On my earlier post on income volatility, D-aquared asked why smaller risk pools would be efficient?
His point is that if the problem is volatility, risk can be diversified away. If 10 families pool their savings, volatility will be lower than if each family saves for itself.
The problem with this type of risk pooling is that there are deadweight losses. The income insurance fund needs rules for paying claims, and each possible rule gives rise to moral hazard.
If I can make a claim whenever my income is below normal, then I have incentives to take a year off or otherwise increase the volatility of my income.
If I can make a claim when I am unemployed, then I lose the incentive to find a new job--or to put up with my existing job.
The more insured I am against income fluctuations, the lower my incentive to save, and the lower will be the rate of capital formation in the economy.
There is also the issue of adverse selection. If I know that my income is going to be stable, I try not to join a pool. I tend to join when I have news that my income is going to be volatile.
The issue of adverse selection poses problems for private markets for income insurance. The issue of moral hazard poses problems for a government market for income insurance. My guess is that a case can be made that an increase in income volatility raises the need for both personal saving and for government-provided income insurance.
Note, however, that if taxes rise with income, that provides a form of income insurance. It is not clear that a new program is needed.
For Discussion. Do we not observe private markets for income insurance because of adverse selection, or because individuals really do not value income smoothing very much?