Sunday, September 14, 2008

Arson, Fannie, Freddy and Uncle Sam

Some time ago I lived in a state that created a entity that was going to provide fire insurance to those who needed it but were ineligible to receive it from private insurers. It was sold as a warm and cuddly thing to do motivated by only the best of motives and opposed only by those who are cold-hearted and cruel.

No one seemed to ask why it was that the buildings in questions could not obtain private insurance. The major reason was that many of these buildings were fire traps. They were badly maintained and were likely fire hazards.

After the program was initiated the papers reported a rash of fires in buildings covered by the state subsidized insurance scheme. Some of these were just what you would expect from high risk buildings. But quite a few appeared to be of “suspicious origins”.

Buildings in such bad condition could be purchased at relatively low prices. They could be insured, at taxpayer expense, at relatively decent prices. And the owner could make an instant profit if his building had an accident. Coincidentally, of course, that is what happened.

Some of my older readers might remember the Savings & Loans debacle. The nation’s S&L’s offered consumers high interest rates to get their deposits. And to pay off those high rates they made some very risky investments. Safe investments tend to have low returns and dangerous investments have much higher rates of return.

Very quickly many S&Ls got into financial trouble. They sought high profits, had large debts to their customers, and went bust. The Left called that an example of the effect of greedy capitalism.

What they neglected was that S&L crisis was similar to fire insurance problem. S&Ls had insurance which the government provided them. The government told the S&Ls that all the profits from their investments belonged to them. As for the risk the government said they would cover the costs. Each account was covered by the government up to a certain amount -- an amount high enough to cover most accounts.

In the fire scam the government told building owners that the pay-out from a fire would belong to them entirely. But the costs of having a risky business would be covered by the taxpayers.

When government does this it distorts how people act. It tells them to take risks they wouldn’t take if it was their own money on the line. It encourages people to do things which have a high probability of turning out badly. When the state subsidizes the cost of risks while leaving the benefits private it increases the likelihood that risks will be taken and expands the potential for disaster.

The Fannie Mae and Freddy Mac situation is another prime example of this. These companies were allowed to keep all the profits from risky mortgages they covered. But when the risks turned out to be real, and the losses were apparent, the government bails them out. Private profits and public risks are a very dangerous combination.

Imagine how this principle would operate with gamers in a casino. Each individual walks in with a stack of chips provided by the politicians. If the gamer is lucky and wins a jackpot they get to keep all the funds. If they lose they didn’t put anything up. The number of gamblers would increase dramatically.

Of course, many advocates of Big Government promote this sort of policy in area after area. They want to nationalize risks and privatize benefits. But sometimes they do the reverse, that is they privatize risk and nationalize benefits. This too distorts behavior.

One example of this is when an entrepreneur works hard to create a profitable enterprise. The risks of venture belong to him or those who invested in his vision. However, should such an endeavour succeed the politicians demand that the benefits of that venture be given to the state for its use. That means, for the use of politicians who use it to buy votes or reward special interest groups that help them get elected. The risk is private, the benefits public.

Of course, the more this happens the less individuals are willing to take risks. This is easily shown if you assume a situation where 100% of the benefits are nationalized but 100% of the risk is privatized. Who would take a risk, with their own capital, to create a business where they would reap none of the benefits? No one!

We live in a world where politicians have created two sets of policies which deal with risks and benefits. One set of policies rewards bad decisions and the other punishes good decisions. Incentives matter but politicians don’t care. And they don’t care because their incentives are not to let markets work -- but to flex power by manipulating markets for their own benefits or those of their backers.

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