The Problem with Health Care

In Tuesday’s debate, Tom Brokaw asked the best question of the night when he asked if health care is a privilege, right, or responsibility.  I think John McCain gave the correct response when he answered that it is a “responsibility”, and Barack Obama gave the incorrect (if popular) answer that health care is a “right”.

But regardless what you call it, health care is a critical issue in all parts of the world.  Here I present a summary of issues that explain the real problem, and what we must do about it.  You will find that, at the root of the problem, are people who dogmatically cling to the notion that free markets always produce the best outcomes, and people who dogmatically claim that dysfunctional markets must always be replaced wholesale by government programs.

Rights v. Responsibilities

A few points should be made on this topic before getting to the real issue.

Obama points to the wealth of the United States when he says that health care is a “right”.  In other words, the right to health care is contingent on our country’s wealth.

I was going to argue that rights cannot be contingent on anything.  But I’d be wrong: the definition of “right” (“a just and fair claim to anything that belongs to a person through law, nature, or tradition”) would argue against this.  Of course, an inalienable right couldn’t be contingent on anything, but a run-of-the-mill right is really synonymous with an “entitlement”: it’s whatever we say it is.

Now, this definition presupposes that the claim is “just and fair”, and that’s the rub.  If, in fact, the country is awash in wealth, then perhaps some claim to universal health care is just and fair.  But, as I recall, we are in the worst financial crisis since the Great Depression.  Are we really that wealthy?  Or do we merely appear wealthy because we’ve borrowed over 10 trillion dollars and we’ve spent it on ourselves?  10 trillion dollars averages out to over $85K per US household – and that doesn’t even consider the roughly $10K that the average household carries in credit card debt, or the value of their car loans.

I suspect that if we removed that illusory wealth from the system, the USA wouldn’t seem so wealthy after all.

I found it ironic that for an hour the Tuesday night debate focused on how broke our country is, and then Barack Obama told us that we are so wealthy that we all are entitled to health care.  I was saddened that John McCain couldn’t elucidate a better rebuttal to this obvious logical fallacy.

The question was a good one, but it misses the point.  The health care systems of the world are broken, and there’s a reason for this.  Until we understand the cause, neither the free market nor a socialist medical program can solve the problem.

Why You Can’t Buy a Good Used Car

In the outstanding, must-read book The Undercover Economist, author Tim Harford explains why you can’t buy a good used car, and how this parable illustrates the problem with the modern health insurance system.  I will paraphrase a fair chunk of the relevant chapter here.  Tim and I each took the time to write it, please take the time to read it.  Until the world can understand this problem, our health care system is doomed.

At issue is the problem of asymmetric information.  When you want to buy a used car, you have no information about the condition of the car, while the seller has very good information about it.  If the car is a peach, then the seller would like to get top dollar for it, say, $4000; whereas if the car is a lemon, the seller just wants to get it off the lot for as little as $1000.  You, who have no idea if a given car is a peach or a lemon, figure that a reasonable price for a car with a 50/50 chance of being a lemon is about $2500, but you quickly discover that at that price, only lemons are for sale.  Were you to offer $4000, you’d also find peaches for sale, but the lemons don’t go away, and $4000 is not a fair price for a car with a 50/50 chance of being a lemon.  So you offer $2500, and the owners of peaches simply take their cars off the market, since they’re better off keeping them.

This example clearly illustrates why there simply is no market at all for good used cars.  The market forces break down completely due to inside information, forcing sellers of good used cars out, and leaving buyers with only a selection of cheap junk to choose from.  As it turns out, there are all kinds of markets that suffer from the problem of inside information, but probably the most notable is the market for health insurance.

Let’s say that I smoke, eat too much, drink lots of alcohol, and have a family history of cancer, heart disease, and leprosy.  Chances are that I am going to incur a sizeable medical bill over the course of my lifetime, so I’d be willing to pay good money for an insurance plan.  On the other hand, someone like you with no risky behavior and an excellent family medical health history would expect to incur few costs over the course of your lifetime and would therefore be unwilling to pay much for a health insurance plan.  The insurance company sets a price that reflects the actuarial cost of the average of both our health costs, plus a little profit, and offers us policies at that price.

The market is doomed from the start. I, who smoke and drink too much, would see the policy as a bargain, and snap it up; while you, in great health, would see it as a rip-off, and decline.  As a result, the insurance company would quickly find itself insuring only people who expected to require a lot of medical care, and would be forced to raise prices and cut benefits.  People on the margin would cancel their policies, leaving even fewer potential buyers in even worse health.  Ultimately, only the sickliest of people purchase insurance, and then only at a price none of them can afford.

The insurance company isn’t helpless, of course: they will attempt to level the playing field by collecting as much information as possible about the insured.  Do you smoke?  Did any family member die of cancer or heart disease?  Do you have a pre-existing condition that suggests a high likelihood of future expenses?

While gathering this information will allow insurance companies to offer more reasonable plans to more people, in reality, it just exacerbates the problem.  You, who can expect few medical bills over the course of my lifetime, would be offered an actuarially fair price for a plan – which means you would pay the expected amount of your future expenses, plus some profit for the insurance company.  People like me, who can expect high future medical bills, would find that their policies are staggeringly expensive.

The conclusion is obvious: insurance can only work well in a market where all players are ignorant of their future outcomes.  When both buyer and seller are well-informed, insurance companies only offer affordable insurance to people that don’t need it, and buyers who need insurance discover that they can’t afford it.  If both sides had perfect information, then the market would disappear completely, since each transaction would represent only the true cost of one’s future health care cost, plus a little profit for the insurance company.

We quickly see the problem: an increasing understanding of the root causes of illnesses which were once medical mysteries is destroying the market for insurance.  This problem will not go away – in fact, as medical technology provides us with greater understanding of the causes of disease, and as information technology makes this information more available, the market for insurance will erode even further.

We see also that relying on insurance to cover day-to-day medical bills, such as checkups and routine office visits is counterproductive, since the cost of these bills is stable, predictable, and relatively low.  Insurance companies will provide the consumer reduced benefit, since they will simply charge the actuarial cost of these expected expenses, and add their own profit and administrative overhead.

Is Government the Solution?

Replacing the entire system with a state-run medical program is one proposed alternative.  But is it a good one?  Government-run systems are typically overcrowded, with little or no patient choice, and a large bure
aucracy required to operate them.  The lack of market dynamics drives innovation almost completely out of the system, which is why the United States’ system, however broken, continues to drive most of the world’s medical advances.

Nor do government-run systems produce significantly better outcomes: while studies indicate that 17% of Americans are happy with the US’ health care system, the same studies show that only 25% of Britons are happy with theirs. And Britain, being much smaller, does not face bureaucratic challenges on the same scale as the US.  In a country universally dissatisfied with the quality of its federal government, it’s easy to doubt the feasibility of a US-run federal health care system.

Real Solutions

We live in a world where it is reasonable and desirable that people should have access to a basic level of heath care.  Call it “right” or “responsibility”, the problem is how to provide the best outcomes to everyone.

The truth is that the market-based approach to health care can offer significant advantages to a state run system: a wide and deep supply of doctors offering a good range of alternative treatments, an innovative medical technology industry, and the potential for lower treatment costs for comparable treatments due to increased supply of providers.

The problem isn’t the market-based provider system.  The problem is the market-based insurance system.

We should start by agreeing on a few goals:

  1. We want everyone in the US to have access to a basic level of affordable health care.
  2. We want to keep choice in the hands of the consumer to the greatest degree possible.
  3. We want to make use of the benefits that the market-based approach offers.
  4. We want to limit the expansion of government as much as possible.

Fairness

If we are going to address issue #1 we must wrestle with the issue of fairness. While a basic level of health care for all Americans is desirable, we simply cannot afford to treat everyone at the very highest level of care.

Consider a treatment that cures cancer, but costs $10M per treatment.  It is a fact that we cannot provide this treatment to every cancer victim without bankrupting our country.  We are forced to choose a standard of health care that is practical and affordable.  This will inevitably result in inequity in the system.

However it is desirable to allow those who can afford expensive treatments to purchase them, because this provides incentives for companies to develop innovative treatments. Until technological advances lower the cost, only billionaires will be able to afford the cancer cure. We must accept that.

It is very unpalatable to some people that wealthy people should have greater access to health care solutions than the poor.  However, wealthy people have greater access to healthy food, safe cars, safe neighborhoods, tutors, and bodyguards.  And we can also see that it is likewise unfair to deny a person with the means to cure his cancer the right to do it simply because he is wealthy.

Fairness is well treated in other parts of Harford’s book.  In short, it’s easy to decry some facet of society as unfair, while it is very difficult to propose improvements.  What we can agree on, however, is that by allowing the wealthy to voluntarily spend large sums on their personal health care, we enable them to fund the research and development that will lead to inexpensive, available health care for all.

Making the Market Work

Now let’s deal with goals 2-4.  The goal is to give maximum choice to the patient while covering them in the event of a catastrophe.  Giving the patient maximum choice means that we must require them to spend their own money.  If they spend the insurance company’s money, then the insurance company will determine which treatments and doctors are available.  Likewise with a government program.  But if people can spend their own money on medical treatments, then they are able to choose any affordable available alternative, and will seek information to help them choose wisely.

The solution is apparent: people should pay for all of their medical care, but insurance should cover the largest and most unpredictable bills; and everyone should have a savings account dedicated to medical bills, to which the government would contribute in the case of the poor or chronically ill.

Medical savings accounts are not new, and make tremendous sense.  For the overwhelming majority of people, the bulk of medical costs are incurred in one’s latter years.  Allowing one to save over the course of a lifetime would provide a sizeable medical fund in one’s elder years when it is most likely to be needed.  When you die, any remaining medical savings can be converted into medical savings for one’s heirs.

Many outcomes are unpredictable and catastrophic.  These remain good candidates for insurance.  And we see that catastrophic insurance is, indeed, quite inexpensive, provided the policy is purchased when one is young and held over the course of a lifetime.  It is only when one is elderly, and much more likely to incur extreme medical costs, that the cost of insuring against catastrophe is increased.

Therefore, we must do away with any insurance model that causes people to periodically lose their insurance coverage, such as the employer-provided insurance model.  Instead, individuals should be encouraged or required to buy and hold a catastrophic insurance plan from an early age.  Here, regulatory oversight will be required in order to ensure that insurance coverage is fair to both the buyer and seller.

Political Observations

As it turns out, and quite by accident, Harford and I both recommend a solution somewhat similar to that proposed by John McCain, and one to which the insurance industry is slowly evolving.

As people experience more and more job turnover, they experience the failure of employer-provided health care, and are increasingly insuring themselves.  Self-insured individuals have long seen the wisdom of a medical savings account, and in fact we see a larger number of people opting to self-insure through a combination of medical savings and cheap catastrophic insurance.  In other words, the market is wobbling towards this practical solution on its own.

Government should help by providing incentives and assistance for people seeking to insure themselves in this way.  McCain proposes a $5000 tax credit that one can use to purchase insurance, as well as a tax on employer-provided insurance benefits.

The tax on employer provided benefits is unfairly maligned.  Why should you pay tax on $5000 you earn and use to buy your own insurance, but not on a $5000 plan offered by your employer?  Such a scheme discourages medical savings and self-insurance – precisely the model we should encourage.  McCain has the right idea: we should instead discourage employer-provided insurance by taxing it like any other compensation, and instead encourage medical savings and self-insurance by allowing individuals to write off those expenses.

We must recognize that the 1950s-style system of wall-to-wall medical coverage through group insurance cannot hold.  We have agree to walk away from such a system.  Implicit in this is an understanding that government managed insurance – specifically, Medicare and Medicaid – are as doomed as private insurance.

Repeat: Medicare and Medicaid are doomed.  We will have to scrap them.  This has terrific political implications for any political officeholder.

As Harford says, “governments can replace markets, but they will often do better to try to fix them.”

Indeed.

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