Skin in the Game

Back in the early 1970's, I did research on neurotransmitters at Massachusetts General Hospital in Boston. Our group collarorated with the Department of Psychiatry. One day while shooting the bull with some post-doc Psychiatry fellows, I asked them what their favorite Psych study was. Several of them mentioned a study which demonstarted that patients get a lot more from their cognitive therapy (counseling) if they actually pay something, even a small fraction, for it. If it were completely free, they did not value it. This little conversation stuck with me.

There is much talk today about moral hazard; the idea that if a third party pays for a service, it is misused or abused. Investment Bankers take excessive risk if they know the public will bail them out. Patients want more health care, even unnecessary health care so long as an insurance company pays for it. The list is endless.

People have been able to buy half million dollar homes with no money down; those with any equity have sucked it out. Having no equity in a house sure makes it easier to mail in the keys and walk away.

My 16 year old daughter had a summer job punching a cash register at the local grocery store. She came home with stories of the fine meats, expensive cheeses and name brand products that people were buying with food stamps--better stuff than most upper-middle class families could afford.

I recall, as a practicing physician, having difficult end-of-life discussions with family members about how aggressive to be with terminal aged loved ones. Many responded that I should do everything possible so long as the insurance paid for it. I love the ads on TV that promise that they can get you a power chair (to get your lazy butt out of the chair) or a scooter (to get your lazy butt around the house) without costing you a cent. While there are legitimate uses for these things, for most patients, the increased inactivity, enabled by these expensive devices, actually reduces health. The power of free is incredible.

The popular book—Predictably Irrational documents the Hershey kiss experiment. The experimenters offered students a Lindt Truffle (very high end chocolate) for 26 cents or a Hershey Kiss for 1 cent. 40% chose the Lindt Truffle while 40% chose the Hershey Kiss. The price of each was dropped one cent and the choices were repeated. In that instance, the subjects chose the kiss 90% of the time. Despite the fact that the price was dropped equally, the “freeness” of the kiss seemed irresistible. Impressively the experimenters tried various other combinations but were unable to avoid the power of “freeness”.

Goldman Sachs was a privately run firm until the 1990's; when it invested in something, it was using the partners' capital--capital that could only be taken out slowly, even after retirement. They were all on the hook personally. Once they went public, they were betting the shareholders capital. Do you think management's tolerance for risk increased?

All of these examples underscore the incredible changes in behavior that are explainable by moral hazard. Perhaps the answer to many of the ills presently effecting society is to substantially reduce moral hazard at all levels. Let's go back to requiring a 10-20% down payment on mortgages (and all loans). Let us require people with food stamps to pay 20% of the cost. Let us require credit default swaps to be limited to insuring a maximum of 80% of the value of the bond in question. Let's require insurance (in total) to cover only a maximum of 80% of the cost of a medical procedure. This simple concept is known as having "skin in the game"; it forces people to actually seriously consider how they use resources--something sorely lacking in today's society. Just as the Hersey kiss experiment showed us, even a small cost makes people more rational and more responsible in their choices.