Thanks to a wise business decision by the New York Times, former economist Paul Krugman nowadays preaches to a smaller, ideologically purer coven than before. Once in a while, though, one of his columns escapes into the Web. A site that advocates socialized medicine a “national health program” has posted his “Health Economics 101”, which purports to answer a “good question” posed by “several readers”:
[W]e rely on free markets to deliver most goods and services, so why shouldn’t we do the same thing for health care? Some correspondents were belligerent, others honestly curious. Either way, they deserve an answer.
Professor Krugman’s answer is simple - and thoroughly misinformed: He starts with the not unreasonable proposition that some health care costs are so catastrophic that no one but the very wealthy can prudently self-insure against them. Therefore, insurance is a key element in the health care marketplace.
But good insurance is hard to come by, because private markets for health insurance suffer from a severe case of the economic problem known as “adverse selection,” in which bad risks drive out good.
To understand adverse selection, imagine what would happen if there were only one health insurance company, and everyone was required to buy the same insurance policy. In that case, the insurance company could charge a price reflecting the medical costs of the average American, plus a small extra charge for administrative expenses.
But in the real insurance market, a company that offered such a policy to anyone who wanted it would lose money hand over fist. Healthy people, who don’t expect to face high medical bills, would go elsewhere, or go without insurance. Meanwhile, those who bought the policy would be a self-selected group of people likely to have high medical costs. And if the company responded to this selection bias by charging a higher price for insurance, it would drive away even more healthy people.
What the professor calls “adverse selection” is, as he would have known back when he practiced economics, the ordinary operation of insurance markets. The concept underlying insurance is not that good risks should subsidize bad. For example, hurricane coverage costs a lot more in Florida than in Illinois. Similarly, neither life insurance nor car insurance has the same price at ages 20 and 50. The fundamental principle of insurance is that policyholders with similar risks of loss pool their funds, so that money will be available to compensate the unlucky ones who suffer catastrophes. A system under which there was “only one [casualty] insurance company, and everyone was required to buy the same insurance policy” at “a price reflecting the [casualty losses] of the average American” would not be insurance in any real sense. It would amount to socialization of the risk of property damage. The same is true for Professor Krugman’s hypothetical monopolistic, compulsory health insurance provider. The free market can’t replicate the hypothetical monopolist, nor is there any reason why it should.
It isn’t hard to figure out what would happen after “universal casualty care” took effect. Builders and buyers would worry less about the risk of fire and storm, claims would skyrocket, and the average loss on which premiums were based would go up and up. The way to avoid such a fate is to charge premiums reflective of risks, which is what health insurers try to do. Professor Krugman sees that self-evidently rational practice not as the solution, but as the problem.
[I]nsurance companies don’t offer a standard health insurance policy, available to anyone willing to buy it. Instead, they devote a lot of effort and money to screening applicants, selling insurance only to those considered unlikely to have high costs, while rejecting those with pre-existing conditions or other indicators of high future expenses.
This screening process is the main reason private health insurers spend a much higher share of their revenue on administrative costs than do government insurance programs like Medicare, which doesn’t try to screen anyone out. That is, private insurance companies spend large sums not on providing medical care, but on denying insurance to those who need it most.
If that were really the case, insurance would be a failure in every market, not just in health care. Why aren’t auto insurers overwhelmed by the administrative cost of distinguishing good from bad drivers? The answer is that, for large groups of people, only a few elements are usually needed to place them into risk categories that are adequate for the purposes of the marketplace. Age, sex and record of previous accidents and traffic offenses are enough to stratify automobile driving risks. Age, smoking habits and what can be learned from a 15-minute physical are all that life insurers need. For sufficiently large groups, they won’t bother with the last two.
Health insurers face no more difficult problem. In a completely free market, they would identify the small number of factors that most strongly correlate to health risks and would base premiums on those. In the current market, which is far from completely free, they don’t spend a lot of money individually examining every applicant, contrary to what Professor Krugman thinks. The outsize administrative costs of the American health care system stem from efforts to prevent the inefficient utilization of medical resources, a problem that plagues any arrangement that (i) has expensive resources available and (ii)minimizes economic considerations in allocating them. The hugely complicated process of Medicare reimbursement shows that administrative burdens are no private sector monopoly.
Returning to Professor Krugman, he concedes that, despite the “large sums” supposedly spent “on denying insurance to those who need it most”, “most Americans too young to receive Medicare do have private health insurance”. He attributes this fact solely to “huge though hidden subsidies”, namely, the exclusion of employer-provided health benefits from taxable income. “One recent study suggests that this tax subsidy may be as large as $190 billion per year.” (To put that figure in perspective, total U.S. health care expenditures are about $2 trillion a year.)
How does this subsidy operate to provide insurance to those who otherwise wouldn’t get it? Professor Krugman doesn’t describe the mechanism – fair enough, as he has only limited wordage, but his readers are likely to be left with the impression that the subventions reimburse insurers for the losses that they suffer from failure to do enough screening of applicants, allowing them to take on risks that would otherwise be rejected. The true picture is so much different that one wonders whether Professor Krugman has ever looked at the American health care market through empirical rather than ideological lenses.
Thanks largely to well-intentioned government regulation, most health insurance is sold on a basis that ought to please Professor Krugman: One price fits practically everybody. In employer-sponsored plans, the dominant form of coverage, there is scarcely ever any variation in participants’ premiums by age, much less to reflect factors with smaller effects. As a result, coverage is overpriced for young, healthy workers. Tax benefits reduce the cost to some extent, though not decisively. If premiums are several times their market level, an income tax exclusion isn’t much of an offset, unless one faces marginal tax rates nearing 100 percent.
Still, overcharged youngsters subsidize their elders, so it is important to keep them in the same insurance pools. The ways in which that is done are a bit mysterious to me, but insurance is a heavily regulated industry, so I’m not surprised that it operates to produce the outcome that soft-hearted, soft-headed regulators desire, namely, health insurance that costs about the same for everyone.
I’m also not surprised that the regulators’ ideal system is not too satisfactory. To attribute the failures of regulation to the market, as Professor Krugman does, is the natural reaction of quasi-socialist minds.
Health care services are as amenable to delivery through free enterprise as anything else that people want to buy. It is not even especially difficult to discern, in general terms, what a system stripped of government intervention would look like.
First, people wouldn’t buy routine or repetitive care through the intermediary of an insurance company. Doing so is prepayment, not insurance, and makes as much sense as buying insurance to pay your grocery bill. Reducing the paperwork surrounding everyday medicine would be an immense, cost-saving simplification in and of itself.
Second, health insurance would become more event-based, instead of concentrating on reimbursing the cost of care incurred in a particular year. The expenses against which one most wants to insure are those that arise from illnesses that may continue for years or decades. A free market would offer that sort of coverage to a greater extent than the current controlled market.
Third, since both routine medical expenses and the risk of catastrophe rise with age, health insurance would be much cheaper for young people, considerably more expensive for old. The lifetime cost would not rise, only the pattern of expenditure. To minimize hardship in later years, policies could double as savings vehicles, taking on some of the characteristics of whole life insurance. The risk of death increases as one gets older, and so does the cost of term life insurance. Therefore, anyne who desires to make sure that he will leave a large estate buys policies that build up cash value through the years. He could, of course, reach the same goal by saving money systematically, but many people find that difficult to do; whole or universal life insurance is a handy crutch. A similar kind of health care policy is possible and is, in fact, emerging in the long-term care market.
I’m no believer in libertarian utopias. A truly private health care system would have its problems, and dismantling the existing apparatus of government control, on which many economic interests depend, could be painful. Nonetheless, if the task is impossible, the obstacle is lack of will to face difficulties, not some strange phenomenon that excludes medicine from the realm of economics.