February 20, 2008 by Tom Armstrong.

Don at Cafe Hayek is right on the money, as always.

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February 20, 2008 by Tom Armstrong.

Where did this bozo (The Naked Economist) get his Ph.D.? They must just give them to anyone these days. He wrote this piece yesterday. In an attempt to discredit the late, great Milton Friedman, he writes:

Ah, if it were only that easy. There’s an equally compelling argument, with strong supporting evidence, that individuals make systematic errors of judgment, and that we’re bad at assessing risk. Thus we obsess about dying in a terrorist attack as we merrily tool around the suburbs in our cars — the latter of which is far more likely to kill us.

We discount the future too heavily. Thus we eat poorly and exercise too little, only to suffer from Type 2 diabetes later in life. Or we start smoking because we think we can quit — and we don’t.

Investors make portfolio decisions that defy the basic rules of finance and lose a bundle as a result. After the dotcom collapse, the Wall Street Journal ran a series of articles on individuals who had taken their retirement savings as a lump sum and then lost most or all of it chasing Internet stocks. The articles were so depressing that I couldn’t read them after a while.

All these examples suggest that government can help save individuals from themselves.

Frederic Bastiat responded to such arguments over 150 years ago. He said:

If the natural tendencies of mankind are so bad that it is not safe to permit people to be free, how is it that the tendencies of these organizers are always good? Do not the legislators and their appointed agents also belong to the human race? Or do they believe that they are made of a finer clay than the rest of mankind? 

The Naked Economist must have purchased his Ph.D. on the Internet.

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February 20, 2008 by Tom Armstrong.

Health questions for Hillary Clinton and Barack Obama, from the WSJ today.

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February 20, 2008 by Tom Armstrong.

A coworker and I had the following discussion yesterday:

He believed his son was charged a risk premium for his car insurance because he was a young, male driver (i.e. high risk). I conceded that this is true, and it is often labeled statistical discrimination. It is a legitimate practice, and my coworker agreed. My coworker, however, believed this risk premium should have been returned to his son once he was no longer a young, male driver. Why? Because, he says, it turned out that his son never had a traffic ticket or accident. I fall in that same category, but I vehemently disagree that the risk premium should be returned. The premium is never returned, and there is good reason why it’s not.

Here is my response to my coworker:

Let’s say you’re a banker, and I need a loan. Furthermore, let’s say the risk-free interest rate is 4%, but I’m obviously not risk free. In fact, let’s say I have a low credit rating and I have defaulted on a few of my debts, but just a few of them. Because of my less-than-stellar credit history, you cannot give me the risk- free interest rate. You decide you must charge me 12% interest before you can justify loaning me money I may not pay back on time, or even pay back. (If you like the analogy better, we could also pretend I’m a new business owner with no history, so I’m a riskier loan applicant, much akin to your young, male driver.) If you provide me a one-year loan of $10,000 at 12%, you can earn $1,200 in interest if I pay you back on time. At 4% you would earn $400 maximum.

If you loan me the money at 12% and I happen to pay you back in full, will you return the $800 difference? I don’t think you will, although I’m sure you are a kind, compassionate person. You decided to finance a high-risk person/business, and you must be compensated for accepting that risk, even though it turned out to be a profitable risk. But, remember, at the time of your underwriting the loan, you did not know for sure it would be profitable. Imagine if you always returned the difference. It sounds compassionate, but the problem is that some of those high-risk loans will turn out to be write-offs. If you had returned the risk premiums to all the customers who happened to pay you back, you would lack the capital to sustain the losses from the bad loans, and you’re business model would fail.

This is precisely why insurance companies do not return risk premiums they charge based on statistical discrimination (or any risk premium for that matter). Companies must charge for extra risk they incur, and they cannot return those premiums if the person/business turns out to be a profitable risk, not if they desire to remain a going concern. If banks or insurance companies always returned the premium, our financial system would be unprofitable and no loans or insurance policies would be available to anyone, low or high risk. If banks and insurance companies were required by statute to return risk premiums, you would quickly see these companies only loan at the risk-free interest rate; that is, credit or insurance would be available only to low-risk people. It is not a matter of right or wrong, good or bad, it is a matter of practicality.

Update:

I received this response earlier today:

In your example you have a history of bad credit. In the example I gave about car insurance there is no history. If I use your example of a new business owner, if you miss one payment I will not raise your rate (or even call the loan due). In car insurance even thought I am charging a higher rate, if you have one accident I am going to raise your premium. Sorry, but it can’t be defended logically.

My response:

You simply tell me I’m wrong. That’s an argument without an argument. I like concrete examples too. That’s why I gave you one. Consider the example again of the new business owner. The bank, just like the insurance company, practices statistical discrimination to price risk. If the new business owner misses on payment, he is harmed. He has a ding on his credit rating and his future rates go up; his current rates may go up too(I was a commercial banker and we had some covenants set to increase rates if some conditions were not met-so you’re not correct).

Take another example. Some companies are in high risk industries, such as the food service industry. They are punished with higher interest rates, just because of statistical discrimination. They don’t have interest money returned to them when they turn out to be a success.

Take another example still. I lived in Memphis, and just because I lived in a higher-risk city, my insurance rates went up. I never had a traffic accident or a ticket, but I had to pay higher premiums in order to compensate the insurance company for taking on additional risk. The insurance company did not return my premiums because everything happened to work out O.K. when I lived in Memphis. The insurance company writes premiums based on the risk it incurs from point A to point B, like a bank prices loans from the risk it incurs from point A to point B. Point C, after the fact, does not enter the equation until the insurance company or bank promises to write a premium or underwrite a loan from point C to point D.

From 16 to 24, I was a high-risk driver, just like your sons. I, unlike yourself, don’t believe my risk premiums should be returned to me because I turned out to have an unblemished driving record. The insurance company took on a high-risk driver for several years without knowing how it would end up. Without these premiums, no high-risk driver would ever have insurance available to him/her.

Let’s say your son gets married, and because he does so, his car insurance rates drop. Let’s say he saves $250 per annum in premiums because he is married. He remains married for the next five years, for a total savings of $1,250. Now, at point C, he gets divorced. His rates go up in the future to reflect this fact, so do you think he should return the $1,250 he was “undercharged” during his marriage?

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