The Perfect and the Free

Should health insurance be mandatory?

Suppose we enact a reform with the following characteristics:

1. Insurers can't refuse coverage for pre-existing conditions.
2. Insurers can't charge sick people more than healthy people. (I don't know that any proposals on the table go so far as to mandate one price for all, but I'm sure that some folks like the idea).
3. Individuals can choose whether to purchase coverage or not.

In a system like this, why would you ever buy health insurance if you were healthy?  The rational thing to do would be to go it alone while you were young and healthy (maybe paying for the occasional checkup out of your own pocket), then sign up for insurance only when you get sick.

If everybody behaves like this, then only really sick people buy insurance.  Since insurance companies a) have to pay claims out of the premiums they collect and b) are only collecting premiums from sick people, they will have to charge incredibly high premiums to survive.  So, yes, the reform says you'll be able to get insurance when you need it, but the price will be incredibly high.

If we drop provision #3 and force everybody to get insurance, then insurance companies will be able to use revenue from healthy people to pay claims.  So long as there's sufficient competition in the market, this will drive the price of health insurance down.  In economics-speak, we get a "pooling" equilibrium instead of a "separating" equilibrium.

The debate about which of these scenarios is preferable is full of red herrings.  From Democrats we hear that the mandate is a "cost-saving" maneuver.  Well, maybe a bit, but it is really more of a "cost shifting" maneuver.  The fundamental question is not how big the bill is but who pays it (only the sick, or all of us).  From the Republican side we hear complaints that the mandate is effectively a tax.  True enough, but guess what.  If you want sick people to get some help with their medical bills (I haven't heard anybody say they support letting sick people die penniless in the streets), somebody is going to have to pay.  You can do it with a mandate, or you can do it by using subsidies (i.e. taxpayer dollars) to cut the cost of sky-high premiums.  Or we can stick with the current "shadow" system where we require health care providers to care for the uninsured, but then let them pass the cost along to the rest of us.  That's a tax too.

There's no such thing as a free lunch.  If you want to live in a society where health care is available to all regardless of ability to pay, you're going to have to open your wallet.  The debate about mandates versus fees versus subsidized high-risk pools, et cetera, amounts to rearranging deck chairs on the Titanic.

Are bankers paid too much?

An interesting juxtaposition of articles in the WSJ yesterday.  At the top of page 1 was the scoop regarding the Fed's plans to place new regulatory limits on pay in banking institutions.  Toward the bottom of the page was a second article describing the lives of workers cast out of the finance industry during the recent downturn.  In recent years, the finance sector has drawn a startling number of recent college graduates, including many from technical fields such as engineering and the hard sciences.

The lush compensation of the financial industry drew the highly educated like moths to a flame.  One can hardly fault these workers for following the money, but the big question is whether this was good for society?  The main concern, as stated in the second WSJ article, is that these talented individuals went to work in a business that came to look less like allocating capital to its most productive use and more like glorified gambling.  They could have created something for a society, but instead they went and played a zero-sum game.  (A zero-sum game, for those who haven't heard the term, is one where two players try to split up a fixed amount: one person's gain is another person's loss.  No such thing as a win-win in this game).

Is this right way to think about it?  Did the labor market get things wrong, allocating the world's talent to the wrong industries?  If so, why?

The first two questions have quick answers: yes and yes.  The third answer goes back to the problems at the origin of the financial crisis.  In today's financial mass market, some institutions have become "too big to fail."  These firms have an unlimited license to take risks, knowing that the government (and ultimately taxpayers) stand ready to absorb the losses if they fail miserably.  Among other things, these firms bid up the prices of talented workers, to the point where other industries without a government backstop could no longer compete.

The market gets things right when all participants fear failure.  A business lacking this fear, because it is "too big to fail," will get things wrong more frequently.  The cost of those bad decisions reverberates throughout the economy.

We end up in a position where a government takeover of payroll decisions seems to make sense.  The more sensible way out would be to restructure the financial sector so no individual bank is "too big to fail."  Banks that actually have to worry about going belly-up have a great incentive not to buy $35,000 toilets.

Michael Moore, meet Adam Smith

 

I was somewhat amused to read Bloomberg's Q&A with Michael Moore, related to his new film "Capitalism: A Love Story."  Sayeth Mr. Moore: 

"I would have an economic system that was democratic and had a moral, ethical code attached to it."

Almost sounds like something Ezra Cornell might say.  Well, Mr. Moore, there is a certain Scottish moral philosopher you might want to consult for this task:

"It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our necessities but of their advantages."

Let every person improve him or herself only when he or she improves the lives of others.  That is the "moral, ethical code" underlying the competitive marketplace.  

The age of the mass market

Do you believe that small mom-and-pop stores can put a Wal-Mart out of business?

That question is what we might call a "no-brainer."  But it conveniently illustrates the important distinction between "free markets" and "competitive markets."  The case for free markets -- that is, markets freed from all forms of regulation -- hinges on the presumption that small businesses can beat big businesses in the marketplace.  In other words, there are no economic bullies with the power to drive their competitors into bankruptcy.

Once upon a time, this argument was probably not too difficult to make.  In 1850, there were 23 million people in the United States and 1.4 million farms -- one farm for every sixteen people.  The business of most Americans was pure survival: ensuring that fundamental human needs were met.  And responsibility for meeting those needs fell primarily on the family itself.  It was a mom-and-pop world.

Things have changed a lot since then.  Transportation became easier and cheaper.  The American industrial revolution brought innovation in production techniques; Henry Ford's assembly line, for example, drastically reduced the cost of building a car.  The cost reductions spread benefits widely: Ford's workers were famously well-paid, their cars were incredibly cheap, and the Ford family did pretty well too.  Publishing and recording technology brought the work of the most talented within reach of virtually everyone in society.  Almost everyone can now enjoy the performance of the best tennis or violin player in the world; there is no need to settle for the closest wandering minstrel anymore.  These innovations have both improved our lives and created incredible rewards for superstar-level talent.

Very few of us would voluntarily go back to the old days -- we may not appreciate these modern innovations on a daily basis, but they have made life much more bearable over the ages.  Collectively, however, they have invalidated one of the central tenets of a "free-market" philosophy: that small businesses can compete on a level playing field with large ones.

Why does it matter if the large have an advantage over the small?  Because when only large businesses survive, competition dies.  And when competition dies, so does the guarantee that unfettered markets will lead us on the path to prosperity.  If the natural progression of free markets is to concentrate production in the hands of one or a few businesses, we can no longer trust that the "invisible hand" will lead them to enhance our own well-being simply by looking after theirs.  A business with competitors must offer its customers quality goods at reasonable prices or it will perish.  A business without competitors faces no such threat.  It is the fear of economic failure that pushes businesses to make our own lives better.  When the fear is gone, so is the rationale for making the consumer's life as wonderful as possible.

An easy case study: Microsoft.  Can you imagine an alternative universe where we select our computer software from one of an uncountable number of companies?  There are great advantages to standardization, and the key to Microsoft's success has been its ability to convince people to accept its products as the standard.  Once this acceptance is complete, however, the company no longer faces the threat of instant bankruptcy should it offer a poor-quality product (e.g., Windows Vista) and sell it for a price much higher than its production cost (e.g., a minimum of $130 for a plastic disc, a book or two, and a box that probably cost no more than $10 to manufacture).  Yes, we are probably better off with the company than without it.  But imagine how much more exciting the world might be if Microsoft had spun off a set of companies, gave them all the license to tweak Windows, and compete to offer the customer the most worthy upgrade at the best price?

In the bygone era of yeoman farmers and Adam Smith, the goal of every business was sheer survival.  In the age of the mass market, the goal of every business is to replicate what Microsoft has done, in some way: to attain a state of competitor-less-ness, where one can sell things for more than what they are truly worth and pocket the difference -- because you know that your customers don't have any other option.  That's what they'll teach you to do in business school.

In the age of the mass market, arguments for free markets are dressed up in the language of Smith, and festooned with the tenets of the modern theory of perfect competition.  In this era, however, free markets are in many cases the antithesis of competitive markets.  In the unfettered modern marketplace, competition may wither rather than thrive, in those cases where large businesses can exploit advantages over the small.  An advocate of free markets can thus be painted (in many cases accurately) as a champion of the few, wealthy, and powerful, and enemy of the little guy.  If you are a "free market" person who really believes in giving small businesses a chance to survive and grow, then you should start thinking of yourself as a "competitive market" person instead.

How does government fit into all this?  If you're a "free market" person, the knee-jerk "government regulation is bad" response makes sense as a universal truth.  Once upon a time, before the era of the mass market, this kind of thinking might have made sense.  In the modern era, government regulation is a two-edged sword.  Yes, there are some types of regulation that harm small business.  There are other types, however, that either promote competition or preserve some of the benefits in dominated markets.  We'll have many opportunities to discuss some of these in due time.

Did stupid people cause the financial crisis?

OK, OK, I shouldn't have said "stupid."  I should have said "irrational."  Forgive me.

I am a big fan of Robert Frank.  I learned from his Microeconomics and Behavior textbook many years ago, and behavioral economists have clearly identified important limitations to the "rational" model of human behavior espoused by traditional economics.  Yesterday Frank appeared to argue that some blame for the financial crisis could be placed on plain human fallibility.  But if you boil down the piece, there are basically just two main points:

1. Rent seeking behavior exists.  Yes, if there are opportunities to make a quick buck, people will spend up to 99.9 cents to try to get it, even though all would be better off if they agreed to limit competition.  This is just a restatement of the prisoner's dilemma, which has been an element of economics teaching at least since ... well, since I took the course using Frank's textbook back in 1991 (page 200-202 of the first edition).  I don't have any trouble believing that these sorts of problems exist out there in the real world, but they won't cause a financial crisis by themselves.
2. People don't pay enough attention to the long-run.  This is a classic behavioral argument supported by a whole lot of research.  But then somehow Frank turns this point into a tirade against leveraged investing.  Yes, when you're gambling with borrowed money you'll tend to act more carelessly, but this isn't because you're an irrational or ignorant person.  It's because you're in a "heads I win, tails you lose" situation -- it's perfectly rational to bet the house (pun intended) in that sort of situation.

Here's the real story of the financial crisis.  You may recall that it all goes back to the housing market. 

There are two ways to value a house: a concrete way and an abstract way.  With the concrete way (another pun intended), you just add up the price of everything you bought at Home Depot, how much you paid for the land, and how much you paid workers to build the thing.  If you try to turn around and sell your house for more than that amount, people will walk away and just build their own (of course, there is the pain of dealing with contractors and all that, but we could easily factor that into the price).

The abstract way is to ask how much money you could make on a house by renting it out forever.  This is more of a guessing game, because you have to think about how much rent will cost forever.

In many parts of the country, the concrete method of valuing houses doesn't work anymore.  Mr. and Mrs. House-Hunter don't have the option of walking away and building their own, sometimes because there is no land left to build on, or sometimes because government regulations make it impossible.  There is a little bit of both of these things going on in California, the Northeast, and Florida.  These natural- and man-made restrictions make housing prices exceed what it costs to build.

If you want to figure out how much a house is worth in these areas, you've got to play the guessing game.  If you think prices are going to go up in a market, you bid a lot for a house.  If you think prices are going to decline, you bid low.  If you're not the highest bidder, though, you aren't going to get the house.  Only the most optimistic people are going to buy houses.  The rational model of economic behavior assumes that people are right on average, but that's very different from being right every single time.  Anybody ever hear of the winner's curse?

Now, how exactly are you going to pay for this house?  You go to a mortgage broker, who gets paid when you sign the contract and then never sees the loan again.  The broker is lending somebody else's money.   If you have no money to put down, you won't be able to get a very favorable loan, but the mortgage broker will tell you not to worry, the coming price increases will give you magic equity that will help you get a better loan in a few years.  Yes, the mortgage broker may be overly optimistic, but being occasionally over-optimistic is not the same thing as being irrational.  All the would-be mortgage brokers who thought the market was going to tank found other lines of work.

The "somebody else" in this process has the consolation that if you are a bum who doesn't pay back the loan, they get to foreclose and take your house.  If they think that housing prices are going up, too, then they don't mind if they lend you $500,000 and then you never pay back a dime.  They'll just take your house and sell it for a profit.  In some cases, lenders are also protected by either a) FHA mortgage insurance or b) the ability to re-sell their loan to Fannie Mae and Freddie Mac.  If Fannie, Freddie, or FHA take the hit, guess who stands ready to pay the bill?

The crisis hits when the world runs out of optimistic people to buy houses and/or optimistic lenders willing to finance them.  Then prices stop going up, you don't get to refinance your loan, you get hit with payment increases, you lose your house to the lenders, but the lenders have a hard time anyway since what they got from you is worth less than what they lent you.

Is this a story about irrationality?  Well, with irrational people this sort of thing might happen more often, but even rational people will get themselves into trouble when a) they have to make guesses and b) they think that somebody else (lender -> Fannie/Freddie/FHA -> taxpayers) will take the hit if they guess wrong.  Even the most rational people in the world will get into trouble sometimes.

Frank ends up arguing that an increase in capital requirements will help prevent future bubbles.  That's a sensible point, although we didn't really need behavioral economics to derive it.  Here are a couple more suggestions for government policy:

1. Ease restrictions on building.  Yes, I know, I don't want a 30-story apartment building in my backyard and neither do you.  Everybody has to recognize, though, that a cost of prohibiting new construction, whether of single-family homes in the suburbs or of higher-rise buildings in the city, is to make the entire housing market more speculative.
2. Give responsibility to those who deserve it.  In the modern mortgage market, the people lending money (or insuring the people who lend money) are several steps removed from those who actually make loans.  Sometimes it isn't even clear who should take the hit in the event of default. Everybody involved in the lending process needs to bear some risk of failure. 

Point 1) here has the added virtue of easing housing affordability problems in the nation's most expensive markets.  Frank's point and point 2) above have the opposite implication: with less money available to lend, and worse consequences if they lend to a bum, borrowers will find it more expensive to get a loan. The three reforms together, though, could still have a net positive impact on affordability.

Of course, there is also the matter of the huge subsidy to owner-occupied housing written into the income tax code.  But that's a subject for another day.

A preview of the coming immigration policy debate

Yesterday I drove down to Charlotte to participate in a "Round Table" discussion on immigration policy, chaired by the Assistant Secretary of Homeland Security for Immigration and Customs Enforcement (ICE -- a much sexier acronym than the old USCIS), John Morton.

A varied and interesting crowd showed up.  Charlotte mayor (and former gubernatorial candidate) Pat McCrory served as the local host, and the 35 or so invitees ranged from county sheriffs and police chiefs to immigration lawyers and advocates.  I sat next to a staffer from Kay Hagan's district office.

Morton sought to focus discussion around four basic questions that the Obama administration is grappling with as it thinks about immigration reform.  Here they are:

1. How can the administration enhance worksite enforcement and worksite protections?  This was an odd question to start out with, as it's fairly small-bore.  Nonetheless, the small business-people in the room stated many qualms with the E-Verify system, namely that they don't know how to use it and don't really see why they should, in the grand scheme of things.  We heard one anecdote about an employer with 2,000 workers scattered across 30 worksites who didn't know what an I-9 form was, let alone E-Verify.
2. What should be done with the 8-14 million illegal immigrants currently here?  This was more of a big picture question.  There seemed to be a general consensus in the room that the 1986 amnesty didn't really accomplish much in the long run, but apart from that there were not really any brilliant suggestions.
3. How can the government put teeth into its enforcement policy post-reform?  A tough question to answer if you don't know exactly what policy you'll be enforcing.  There was one substantive suggestion, from a county sheriff, to make immigration violations a matter of criminal rather than civil law.  The idea would be that jail time would act as a more serious deterrent than deportation.  Responses to this idea included a) jail time might be pretty nice compared to what some immigrants face back home and b) where exactly are we going to house all these criminals?
4. What should happen to the flow of legal immigrants into the United States?  Should speed up the process of obtaining a legal visa or make it more difficult?  Should we try to alter the flow of immigrants into the country, e.g. with a Canada-style "points" system?  This is a huge question and we ended up with only a couple of minutes to discuss it.

At the end of the session, we learned that DHS has employed three full-time staffers to read and respond to comments delivered to the following email address: immigrationcomments@dhs.gov.  So put your tax dollars to work and send comments if you've got 'em!

More health thoughts

The real health care debate comes down to two questions, regarding values and cost.  First, how strongly do we value equality?  Should the nation's health care bill be divided equally among the sick and the healthy (with the rich also paying extra to cover the costs of the poor)?  Or, realizing that to some extent health is a function of lifestyle choices (eating, smoking, drinking, and so on), should we permit the healthy to reap some benefit of their own good habits and good fortune?

Second, what if anything needs to be done to hold down cost?  One could make the argument that we don't need to worry about cost -- if our society ends up spending half its income on health care, then so be it.  But for those who worry about the impact of health costs on our international competitiveness, cost is a big concern.

The traditional Democratic attitude is to be concerned first with the values question and second with the cost question.  The traditional Republican attitude is to think about cost first.  The most realistic perspective would realize that these two questions are inextricably linked; a monomaniacal focus on one can have disastrous consequences in terms of the other.  One reason many people can't afford health care is because it costs so much.  And one consequence of the pursuit of equality is moral hazard (i.e., my medicine that costs $1825/year and doesn't accomplish much), which will naturally exacerbate cost problems.

This is where the real debate needs to focus.  Obama's speech last night did, thankfully, address the concern that a public insurance alternative would have an unfair recourse to tax funds.  But is it really possible to credibly commit to keep the public option's hand out of the general tax revenue cookie jar?  Even if the answer were "yes," it's hard to see how taking a chunk out of overhead costs would solve the problem of cost escalation that is plaguing even single payer systems (see yesterday's post).

The Republican response hit a couple of good notes, but their contributions to the debate might carry further if they stopped insulting people's intelligence.  Well, maybe it was just my intelligence that got insulted, and maybe I'm overly sensitive about these things.  But I suspect not.

  

The public option option

It's public option day!  Normally, I try to keep a low profile on issues of health policy since another member of my household is more of a real expert.  But I've been following the debate on this and have been scratching my head a little bit.

First, the other week Glenn Hubbard buried a really great tidbit at the end of his half-memoir-half-opinion piece in the NYT.  The health care debate is really about two only somewhat related questions:

1) How the heck are we going to keep health care costs at a moderate level?  (There's a more existential debate about what a "moderate level" is, but ignore that for now)

2) What the heck are we going to do about people who can't afford this tremendously expensive health care of ours?

OK, so setting the stage that way we can think seriously about the public option.  Krugman says that the public option does two great things.

a) it introduces competition into many local health markets, which are now (thanks in part to various state regulations) virtual or actual monopolies.  Introducing competition is a widely accepted means of controlling prices.

b) it offers consumers the possibility of buying into a system that has really low overhead costs.  What's more, a big player in the insurance market might have the power to bully health providers into cutting prices (a classic Wal-Mart strategy also practiced by Medicare).

This all makes sense, really.  But you just have to ask, if it's competition we want, might not the more obvious strategy be to relax those regulations that stifle or eliminate it?  And I'm all for low overhead costs, not quite so sure about browbeating doctors and hospitals, but here's the thing everybody has to understand.  We've got a few buddies overseas who do this sort of thing and yes, they do spend less on healthcare than we do, but their spending is really catching up.

If it's cost reduction you want, here's the real problem to think about.  When doc and patient talk about what tests to run, what medication to describe, etc, the people paying the bill are not in the room.  Case in point: I've got asthma, and one of the three medications I take has a street price of about $5 per day. It improves my respiratory function a little bit, but not a whole lot.  If I had to pay $5 per day, I'd say no thanks.  But, the way it works is that I actually pay about $1.17 per day, and somebody else pays the rest.

So, America, I've got your first $1825 in annual health care savings right here... just write a policy that replaces my insurance plan with something that gives me more skin in the game.

One final note.  What's puzzling about the various defenses I've seen about the public option is that they don't make any effort to attack the main conservative criticism I've seen, which is that the public insurance program has a license to lose money.  Private sector insurers need to collect enough in premiums to offset their costs, while government programs can be subsidized out of general tax revenue.  Why isn't anybody addressing this, or coming up with a way to introduce a public option that avoids this concern?  Maybe there just isn't a credible way to write legislation that says the "public option" must be self-financing.  There aren't too many examples of other government forays into ordinary business ventures that meet this criterion.

So bottom line, I just don't get why the public option is the battle everybody has chosen to fight.

The four horsemen of the (economic) apocalypse

This is a really boring, basic post that I need to stick into the blog for reference purposes.  If this is the first thing you read here, then I'm really sorry.  The idea is that later, more interesting posts will link back here for reference purposes.

Markets work, except when they don't.

When markets work, people and things are put to their most productive use, and the result is a guaranteed ascent to the highest possible standard of living in a society.  This is the traditional "free market" argument, which really should be thought of as a competitive market argument.  Of course, markets don't guarantee anything about fairness or equality, but that's a subject for a different post.

Sometimes markets don't work.  A common refrain is that government gets in the way of markets, and that is true sometimes.  But government is but one of four threats to competitive markets and their capacity to improve the human condition.  The four horsemen of the economic apocalypse are:

1. Missing Markets
2. Bullies
3. Secrets
4. Government

Government plays a paradoxical role: it is both a horseman itself and our best possible defense against the other three.  We'll leave it at that for now, with more "backgrounder" posts in store to introduce the horsemen individually.

An Introduction To the Blog

Jacob Vigdor is Professor of Public Policy and Governance at the Evans School of Public Affairs at the University of Washington, and a Research Associate at the National Bureau of Economic Research.

Curriculum Vitae

This post originally appeared on 9/7/2009.

There is virtually no cost to disseminating information via the internet.  Since the cost is close to free, it stands to reason that the average piece of information on the internet is close to valueless.  That's just basic economics: in equilibrium, marginal cost equals marginal benefit.  This in and of itself should give pause to any serious individual who wishes to get into the blogging game.  With hundreds of millions of people already in the market, how can there be any valuable niche left to fill?

In spite of this compelling logic, I initiated this blog on Labor Day 2009 with the hopes of establishing a community.  A rough draft of the community's manifesto would look something like this:

• Competitive markets are the most important institution promoting the advancement of the human condition.
• In public discourse, the term "free markets" is used much more frequently than "competitive markets." (there are twice as many google hits for the former than the latter).
• "Free markets" and "competitive markets" may seem synonymous to some people, but they really aren't.
• While government intervention is sometimes a threat to the competitive marketplace, even greater threats lurk within the marketplace itself.  To call government "the problem" or "the solution" is to horrifically oversimplify reality.

The third bullet point is the biggie.  People trot out the term "free markets" thinking that it is a term familiar to any half-wit who has sat through econ 101.  That's not really true.  We economists try to teach people about the implications of perfectly competitive markets, not free markets.  (Hence the title of the blog)

The trouble with this confusion is that proponents of "free markets" end up espousing some viewpoints that are very easy to caricature.  These proponents then risk being drowned out of important public debates.  What the world (or more specifically the US) needs are proponents of competitive markets, who can articulate the potential for competition to improve the human condition.  And that's why I'm here.

I've talked to a couple of publishers about writing a book along these lines.  The trouble is, books are a really iffy way to build communities these days.  Sure, there are some success stories out there.  But I have a lot of smart colleagues who have written insightful books that nobody reads.  Maybe nobody will read this either, but at least I spare myself the pain of having to deal with reviewers, editors, and so forth.

So, if all this sounds intriguing to you, please stick around.  There is more groundwork to lay out in the initial posts, but before long this blog should converge to a lively discussion of current events and debates from a "competitive market" perspective.