forgotten attachment

[Michael Harrington <mharrington@milken-inst.org>]

Sorry....here is the attachment I mentioned in the last email


The Insurance State and Capital Markets 
By Michael Harrington 

 The Great Budget Debate of 1999 is soon to commence. When Congress returns
to work, it will have to deal with a sure veto of its $792-billion tax
reduction bill, as the administration pushes for saving the surplus for
Social Security and Medicare while simultaneously expanding the size and
scope of government. Judging from the political rhetoric on the stumps, it
seems like déjà vu all over again. 
Is there a way out of this chronic tug-of-war over budgetary priorities?
Perhaps. First, we should step back and focus on the bigger picture-the
policy objectives of national government and the best ways of achieving
them. This requires a firmer understanding of the functions of modern
democratic government.
A breakdown of the federal budget shows that one-third of expenditures is
directly targeted to two primary social-insurance programs: Social Security
and Medicare. This share is projected to increase to 38 percent by 2002.
Income-maintenance programs, such as unemployment and disability benefits,
federal pensions, health programs, and veterans benefits, will increase to
28 percent by 2002. The remainder will be largely divided between defense
(14 percent) and interest on the debt (11 percent). 
This picture tells us that, absent interest payments, almost three-fourths
of federal expenditures will soon be devoted to income security programs,
with the remainder devoted to military security. Because these expenditures
are paid by taxpayers who collectively benefit from the programs, our
national government actually resembles one massive redistributive insurance
pool. 
This pattern is not unique to the U.S., and is actually more pronounced in
many other developed countries. This phenomenon reflects voter demands for
economic security through collective risk management. Thus, the modern
democratic welfare state may be more accurately characterized as the
insurance state.

This insurance perspective gives new insight into the policy challenges
faced by modern democracies. Many of the structural problems of unemployment
and the misallocation of resources that plague developed democracies have
been attributed to a problem inherent to insurance called moral hazard.
Moral hazard occurs when an insured person changes behavior due to the
reduced risk of loss. For example, a person entitled to Social Security
benefits saves less. A worker assured of unemployment benefits is less
pressed to keep a job or quickly find a new one. A banker takes excessive
risks if there is an expectation of a government bailout. 
Moral hazard is indicative of the uncertain information any insurer has
about the insured. This information gap is unavoidable. Private insurance
carriers seek to minimize the cost of this problem through careful selection
processes, periodic reviews of claims, and premium adjustments. But all of
this can be quite costly and governments, as insurers, are rarely in a
position to enforce effective monitoring of social insurance programs. Thus,
the inefficiency costs of moral hazard are greater in such programs. 
The second major problem afflicting governments is the budgetary deficits
that occur when program costs outrun the willingness of taxpayers to foot
the bill. This situation is analogous to the insurance problem of adverse
selection. Adverse selection is caused by the tendency of good risks to opt
out of insurance pools where the average premium is higher than the
perceived value of the insurance. The remaining risk pool is more risky, so
premiums must rise, causing more good risks to leave the pool.  
As with moral hazard, private insurers try to minimize adverse selection
problems through careful selection, cancellation, and differentiated
premiums. These strategies do not work, however, for government-run social
insurance programs where participation is a right of citizenship. 
Governments try to eliminate the adverse selection problem by making social
insurance universal and compulsory, with no one having the freedom to opt
out. This transforms the exit option into a voice option so that when
premiums (taxes) get too high, voters begin to demand reductions (tax cuts)
or significant reforms (benefit reductions, more stringent regulation, or
means tests). Politicians react by expanding benefits when they can, cutting
taxes when they must, and running deficits for someone else to pay later-a
losing strategy in the long run. So what can governments do?

Private capital markets are key. The problems associated with moral hazard
and adverse selection can be reduced with alternative market-based
strategies geared to ensure greater economic security. Modern portfolio
theory shows that the most effective way to reduce economic risk is through
asset diversification. Capital markets, representing the most liquid and
diversified asset markets, offer the most effective means to manage risk
through efficient pricing and allocation according to risk preferences.
Efficient risk management is, in fact, the raison d'être of capital markets.
Insurance pooling is simply a form of diversification through risk sharing
that becomes necessary when asset markets for diversification are
incomplete. The advantage of asset diversification is that it does not carry
the attendant costs of moral hazard and problems of adverse selection.
One can apply the principle of asset diversification to a wide variety of
people's concerns about economic risk. If citizens are able to accumulate
diversified financial assets in private accounts, they will be in a better
position to manage the economic risks of unemployment, medical care, and old
age. In the old days this was called saving for a rainy day.
Numerous policy reforms can enhance asset accumulation, especially tax
reforms affecting savings and investment behavior, private retirement
accounts, and Medical Savings accounts. More importantly, such policies are
most crucial at lower wealth levels where economic inequality and insecurity
are greatest. Applications of capital market solutions to policy problems
related to economic risk are bounded only by the limits of the imagination.
Private capital markets are not a panacea for all of society's ills. The
promises of asset accumulation and diversification do not obviate the need
for insurance, both private and social. Insurance and portfolio
diversification are complements as markets supply an important
self-insurance supplement. Where asset diversification is unavailable and
private insurance markets fail, there is a real need for social
insurance-type safety nets. 
Nevertheless, many of the problems afflicting modern democracies stem from a
programmatic expansion of social insurance, especially the "pay-as-you-go"
kind. The attendant costs and perverse political pressures are
unsustainable. Since national policy is mostly about collective risk
management, private capital markets provide an important alternative policy
tool. These markets have evolved significantly in recent years through
financial innovations employing new information technologies and
risk-management techniques.
The level of diversification available today across asset classes and across
the globe in international capital markets is unprecedented and offers an
exceptional opportunity for democratic governments to meet the needs of
their citizens by more efficient methods that also serve to increase
individual choice and freedom.

Michael Harrington is a Research Associate in Capital Studies at the Milken
Institute, a non-profit, independent economic think tank in Santa Monica,
California.