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There is much disagreement over whether President Biden’s decision to excuse $10,000 of student loan debt from certain borrowers creates perverse incentives and/or moral hazards.
Colleges have no incentive to rein in their education costs because they are borne by students and the government.
The moral hazard issue arises because the student borrower does not bear the full brunt of their commitments. Taxpayers do.
That the incentives and the hazards exist is obvious; whether it is a good program despite these is more difficult to determine.
But before anyone gets on their high horse on either side of the debate, let’s look at our own lives and see some of the consequences and hazards of incentives.
When you are providing support to your adult children you are potentially creating perverse incentives, as well as a moral hazard.
The perverse incentive is that in order to make your children’s lives easier, you may be sending a message that easier is better, they are inadequate, budgets don’t matter, or that you are always there for them. Easier in and of itself is neither good nor bad; what matters is how the recipients view the support.
If the support increases their standard of living to a level that is beyond their means, then the perverse incentive may have turned into your personal moral hazard. You may end up being their permanent backstop.
But a different outcome is created when you only help your children if they comply with the rules that you have established for them. The unintended result is that the gifts you make, for which you may expect some level of appreciation, become contracts.
While you are helping your children, you are fulfilling your will, not necessarily theirs. They may end up resenting you for your largesse. Having a conversation around gifting and what it means to everyone involved is far more powerful than controlling others through your support.
Incentives blind us from the full story. People often move because they want something different or feel they need more space. They may like their larger house, but may not like some of the increased costs that are associated with it.
Higher taxes, upkeep and energy costs may find them making career choices that they otherwise would not choose. It may take them longer to clean and take care of this larger place. They may not have as much in common as they did with the neighbors they left, potentially causing them to feel isolated or spend time in their old community.
When considering big decisions, it is useful to create a chart with what you are gaining and what you are losing by the choice. It is easy to get swept up in the excitement of change before fully considering its effects.
When you overspend you are creating a potential moral hazard for someone who eventually will need to take care of you. Clients who spend too much cannot say that they don’t want to be a burden on their children because they likely could be.
When you save too much you have the perverse incentive of your investments being the end rather than the means to an end. While it seems odd to think that hoarding is an incentive, it is usually couched in terms of security.
When the markets fall as they have been in much of 2022, are you actually less secure?
A positive impact of market declines is they can give you reason to reassess whether you are living aligned with your values or whether you are holding on for dear life.
For most people who want to include a percentage of their portfolios in what they will live off of, these markets have done a couple of things. First, they have increased the returns that you will get on less volatile assets like cash and bonds. Second, they have increased the expected future returns of more volatile assets.
The old rule of thumb of being able to spend 4% of your portfolio and have it last through your lifetime is easier to reach today because interest rates and expected returns are so much higher. If you had 40% of your investments in bonds that were paying 2%, you would have needed stocks to grow at a ridiculous clip. Now things are a bit more normal.
The important thing to notice is not how much less you have, but how will it impact what you want to do. In simple terms, a $10,000 portfolio drop may cost you $400 of annual spending (less than $35 a month). Uncomfortable, but probably not Earth-shattering.
Student loan forgiveness is neither a disaster nor a lifeline. Like virtually all incentives, it could both help and hurt.
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