Everyday Economics

How Big a Safety Net?

The philosopher says we have a moral obligation to create a social safety net. The economist asks, how big, and whom should it cover?

Why do we have a social safety net? It depends on whom you ask. Some say it’s a matter of political prudence (e.g. “The alternative to a safety net is a revolution”). Others say it’s a moral imperative.
       Among the latter, the most influential is Harvard University professor of philosophy John Rawls. Rawls likens the safety net to an insurance payout. Here’s his argument: Back before you were born–in fact, before you were even conceived–nobody knew you were going to develop into the sort of sophisticated individual who reads Slate. For all anyone knew, you might have been born without enough skills to boot up a computer–or to earn a decent living.

If your unborn soul could have bought an insurance contract, then you’d probably have snapped up some kind of “skill insurance” in which everybody pays premiums, and those who land in the shallow end of the gene pool split the pot.
       Of course, you didn’t buy insurance. But that’s only because there are no telephones in the world-before-birth, so the insurance salesmen couldn’t contact you. According to Rawls and his followers, you would have bought the insurance if you could have, and that creates a moral obligation upon all to pay the premiums.
       That’s a very powerful argument, but it’s incomplete. Here’s why: It offers no estimate of how much insurance your unborn self would have wanted. Rawls says we should enforce a bunch of hypothetical insurance contracts, but you can’t enforce a contract if you don’t know what it says. So, to convert the Rawlsian argument into a concrete policy, you first have to determine what terms we’d have written into those pre-birth agreements.

Here’s how the philosophers solve that problem: They guess. Most of them guess that our unborn selves would all have cheerfully signed on for a pretty substantial welfare state. Being an economist and not a philosopher, I am inclined to think about such questions a little more deeply.
       How much insurance would an unborn soul want to buy? We already know a lot about the demand for insurance from available data on how much of it (fire, life, disability, auto, etc.) people in the real world buy.
       Some people demand more insurance than others do because they face more risk. So before we can estimate how much skill insurance your pre-birth self might have purchased, we must first estimate how much risk you were facing when God was handing out the brains.

The right way to measure risk is to measure the statistical variance of the possible outcomes. In this case, that means measuring the statistical variance of human talents. You can’t measure talent directly, but you can measure it indirectly–say by observing people with similar education and training, and measuring the variance in their earnings. After you’ve controlled for education and training, earnings are at least a rough measure of talent.
       Once you’ve measured that variance, you’ve measured the risk, so you can go back to the insurance markets and observe how much insurance people choose to buy when they’re facing similar risk levels. That gives at least a rough estimate of how much we should all be paying into the general welfare pool.

E conomists James Kahn (of the New York Federal Reserve Bank) and Hugo Hopenhayn (of the University of Rochester) recently sacrificed a lunch hour and the back of an envelope to computing that rough estimate. The bottom line turns out to be astounding: If you take the insurance metaphor seriously, then 23 percent of the population–the 23 percent with the fewest skills–should be permanently unemployed and on welfare. In other words, the present-day welfare state is not nearly as large as it ought to be. So, if the Rawlsian philosophers had bothered to do a little arithmetic, they might have discovered that their arguments are a lot stronger than they dared to expect.      But Kahn and Hopenhayn’s arithmetic leaves something out. They implicitly assumed that it would be costless to identify the people with the fewest skills so that we can put only those people on the dole. That assumption becomes invalid if highly skilled people can hide their abilities in an attempt to defraud the system. Policing such fraud can make social insurance policies considerably more expensive, and when insurance is more expensive, people want less of it. Factor that into the equation, redo the calculations, and you end up concluding that the fraction of the population on welfare should be just 0.6 percent–in other words, practically zero.

The truth probably lies somewhere in between 23 percent and 0.6 percent: We can’t costlessly observe each other’s skills, but we can’t costlessly hide our own skills, either. In other words, maybe the social net should be drastically expanded, and maybe it should be drastically slashed. Not too definitive a conclusion. But it’s the result of just one afternoon’s work, and it’s more precise than anything the philosophers have come up with in the quarter century since Rawls first made his argument.
       Personally, I’m not sold on the insurance metaphor to begin with, for reasons that could fill a separate column. But the broader point is that if your argument is based on metaphors, you should be prepared to treat those metaphors with respect. If the safety net is really just like insurance, then we should be buying it in quantities commensurate with our other insurance purchases. And we should be making an honest effort to calculate what those quantities are. The philosophers don’t seem willing to meet that responsibility. That’s why we need economists.