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Sunday, November 20, 2011

The downside of socializing risks

Much has been made of governmental interventions with socialized financial risks while the gains of these same interventions appear to have been garnered by specific private parties (Wall Street vs. Main Street). However, state interventions which result in socializing risks are not limited to the financial sector. They essential permeate every state activity and create moral hazards at each turn.

There are two elements to life which are invariant and unchanging. First, everything changes. Second, risk is everywhere. Despite all of our technological progress, human existence is precarious and touched by risk constantly. Basically, every human institution has developed as a consequence of attempts to blunt and mitigate risk. Initial efforts required were to mitigate the risks of injury by the elements (freezing in winter), starving, being devoured by wild animals, or killed by enemies. In order to address risk, people can make efforts as single individuals, organize into groups voluntarily, or form organizations where membership and participation are compulsory. The latter essentially represent state or governmental entities which have the power to compel activity.

Fast forward to our modern era and the modern state. The modern era has brought us unprecedented private and state initiatives which were put in place to basically to mitigate personal risk. The development o the modern insurance industry was an essential innovation which was required for expansion of the modern economy. Many different strategies and products were deployed. However, innovations by private entities are always imperfect.and history is punctuated by repeated individual and institutional failures, often within financial institutions but certainly not limited to this domain.

Enter the state. The state has always play a role in socializing certain risks. There is a reasonable consensus that the risk of invasion should be socialized in the form a common defense organized by the state. The specifics may be problematic. The state's role in socializing risk has basically exploded in the 20th century with the creation of entities to protect against a host of risks; the risk of surviving into advances age,  the risk of illness, the risk of disability, and the risk of unemployment, the risk of making bad investments, and the risk of making unwise decisions in general.

The idea to increasingly move risk mitigation to states is seductive. It is simple. Why charge many different entities with risk mitigation when you can put all responsibility in one place? While it might appear attractive and simple, nothing could be farther from the truth. One entity means a singular approach which has as much chance of  being the wrong approach as it does the right approach. In addition, placing risk mitigation in the hands of the state consistently results in application of actuarial models which are biased toward under funding with the knowledge that states are back stopped by what appears to be the unlimited deep pockets of the taxpayer. Once you get people hooked on the promise it is easier to hike taxes and borrow from future generations.

What could be more seductive than a promise to mitigate the risk of the cost of illness or the risk of outliving your savings? The lessons of these entitlement programs are very stark. Every actuarial estimate regarding the cost of these programs (Medicare, Medicaid, and Social Security) were off, not subtly but off by orders of magnitude. Private entities who make such bad bets (for example in  pensions) go broke. The same may be true of states but the displacements that result are so much more tragic.

One product of all this activity is the creation of the belief that states are the most effective entities which can mitigate risk. There is little empiric evidence that this is the case. Perhaps the worst hazards associated with this belief system are the moral hazards where embracing the idea that state risk mitigation activities insulate people and entities from risky behaviors, thus influencing behaviors in such a way which increase the likelihood of the very things we all want to avoid. Risks will always be with us and the greatest tool to mitigate risks is personal awareness that our activities can either put us at or mitigate risk. If we believe that state programs can insulate from our own stupidity, we tend to act stupidly.

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