Friday, February 19, 2010

Krugman's Logic Death Spiral

One of the fundamental tenets of economic logic is that the farther away one gets from the simple relationship of a consumer paying directly for a good, the more the economic calculation for such exchanges becomes muddled. Thus it is with health insurance.

Think of it; most of us receive insurance from our jobs. We pay a premium, our employer pays part of it, which goes to the insurer, and then the insurer pays the doctors, does the negotiations, sets the standards, etc. This is a recipe for permitting costs to get out of control.

One of the fundamental tenets of Austrian economic theory is that the factors of production gain their value from the value that consumers place upon the final product. (Carl Menger spends a lot of time on this point in the first two chapters of his ground-breaking 1871 classic, Principles of Economics.) It is not hard to see that the way health insurance today is structured, that it is a recipe for out-of-control costs.

Paul Krugman has been writing on health insurance and economics for many years, and from what I have been able to tell, his main points are as follows:

  • Health insurers are greedy and raise premiums because they are greedy;
  • Health insurers can only make money by denying coverage;
  • Medical costs rise because doctors and insurers are greedy;
  • Only government price controls and regulation can ensure that medical costs will be low and medical care will be abundant for everyone.
Now, if one sees some internatl contradictions in this whole scenario, well, that person is applying simple logic, something that is missing from most Krugman columns. However, instead of making accusations against Krugman, let him say things in his own words:

Sky-high rate increases make a powerful case for action. And they show, in particular, that we need comprehensive, guaranteed coverage — which is exactly what Democrats are trying to accomplish.

Here’s the story: About 800,000 people in California who buy insurance on the individual market — as opposed to getting it through their employers — are covered by Anthem Blue Cross, a WellPoint subsidiary. These are the people who were recently told to expect dramatic rate increases, in some cases as high as 39 percent.

Why the huge increase? It’s not profiteering, says WellPoint, which claims instead (without using the term) that it’s facing a classic insurance death spiral.

Bear in mind that private health insurance only works if insurers can sell policies to both sick and healthy customers. If too many healthy people decide that they’d rather take their chances and remain uninsured, the risk pool deteriorates, forcing insurers to raise premiums. This, in turn, leads more healthy people to drop coverage, worsening the risk pool even further, and so on.

Now, what WellPoint claims is that it has been forced to raise premiums because of “challenging economic times”: cash-strapped Californians have been dropping their policies or shifting into less-comprehensive plans. Those retaining coverage tend to be people with high current medical expenses. And the result, says the company, is a drastically worsening risk pool: in effect, a death spiral.

So the rate increases, WellPoint insists, aren’t its fault: “Other individual market insurers are facing the same dynamics and are being forced to take similar actions.” Indeed, a report released Thursday by the department of Health and Human Services shows that there have been steep actual or proposed increases in rates by a number of insurers.

In economics, we have another term for what is being described: adverse selection. That is a common problem with insurance, and there are no perfect solutions, since people either will become sick or have accidents or have their houses burned down. That is life. Furthermore, with insurance, any insurer that does not try to control its costs is going to go bankrupt. (The Great Chicago Fire of 1973 was a classic example of the Worst Case Scenario, as a number of insurance companies went under because they had so many claims.)

Now, at one level, Krugman is correct. If we are going to use health insurance as a payment plan for nearly ALL health-based activities, and if health insurance is going to be the gateway for most care, then those who don't have insurance are going to find it more difficult (but certainly not impossible) to receive medical care.

However, what does Krugman suggest? It is something akin to taking the "hair of the dog" when one has had too much to drink. His "hair of the dog" theory of health insurance goes like this: Health insurance is too expensive and is not readily available, so the cure is to have the government impose price controls and provide "insurance" itself, and then everyone will have abundant care.

I don't think so. If, as the Austrians note, the problem is one of economic calculation, throwing even more distance between the consumers and providers of medical care will not solve anything, but, rather, make the problem worse. Yet, that is precisely what Krugman is demanding:

What would work? By all means, let’s ban discrimination on the basis of medical history — but we also have to keep healthy people in the risk pool, which means requiring that people purchase insurance. This, in turn, requires substantial aid to lower-income Americans so that they can afford coverage.

And if you put all of that together, you end up with something very much like the health reform bills that have already passed both the House and the Senate.

What about claims that these bills would force Americans into the clutches of greedy insurance companies? Well, the main answer is stronger regulation; but it would also be a very good idea, politically as well as substantively, for the Senate to use reconciliation to put the public option back into its bill.

Let me translate. The "solution" is more coercion and government-induced price controls. I think that "solution" speaks for itself.

12 comments:

steve B said...

“Think of it; most of us receive insurance from our jobs. We pay a premium, our employer pays part of it, which goes to the insurer, and then the insurer pays the doctors, does the negotiations, sets the standards, etc. This is a recipe for permitting costs to get out of control.”

Agree a large part of the problem is the fact insurance is employer based. With that said, what would the ‘Austrian’ solution be?

“One of the fundamental tenets of Austrian economic theory is that the factors of production gain their value from the value that consumers place upon the final product.”

Isn’t this the perfect argument for why a free market for medical care and services will never exist? The value placed upon the product by the customer increases to levels that are unattainable for most when demand is at the highest (and sometimes life threatening). A system of insurance seems to be the most logical solution, but as you say, is “is a recipe for permitting costs to get out of control” and “throwing even more distance between the consumers and providers of medical care will not solve anything”. So what would the Austrian solution be?

“Paul Krugman has been writing on health insurance and economics for many years, and from what I have been able to tell, his main points are as follows:
• Health insurers are greedy and raise premiums because they are greedy
• Health insurers can only make money by denying coverage

He’s not too far out of line on this point. The for profit health insurance model consists of pushing premium increase through as much as possible each year regardless of expected costs (which is exactly what an industry w/ pricing power should do) and then finding ways to deny claims at all costs. This last point is the reason why medical cost ratios have plummeted while premiums have skyrocketed and it must be corrected. Unfortunately, this article is all too truthful.

http://www.nytimes.com/2009/08/27/opinion/27kristof.html

William L. Anderson said...

You really are asking the wrong question, in that I take it you want the "Austrian response" to insurance, not medical care. Obviously, I cannot speak for the Austrian School, but I can say that most Austrians would hold that insurance is appropriate for those things which need insuring, and for which one can apply actuarial analysis.

That is NOT what we have with health insurance today. Let me present an analogy. What if we had "grocery insurance"? We would show our "insurance card" when we went to the market, and then we would have a co-pay, and then take what we wish. Can you see how the connection between what we paid and what we received would be lost?

Furthermore, the incentive with health insurance is always to outspend your premiums, as you wish to get all of the care for which you have paid. Obviously, we are not dealing with a sustainable model.

Once upon a time, people paid for medical care when it was received and had insurance for catastrophic events. Today, government has outlawed that model, as we cannot purchase that kind of insurance because of mandated benefits.

There is no way to "reform" this system. My point regarding Krugman's explanation that it is all due to private "greed" is that as an economist, that is no explanation at all. Gee. People are greedy? Wow! Such insight!

An economist needs to be able to analyze a situation and go to the heart of the mess, not engage in name calling and then claim that government coercion can work magic. That is not economics; that is Harry Potter Science.

steve B said...

Thanks for taking the time to respond to my post

“You really are asking the wrong question, in that I take it you want the "Austrian response" to insurance, not medical care….I can say that most Austrians would hold that insurance is appropriate for those things which need insuring”

Actually, that is the question I was trying to ask, just not very clearly! My apologies. What I was trying to ask in a not so eloquent manner is how would an Austrian economist approach the medical care industry and what suggestions would they have for policy makers?

“That is NOT what we have with health insurance today. Let me present an analogy. What if we had "grocery insurance"?”

Agreed this is not what we have today. However, I disagree with your grocery insurance analogy. First, we do have grocery insurance. Food stamps. Second, any doctor that allows you to pay “a co-pay, and then take what we wish” is not doing their job, and should be disbarred from practicing medicine. Maybe I’m wrong, but I would like to think this is not a common practice among doctors, and, if it is, then aren’t you saying with this analogy that private greed is part of the problem? Third, can we really compare the marketplace for groceries to medical care? We can survive off a minimum level of food which is affordable to virtually all Americans; this can not be said for medical care, can it? And when I say medical care, I do not mean check ups, routine visits, etc.

“Once upon a time, people paid for medical care when it was received and had insurance for catastrophic events”

I could not agree more. More of the cost burden for routine services needs to be pushed to the patient/consumer. Doing away with employer based insurances helps with this. If insurers offered low premium, high deductible plans, this would be a huge win for consumers and the overall market. The problem with this model is who defines catastrophic events? We are back to benefit mandates.

“An economist needs to be able to analyze a situation and go to the heart of the mess, not engage in name calling and then claim that government coercion can work magic”

Agreed. Respectful discourse is no longer the norm. Unfortunately, it’s not limited to Krugman and it has become an annoying fact of life. With that said, I don’t think it’s fair to sum up his view on healthcare as “that it is all due to private "greed"” He has done a lot of real analysis on the subject. Some of it very good. Some of it not so good.

I appreciate your time and look forward to a response on this subject.

burkll13 said...

"the problem with this model is who defines catostrophic events?"

well, that would be agreed upon by the consumer and the insurance companies. if they were allowed to exist in a compatative evironment, the need for profit would demand that they provide a better product for the consumer. thats how it works in the free market, successful businesses exist only because they satisfy consumers better than unsuccessful ones. unfortunatly, government regulation has done the exact opposite of its intended purpose. it has allowed insurance companies to exist in a bubble where they can engage in behavior that runs contrary to customer satisfaction, and still be successful. but thats only half the problem.

its a scary proposition to change back to a free market insurance model in todays medical environment. if i didnt have insurance, i would have had to pay $1200 out of pocket to go to a doctor to get misdiagnosed. government has thrown up so many restrictions that the supply of adequate care is out of line with the demand for care. this causes prices to rise to fill that demand. thats my 2 part plan anyway.

Andy Mackenzie said...

---"First, we do have grocery insurance. Food stamps."

I wouldn't equate food stamps to grocery insurance. You don't pay a premium for them and they have a set value, limiting what they may purchase. They're more a form of welfare than an insurance policy.

---"Second, any doctor that allows you to pay “a co-pay, and then take what we wish” is not doing their job, and should be disbarred from practicing medicine."

True, but nonetheless there is an incentive for doctors to partake in this kind of behavior because they simply bill the rest of the cost to the insurer, and the consumer doesn't directly experience their medical costs rising because they do not have to pay up front.

One issue with the way our healthcare is run (due to government mandated benefits) is that it creates an environment expressed in game theory:
Person A is paying the same as person B for insurance. Person A tries to get the most out of his insurance (by using it even when not necessary) because he splits the cost with person B when their premiums rise. Now person B is getting a good deal and person A isn't, so person A utilizes their care more, raising costs, premiums, etc.

And the cycle continues. This is exactly what we need to stop. What Krugman is incapable of realizing is that this monster is a product of government and not the free market.

steve B said...

"well, that would be agreed upon by the consumer and the insurance companies."

So consumers will think of every possible outcome over the life of the policy and write this into the policy? As if rescission is not already a big enoug problem.

steve B said...

"They're more a form of welfare than an insurance policy."

But welfare is a form of insurance. And we all pay the premiums for food stamps either in the form of taxes or deficits.

"there is an incentive for doctors to partake in this kind of behavior because they simply bill the rest of the cost to the insurer, and the consumer doesn't directly experience their medical costs rising because they do not have to pay up front."

Agreed. So you agree with Krugman that greed is part (not all) of the problem. So how do we change doctor incentives?

"What Krugman is incapable of realizing is that this monster is a product of government and not the free market.

True. But nobody has come up with a free market solution to affordable, near universal coverage as well.

burkll13 said...

@ steve B- maybe i should have been more specific.what is "catastrophic" would depend on the deductible, an agreed upon term. i didnt mean to imply that they would need to write in absolutely every possible outcome. that wouldnt be an ideal situation for the insurance company. think about it like this, AAA doesnt offer free roadside service to screw the customer, they offer it as a benefit, to better serve the customer. happier, more plentiful customers more than make up for the cost of that benefit. health insurance would work in a similar fashion.

Andy Mackenzie said...

---"They're more a form of welfare than an insurance policy."

I see your point. However, we apply it only on a small scale (to those who require it) and the government doesn't propose that we all use food stamps to purchase food, like it does with respect to insurance and medicine.

The food stamps-insurance analogy would be more proper if the government issued us all food stamps as the only form of purchasing food, much like how it regulates all insurers and proposes that we all be on the government plan. Sure, we could go outside the system and buy food with money, but why do so when your food has already been paid for?

---"Agreed. So you agree with Krugman that greed is part (not all) of the problem. So how do we change doctor incentives?"

I think this may be asking the wrong question. The very foundation of economics and capitalism (Austrian included) is that individuals act in self-interest. Doctors who over-proscribe treatment are simply responding to incentives and acting in the same self-interested manner that all humans do.

The question we should be asking is how do we make the consumer more fully realize the cost? And the answer to that is to remove government mandates on coverage so that only the procedures which we actually need insurance for are covered. Thus consumers will order fewer procedures/medication/treatment they don't need and demand and costs will consequently fall (not to mention waiting room times).

---"True. But nobody has come up with a free market solution to affordable, near universal coverage as well."

Well this is partly more a philosophical argument about whether or not there is a right to coverage (specifically, one which may be enforced at gunpoint). The Austrian solution is to let market forces deliver the most coverage possible at the most manageable prices. Right now there are mountains of regulation preventing that. I would propose that between the duty of doctors to serve everyone "Hypocratic Oath", charity, and the consistent ability of the market to deliver high quality goods at low prices (we see examples of this in mostly unregulated markets like the technology sector) we would see "near universal coverage" if we adopted Austrian economics.

Andy Mackenzie said...

I apologize for the broken English and/or confusing nature of that last sentence in my response.

What I meant to say is:

"I would propose that between (1) the duty of doctors to serve everyone (via the "Hypocratic Oath"), (2) charity, and (3) the consistent ability of the market to deliver high quality goods at low prices, we would see "near universal coverage" if we adopted Austrian economics. For example, we see examples of a relatively unregulated market delivering quality and affordability in the technology sector."

steve B said...

Thanks for the comments and dialogue. This is great.

“The question we should be asking is how do we make the consumer more fully realize the cost? And the answer to that is to remove government mandates on coverage so that only the procedures which we actually need insurance for are covered.”

Could not agree with you more. This is the question we should ask, and it baffles why more people are not asking this question instead of ranting about death panels and government takeovers. Where I disagree, however, is the belief that simply removing government mandates will solve this problem. Many (most) industries function just fine with various degrees of mandates/regulations. However, most industries are not subsidized by the tax code. Employees repeatedly substitute benefit increases for wage increases, and it hides the true cost of care to the consumer. Employers have tax incentives to continue this trend. Removing the tax incentive would put more of the burden and responsibility of routine medical care on the consumer, then a market for emergency/catastrophic risk could prosper. It’s no coincidence the two biggest economic issues we face, rising healthcare costs and too much debt, are both distorted by the tax code.

Andy Mackenzie said...

Well said! It's been a pleasure.