What is a Waste of Resources?

Obama promises to cut $500B of waste, fraud, and abuse out of Medicare and Medicaid over 10 years. To say that this claim has been met with skepticism would be an understatement.

I am not nearly so skeptical because what Obama and the left wing are really demanding from Congress is more power to ration government provided health care, as well as to pay drug companies, medical equipment companies, doctors, and hospitals less for their products and services (which will of course lead to more rationing).

I think the savings in terms of money could easily materialize. The problem I have is that saving the government little green pieces of paper is not a worthy goal in and of itself. After all, the government can create little green pieces of paper almost for free.

If the government were to save $50B/yr in Medicare costs by cutting Medicare reimbursement rates and by raising the eligibility age from 65 to 67 years, would anybody think that is real savings? How about if the government mandated that no doctor be allowed to make more than $100K per year? Or that all drugs currently on the market are deemed no longer on patent? All of these changes would dramatically lower the cost of government provided health care, but would they actually prevent the waste of or increase the supply of health care resources?

Resources are tangible things -- valuable services, goods, products, information, trained people -- and not little green pieces of paper. Tackling waste means freeing up or increasing the amount, quality, and availability of resources. Paying people less doesn't do that.

Consider the following paired examples:

1.
(A) A drug company wins a patent extension which allows it to keep charging high prices for a successful and effective cancer drug;

(B) A drug company realizes that its new cancer drug provides essentially no benefit over existing ones, but decides to spend $1B developing and promoting it anyway because it calculates that it can capture a significant share of the market and generate a net profit;

2.
(A) a health insurance company CEO is granted a bonus that exceeds the industry average by $10MM even though by most measures he is doing a mediocre job;

(B) a health insurance company with an antiquated billing and reimbursement system spends $10MM more than it should this year on administration costs;


3.
(A) a doctor submits fraudulent claims to Medicare for services he never performed;

(B) a doctor orders unnecessary MRI tests for most of his patients because he has an equity interest in the MRI facility;

4.
(A) a doctor has to pay $150K/yr in malpractice insurance;

(B) a doctor orders a wide range of unnecessary tests for a patient, in order to protect himself from a potential malpractice suit in case of an adverse outcome;


I believe that to first order the (A) examples are merely (possibly unfair) transfers of money from one entity to another, but not a waste of resources.

The (B) examples represent true waste. Real (mostly human) resources are being used which could have been deployed better elsewhere.

It is not surprising that the focus of politicans is on the (A) examples. Perceived unfair transfers of money get people riled up, and being natural demogogues, our politicans cater to that anger.

Ironically, putting in place policies that curtail the (A) examples will, if anything, decrease the supply of health care resources (which is not necessarily a bad thing - see further down).

Reducing the amount of money transferred to the health care industry in the aggegate (even including outrageous examples of overpayment, abuse, and fraud) will not encourage an increase in supply.

When Obama and his speechwriters make the mistake of lumping corporate profits in with overhead (as they do repeatedly), it is clear that they don't understand any of this at all.

Now I am not claiming that we should tolerate overpayment and fraud. Far from it. A distortion in favor of the health care industry is just as bad as a distortion against it. As only one part of a complex economy, the health care industry should have no stronger claim on aggregate resources than any other area. Too many people becoming doctors, for instance, is as bad as too few. [How we could know how many is the right number is something that the free market is best at determining, by the way.]


Finally, here's a trio of hypothetical examples. Which of these represent a waste of resources?

5.
(A) a drug company spends $100MM on a public and doctor-focused advertising campaign to introduce its new product;

(B) a drug company spends $100MM in litigation defending itself against claims that its product causes serious problems in approximately 1% of patients;

(C) a drug company spends $2B developing a new cancer drug that gives terminal patients a 25% probability of living an extra 2 months;


I am inclined to believe that (A) and (B) are wasteful, but (C) is not.

Advertising is a complex subject. Some economists consider marketing expense a dead weight loss to the economy. I have always felt that it has some informational value for consumers, but it also appears to be necessary for free market competition.

The competition hypothesis seems less convincing in the case of drug companies, however, since they only compete directly in those rare instances when they have identical drugs on the market.

The benefits of litigation are difficult to quantify as well. Obviously, one way that the sanctity of contracts is upheld and consumers are protected is through litigation. But our system has gone awry, and you probably couldn't find one serious economist today who didn't think that the US is an overly litigious society and that the costs of litigation are excessive.

As for example 5.(C), the drug company would be wasting resources only if its prospects for making a profit depended upon the market price for the drug being anomalously high. It is in the nature of our 3rd party payer system for medical care to create such inefficiencies. Since consumers don't see the true cost, they make inefficient cost benefit decisions.

Still, my sense is that the medical community has generally made sound choices when it comes to approving expensive new drugs. My evidence is that hundreds of miraculous drugs have been invented over the last 30 years, and yet drug companies account for only about 1.5% of world GDP (in the US, it's about 2%). I would be willing to spend that fraction of my income on Claritin. Fortunately, it's much cheaper than that.

Health Care Rationing

There will be rationing under a government health insurance system. That is just simple economics. If you give away a valuable thing for free, then demand will exceed available supply. The government will have to allocate health care resources according to some formula, and I guarantee you, this will be extremely controversial and morally agonizing.

Proponents of a government health plan point out that in a free market rationing is also done, but it is done by price rather than by bureaucrats and lawmakers. The price rises until demand and supply are matched, and those unwilling or unable to pay that market clearing price will receive less health care.

This is certainly true, but rationing by price is more efficient and morally sound. Those that value health care a lot will be more likely to obtain it than those who don't value it very much. It is important to remember that health is not something everybody values equally. And pretty much everybody makes tradeoffs between health and money. That is why some people are willing to be coal miners or firefighters or football players, or are willing to work overtime with little vacation or even rest. It is also why some people don't eat healthy foods or exercise or stop smoking.

Some people care a lot about having (painful) surgery so they can continue to play tennis. Others not so much.

When you have rigid rules divvying up resources, you inevitably wind up giving something the government bureaucrats say is worth X to somebody who values it at X/10. Meanwhile, a person who values that thing at 10X must go without.

Perhaps most important of all, rationing by price will lead to more production of the health care services that are the highest price and therefore in the most demand versus available resources. In the long term, a market-based system will produce vastly more health care resources for everybody.

It's amazing that some people (read Barack Obama, Nancy Pelosi, Harry Reid, and other Democratic leaders) so easily forget the lessons of the Soviet Union and Communist China. Government control of the market stifles economic growth. It has been shown empirically that government bureaucrats simply can't do as good a job as the free market at pricing goods and services, providing incentives, and stimulating increases in productivity.

Some people want to believe health care is or should be exempt from market forces, but it isn’t, and it shouldn’t be.

Health Care Fundamentals

Health care is fundamentally no different from any other area of the economy. We live in a world of limited resources. Therefore, we need a mechanism to allocate those resources efficiently and fairly. Every individual decision about allocating a resource comes with a cost and a benefit, and neither benefits nor costs are the same across all individuals. As with every other area of the economy, a free market, in which individual consumers can make their cost-benefit decisions freely, and individual employees, employers, and companies can make their cost-benefit decisions freely, will provide a more efficient allocation of resources than a government controlled market. But perhaps not a fairer allocation.

Liberals are being disingenuous when they claim that giving the government more control will make the system more efficient. It will not. It cannot. I will get into the weeds on this later, but for now I think that most liberals want more government control over health care for one reason and one reason alone -- "fairness."

They have accepted to a certain degree that free markets lead to unequal outcomes in general consumption, in housing, in leisure time, and even in education. But they think that health care should not be treated as just another commodity. Poor people should not get worse health care than rich people. A person should not have to die early because he is poor. A corollary of course is that a rich person should not get better health care than a poor person, and a rich person should not be allowed to live longer because he is rich.

I have brought up the point about "fairness" and redistribution of wealth/income/consumption before, and I have basically accepted that there is no right answer. I have put "fairness" in quotes because there are many people who don't believe that unequal outcomes are necessarily unfair. Be that as it may, people value equality of outcomes differently, with liberals tending to value equality of outcomes higher than conservatives. I lean towards the conservative side. I believe there should be a safety net providing a floor on poverty, but I certainly don't believe in taking more than we are currently taking from the rich to provide for it. I cannot say that I am right, and those who are more liberal are wrong (and vice versa). We are just starting from different axioms.

The two claims I can make with confidence, however, are these:

1) treating consumption of health care as fundamentally different from other types of consumption is simplistic and wrong; and

2) a free market in health care in the US will lead to unequal outcomes but will make far more health care resources available for consumption by all (including the rest of the world, not just Americans).
　
To back up my claim in (1), I'll make two points. First, being poor is bad for health, regardless of the level of health care received. Poor people eat less nutritious food, they live in unhealthier places, they are exposed to more violence in their neighborhoods, they drive less safe cars, and they have more stress due to lack of money. There is a recent UK study that showed that low job status, which presumably leads to more stress, was a significant contributor to poor health. So to consider health care as having special moral implications is naive.

Second, we live in a world where many hard-working, smart people go into fields other than medicine. When somebody decides to become a financial analyst rather than a doctor, that decision reduces our aggregate health care resources, and therefore has consequences (probably negative) for the health of other people in the future. To the extent that such a career decision is largely an economic one, and it usually is, there is an entanglement between the economics of health care and the economics of all other fields, so that it is kind of meaningless to treat health care as an isolated area of the economy where the free market should not apply.
　
I will have more to say about (2) in later posts.

Cash for Clunkers -- The Final Phase

I've been obsessed with this topic because it is perhaps the most obviously and perfectly stupid government program I have ever seen. It's not all that important because it represents only a few billion dollars (as of this moment, $3B in total) of government waste and distortion in a $13T economy, but it does serve as a reminder that government can enact incredibly bad policy in a very short time. The forces of rationality and prudence take time to gather and gain critical mass, but by then it is often too late. Something to ponder as the Democrats try to ram health care reform through Congress without meaningful analysis and debate.

I predict that by the end of the year, you will see stories appear in the media which are highly critical of the results of the Cash for Clunkers program.

To wit:

1) the boost in GDP for the 3rd quarter was temporary -- this will be exacerbated by the way GDP is calculated; inventory drawdowns count towards GDP, but inventory builds do not [Update: Oops, I got this exactly backwards. Inventory builds count towards GDP and drawdowns do not. What I described would be correct for what is called the Final Sales number];

2) the boost to the auto industry was temporary; although domestic car sales had until recently been running at an unsustainably low level (9MM/yr, although there are over 200MM cars in the US), the Cash for Clunkers boost is unsustainable as well and has cannibalized future sales; in addition, Cash for Clunkers has induced many people to buy new cars who probably shouldn't have bought them, and those people will either be dumping them soon or going a good long time before buying another new car;

3) a detailed analysis shows the environmental/energy savings of the program (in terms of carbon emission or imported oil -- both questionable metrics in any case) was nil or negative because the mileage improvement was offset by the energy used to make new cars and destroy old ones, and the old cars weren't driven nearly as much on average as the new cars;

4) used car market prices rose making it harder for poor people to afford a car;

5) engine parts for older cars became scarce making it difficult for owners of clunkers to keep them running at an affordable price;

6) the lion's share of the government largesse actually went to car dealers rather than clunker owners because dealers raised prices on eligible new cars in the face of very high demand;

7) many clunker trade-in buyers ended up with buyer's remorse as they realized they traded in a $2,000 car for a $4,500 rebate but actually paid $2,500 more for a new car than they would have had to if the government hadn't distorted the market;

8) many clunker trade-in buyers were tricked into spending more than they could afford for a new car that they didn't really need or want;

9) new car buyers who didn't have a clunker to trade in had to pay far more than they would have had to just a couple of months before;

10) Cash for Clunkers was effectively a huge subsidy for car dealers as the program provided them with free cash, free advertising, and a huge distortion in customer preferences towards consuming new cars;

Keep in mind points (7) and (9) above as you read stories about auto inventories becoming depleted in the face of huge Cash for Clunkers demand. I suspect that clunker owners are getting no advantage out of the program at this point relative to the deals that existed in June. And yet they will keep buying anyway because human beings are susceptible to marketing schemes that make it look like a special deal is to be had. On top of that, they will be buying "eligible" new cars from depleted inventory, which means that they probably won't even be buying their first choice car (e.g. model, options, color).

Clunker trade-in buyers, regular car buyers, and taxpayers have become dupes of the auto industry.

More Cash for Clunkers

I admit it. I have a bug up my butt about this Cash For Clunkers program. I have a bug up my butt about health care reform too (at least all of the proposals currently on the table), but health care reform is ridiculously complex, and I don't feel I have my act together enough to opine (yet). Cash For Clunkers, however, is straightforward enough that it can perhaps be a teachable moment, as certain moral preeners like to say.

Positive news stories about Cash for Clunkers have dominated media coverage in the last week as the Senate ponders whether to join the House in adding $2B to the program. I see web video interviews with happy car buyers who just traded in their 15 year-old pickup truck to buy a hybrid SUV. I see Wall Street research papers about the positive effect on GDP -- upwards of 0.40% boost this quarter, and I see administration flacks talking up how good the program is for the economy and the environment. Most people believe that this government program is a smashing success (no pun intended).

I was gratified therefore to see Jonah Goldberg's article today. Jonah gets to the nub of the issue, which is Frederic Bastiat's main theme in his 1850 essay That Which is Seen and That Which is Unseen.

In this case, the government is managing to juice GDP this quarter by encouraging new car sales, but it will come at the expense of GDP in future quarters. What is unseen here is that many people made the decision to buy a new car only because the government was essentially giving them several thousand dollars off of the dealer price. Those who were planning to buy a new car anyway have done so earlier than they were planning but won't need another for quite a while. Those who weren't planning on buying a new car now have a lot less spending power to use for a new refrigerator or a new computer or for remodeling a bathroom. That is an unseen loss to GDP.

Then there is the unseen effect of removing cheap cars from the market. Perhaps a landscaper was getting ready to start a business, but he can only afford to purchase a clunker pickup for $3,000 to get started. Alas, they are not available anymore. The lowest price he can pay now is $5,000 because of the diminished supply.

The simplest analysis though focuses on what was destroyed. The government is paying people to destroy something of economic value. That something could have been used for recreation, or it could have been used to contribute to GDP. To make matters worse, resources were used to destroy those things (the car demolition and towing operators' resources), and even more resources (the car manufacturers' resources) were used to create expensive replacements for the things that were destroyed.

I hope Jonah's article is the beginning of some pushback from people who actually understand economics.

There is one other idiocy in the program. As my friend DJ pointed out with respect to the (admittedly stupid) CAFE standards, the government at least gets the math correct for CAFE by calculating the arithmetic average of the gallons per mile that cars get rather than miles per gallon. The reason is that all other things being equal, a 10mpg car uses twice as much gas as a 20mpg car, but a 20mpg car only uses 50% more gas than a 30mpg car.

The Cash for Clunkers program, of course, only looks to the arithmetic improvement (in the case of a new SUV/minivan/pickup truck, 2mpg-4mpg for the $3,500 rebate and 5+mpg for the $4,500 rebate). The improvement is 50% when you go from a 10 mpg SUV to a 15mpg SUV, but it is half as much in going from an 18mpg SUV to a 23mpg SUV. True to form, the government has a floor mpg on new SUVs of 18mpg, thereby ensuring that you are in the un-sweet part of the non-linear gas mileage improvement curve.

This brings me to yet another point in my rambling screed. The theory behind laws based on gas mileage (like CAFE and CARS) is that gas mileage is a good measure of how efficient a vehicle is. But it really isn't because gas mileage scales inversely with the weight and size of a car. Extra size and weight usually means extra passenger safety and extra carrying capacity. I have seen plenty of discussion about the tradeoff between passenger safety and higher CAFE standards, but I haven't seen much about the tradeoff between carrying capacity and higher CAFE standards.

The government obviously recognizes this tradeoff to some extent because it exempts larger trucks and buses from the CAFE standards, but I wonder why it doesn't distinguish between an 8-passenger minivan and a 4-passenger Ford Focus. A family with 3 kids in car seats isn't going to fit into most sedans, yet it fits comfortably into any minivan, with plenty of room for storage. Would the government rather the family drive two "fuel efficient" cars to its holiday destination or one gas-guzzling minivan?

Cash for Clunkers and the Broken Window Fallacy

The Consumer Assistance to Recycle and Save (CARS) Act (a.k.a. Cash for Clunkers) was passed and signed into law last month and can now be implemented thanks to the publication today of rules by the National Highway Traffic Safety Administration (NHTSA). I was going to write about this proposed (at the time) law a while ago, but I honestly didn't think such idiocy would actually pass the Congress. My bad.

The CARS program pays people up to $4,500 for buying a new car if they trade in an old car which gets 18mpg or less. This already sounds like a pretty dumb and pretty obvious government handout to the auto industry. Wouldn't it be nice if the government could just be honest and hand out cash to their favored industries and lobbyists? It would certainly save a lot of time and resources to pay off your political supporters in a straightforward way.

It gets worse, however, because some in Congress have actually convinced themselves (or at least their constituents) that the purpose of the CARS Act is to reduce fuel consumption and carbon dioxide emissions by getting cars with poor gas mileage off the road. Therefore, the old trade-ins must be destroyed. The following excerpt from the NHTSA's rules is practically Orwellian:

The agency has determined that a quick, inexpensive, and environmentally safe process exists to disable the engine of the trade-in vehicle while in the dealer’s possession. Removing the engine oil from the crankcase, replacing it with a 40 percent solution of sodium silicate (a substance used in similar concentrations in many common vehicle applications, including patching mufflers and radiators), and running the engine for a short period of time at low speeds renders the engine inoperable. Generally, this will require just two quarts of the sodium silicate solution. The retail price for two quarts of this solution (enough to disable the largest engine under the program) is under $7, and the time involved should not substantially exceed that of a typical oil change. The agency has tested this method at its Vehicle Research and Test Center and found it safe, quick, and effective. As with many materials used in the vehicle service area of a dealership, certain common precautions need to be taken when using sodium silicate. The same is true with regard to workers who may come in contact with the substance during the crushing or shredding of the engine block. We have discussed the matter with the EPA and the Occupational Safety and Health Administration (OSHA) and are aware of no detrimental effects related to the disposal of the engine block with this material in it.

I'm surprised that they don't require the cars to be buried and then the ground above sown with salt.

The CARS program has been variously described as an economic stimulus, as good for the environment, and as a way to reduce our dependence on foreign oil.

If one gives this even one minute of thought (something that Congress apparently did not), it becomes clear that, except for war, vengeance, and spite, no good could possibly come from destroying something of economic value. There is something called the broken window fallacy, introduced by Frederic Bastiat in 1850, and I refer you to the following link for a discussion.

Unfortunately, the CARS program is essentially a program to break windows. It encourages society to destroy all eligible clunkers with market values up to $4,500.

As we can infer from their market value, clunkers in fact have an important role to play in our economy and our society. They can actually move people and stuff from place to place at reasonably high speeds, and to the extent that a significant majority of people in this country can't actually afford to buy a new car, or even a slightly used one, clunkers allow those people to enjoy the fruits of a technology that has been around for the last hundred years.

This law is particularly annoying because the cutoff fuel efficiency for clunkers is 18mpg, and my 2000 Buick Regal gets 19mpg. The market value is probably barely higher than $4,500, but I figure I could have smashed a few things, collected the insurance money, and then traded it in.

Arthur Laffer's WSJ Op-Ed

I'm a fan of Art Laffer, and I think he is one of very few economists you see on TV who actually understands fiat currency economics.

However, his article today left me scratching my head. The following paragraph in particular makes no sense to me:

With an increased trust in the overall banking system, the panic demand for money has begun to and should continue to recede. The dramatic drop in output and employment in the U.S. economy will also reduce the demand for money. Reduced demand for money combined with rapid growth in money is a surefire recipe for inflation and higher interest rates. The higher interest rates themselves will also further reduce the demand for money, thereby exacerbating inflationary pressures. It's a catch-22.

Let me try to parse it.

To start, the first sentence doesn't capture the complexity of how the crisis unfolded. "Demand" for money usually means a desire to borrow for the purpose of spending ("spending" includes investment in a business, by the way, and not just consumption). Money demand increases when the economy is growing, and prospects look rosy. And higher demand with fixed supply means higher interest rates.

However, this bears no relation to the crisis. People didn't want money so they could spend it. They just wanted to move it to a safe place. There was a collective loss of faith in the creditworthiness of the financial system. In September 2008, T-bill rates were effectively pinned at zero (there were even some scattered trades at negative yields). That shows just the opposite of a demand for a money. Yields on all risky fixed-income products sky-rocketed, but this wasn't because of a sudden spike in the demand to borrow. It was due to a belief that defaults were imminent. That's a big difference.

The Fed's response, of course, was to devise a number of programs to flood the market with money as a way to induce investors to buy the risky products again. The flood of money hasn't worked all that well actually. Other things have. What brought down the interbank lending rate (i.e. Libor) wasn't so much the flood of money but the government's increasingly explicit guarantee of all of the big banks. What brought down spreads in the agency debenture and agency mortgage market was the Fed's direct purchase program. What brought down credit spreads in the consumer loan market is the Term Asset-Backed Loan Facility (TALF) which basically grants a government subsidy to investors in the form of a free put option.

It's all pretty obvious when you think about it. If you don't want to loan Chrysler money because you think they'll default, you're not going to change your mind just because the Fed is willing to lend you $100MM interest-free to do it. You still have to pay back the Fed after all.

Laffer's second sentence is unobjectionable. A recession causes a reduction in the demand for money since business prospects look bleaker and people are more inclined to save money rather than spend it. I should point out that causality works the other way as well. An increase in the desire to save money means less consumption and investment and therefore less economic activity.

The third sentence is completely screwed up. Reduced demand for money is offset by the Fed's increase in the supply of money which lowers the price of money (i.e. the interest rate), which in turn raises the demand for money (since the price is lower). Yes, when the demand rises again (due to the lowered price), the cycle will renew itself. The economy will start growing again, and inflation will start to pick up, but interest rates will be wherever the Fed wants them to be.

Short-term interest rates will go up only if the Fed chooses to raise them (by reducing the money supply) in order to fight inflation. Intermediate-term rates will go up only if the market anticipates that the Fed will raise short-term interest rates. Long-term rates are driven by more complicated factors including risk premia, but let's just say that if the Fed maintains its inflation-fighting credibility, long-term rates will remain moderate.

The fourth sentence in our excerpt starts out ok, but then ends with a completely false statement. Yes, higher interest rates will reduce the demand for money (which had already been raised by lower interest rates and subsequently a growing economy), but this will serve to quash inflation, not stoke it. Higher interest rates do not exacerbate inflation; they do exactly the opposite. They discourage borrowing and spending and encourage saving. They reduce the aggregate demand for goods and services and therefore cause prices to rise less quickly (or even drop). Yes, some economists have theorized that there can be a small short-term cost-push effect on prices in which businesses try to pass on their higher borrowing costs to the consumer, but this isn't real inflation. It is at worst a very short-term and very small effect. At best, it doesn't exist.

Finally, I disagree with Laffer that the Fed is in a Catch-22. A better metaphor is that the Fed is trying to thread a needle. It must aggressively lower the price of money in order to boost aggregate demand for goods and services, but once the economy is safely back on track, it must move quickly to drain the excess liquidity from the system and raise interest rates. If the Fed moves too soon, the economy could be thrown back into recession (this was the Bank of Japan's mistake 10 years ago). If the Fed moves too late, then inflation could get out of hand.