Asymmetric information plays an important role in macroeconomics. There has been a great deal of public discussion regarding the expense of health insurance programs provided by the government (Medicare and Medicaid), as well as plans for rescuing distressed financial corporations (TARP and FDIC insurance). Recent criticism of government-provided health care by Liz Cheney, and a rebuttal by Jon Chait show just how vitriolic the debate can be regarding government provided benefits.
The justification for providing health care or financial market oversight is typically that the goods in question should be provided by the government because markets fail to provide a “socially optimal” level of protection. This however does not mean that the current level is ‘optimal’ from any perspective (See a recent opinion debate in the WSJ and Bloomberg).
Government programs exist to aid in solving asymmetric information problems. Federal deposit insurance represents an attempt at solving the “principal-agent” problem. Bank depositors (i.e., the principal) should watch after a bank (i.e., the agent) to see that they are investing their money wisely. Unfortunately, most people fail to understand that banks are actually lending their money to others, and even if they did, they probably wouldn’t understand how to monitor a bank. So, if the agent’s incentive is to take big risks to make a big profit, incentives are misaligned between the principal and agent. This misalignment leads depositors to underestimate the potential for calamitous failure of their bank when the market turns sour. Thus, deposit insurance guarantees that depositors are protected-to an extent-from the risk of bank failure. However, with deposit insurance in place, depositors no longer watch what the bank does, leaving regulators to play the role of watchdog. The recent example of bank failures in Cyprus shows that there is a limit to deposit insurance, especially when the banking system turns out to be a huge portion of your country’s economy.
Health insurance provided by the government (including Medicare, Medicaid, and Tricare) are all attempts at overcoming the problems of adverse selection in private insurance markets. Those who are either very risk averse or know they will likely need a lot of care are the first to line up to get health insurance coverage. Knowing that these individuals will cost a lot to cover, insurers would rightfully charge them very high premiums. By bringing all retirees and disabled individuals under one gigantic plan, both the healthy and unhealthy are covered. This brings down the average cost of coverage, while driving up the total cost substantially. The same logic is in place for the recently passed Affordable Care Act. If the government can lure almost everyone into a health insurance plan by taxing them if they don’t buy coverage, then average costs for an individual health care plan will come down. Since the ACA hasn’t gone into full effect yet, it’s hard to see the actual costs. The big point is this, poor elderly Americans would have little ability to pay for their health care if it were not for some government provided or charitably provided health insurance.
In private markets-like used cars or televisions-there are often privately provided solutions that avoid the reach of government. Warranties are able to offset much of the risk in products purchased in market transactions, while insurance allows those who are afraid of risk to pay to prevent possible outsized losses.
Questions you might answer:
- Do you believe that the government should play a role in helping to solve particular problems of market failure? If so, provide an example where they have effectively solved the problem. Also point out some unintended consequences of the government intervention. If not, what could be done in order to solve the market failure? What is the consequence of non-action?
- Give an example of a government action that was necessary/unnecessary. This can be a local, state, or federal example. Your example could be as simple as sidewalks or parks, or as complex as the F-35 joint strike fighter. Link your reasoning for the necessity of action based on the provision of public goods, private goods, market failure, asymmetric information, and/or cost-benefit analysis. Could a private market have provided the same level of support? Provide some empirical evidence to support your story.
- With respect to government provided health insurance or financial market oversight, do you believe the government plays the proper role? If so, provide empirical support to your analysis. How big is the program? How many workers/bureaucrats are supported by a program? Could it be cut? Should it be expanded?
- What are alternatives to the current deposit insurance scheme in the U.S.? Should we adopt a system similar to the EU? Cyprus? China? What are some other systems that could be used to prevent bank runs? What are recent examples of bank runs, even when there is deposit insurance? How has deposit insurance helped them? How has deposit insurance failed governments? (Hint: Think Iceland, Ireland, Cyprus, Spain, Italy…)