time, to prevent the housing and financial crises of the past few years.  What is the point of the suit, then?  Does the U.S. Federal government really need the money that they can get from these banks, as damages, and will they give it back to all of us who lost money during those years?  The U.S. might sue for around a billion dollars, which is peanuts these days.  Divided by 333 million Americans, that would be about three dollars each.  Why bother?

An important conceptual point here is the difference between ex post liability (after the fact) and ex ante incentives (beforehand).   The point of this suit is not to collect a billion dollars after the fact, although arguments are made about the fairness of those liable to pay for damages.  Rather, the point is to provide the proper incentives to private companies before the next time.  To a private company, a billion dollars really is a lot of money.  If they have to worry about the loss of a billion dollars, for ignoring their legal responsibilities, then maybe next time they’ll be more careful to follow the law.

Government regulation can take alternative forms.  One alternative is to send auditors and inspectors into every bank, every day, to check what they are doing.  That would be very expensive.  A cheaper alternative is to let the banks decide for themselves if they are exercising due diligence, but with the “threat” hanging over their head that they might get sued if they don’t.

Many gas taxes, but falling over time

Filed Under (Environmental Policy, U.S. Fiscal Policy) by Don Fullerton on Apr 1, 2011

Per gallon of gasoline, are we paying more in taxes over the years, or less?   In my last post, I examined the Federal gas tax and inflation adjustments.  As it turns out, the overall price of gasoline adjusted for inflation just hasn’t changed that much over the past fifty years!  Regarding the Federal tax of 18.4 cents per gallon as a tool to collect revenue, however, the impact is significantly weakened by inflation.  It is a “unit tax” (fixed over time per unit of gasoline), and so it becomes a smaller fraction of price as the gas price rises.  In contrast, any “ad valorem” tax would be a fixed percentage of price (like an 8% sales tax).  When inflation increases the price, an ad valorem tax rises with it.

State and local gas taxes in Illinois are a bit more complicated. In 1990, the State of Illinois raised the gas tax from 16 cents to the current 19 cents per gallon – another “unit” tax.  The flat blue line in the figure below looks at that same fixed 19 cents per gallon since 1990.  The orange line shows its “real” value, adjusted for inflation, all in current 2011 dollars.  It shows that the 19 cents today is really the equivalent of 33 cents back in 1990.  So the real value of the state’s unit tax on gasoline has fallen from 33 cents to 19 cents per gallon.

In addition to the 19 cent per gallon state gas tax, we also pay 2 cents per gallon to the city of Urbana.  Furthermore, gasoline is subject to the general sales tax, which in Urbana is 8.75%.  (It is composed of 5% to the state, 2.25% to the city, 0.5% to the county, and another 1% to the school district). 

Here is how it all works.  Suppose the net-of-tax price of gas kept by the service station is exactly 3 dollars.  Then the combined state and local ad valorem sales tax (8.75%) applies to that $3.00 per gallon.  That tax would be $0.2625 (in other words, 26.25 cents).  Then the federal unit tax is 18.4 cents, the state unit gas tax is 19 cents, and the city unit gas tax is 2 cents.  The total of all those taxes is 75.65 cents per gallon.  These four major taxes per gallon are shown in the table.

Level of Tax

Tax in Cents per gallon

Federal unit tax


Illinois unit tax

Urbana unit tax


Combined sales tax





That total 76-cent tax adds to the $3 per gallon price, and you pay $3.76 per gallon.   (And actually, a few other minor taxes are ignored here, such as the “Underground Storage Tank” fee and other environmental fees!)

 Yet only the ad valorem sales tax can keep up with inflation.  With every year that a unit tax on gasoline is not updated, the tax loses its value and fails to collect as much real revenue.   The State of Illinois revenue from the 19 cent gas tax is falling in real terms with inflation, as all the necessary expenditures by the State are rising.

Why the Government Should Not Issue Annuities

Filed Under (Retirement Policy) by Jeffrey Brown on Mar 1, 2011

In Sunday’s New York Times, Professors Hu and Odean published an op-ed entitled “Paying for Old Age.” After reading it, I concluded that it needs a response, as I am afraid that the authors have misdiagnosed the main problem.

First, let me say that I am a big fan of Odean’s academic work, including that which uses proprietary brokerage data to provide insights into individual investor behavior.  And Henry Hu is also a highly respected law and finance scholar who is well-known for his work on financial risk.  I am delighted to have more super smart academics taking an interest in the important issue of guaranteed lifetime income (and I don’t mean to imply by “more super smart academics” that I consider myself super smart!  Rather, this is a topic that has been researched by some of the brightest economic minds of the last 25 years, including Nobel Laureates Peter Diamond and Franco Modigliani, as well as other leading economists such as Jim Poterba, Doug Bernheim, Amy Finkelstein, Olivia Mitchell, and many others.)

In essence, Hu and Odean are suggesting that the U.S. government should issue inflation indexed life annuities directly to the public.  They are not the first to propose this – the Aspen Institute had a similar proposal several years ago.

I understand the motivation of their proposal.  After all, we know that counter-party risk is one reason that individuals may be concerned about entering into long-term annuity contracts with insurers, and this is especially true after the recent financial crisis that witnessed the disappearance of venerable financial institutions.  Perhaps even more importantly, we know that many 401(k) plan sponsors have concerns about fiduciary liability when it comes to choosing an annuity provider.  Having the government provide the annuities directly is meant to address this concern.  So it is fairly straightforward to write down a simple economic model in which I can show that optimally structured government intervention appears to make people better off.

Even so, I think the proposal is off base, for several reasons.

First, I think they have misdiagnosed the reason people do not buy annuities.  While concerns about counter-party risk are certainly heightened today, the demand for annuities was ridiculously low even a decade ago when most consumers were not even thinking about the issue.  Nor is there much evidence that the lack of inflation protection or high prices are the primary reasons for limited demand.  While these probably contribute a bit on the margin, they are only three items on a very long list of reasons that demand for annuities is limited, which I have discussed at length elsewhere.

Second, I have no confidence in the government’s ability to run this program effectively.  The same holds true for the idea of the government providing a government backstop for private annuity providers.  Last year I published a book (a collection of papers from an AEI conference that I organized two years ago) that includes analyses of 6 major government insurance or reinsurance programs, including programs to insure DB pensions (PBGC), bank deposits (FDIC), crops, terrorism, floods and natural catastrophes.  As I discuss in my intro chapter to that book, one of the themes that came out of these analyses is that the U.S. government simply does not seem to be capable of structuring insurance programs in a manner consistent with basic economic principles.  They almost universally fail to charge appropriate prices for the insurance (in two ways – premiums are too low on average, and they are not properly risk-adjusted), which distorts incentives and leads in some cases to excessive risk-taking (a form of moral hazard).  They tend to create large unfunded liabilities that put taxpayer funds at risk.  There are other problems as well (which you can read about if you read the book!)

So while an optimally-designed government backstop would have real value, the U.S. government has an abysmal record of optimally designing such systems.  So we are immediately thrust into the world of “second best” policies where it becomes difficult to ascertain whether a poorly designed program is really better than none at all.  I am extremely reluctant to run the “experiment” because, to paraphrase Milton Friedman, “there is nothing so permanent as a temporary government program.”

Third, despite the authors’ attempt to sell this as an “everybody wins” idea, I think it is pretty clear that this would crowd-out private annuity provision, and all the future innovation that may come out of it.  (Disclosure: I am a trustee for TIAA, one of the world’s largest annuity providers.  I have also done work over the years for many other life insurance companies. )

Finally, I believe that other market-based solutions are emerging.  There has recently been a lot of discussion, and some activity, of “multi-insurer solutions,” in which a plan sponsor enters into an agreement with multiple insurers who essentially each agree to kick in to cover one another in the event that one provider experiences financial distress (of course, this does not help if the whole industry goes down.)  The idea is still young and new, and I would hate to kill the innovation by starting yet another government program.

In essence, I do not think that direct government provision of annuities is necessary or desirable.  The problem in the private market is not that the products do not exist, it is that people do not buy them.  Nothing in this proposal will change that.  We would be better off focusing our efforts on policies such as reducing fiduciary risk to plan sponsors that would like to provide annuity options to employees.  Or reforming our minimum distribution requirements so that they no longer discourage annuities.

Bottomline – rather than having the government provide annuities, I would like to see the government stop discouraging the use of annuities that private providers would be happy to make available.

Reflections of a Conservative, Lefty, Right Wing, Do-Nothing, Liberal, Moderate, Tea-Partying Privatizer

Filed Under (Health Care, Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Nov 29, 2010

In American politics, individuals who advocate a move in the direction of more limited government, greater reliance on market force, and who emphasize the role of individual choice are often labeled as conservatives, neo-cons, right-wingers, privatizers, or, in the last election cycle, tea partiers. Those who advocate a greater government role, restrictions on individual choice, and more regulation are labeled as liberals, progressives, left-wingers, and socialists.

Lately, however, I have been thinking about how meaningless some of these phrases can be when describing specific policies reforms relative to the status quo. The reason is that U.S. economic policy as a whole lacks ideological consistency. This reflects, in part, the fact that our existing set of laws and regulations are often creatures of the time period in which they were passed.

As an example, I want to focus on a broad issue on which I have spent much of my professional life as a researcher and policy adviser. Namely, how we as a nation choose to handle risk. In particular, how we allocate risk – and insurance for risks – across the public and private sectors.

If you think about it, the allocation of risk is one of the primary roles of government in the modern era. Indeed, I once heard the U.S. government described as “a very large insurance company with an army.” This is not a bad description. The U.S. government runs the world’s largest life- annuity and disability programs (Social Security), some of the largest health insurance programs (e.g., Medicare, Medicaid, the VA system), a pension default insurance program (the PBGC), a deposit insurance program (the FDIC), an unemployment insurance program, a crop insurance program, a terrorism risk insurance program, and many more.

There is tremendous scope for reasonable and intelligent debate about the appropriate role of government when it comes to intervening in private insurance markets. I do not pretend to have the only “correct” view – how could I, when some of the economists I most respect in this world have come to different conclusions than I have?

But I do believe that I have developed a world-view about what constitutes a sensible and appropriate division of responsibility between the public and private markets that is informed by economic theory, empirical evidence, a dose of experience in how the government operates, and my own ideological predisposition towards individual freedom over government control. The world view that I have developed is one that believes that when it comes to the allocation of risk, we should find the least intrusive role possible for the government that is consistent with providing citizens with adequate opportunities for insuring against risks when doing so enhances societal well-being.

Yes, that is a mouthful. So let me briefly explain. I first note, however, that you need not agree with this world-view to agree with the main point of this blog. But allow me to – very briefly – explain my rationale. Basically, for nearly any economic policy, I go through the following thought process:

1. Can the private market achieve an efficient outcome without government intervention? Here, I define efficiency is the usual economist way of “1st best” outcome that would be generated by Adam Smith’s ideal of a perfectly competitive market without market failures. If the answer is “yes” – as I feel is typically the case with most markets for goods and services, then my belief is that the government should stay out of the way and let markets work their magic.

2. If the answer to question 1 is “no” because of the existence of a market failure (such as adverse selection or moral hazard in insurance markets, the existence of externalities, etc.), then I ask whether the government is capable of over-coming the market failure. Importantly, the answer is often “no.” In many cases, the government faces the same problem as private markets. For example, if there is moral hazard in insurance markets (e.g., if people behave in inefficiently more risky ways when they are insured), then there is very little the government can do about it. The answer is sometimes also “no” because of “government failure,” that is, a political process that leads to even good ideas being poorly implemented due to policy being influenced by special interests or policies being poorly implemented by an inefficient bureaucracy. Whatever the reason, if the answer to this question is “no,” then I will again favor the private market solution, even with its flaws.

3. In the relatively small subset of cases where the private market does not work, where the government has the ability to overcome the market failure, and where the government solution is likely to be designed and implemented in a sensible manner, then I am entirely willing to back such a policy. Even then, however, I will favor the most limited form of government intervention necessary to overcome the market failure. Thus, for example, I have no problem mandating that drivers carry collision insurance because a government mandate can overcome the adverse selection problem that might cripple a purely voluntary market.

Because my approach starts with a belief in the power of free markets and a healthy dose of skepticism about the political process and the skills of bureaucracies, my view is definitely “right-of-center.” But it is clearly not an unabashed “free markets all the time” view because it does recognize a need for limited government intervention in some cases. You may not agree with this view – but it is an ideologically and economically coherent and internally-consistent approach to economic policy.

But now, let us return to the how my views would be labeled by the political process in America today. In practice, application of my world-view to policy means that I often favor having the government encourage insurance through automatic enrollment or even a mandate (in order to overcome adverse selection), but then allowing competitive private market to actually provide the insurance.

But the U.S. is all over the map when it comes to how we treat insurance programs. Consider two dimensions of the problem:
1. Is insurance mandatory or voluntary?
2. Is insurance provided by the government or the private sector?

There are 4 possible combinations of answers, and we have programs in each. Here are a few examples:

Voluntary/Private – dental insurance, 401(k) plans
Voluntary/government – long-term care under the new CLASS Act
Mandatory/private – automobile insurance
Mandatory/government – Social Security, Medicare, PBGC, FDIC

My view is that we ought to have lots of programs in the mandatory/private, when in fact this is one of the least used approaches. What is interesting, however, is how advocating movement towards mandatory/private is viewed relative to the status quo. Over the years I have publicly advocated the use of personal accounts as a supplement or partial replacement for Social Security, and I would be perfectly happy to make them mandatory (or at least the default option). I have also publicly advocated replacing the PBGC with mandatory private pension insurance. I’d also like to see our public sector defined benefit plans reformed so that they have a defined contribution component. In all of these cases, I am advocating a move from mandatory/public to mandatory/private. As a result, I have been labeled a “conservative” or “neocon,” a “right-winger” and a “privatizer.”

In recent years I have also advocated that we consider making annuities the default distribution option from 401(k) plans, and in a blog in October I suggested that we considering mandating that people buy long-term care insurance in order to eliminate dependence on the inefficient Medicaid program. In these cases, where I am trying to move from voluntary/private to mandatory/private, some people labeled me a “lefty” and “liberal.”

Now, let’s take my view about automobile insurance. In essence, I think we have a reasonable approach – namely, that we mandate coverage but allow private insurance providers to provide it. This has not been a major policy issue in recent years. So I can be fairly characterized as having a “do nothing” or “status quo” approach to this policy issue.

At the other extreme, I cannot help but point out that the recent CLASS Act is precisely the opposite of what I would design. It is voluntary, so fails to overcome the main problem in the market but is provided by the government, despite the fact that the private market is fully capable of providing it! Here I just get labeled as a critic.

So, where does this leave me? Am I a right-wing, small government, neo-con intent on privatizing major government programs? Or am I a left-wing advocated who wants to take away individual choice? Or am I a defender of the status quo? Or am I just a critic of government policies?

The answer to all of these questions is “yes.” But this does not mean that I am a flip-flopper or ideologically inconsistent. To the contrary, it means that I am applying an ideologically consistent world-view to a wildly inconsistent set of existing public policies.

At the end of the day, I believe that much of our political rhetoric has become vacuous, school-yard name-calling that does little to illuminate our policy discussions. I find it frustrating – even sad – that we so often mindlessly label and name-call instead of engaging in well-reasoned, analytical discussions of important policy issues.

Adverse Selection — California Style

Filed Under (Health Care) by Nolan Miller on Feb 9, 2010

News from the West Coast today that Anthem Blue Cross, one of the largest private insurers in California, is raising the prices for the 800,000 or so people it sells individual health insurance policies by up to 39%.  The Obama administration is not happy, to say the least.  HHS Secretary Kathleen Sebelius fired off an angry letter to Anthem and its parent company, WellPoint, demanding an explanation.  Of course, this also comes at a time when the Obama administration is struggling to make the case that health insurance reform is urgently needed, so this also provides a perfect example for them.  The letter is kind of cool, since I have never seen an angry letter from a Cabinet Secretary before.  The text is here.

What I find more interesting as an economist, however, is WellPoint’s response.  They haven’t replied formally to the letter yet, but in a statement WellPoint’s spokesman said the following:

“As medical costs increase across our member population, premium increases to the entire membership pool result. Unfortunately, in the weak economy many people who do not have health conditions are foregoing buying insurance. This leaves fewer people, often with significantly greater medical needs, in the insured pool. We regret the impact this has on our members.”

So, where’s the economics lesson here?  In a competitive market, health insurance prices are driven by the cost of caring for the average person in the insurance pool.  That means that healthy people usually pay more than their actual cost of care and sick people pay less.  Although healthy people pay more than their average health expenditures in any year, they’re still willing to buy insurance because it provides them with, well, insurance.  In the event that they have a car accident or other unexpected, large expenditure on health care, they’re protected against the financial consequences.  This works fine as long as the premium (driven by the average cost of care) doesn’t get too high above what the healthy people are willing to pay for insurance against relatively rare events.

Now, enter the recession.  People are losing their jobs, wages for the employed are stagnating, and people are losing money on housing and financial investments.  In light of these challenges, some healthy people are looking at their health insurance premiums, their income, and the likely cost of going without insurance, and deciding not to buy health insurance.

This is a perfectly rational response to increasing premiums and decreasing incomes.  However, it results in the remaining people in the insurance people being, on average, sicker.  This means that the average cost of caring for the insurance pool will be higher, which will necessitate higher premiums.

Unfortunately (and interestingly if you study this stuff), this leads to the potential for what is known as an “adverse selection death spiral.”  The idea is that once premiums rise, the healthiest people who are still buying insurance may decide to drop out of the pool.  Since the remaining pool is even less healthy on average, premiums will once again need to rise to cover their higher medical needs.  And then the cycle starts over again.  In extreme cases, the premium just keeps going up until nobody is willing to buy insurance.

So, what next?  Well, the adverse selection story holds in competitive markets.  But, you can already see Secretary Sebelius telegraphing the administration’s punches.  They will argue that the price increases are not due to competitive pressure and an increasingly unhealthy insurance pool but rather a greedy, for-profit insurer trying to take advantage of people when they’re down.  For their part, WellPoint/Anthem will argue that this just shows why health reform is needed, but health reform of a fundamentally different sort than Obama has proposed.

My prediction is that we’re headed for a highly charged series of Congressional hearings that boil down to an attempt to drive home to voters that something needs to be done.  Really went out on a limb, there, didn’t I?

A Solution in Search of a Problem: A Look at the “CLASS Act” Proposal for Federal Long-Term Care Insurance

Filed Under (Health Care, U.S. Fiscal Policy) by Jeffrey Brown on Nov 24, 2009

Deep within the “Patient Protection and Affordable Care Act” – the short title of the 2000+ page health care bill winding its way through the Senate – is a provision that came from legislation previously known as the CLASS Act.  The CLASS acronym stands for “Community Living Assistance Services and Supports” and is a plan to “establish a national voluntary insurance program for purchasing community living assistance services.”  Essentially, this legislation would create a voluntary, public long-term care insurance program.      


This provision has received almost no attention from the press, which is actually pretty surprising given that it would represent a major change in the federal government’s role in providing insurance for long-term care.  It would be a voluntary program through which individuals – in return for paying premiums to the government program for 5 years – would be eligible for a benefit of approximately $50 per day that they are receiving eligible care (where eligibility is triggered by an individual’s inability to engage in activities known as “Activities of Daily Living,” or ADLs – things such as bathing – without assistance.)


It is understandable that there is tremendous interest in rethinking our approach to long-term care.  The private market for long-term care insurance is quite small (e.g., only about 10 percent of the age 50-70 population is covered, and only about 4-5 percent of long-term care expenses are covered).  The government is already the largest source of payment for long-term care services through Medicare and Medicaid.  These expenditures are expected to grow rapidly in the coming decades due to population aging, among other factors. 


But as I read this legislation, the same question keeps nagging me over and over.  The reason it is nagging at me is that I cannot figure out the answer.  The question is, “exactly what problem is this legislation meant to address?” 


The legislation would create a public insurance program under the assumption that people cannot get the insurance privately.  In other words, it seems to be assuming that the problem is that private insurers can’t or won’t provide good insurance.  But there is not much evidence of this.  To be clear, we know the private market is imperfect.  My own research with Amy Finkelstein has shown that prices are higher than actuarially fair, and the benefits provided are not very comprehensive.  But we also show that the limited size of the overall market is almost surely driven by limits to consumer demand for these products, not because of problems with insurers providing insurance.  


So if the government wants to solve the problem of people being inadequately insured against long-term care expenses, it needs to address the issue of demand.  But, best I can tell, this legislation does virtually nothing on this front.  For example, if you think people are not buying it because they underestimate the risk, or because they are in denial about needing care, or because they think they have substitute forms of care, there is nothing in this legislation that will change this.  It is, after all, still voluntary to purchase it and simply having a government-run program is not going to change these beliefs.


On the other hand, Amy and I also show in our research that the Medicaid program serves as an enormous disincentive for purchasing private insurance.  In a nutshell, people do not want to pay for private insurance if most of the benefits they are paying for are simply duplicative of what Medicaid would have provided for free had they not purchased private insurance.  This public program would have the same problem – why should I pay premiums for this program so long as Medicaid will still pick up the tab if I fail to pay the premiums?  The feature that allows individuals to keep part of the benefit when Medicaid picks up the tab is presumably meant to address this, but I’m afraid it simply is not going to be sufficient to overcome this concern.


The government seems to implicitly understand that there are limits on demand – their own estimates are that only 5% of the population will take up this insurance.  That hardly sounds like a resounding success to me.

In short, it seems that the government has developed a solution to a supply problem that does not exist, but has failed to address the demand problems that do exist.  Needless to say, I am not optimistic as to this program’s future …