Monthly Archives: August 2012

Game Theory and the Politics of Entitlement Reform

Mitt Romney’s choice of Paul Ryan as his running mate ensures that this Presidential election will be more than a simple referendum on Barack Obama’s handling of the economy over the last four years.  The election will now also involve a debate about the need for significant entitlement reform and the role of government.  Given that polls show the majority of Americans still oppose large changes in Medicare and Social Security, what will it take for Republicans to win this battle?

As I wrote in an earlier blog post, Republicans must hope that voter preferences line up a certain way and they must then fashion reform policies that match those preferences.  In evaluating major reforms to government programs, each voter usually takes the decisions of others as given: there is very little that any one person or group can do to influence others.  Government programs, including tax breaks, are spread out over a large number of beneficiaries.  Each beneficiary can decide how hard to fight in order to get or keep their specific program, but their decision usually does not influence what other groups do.

If reform decisions are made piecemeal, addressing one tax expenditure or spending program at a time, then each voter faces four different outcomes (see chart below).  First, let’s assume that the individual refuses to give up any program that benefits him.  In this case there are two possible outcomes.  If all other programs are reformed, we have Case I where the individual is a clear Winner: he gets to keep his government subsidy but no longer bears the cost of everyone else’s.  Other citizens may not be so generous, however.  In the more probable case where no one gives up anything, we revert to Case II, the Status Quo.  This is where we currently seem stuck.  There are reasons to think that being here is quite costly.  The nation’s main entitlement reforms are not sustainable over the long-term with out significant tax increases or difficult to achieve reductions in the cost of health care and current tax policy creates perverse incentives in many ways.  Moreover, because the government is in the business of handing out benefits, significant resources are devoted to seeking and defending favors from the government rather than to creating social wealth.

If on the other hand, the individual gives up his special benefit, the rest of society may reciprocate, leading us to Case IV,  which maximizes social welfare.  In this case government programs seek to maximize social rather than personal wealth, groups do not feel the need to spend large amounts of money lobbying Congress for favors, and resources end up wherever they are most valuable.  But more probably, the individual’s sacrifice will not result in significant reform.  In this Case IV the individual is clearly a Sucker.  He has lost his benefit but still has to bear his share of the cost of all the others.  Although the outcome may have significant consequences for the individual, society as a whole is virtually unchanged.

We can draw some conclusions from this game.  First, if every person makes his decision separately, then no one is likely to agree to entitlement reform.  No matter what others decide, individuals are always better off keeping what they have.  This makes it impossible to get to the Social Maximum.  Second, it might very well be true that everyone prefers the Social Maximum over the Status Quo, but because there is no way to  reach it, individuals effectively face a choice between the  Status Quo and being a Sucker.  Third, if the Social Maximum is to be reached, two things must be true.  First, individuals must prefer it to the Status Quo.  Second, there must be a global agreement in which everyone gives up their programs if and only if everyone else does the same.

There are good economic reasons for thinking that tax and entitlement reform would boost national welfare.  But it is not yet clear that the public perceives this to be the case.  For entitlement reform to happen, most voters must believe that they would be better off after reform than they are now.  There is not a lot of evidence that they do and I think that part of the reason is because they doubt that the gains from faster growth will be distributed widely.  But part of the reason may be because few people think true reform is possible.  They view their choice as being between the Status Quo and a Sucker.  Jumping to the Social Maximum requires a grand bargain in which reforms are considered en masse rather than individually.  That requires both leadership and vision.

Republicans must now develop that vision in some detail.  Most probably, it will have to involve aspects of fairness and income equality in addition to economic growth, because many people are more concerned with losing what they have than they are with gaining more.  It should also ask much more of the wealthy and privileged, of whom nothing has been asked and much has been granted.  And it will have to be broad.  Maximizing economic growth cannot be the only, or even most important, objective.  Developing and selling such a program will test the Party’s ability to understand and represent the average voter.  In the end, entitlement reform is inevitable.  We simply cannot pay all that we have promised.  The sooner we begin to straighten our balance sheets the better.  But that does not mean that Americans are ready for it or believe it can happen.

Finally, even if the Social Maximum is reached, the game goes on.  Each person is still better off if he can restore his program without giving up the other benefits of reform (Winner).  Thus government must be ever vigilant to prevent the type of  backsliding that occurred after the 1986 tax reform.  As long as government is in the business of handing out favors, the game of rent seeking and special interests will merely begin again.

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How Ryan Changes the Race

Mitt Romney swung the presidential race in a new direction when he chose Paul Ryan to be the Republican Party’s candidate for Vice President.  Senator Rob Portman would have been the safe choice.  Portman has much more experience at higher levels both in the Senate and in both Bush Administrations including as Director of the Office of Management and Budget and U.S. Trade Representative.  Portman also would have helped in Ohio, a critical swing state.

Until now the election bore a close resemblance to the Carter-Reagan race of 1980.  In both cases a weak but likable Democratic incumbent with high disapproval ratings faced a Republican challenge who portrayed himself as a strong conservative.  Many voters had already decided that they did not want Carter to serve a second term, but they needed to see the challenger clear a reasonable bar of competence before they could support the challenger.  Somewhere in the debates Reagan cleared this threshold and what had been a close race became a rout.  Voters have a similar opinion of Obama.  Even his signature accomplishment, health care, counts against him with the a recent Real Clear Politics average of polls showing that almost 50 percent of voters favor its repeal while only 42 percent oppose repeal.

The dominant fact of this election can be seen from a recent Quinnipiac University/New York Times/CBS News poll of six swing states .  The key question in that poll asked voters about the effect that each candidate’s policies would have on their personal situation.  The results are shown below:

The results are pretty dramatic.  In Colorado the margin is 21 percentage points against Obama and in no state is the margin of loss less than 12 points.  A significant plurality of voters think that the President’s policies would make them worse off.  This is not a question about likability or competence.  It goes to intent and the direction the country should go in.  It is hard to see how any candidate with these number could get elected.

Romney, in contrast does much better, despite the President’s attempts to portray him as an extremist whose policies would gut the middle class in favor of the rich.  The Governor actually wins the question in Colorado and Florida and comes close in Virgina, Wisconsin, and Pennsylvania.  Only in Ohio do the two candidates face equal skepticism.

Until now, the primary question in this race was whether Romney could reassure voters enough about his basic qualifications and intentions to justify their abandoning Obama.  Given the Presidents job approval numbers and the above opinions, this bar is set very low.  Although Romney has had some difficulty clearing it, the debates would have been his real test and opportunity.  It is very likely he would have met the criteria.

The choice of Ryan fundamentally changes the debate.  It introduces the issue of dramatic entitlement reform front and center.  It will be very difficult for Romney to keep the focus solely on the economy’s performance during the last four years.  The problem is that there is very little evidence that the American people are ready for the kind of entitlement reforms that Paul Ryan is advocating.  For that reason the choice of Ryan may hurt Romney’s campaign.  Having Ryan on the ticket will energize the base.  But it may alienate independents and many moderate Republicans who are reluctant to see dramatic changes in Social Security and Medicare.

Anyone who has heard Paul Ryan speak knows that this is a debate he relishes and thinks he can win.  It is also a debate the country desperately needs to have and soon.  Once you rule out the possibility of dramatic tax increases or a magical slowdown in the rise in health care costs, cuts in spending, especially the large entitlements, become inevitable.  The United States is still a rich and productive country and there is plenty of wealth to make sure that everyone has enough, but the sooner we come to grips with fiscal insolvency the better off we will be.  A Romney win, especially one of five percentage points or more would have to be seen as a mandate to enact these reforms.  The President’s policies are known and are not going to change.  The Romney/Ryan challenge is to convince enough voters that their policies, while perhaps painful in the short-run will make their future and the nation stronger.

This campaign now promises the most open and honest debate about the role of government, the structure of its taxing and spending programs, and the tradeoffs between income inequality and economic mobility that we have had in a long time.  And there is no more passionate and skilled advocate of his side of the argument than Paul Ryan.  It is a debate we need to have.  It is also one that will make us stronger.

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Private Colleges and Accreditation Standards

New America Foundation’s Higher Ed Watch recently blogged about a Senate bill introduced by Senator Harkin that would apparently remove federal assistance to for-profit schools whose programs are not accredited.  For many professions in many states only applicants from accredited programs may take the relevant entrance test for their profession.  This gives the accrediting bodies enormous power to protect existing programs and to restrict the flow of new people into the profession.

Because of this it is very likely that the bill focuses on the symptom rather than the cause of the problem.  I agree that students should be told about the importance of accreditation and whether the program they are applying for is accredited. But the deeper question is whether accreditation bodies are unfairly limiting the number of programs and thus new job entrants in order to protect existing programs and practitioners.

There are some good indications that they are.  One way to find out would be to let students from all programs take the qualifying test.  If a high number of students from nonaccredited schools pass, that would be a good indication that the accreditation bodies are unjustly limiting the upward mobility of workers.  The licensing test is, after all supposed to measure whether a particular person is qualified or not.  If the test is accurate, accrediting standards seem redundant.

By focusing solely on the private schools regulators miss the important role of accrediting standards in artificially limiting the number of people allowed to practice any profession.  The effect is to limit the upward mobility of those at the bottom and to impose a tax on consumers in the form of higher fees for those who are allowed to practice.

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Three Types of Debt and How to Tell Them Apart

I am becoming more convinced that much of the underlying trouble facing the economy is the large overhang of debt that remains unaddressed.  But I am not quite sure that we are viewing the issue correctly.  Basically there are three kinds of debt: the good, the bad and the ugly.  If we cannot tell them apart, we are in for a rude surprise.  The distinctions affect not only the current deleveraging of current debt in the economy but also the debate on reviving the economy by spending more on infrastructure.

First a word about debt.  Debt can be explicit or implicit.  A mortgage is an explicit debt in which a bank loans money to a homeowner to buy a house.  The mortgage documents clearly spell out the terms of the loan.  Implicit debt is much more difficult to identify because it can be hidden.  The difference between Social Security’s promised  benefits and the revenues available to pay those benefits is a form of implicit debt in which the U.S. government may (or may not) be on the hook for paying benefits even if payroll taxes are exhausted.  The distinction is in whether the debt is clearly identified and acknowledged by both sides.  It is important to remember, however, that explicit debt can be reneged on even while implicit debt is honored.

Debt is good when it is invested in an asset that generates enough of a return to pay off the debt.  In this case the borrower is clearly better off for having taken out the loan.  Note that the key distinction is not in what the investment is called but whether it generates enough of a return to pay off the loan.  This type of debt makes society better off.

Debt is bad when it is used to fund consumption.  In this case the borrower is merely transferring consumption from the future into the present.  Rather than saving up for a boat, he is borrowing the money and paying the loan off in future years.  He gets to enjoy the boat now, but his future living standard will be lower than it otherwise would be.  It is all too easy to classify spending on bridges, roads, and education as investment.  If they generate a rate of return they are.  Otherwise they are merely disguised forms of consumption which are payed for by lower livings standards in the future.  This type of debt may affect individual consumption patterns but it does not make society any better or worse off.  Lets say I lend you $100 to buy a work of art.  If you pay me back, I have $100 and you have the art work.  If you renege, you have both the $100 you were supposed to pay me and the art work.  In both cases our joint wealth is the same.

Ugly debt exists where one party believes it is going to get paid something in the future but the other party acts like it doesn’t have an obligation.  Normally a debt shows up as an asset for the lender and a liability for the debtor.  Together they cancel each other out.  But when one party acts like it has an asset and the other party acts like it does not have a liability it is possible for society to believe it is richer than it really is.  Either way, the end result is deflationary.  A classic example isunfunded pension and health care liabilities.  Either beneficiaries will have to lower their standard of living when the benefits do not come as expected, or taxpayers will have to bear higher taxes and lower services than they are used to.

A key hurdle in getting back to strong growth is to acknowledge and deal with the large amount of ugly debt in the system and the first step in doing that is to recognize it.

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