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March 24, 2005

Fire Insurance is not Welfare and Neither is Social Security

[Update: See also "The Need for Social Insurance" posted 4/2/2005] Robert Samuelson, and many others, appear to believe that any time there is a transfer of income between individuals or groups it is welfare. This is wrong. According to Samuelson:
Welfare is a governmental transfer from one group to another for the benefit of those receiving. The transfer involves cash or services (health care, education). We have welfare for the poor, the old, the disabled, farmers and corporations. Social Security is mainly welfare...
Not it isn’t. Social Security is mainly a means of insuring against economic risk. It is fundamentally an insurance program, not a saving program, and as such it is not welfare. Just because an economic activity transfers income from one person or group to another does not make it welfare. Fire insurance transfers income. Some people pay premiums for their whole lives and collect nothing. Others, the unlucky few who suffer a fire, collect far more than they contribute. Does that make it welfare? Of course not. Social Security is no different, it is an insurance program against economic risk as I explain in this Op-Ed piece. Some people will live long lives and collect more than they contribute in premiums, some will die young and collect less. Some children will lose their parents and collect more than their parents paid into the system, others will not. But this does not make it welfare. Is gambling welfare? Gambling transfers income from one person to another. Does that make it welfare? Loaning money transfers income when the loan is paid back with interest. Are people who receive interest income on welfare? There is an important distinction between needing insurance ex-ante and needing it ex-post. Insurance does redistribute income ex-post, but that doesn't imply that it was a bad deal ex-ante (i.e., when people start their work lives). Thus, by this definition, farm subsidies are welfare. Steel tariffs are welfare. R&D tax credits are probably even welfare, and so is AFDC. All of these are pure ex-post redistributions. That is fundamentally different from the purchase of insurance. Angry Bear agrees with me on this and the two of us have been independently saying the same thing (in fact, I first encountered AB in a Google search on Social Security, insurance, and risk). As AB said (the full text is well worth reading):
What does all of this have to do with Social Security? Those who are hard-working, fortunate, and not too profligate will have a large nest egg at retirement and Social Security will account for only a small portion of their retirement portfolio. This is tantamount to paying for insurance and then not needing it. This happens all the time -- every year someone fails to get sick or injured and, while surely happy in their good health, would have been better off not buying insurance. That's the nature of insurance: if you don't need it, then you'll always wish you hadn't purchased it. Only in the context of retirement insurance is this considered a crisis. On the other hand, those with bad luck or insufficient income will not have a nest egg at retirement. Because of Social Security, instead of facing the risk of zero income at retirement, they are guaranteed income sufficient to subsist. This is precisely like the insurance example I worked through above: people with good outcomes will wish they hadn't paid into the insurance fund; those with bad outcomes will be glad they did. Ex-ante, everyone benefits from the insurance. Overall, society is better off because risk is reduced; because people are risk-averse, the gains are quite large.
When I think of welfare, I think of pure money transfers from one group to another without any economic basis for the transfer. In such cases, one person’s gain arises from another’s loss. But economic activity that results in the exchange of goods and services is different. It is not a zero sum game. One person’s gain does not come at the expense of someone else. The main feature of Social Security is not welfare as Samuelson asserts. The main feature is insurance against economic risks and as such it makes us collectively better off. Calling it welfare when it isn’t is misleading and causes unnecessary class distinctions and resentments from the losers ex-post. More importantly, it ignores and obscures the important role Social Security plays in society as insurance against the economic risks we all face. If you think you are so rich and powerful that you don’t need such insurance, consider this. The stock market collapse of 1929 at the onset of the Great Depression wiped out substantial quantities of wealth. The typical stock was worth only one sixth its pre-crash value once the bottom was reached. Whatever insurance existed in the stock market evaporated as the crash unfolded. It wasn’t the poor jumping out of windows on Wall street. If you think it can’t happen to you, think again. [Update: Maxspeaks also comments on Samuelson's piece in Robert No-Relation-to-Paul-Samuelson-Doesn't Get Social Insurance and notes his failure to understand Social Insurance. "Why are so many Washington Post columnists intellectual pygmies?" he asks...] [Update: A question that comes up repeatedly in response to the fire insurance analogy is why it is that with fire insurance only the losers are compensated, whereas with Social Security everyone is compensated. Why isn't there any distinction between the winners and the losers (means testing). I talk about this a little bit in the comments to this post and note some of the political realities involved in the decision to give everyone “ownership” in the system. On the economic side, there are market failure issues that lead to a need for government intervention to ensure that people have sufficient resources available upon retirement. There are both moral hazard and lemons market problems in the private sector, e.g. moral hazard because the government won't let us starve and lemons market issues due to private information on health status that gives a person a better idea about longevity that the market can assess. You could solve the latter by making medical records public, but you'd still be left with other market failures and less privacy. Thus, the argument is two-pronged. First, there is a need for Social Insurance to ensure against economic risk. Second, market failure in the provision of retirement insurance and retirement saving lead to a need for government intervention. The other comment is that the payout is too generous making it a retirement savings account rather than insurance against poverty. I totally agree that the level of socially acceptable insurance is an open question. What you might see as a retirement savings account, I might see as nothing more than a poverty level guarantee due to different normative judgments. The acceptable level of social insurance is an area that we can debate, but it is ultimatately a normative question. Some thoughts on this are at The Visible Hand: Adam Smith on Equity. A final comment is in response to comments on the redistributive aspect of the insurance system. The contributions to the system may go beyond what is justified by the probability of a rich person going broke (in terms of their contribution versus expected payout). But that is a question of the political realities of reducing the contributions of the wealthy versus the efficiency arguments arising from economic analysis. It would be possible to adjust the payments so that the wealthy contribute less to the system and take less out in an actuarially fair manner. However, the redistribution question is separate from the efficiency question. Paying in more than is actuarially justified does not necessarily imply income redistribution so long as each income group gets back what they pay into the system. In any case, the redistributive questions do not overturn the arguments concerning the need for a social insurance program. The questions are about adjusting the payments so that such redistributions do not occur, and so that they are consistent with expected payouts for each group (these are two separate issues, one involves making sure there are no redistributions by giving each group exactly what they pay into the system, the other involves making the payments equal to the expected payout thereby achieving economic efficiency). Sometimes politics matters. I have no problem with means testing so long as it does not undermine the system in the long-run.]

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