Moral Hazards & Perverse Incentives

One economic concept that's played such a prominent role in our current economic debacle is: Moral Hazards. According to Wikipedia:

"Moral hazard arises because an individual or institution does not take the full consequences and responsibilities of its doings, and therefore has a tendency to act less carefully than it alternately would, leaving another party to hold some responsibility for the consequences of those actions."

For example, we can be certain that if Fannie Mae and Freddie Mac were not implicitly guaranteed by the government, they would not have been reckless in issuing sub-prime mortgages. And of course the multi-billion dollar bailouts that the Obama Administration is providing their corporate cronies will not encourage the recipients to engage in more sound economic behavior.

Another concept is perverse Incentives, which is defined as an incentive that has an unintended and undesirable effect, that is against the interest of the incentive marker.

These economic phenomena figures prominently in socialized medicine.

We can argue the merits of providing health care for the truly impoverished, but beyond that we enter the murky territory of moral hazards. By expanding the Medicaid eligibility from 185% to 400% of the poverty level, Blagojevich allowed families earning up to $80,000 to partake in socialized medicine. With some exceptions, the majority of families with this income level could adjust their spending and saving patterns to allow for the purchase of private health insurance. This may mean making tough choices, like opting for a smaller home, a more modest wardrobe and eliminating eating out. But once the option of socialized medicine is presented, their incentives to economize and make tough decisions are essentially eliminated. Many families who would have otherwise purchased their own insurance will opt for government assistance, which is a major factor in the expansion of Medicaid users in Illinois by 62.86% (between 2000 - 2008).

One lesser mentioned, but equally important aspect of moral hazards are the reduction of incentives for personal, professional and economic improvement. To start off with, many private insurance firms will offer lower rates (positive incentives) to those who don't smoke, watch their weight and avoid needless procedures. In contrast, socialized medicine rarely if ever offers such incentives, which predictably lowers incentives for healthy, economical behavior.

In regards to professional development, I can provides countless examples of people who were unhappy with their economic circumstances and decided to invest their time and money in developing new skills in order to pursue more profitable career paths. In the course of improving their productivity they also help create a more dynamic, productive economy. But, with the growth of a cradle-to-grave nanny state, that care for the unproductive and penalizes the productive (via higher taxes and regulation), there are simply less incentives for personal and professional improvement. In fact, Medicaid provides very powerful perverse incentives against professional improvement. For example, in Illinois a family earning $75,000 would lose thousands and thousands of dollars in Medicaid benefits if they raised their earnings to $80,500.

Does this mean that the state should not attend to the health and welfare of the most vulnerable citizens? Of course not. It merely means that we must be extremely cautious of engendering moral hazards that reduce incentives for economically positive behavior and perverse incentives that increase economically and socially destructive behavior.