Economics

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Health Care and Market Forces

I find myself in conversation sometimes, say over dinner, with people who are both very well informed and highly passionate about the economy and subjects like health care reform, and yet who lack some of the analytical insights that would clarify their views.

That’s not their fault of course. They’re way too busy to get into the details. And, besides, economics is frightfully dull and intricate unless you want to plunge in headlong.

“to all my right wing friends. Do not defend profits. They are bad. Defend competition. Price cutting and innovation benefit consumers. Only competition assures them. Profits are a sign of dysfunctional markets.”

But.

The past few months have seen a political discussion that can only take place properly if the voting public has a better understanding of what it is being talked about.

Stimulus packages, bank bail outs and health care reform are all economic topics. They all have an ideological twist to them. It is all too easy to allow the ideology to substitute for economics.

Which is why I find the topics frustrating at times.

Take the topic of a ‘market’.

Many people I come across think that America has a ‘market driven’ health care system.

Well it does only to the extent that the government plays a role only in certain areas, rather than across the board.

The numbers don’t lie:

Almost half of all the dollars spent on health care in this country flow from the government. The elderly and our veterans are getting government provided health care. And they like it. Both Medicare and the VA system get higher customer ratings than any private insurance system does.

So where does the ‘government is hopeless meme come from? I don’t know. It’s a myth.

Further:

I often hear people arguing that markets let private people make profits, so any government system must be inherently ‘anti-profit’.

Wrong. The theory of free markets as you would find in a text book doesn’t have any profits in it. Rub your eyes and then read that again: there are no profits in a free market. None. Zilch. Nada. Profits are a bad thing in economics. Not that you could tell from the ideologues who supposedly espouse to free market economics.

Huh?

There is a big difference between profits, and ‘the profit motive’.

You see, markets are supposed to be full of ‘profit motivation’. So full that they attract tons of competitors. This piling in of competition drives down prices. So much so that no one actually ends up making a profit – they merely cover costs. So a free market if properly ‘free’ cannot have profits in it.

Anyone who defends profits is, by extension, defending something other than a ‘free market’. So a capitalist who wants to defend profit has to prevent a market from being truly ‘free’.

They can do this in all sorts of ways: limit competition; create industry ‘rules’; get patents or copyrights on inventions; co-opt the legal process; establish monopolies by buying out possible competitors etc.

In fact there has never been a CEO who wanted a free market. You might not realize this from reading their public statements, but it is evident from their behavior.

So, as we think about our health care system, anyone who defends the ‘right of insurance companies to make a profit’ doesn’t want a ‘free’ market. They want a rigged market. And a rigged market is exactly what we have: in the vast majority of states one or two insurance companies dominate the market and hence rig prices. Consumers are paying way above the prices they would were the market actually ‘free’.

What about innovation?

It is competition that drives innovation. Not profit. Innovation is a method for a company to open up a short term profit window. Over time that window should be shut by other companies copying the innovation and driving prices down. So constant profit is a force preventing innovation: this is because companies defend their profits by preventing innovators eating away at their margins. Why did Microsoft buy up so many small high tech upstarts? To eliminate them in order to keep the profit stream from Windows alive.

So: to all my right wing friends. Do not defend profits. They are bad. Defend competition. Price cutting and innovation benefit consumers. Only competition assures them. Profits are a sign of dysfunctional markets.

That’s the theory anyway.

Now let’s see if all those Republicans start campaigning for more competition. You know, the kind of thing we don’t yet have, but that they seem to want in our health care system.

Don’t hold your breath. Profits make for nice campaign contributions.

Which are just another way to distort ‘free’ markets.

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Monday Morning Blues

Originally I thought that today would be a sleepy summer day, perhaps a day off. But Wall Street seems to be roiled and has begun to reverse the steady march it had been on since the early part of the year.

I wonder why?

Here’s what I see going on.

As we all know Wall Street is perennially optimistic. Investment is inherently an act of optimism about the future, just as savings are a cautionary statement. In an economy that is growing, and where confidence is high, investors are happy to pile their money into assets like stocks, businesses buy new machinery and build factories, and consumers put their money into more expensive and longer term goods like new homes and cars.

Conversely, in a recession the opposite occurs: money tends to be stockpiled in liquid assets – things that can easily be disposed of to provide a cushion against difficult times.

So in a recession savings rise, and in a period of growth investment goes up.

As you can see this is a profoundly psychological process. If people start to feel good, if personal financial security is high, then they start to spend more. This process becomes self-sustaining and the economy booms.

The Depression gave us two great phrases to summarize this: FDR’s ‘We have nothing to fear but fear itself’; and John Maynard Keynes description of ‘animal spirits’ being the driver of a modern economy.

Both insights are something to dwell on this week.

Fear is what is now holding the economy back.

As the fear of collapse melted away early this year Wall Street started to seek ways to make money again. It sought to take its cash out of safe storage assets like US Treasury bonds and put it to work in higher yielding assets like stocks. As the storm abated this investment attitude took hold even more, and the result was that stock prices rose from the depths they had fallen to over the winter, and US bond prices fell as cash flowed out of the bond market to seek those higher returns. As bond prices fall the interest rates on bonds rises.

Some people misinterpreted this rise in bond prices as a warning that the bond market was signaling rising inflation rates. It was no such thing. It was simply a recovery from the extraordinarily low ‘panic’ interest rates that prevailed at the height of the financial crisis last Fall. Bond rates are now back to more ‘normal levels’ and there seems to be no pressure from inflationary expectations to keep them rising much beyond where they are now.

The reduction in fear came from one source, the US government; and in two directions.

The first direction was aimed at settling the financial markets. This was the purpose of all those bailouts. It worked. In fact it worked really well. Risk spreads are back to normal ranges, rates are also in normal ranges, and bank profits are higher – albeit rigged by the accountants! So the first part of the government rescue plan worked like a charm.

The second part was the stimulus plan.

This part was more controversial because many people reacted to its cost and thought that the huge run up in debt it implies was too much a burden for the future.

As you know I thought the stimulus was too small.

But it is now flowing through the economy and seems to be doing exactly what we wanted it too: it is savings jobs – about 1 million so far.

I find it odd that many folks still argue that this part of the rescue plan was controversial. On the contrary, it is text book economics – as long as your text book has a chapter in it that talks about the Depression. If you are a right winger then I suppose you will be predisposed to see no value in government spending in a crisis. You may even agree with the Republican leadership who wanted to tighten the government’s belt and cut spending rather than increase it. But that position was totally demolished and discredited by the Depression: back then the economy was recovering until the government started to tighten up and the Fed raised interest rates prematurely thinking that the worst was over. Instead those actions plunged the economy into what we now call the Depression.

Which, presumably, is what we are trying to avoid now.

It is incredible that many people think that the ‘market’ will fix things and that the government should ‘just get out of the way’.

That’s ridiculous.

A recession is exactly the collapse of the private sector.

Let me repeat that: the private sector gives way and fails. So demand falls. That’s what a recession is. We can prolong a recession and turn into a depression by letting the private sector work things out by itself. Prior to the Great Depression the US suffered regular depressions, some lasting several years. The 1800’s had many. There was one at the turn of the twentieth century. The worst, though, was the one we now call the Great Depression, and it was during that one that we learned how to cope better so the damage to society was minimized.

That learning took two forms: better monetary policy in the form of aggressive interest rate management by the Fed, plus the development of ‘unorthodox’ monetary policy actions like bulking up the Fed’s own balance sheet. The second was Keynesian demand management: getting the government to fill the demand void created by the implosion of the private sector so as to put a floor under the collapse and re-instill investor and consumer confidence.

Both these lessons are being applied in spades now. Which is why it is precisely government action that is saving us from depression at the moment.

Put it another way: without government action, especially the stimulus plan and the bank bailouts, we would certainly, absolutely, be in depression and facing the prospect of unemployment levels way above those we have now, far greater loss of wealth, and a very long and arduous climb back.

We dodged a depression very narrowly, and the private sector is still contracting.

Which brings me back to this week and Keynsian ‘animal spirits’.

The stock market rose strongly this year based upon an ebullience about the future: we had survived and were now undoubtedly going to recover. That meant that the depths to which prices had fallen were viewed as too low, thus stocks represented ‘cheap bargains’ relative to the value implied by the future profits the recovery would generate. Money flowed out of bonds and into stocks. Hence the run up. Everything was based upon a new set of expectations about the economy in 2010 and beyond.

But the gloss has come off a bit.

As usual, the guys on Wall Street over-reacted. They always do. They over-estimate profits and they under-estimate losses in good times and then do the opposite in bad times. That’s why the stock market is a very imperfect predictor of the economy. Those ‘animal spirits’ dominate. Cold hard reasoning doesn’t.

Extending this argument, Keynes also taught us that the entire economy was unstable due to ‘animal spirits’ driving consumers too: they tend to take on too much debt in good times and save too much in bad times. Banks too: they lend too easily in good economies and not enough in recessions.

The Keynsian vision is thus that of an economic system with inbuilt tendencies to lurch off track periodically. Since the private sector was inherently unstable it was the role of government to help smooth things out and act counter-cyclically.

Since this flies in the face of right wing ideology, economists like Milton Friedman and Robert Lucas have worked tirelessly to ‘disprove’ the Keynsian vision and re-establish a view of markets as flawless machines best left to themselves. They failed, but they managed instead to influence politics and the public sufficiently to produce the backlash against the stimulus. Their economic theories have just taken a beating, but their failure has yet to be absorbed by non-economists.

We get a better read on why the stock market is pulling back somewhat when we look through a Keynsian lens. The animal spirits that drove the ebullience of spring has now turned into an overly cautious doubt that there will be growth. So the conclusion is that prices where driven too high – the likelihood is that profits will be hard to grown much for a year or two – and so the market has to back off those heights.

This calmer view suggests that the recovery was going to be weak all along: consumers have a long way to go to recover their own ‘animal spirits’! Confidence remains low – it has actually slipped this summer after building quite well earlier. To paraphrase FDR: we still have fear to fear.

The inventory build up that is currently going on will end the recession this quarter or next. But until consumers get back to buying and stop saving we run the risk of stalling again next year.

We cranked the handle once to get the private sector going. There was a cloud of black smoke as it coughed out its excesses. It turned over a bit. But we made need to crank it again this Fall to ensure that the engine springs back to life on its own.

Wall Street has suddenly realized this. Hence the Monday morning blues.

Addendum:

For those of you who want to get into the notion of unstable economies – no doubt you’ve been brought up on equilibrium economics – I highly recommend reading any of Hyman Minsky’s books. He took Keynes and extended it into finance and banking. The best start is his compendium of essays ‘Can ‘It’ Happen Again?’ [‘It’ being the Depression]; or perhaps his ‘Stabilizing an Unstable Economy’. Minsky is a ‘must read’ for anyone wanting to understand what’s just gone on and what we should do about it.

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Consumers Swoon; Inflation Flat; Weak Weekend

The flow of weak data continued this morning and leaves us all with plenty to ponder over the weekend: the economy may well be headed out of recession as inventories are adjusted, but beyond that the horizon is murky to say the least.

The theme all week has been the abrupt ebbing of forward momentum and today’s news that consumer confidence fell in July – the index dropped to 63.2 from 66.0 – merely reinforces a worrying trend. The consensus prediction among analysts had been that the index would rise to 69.0, so obviously plenty of people have been carried away by the hoopla over recovery rather than getting a solid read on the underlying factors affecting consumers.

Wall Street analysts are perennially optimistic and tend to see a bright future on the basis of the slightest break in the clouds. This is what has happened over the past two months. As all the data started to suggest that the economy was no longer in free fall Wall Street immediately rushed to the conclusion that it would adjust back to normal quite quickly. Hence the run up in stock prices that seem to be based upon profit projections unrelated to where business is today.

I would urge caution.

While it is very clear that the economy has started to level off and is no longer imploding at the rate it was last year, we remain very far from a sustainable recovery. On the contrary the turn around has all the makings of being a ‘technicality’ rather than a ‘reality’.

Consumers seem to agree.

Dark clouds are hanging heavily over consumers: unemployment is the leading issue, and there seems to be no prospect of job generation in the next few months. Home prices are devastated which has destroyed many people’s savings – home equity is a false measure of ‘savings’ but many families fell into the trap of believing it was secure. And even those who are still employed are facing shorter work weeks, lost benefits, and reduced wages. This is not a recipe for rapid recovery. Indeed it may not support recovery at all.

Prices reflect this weak activity.

The Consumer Price Index was flat month on month in July, which was about what everyone had expected. Food and energy prices fell sufficiently to offset increases elsewhere, especially in health care costs. Unfortunately the CPI has now fallen 2.1% since this time last year, which, while not unusual in a recession, is not a trend we want sustained for long: the threat of prolonged deflation is too damaging to be viewed without alarm.

The enormous slack in the economy provides businesses with no room for price increases; commodities are generally in good supply relative to the now low levels of demand and so their prices are not under great pressure; and labor costs are still falling. All of which suggests that prices will be quiescent for a while longer.

Overall I doubt inflation is a concern any time soon – until well into next year. This is despite the huge flood of money that the Fed has pumped into the economy over the past year. Most of that extra cash is now sitting as excess reserves held by banks at the Fed – it hasn’t found its way into the economy by way of credit growth. As long as that cash sits in the vault it represents no threat of inflation. But nor does it help us re-ignite growth. The Fed’s dilemma next year, or maybe in 2011, will be how to suck that cash out of the economy so as to prevent sudden uptick in prices.

You will read plenty of panicky stories in the financial press about the risk of inflation stemming from the enormously lax Fed monetary policies of the last year – pay them little or no heed. The people who are now worried about inflationary expectations driving up long term interest rates are ‘fiscal hawks’ – they are not focused on the depth to which the economy has plunged and the gap that has now opened up between actual activity and potential activity. My advice is to focus on that gap: until we have worked off the slack in the economy, that is until factories are humming, jobs are abundant, and workers are hard to find because they are all employed, inflation will be a theoretical rather than actual threat. Over a five year horizon I see rising inflation along with rising taxes to rein in fiscal deficits. Over the next two years though I don’t see inflation as much of an issue – not yet anyway.

So the week ends on a weak note. The optimists still cling to a vision of a recovery sufficiently robust that it self-sustains and thence accelerates. My view is that the recovery is less secure: until consumers are a firm footing with debts well covered, jobs safe, and wages growing, the economic engine will continue to sputter. As I reported yesterday: the entire GDP growth later this year can be attributed to the effects of the stimulus and an inventory correction. This means that the private sector is falling well short of the kinds of activity we need for a sustainable recovery to emerge.

This really does have all the makings of a jobless recoveryso we may well need more stimulus this fall.

The prospect for that is not good. Let’s hope that the next few weeks brings a turn about in consumer sentiment. Then we can look forward to 2010 with more optimism.

Addendum:

A brighter note:

Today’s release of real incomes shows a slight uptick in weekly wages from June to July. The growth came entirely from longer work hours as factories increased output to restore inventories. This is exactly the kind of impetus that the more optimistic analysts use when they forecast a self-sustaining recovery taking hold later this year. This evidence supports their case, let’s hope it continues.

More interesting in today’s report is the fact that wages increased 0.1% from July 2008 to July 2009. This looks very poor until we factor in the drop in CPI I mentioned above. Take the two together in order to arrive at inflation adjusted incomes, and real wages – which in theory are the measure we should be looking at – rose a decent 3.5% [ don’t add the CPI to the wage growth number: there is a separate CPI-W for wages, which deflated a little more than the overall number!] . This provides some extra hope that consumers will start to feel better about the future.

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Retail Sales and Jobs: Both Weak

For those in search of evidence that the recovery will be robust today is a distinct downer. The only good piece of news released today is that the inventory to sales ratio is still declining which tells us that businesses are getting closer to getting their houses in order, albeit at much lower levels of activity. We have been calling the recovery ‘inventory led’ so we should expect that ratio to snap back in line with historic standards.

For the rest: today’s news was decidedly glum.

First retail sales.

Were it not for the government’s ‘cash for clunkers’ program which generated a decently strong level of car sales, today’s report would have been really bad. The all-in sales levels fell by 0.1% in July, whereas most ‘experts’ had expected growth of around 0.8%, which would have been the same increase as we saw in June. Take out car sales and the fall is even more dramatic at 0.6%. So after three months of growth and plenty of optimism that consumers were finally getting back to the stores, we have to be struck by the sudden stop. Clearly an atmosphere of hesitancy still pervades the economy and we have every long way to go before confidence is restored sufficiently so we can predict sustainable growth.

Yes the numbers contain some quirky details: gasoline prices fell quite a bit – enough to pull gas sales down by 2.1%. In fact gasoline alone accounts for much of the overall weakness. And it is sometimes hard to explain why something like lower prices, which are obviously beneficial to consumers, aggregate into something bad at the national level. Nonetheless sales are sales: we need the cash to flow through the economy and not sit in savings accounts if we are to get job growth back on track.

Speaking of which: today’s weekly first time claims for unemployment assistance figures were also disappointing. All of the evidence last week was that we have hit a different point in the employment cycle: fewer jobs are being cut so the pace of loss is easing, but there is still no sign of re-hiring. Today’s report that claims actually rose slightly, by 4,000 to a total of 558,000. Most people had been forecasting a steady decline, so the jobs report is very disappointing.

To put the job market in perspective: this rate of new claims is 27% higher than this time last year. Even worse is the number of ongoing claims, a measure of longer term unemployment, which dropped by 116,000 last week but now has soared a full 83% over last years level. There is no evidence that the drop in ongoing claims relates to a burst of hiring: on the contrary the more likely cause is that a growing number of unemployed workers are exhausting their benefits and simply dropping off the statistical database.

This cannot be good news for the economy.

Putting all this together, and taking into account the productivity news from earlier this week, we can begin to see the shape of whatever recovery is now occurring: it is truly jobless.

The critical point to keep in mind is that the economy has huge slack in it. Businesses have shed not only vast numbers of workers, but also hours worked by the people still employed. So any immediate pick up on sales activity can be met easily by extending the work week back to more normal lengths rather than through re-hiring. This is why the unemployment rate is likely to stay stuck in the 9% to 10% range for a while: if it comes down at all the decline is more probably driven by disaffected workers leaving the workforce than through job generation. So we are no going to see a rapid turn about in employment. On the contrary this has all the makings of stagnation as businesses protect profits rather than expand.

If this outlook for jobs is correct, and the odds are well over 50-50 that it is, then the uncertainty that is preventing a recovery in consumption will continue to dampen growth even more: household wealth has taken such a beating, debt levels are adding to the burden – the number of homes where the mortgage is more than the sales value of the home is at record levels – and job security is sketchy to say the least.

With this as background I repeat my warning that we may well slip back into recession next year unless there is more stimulus.

Think of it this way: if the forecast growth for the rest of the year of between 1% and 2% is correct, and if our estimates of the impact of the stimulus package are accurate -which despite Republican naysaying we have no reason to doubt – then that entire growth will be accounted for by the government package. All of it. Put alternatively: without stimulus we would still be in steady decline right through this year.

As the stimulus works its way through next year we need to see a lot more evidence that the private sector is back on its feet. Only then can we argue credibly that no more stimulus is needed.

On the basis of today’s news we are a very long way from that point. Those ‘training wheels’ can’t come off for a very long time!

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Astrological Economics: Just What is Bernanke’s Sign?

For a subject as dry and mathematically inclined as economics, at least in its orthodox version, the linkage between the real world an the merely imaginary is more tenuous than most laypeople would think.

This occurred to me today when I read an excellent letter in the Financial Times. In it an MIT lecturer talks about how limited the average person’s grasp of rational choice is. We are mostly quite irrational even though we often try to be very sensible in our decision making.

“Star charts are as useful in predicting asset price bubbles as orthodox theory. Why? Because at least an astrologer doesn’t doubt their existence.”

This is, of course, not news to any of us. That’s why many of us find it quite difficult to make decisions about even trivial aspects of life.

The so-called ‘Paradox of Choice’ is a good example. [See Barry Schwartz’s book] Economists theorize that giving consumers a myriad choices will, inevitably, produce the best result: the more choice, the more likely that a consumer will find something that exactly matches what they want.

But this flies in the face of our evolutionary roots. We are not cognitively equipped to get into finely grained decision making, where we are required to evaluate nuanced differences. We are it bit brutish in our thinking. We are equipped for simple and often binary decision making: the kind of on-the-fly type of thinking that primitive animals have to make in order to survive to live another day. So when confronted by a plethora of choices most of us simply freeze up and avoid making any choice at all.

A practical example of this is the supermarket. Researchers have shown that someone going to the supermarket with a specific purchase in mind – say toothpaste – will often turn around and leave if there are too many varieties, flavors and brands on the shelf. It is better, in other words, for the shelf to sport a quite limited choice. Sales will be higher and consumers happier.

Contrast this real world research finding with the assumption within free market economic theory that consumers are ‘perfectly rational’, and we can start to comprehend why economics is such a mess. It is more astrology than science.

The entire edifice of free market theory rests on the notion that you and I are supreme calculators. That we are not defeated by shelf loads of products, but that we are capable of feats of analysis, consciously or not, that allow us to arrive at extraordinarily precise decisions that inevitably lead us to maximize our welfare. We never make mistakes. Never.

Sound familiar?

No, I didn’t think so.

I realize it seems very dull, but I want to reiterate the importance of of this small example: our economic lives have been run for years by people who’s outlook on life is conditioned by, and depends upon, on exactly the theory derived from assumptions like that of ‘perfect rationality’.

Take away perfect rationality, and the superiority of markets, as opposed to, say, governments, as allocators of scarce resources crumbles. That means no one can ‘prove’ that markets left to their own devices will always outperform the government.

So the debate reverts to a political one.

Which is why it is urgent that economics recovers itself from the dead end it was driven into seventy years ago and abandons most of the thinking accumulated since then. It simply isn’t true. Worse: it leads to severely handicapped public policy making. It allows ideologues like Reagan and Bush to slam the government – which is their right from an ideological perspective – from within an aura of scientific discipline.

There are times when markets are terrible – sub-prime mortgages anyone?

Bubbles are common structure within capitalist economies. So are business firms. But both bubbles and firms cannot exist within the purity of orthodox economics. Perfection has no room for the messiness of either.

The Nobel prize winner Ronald Coase pointed out to his economics colleagues in 1937 that since business firms seem to be quite common the profession ought to re-consider its allegiance to perfection. Instead he was ignored for decades and only much later did a subculture sprang up inside the profession studying firms. But the textbooks remain pristine. Indeed the firm as an economic entity remains a curiosity and is ignored by most academics.

So too with bubbles. Visit most academic economist websites and you will find all sorts of opinions as to why bubbles cannot be predicted. Many will deny they exist – even now. This is because they are all so inculcated with the perfectionist view that they fail to see the real world. And rather than admit their subject has a big hole in it, they attempt to explain away the Emperor’s nakedness by resorting to all sorts of arcane and highly jargon laden reasoning.

Economists have even begun to argue that their inability to reject a negative argument against their own theory is sufficient to justify its continued existence. Think about that: they take the fact that they have nothing to say as support for a theory. This is hardly Popperian refutation. It is vacuous.

The fact remains that economists are faced with a choice: either their subject is failing to explain many very common economic structures; or it is akin to astrology.

There are hopeful signs: people like Robert Thaler, mentioned in the letter I referenced at the beginning of this post, are slowly chipping away at the outmoded and mechanistic thinking that supports the orthodox theory. But they have a very long way to go.

Meanwhile ideologues still latch onto the orthodox theory in order to justify their politically motivated views. Which affects all of us. The current debate about health care reform would be so much more sensible were it rooted in real world claims about the efficacy of markets rather than being supported by an orthodoxy that resembles the reading of star charts.

So too would the re-regulation of banking.

The relevance of economic theory has never been greater. That’s why it is fun to get involved in the debate. In large part, the crisis we are living through is a creation of orthodox theory. Which is why it’s protagonists are so vocal in their attempts to misdirect our attention: Robert Lucas, Martin Feldstein, Robert Barro, John Taylor, and many others are constantly popping up in the media to pull the wool over our eyes. Their common theme is that it is the government’s fault. Or, failing that, they throw their hands up and claim that no one, absolutely no one, could possibly have seen the crisis arising.

They protest too much.

Their economics is beautiful. Intricate. Intense. Intellectually fascinating. Difficult to master. Brilliantly conceived. And about as scientific as astrology.

Star charts are as useful in predicting asset price bubbles as orthodox theory. Why? Because at least an astrologer doesn’t doubt their existence.

So with respect to the discussion over whether Bernanke should be re-appointed as Fed chairman: only if he was born under a propitious sign. Turns out he’s either Sagittarius or Capricorn. It is quite obvious that the Fed has far too many of those already. Time for one of us more solid, some would say dull, Taureans?

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