ABCs of Health Care

FYI, this appeared in the WSJ last Friday.

• OPINION
• OCTOBER 16, 2009, 10:36 P.M. ET

The ABC Dilemma of Health Reform

Third-party payment creates a big incentive problem.

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By VERNON L. SMITH

There is widespread agreement with the principle that our health-care system needs to be reformed. But our representatives and our neighbors have much trouble in reaching agreement on the particulars. There have been many legislative bills offered and hundreds of amendments with no clear path to a resolution.

Health-care systems everywhere encounter cost overruns and rationing devices, like queues, in their diverse attempts to deliver products for which demand has long grown faster than other economic sectors. Why is it so difficult to find the private and public means, the combination of markets and government assistance, that enables a preferred outcome to emerge?

This question has a simple answer that plagues health care everywhere.

The health-care provider, A, is in the position of recommending to the patient, B, what B should buy from A. A third party—the insurance company or the government—is paying A for it.

This structure defines an incentive nightmare. You do not have to be an economist to realize that, when phrased in this way, nobody knows how to solve this problem. Hence the many experiments, all of which have been deemed less than satisfactory.

I don't know whether this problem has a solution. If it does, I think it requires us to find mechanisms whereby third-party payment is made to the patient, B, who in turn pays A, supplemented with any co-payment from B for services. Hence, from the moment B seeks services from A both know who is going to be paying A for what is delivered. A and B each has need for what the other brings to the table, and this structure carries the potential for nurturing the relationship between A and B. B is empowered to become better informed about the services recommended by various A's that he might choose among, and the A's might find it particularly important to build good reputations with B's.

Mr. Smith, the 2002 Nobel Laureate in economics, is a professor at Chapman University.

Pretence and Economic Knowledge

Paul Krugman critiques the economics profession for widely shared views that failed to anticipate and ill prepared us for an economic crisis that promises to be the worst since WWII.

Hayek made a similar charge in his Nobel Lecture of December 11, 1974, The Pretence of Knowledge: “… the economists are at this moment called upon to say how to extricate the free world from the serious threat of accelerating inflation which, it must be admitted, has been brought about by policies which the majority of economists recommended and even urged governments to pursue. We have indeed at the moment little cause for pride: as a profession we have made a mess of things.” Although Hayek saw the problem as stemming from an inappropriate "scientistic" attitude, he explicitly wanted “…to avoid giving the impression that I generally reject the mathematical method in economics.” Rather, his main message was that “If man is not to do more harm than good in his efforts to improve the social order, he will have to learn that in this, as in all other fields where essential complexity of an organized kind prevails, he cannot acquire the full knowledge which would make mastery of the events possible…The recognition of the insuperable limits to his knowledge ought indeed to teach the student of society a lesson of humility which should guard him against becoming an accomplice in men's fatal striving to control society - a striving which makes him not only a tyrant over his fellows, but which may well make him the destroyer of a civilization which no brain has designed but which has grown from the free efforts of millions of individuals.”

Economic scientists have precious little understanding of this rule governed complex order, and how to keep it on its demonstrated long term path of growth and human betterment without suffering too irreparably from the kind of unpredictable reverses that we are now mired in. Less pretence and a commitment to learn from the new data being generated as I write, will be both humbling and informative, after the inevitable human political impulse to blame one’s long standing political adversaries has run its course.

What is most impressive in the current crisis is that even those who find bubbles unsurprising, and who had warned of the housing bubble debacle, did not anticipate its ability to undermine the financial system so decisively and thereby to devastate a good performing economy. This is revealed in a fairly crisp timeline: residential home prices started their decline in 2006; mortgage market collapse in July-August, 2007 (which kick-started the Fed into taking “enhanced liquidity” measures); the fourth quarter 2008 events—the Treasury, Fed, FDIC joint announcement of crisis action, unprecedented extensions of FRB credit to holders of all varieties of underwater assets in implicit recognition that the financial system was under reserved and insolvent, not just illiquid.

Economists and policy makers have been learning as we go, and no one can be sure how long that process has yet to go.