August 17, 2009

Health Care, Cost, and Insurance Theory--Posner

The focus of the Administration's health-care plan, and of its campaign to enlist public support for the plan, is dissatisfaction with health insurance. To see the problem--or whether there is a problem--compare health insurance to fire insurance. Almost everyone has fire insurance (even if he doesn't want it, invariably it is required by the mortgagee, if there is one). The reason is that a fire can wipe out a big part of most people's wealth, and, given declining marginal utility of income, which makes most people prefer a certainty of obtaining a million dollars to a 50 percent chance of obtaining $2 million (and a 50 percent chance of nothing), the cost of fire insurance is a good investment. The insurance company knows how much it may have to pay if there is a fire because the insurance policy has a dollar limit.

If someone is convinced that his house is fireproof and therefore fire insurance would be of no value to him, and therefore refuses to buy it, the insurance premiums charged the buyers of fire insurance will be slightly higher (because his being in the pool would have reduced the expected cost to the insurance company). But no one is concerned with this, because very few people opt out of fire insurance.

Health insurance is different superficially because of the extreme variance in costs of medical treatment; some people have medical conditions that cost literally millions of dollars to treat. But this is a problem in other forms of insurance as well, such as liability insurance in which the insurer undertakes to pay the insured's legal expenses, which can be astronomical; and insurers deal with such difficult-to-estimate risks through reinsurance and large deductibles.

Health insurers, if left to themselves, generally refuse to insure the cost of treating pre-existing conditions; but that is no different from a life insurer that refuses to issue a policy (or charges more for it) to someone whom a medical exam reveals to have a short life expectancy. Prudent people buy life insurance when they're young and in good health.

Health insurers often cancel an insurance contract, or refuse to renew it, after discovering that the insured is in bad shape and likely to cost the company a great deal in the future. Fire insurers and automobile insurers often do the same thing. If people want to have lifetime protection, they have to pay higher premiums but it is hard to see why health insurers would refuse to offer such contracts; in fact some people do have such health insurance.

There are several puzzling aspects to health insurance, one of which, however, is rather easily solved, and that is the fact that a significant fraction of the population has no private health insurance. If your house burns down and is uninsured, tough luck. But if you get sick and have no insurance and no money, you can still get treatment at the nearest hospital emergency room. (You will be billed, and if you have enough money you will have to pay the bill.) If you have no money, you're a free rider, but the amount of free riding is kept down by the cost that emergency rooms impose on patients by making them wait--and a queuing cost is a real cost to the people forced to stand in the queue.

Many of the uninsured are young and healthy; they are like the person with the fireproof house. If they were forced to insure, therefore, premiums for health insurance might fall, though this is highly uncertain. Many of the uninsured, rather than being young and healthy, are uninsured because of pre-existing medical conditions that imply that these people will incur abnormally high costs of treatment in the future.

Medicaid, charity treatment in emergency rooms of hospitals, and Medicare when utilized by indigent people constitute a form of poor relief. There is no reason why Medicare shouldn't be means-tested; people who can afford medical care should pay for it themselves.

The fact that, because of tax subsidy, most health insurance is offered as an employment benefit screws up the health-insurance system considerably. Not only does the subsidy result in giving people more medical benefits that they would want if they had to pay the full, unsubsidized price. They lose the insurance if they lose their job or if the employer cancels the group insurance policy, and when they seek new insurance they may find themselves turned down, or made to pay a very high price, because of their age or because they now have a pre-existing condition.

If people were willing to pay high premiums, and accept high deductibles and copayments, they could buy health insurance policies that would give them lifetime protection against all major medical problems they might encounter. But people are not willing to pay high premiums or (mysteriously) to accept high deductibles and substantial copayments. They prefer to take a chance on their employer-supplied health insurance and on making it to 65 (Medicare eligibility age) without going broke as a result of a medical condition for which they are not adequately insured. And if they have no employer-supplied health insurance they may decide to do without and hope for the best even if they could afford to buy an expensive individual policy.

Repealing the deductibility of employer-supplied medical benefits from federal income tax, and instituting a means test for Medicare, would reduce the demand for, and therefore total cost, of medical services and reduce the federal deficit as well, since Medicare costs the federal government more than $300 billion a year. Since Medicare would cover fewer people, there would be less need to institute procedures designed to limit expense by limiting treatments--something people fear, whether rationally or not.

It is doubtful whether any other measure consistent with American culture and values would reduce medical costs substantially, though one can imagine a series of modest reforms that might add up to a net savings, including limiting liability for medical malpractice, imposing large deductibles for medical treatment for injuries experienced in dangerous recreational activities, reducing highway speed limits, and taxing fattening foods and beverages. None of these is likely to figure in any health reform enacted by Congress at the present time, however.

The opposition to the Administration's health plans is understandable, though some of it is uninformed and even irrational. The Administration's problem is that it wants to expand insurance coverage, and this will increase the cost, including the public cost, of the health-care system, but that the only serious way in which the Administration can imagine limiting the cost increase (as there is insufficient public support for terminating the tax subsidy of employee health benefits, let alone for limiting Medicare to people who can't afford private health insurance) is by curtailing treatment. And that upsets people, since they don't trust the government to decide what medical treatments are cost-justified. (And why should they?)

In all likelihood, moreover, the Administration is underestimating the cost of expanding coverage. It wants to push as many of the currently uninsured as possible into insurance plans, and this will not only cost a lot in subsidies, as well as in higher costs to employers; it will also increase the demand for and thus the aggregate cost of medical services (because supply is inelastic). Once a person is insured, the marginal cost (which includes the queuing to which the uninsured are subjected, as well as monetary cost) to him of treatment drops to the copayment or deductible. The government also wants to forbid insurers to deny coverage on the basis of pre-existing conditions or to rescind policies after paying a large claim to an insured (and foreseeing future such claims). This will increase the cost of health insurance, and the government will doubtless end up picking up the tab, because there is great resistance on the part of the public to paying higher insurance premiums.

The cost of the projected health reforms cannot be estimated. One reason is that no one seems to know what is actually in the literally thousands of pages of health-reform bills drafted by different congressional committees. Or if they know, they are not telling. Another reason for uncertainty about cost is that no one outside government (maybe inside it as well) knows what the Administration is likely to settle for in its negotiations with the various interest groups and legislators.

But worse than not knowing the cost is not knowing how it is going to be paid. Higher taxes, unless trivially higher, seem politically infeasible, which means that health reform if enacted will add to our soaring national debt--and probably add a lot, though we cannot know how much.

Posted by Richard Posner at 9:40 AM | Comments (53) | TrackBack (0)

American Health Care Once Again-Becker

In a recent post (see my discussion on July 28) I explained why the American health delivery system is superior in some important dimensions to health care in most other advanced countries. Americans have considerably longer life expectancies when they contract serious diseases, like cancers and heart conditions, than do persons living in these other nations. That post emphasized that many criticisms of the American system do not sufficiently appreciate its positive effects on both the quantity and quality of life.

Here I address a few of its major shortcomings, and suggests ways to overcome, or at least moderate, these without eroding the strong parts of the system. I recommend to readers the many high quality discussions of health care reform by John Goodman of the think tank, The National Center for Policy Analysis, and also a good op-ed piece in the Wall Street Journal of August 12th by John Mackey, CEO of Whole Foods.

A glaring weakness of the American health system is the over 40 million Americans without health insurance. To be sure, they impose much less of a cost on the health care system than is commonly claimed, partly because the majority of the uninsured are young and healthy. Still, in a country as wealthy as the US, this is embarrassing, and should be rectified.
The least bad solution, strangely, opposed by many conservatives, is to require everyone to take out catastrophic health insurance that covers each person against major illnesses. Those individuals and families that lack the means to pay for such insurance would be supported under a version of Medicaid. Such compulsory insurance for everyone would greatly reduce the uninsured problem, in particular their free riding on others when they get seriously sick and go to hospitals for extensive care. Increasing their medical coverage in this way would add to total spending on medical care, but it might well reduce the cost of medical spending to others. Since the uninsured would be forced to take out such insurance, they would pay for any major medical care through insurance premiums rather than imposing the cost of their care on taxpayers and other groups who pay for their hospital care.
Another feature of the present system is that most Americans receive their health insurance through employment. Americans are stuck for political reasons with this system for a while, yet a few important changes may be politically feasible to significantly reduce its cost, inequities, and inflexibilities. To start, a cap should be placed on the amount of employment-based health insurance that is tax-deductible, so that employees would have to pay for so-called "Cadillac" plans out of their own incomes rather than out of taxpayers' incomes. A second reform would be to provide the tax savings from these plans in the form of tax credits rather than tax deductions, so that higher income employees would not have a tax advantage to opt for expensive plans only because taxpayers foot much of the bill.
A third and very important reform of the employment -based health insurance system would be to make the same tax savings available to persons who buy health insurance outside of their jobs. One advantage of encouraging the purchase of non-employment-based health insurance is that persons changing jobs would not risk losing their health insurance. This would also raise the attractiveness of working at small companies that find it too expensive to provide health insurance. This extension would increase the taxpayer burden from health insurance, but that burden would be offset by the elimination of the tax deductibility of Cadillac plans.
Perhaps the greatest problem facing the health care system is the high and rapidly growing cost of Medicare for the elderly as the American population ages, and as new drugs and surgical procedures are developed to treat diseases of old age. I agree with Posner that a means test for Medicare should be implemented, so that older men and women who can pay for their medical care should get a much smaller subsidy. This would reduce the incentive for these persons to opt for expensive drugs and surgeries only because they pay a small share of the cost. I do believe that older persons would still be willing to pay a lot to extend their lives, partly out of their fear of death. But that belief should be put to the test by requiring the elderly who are reasonably well off to spend more of their own money for their medical care.
In order to increase the number of older persons with enough financial means to cover much of their spending on medical care, further encouragement should be given to tax exempt health savings accounts, where unused balances can be carried over to later years. By age 65, families that have made prudent use at younger ages of the monies in these accounts would then have accumulated sizable balances that will prepare them much better financially for the medical risks of old age.
Another way to reduce medical spending by the elderly in the long run is to encourage, not continue to attack, drug and biotech companies, so that they invest more in developing new drugs that treat better the major diseases of old age. The research and development work required to expand significantly the production of new important drugs would add only a very small fraction to the huge total medical spending. Moreover, this cost would be more than offset by the savings from substituting drugs for expensive surgeries or hospital stays, for drugs have the major advantage over these other treatments that they can be used to treat large numbers at relatively small additional cost. The cost structure of drugs- high initial costs and then low costs of extensive use among the population- is especially advantageous to a health care delivery system, like the American one, that has trouble denying available medical care to persons who might benefit only very slightly.
The current Congressional bills on health car reform generally include a public insurance option; that is, a federal government health insurance plan that would compete against private plans. The Obama administration is retreating from its emphasis on the importance of including this option, and the details about the form such an option will take have not been spelled out. Nevertheless, the experiences of other government-run operations strongly indicate that whatever Congress says in these bills, such an option will cause far more harm than good. For one thing, employees of a government-run health plan are likely to be unionized, just as public school teachers and postal workers are unionized. These unions have raised the costs of operating schools and the postal system through their pay structure, and they have reduced the efficiency of these operations through opposition to innovations, merit pay, and other efficiency-raising changes.
Supporters of a government-run plan claim that it will be financially self-supporting, and will provide a standard for private plans. To see how this would work out in practice, consider the postal system, a nominally private but basically a very old government -run business. The postal system is also supposed to be self-supporting, but only recently it once again asked Congress for additional subsidies to cover deficits. It strains credibility to expect that a large government-run health care option will not run huge deficits. Just as part of the postal deficits are caused by government mandates, such as providing Saturday deliveries at no added cost, so Congress will also impose costly and inefficient mandates on the government health care option, in addition to other inefficiencies of such a government health care organization.
The micro details of the way the postal system operates are hardly reassuring about the efficiency or flexibility of a public insurance option. To illustrate, we summer in a small town on Cape Cod that has about a 1,000 year-round population that rises to about 10,000 during the heart of the summer. In responding to this large seasonal change, Fed Ex, a non-union private company, rents delivery trucks from auto rental companies to supplement their own fleet of trucks, adds temporary workers, and extends their hours of operation, so that they often make deliveries long after sunset. By contrast, the local post office maintains exactly the same hours as during the off-season. This includes closing for lunch from 12-1, closing at 4:30PM every weekday, and staying open only for a few hours on Saturdays. Since there is no regular mail delivery because the all year round population is too small, many families rent boxes at the post office. Instead of arranging to allow box-holders to access their boxes at most hours even when the postal window is closed, box access is only marginally better than access to the postal window, including no Sunday box access, and only morning Saturday access.

Posted by Gary Becker at 9:10 AM | Comments (19) | TrackBack (0)

August 16, 2009

Notice

We will be posting tomorrow (Monday).

Posted by Richard Posner at 10:41 PM | Comments (7) | TrackBack (0)

August 9, 2009

The World Recession is Ending: What Next? Becker

The latest output and unemployment figures for the United States indicate that the recession in this country is very probably finally over, given the usual definitions of the turning points of recessions. Aggregate output fell for the fourth quarter in a row during the second quarter of 2009, but the latest fall was small. All the indications are that American GDP will increase during the current quarter, although not sharply. The unemployment rate actually fell slightly in July. This may be a one-month statistical anomaly since unemployment usually lags the economy, but the rates of fall in jobs and unemployment have been declining for several months now.
The recessions in China, India, Brazil, and a few other countries have also ended, so it strongly looks like the world recession is also over. Some countries, like Spain, have still not turned the corner, but they will be helped by the end of the global recession. It was a severe recession, in many respects the most severe global recession since the 1930s, such as the cumulative fall in aggregate output. But even that only amounted to about four percent. Moreover, it was not the most severe in all the important dimensions. For example, the latest unemployment figure for the US is 9.4%, which is high, but well below the 10.8% reached at the end of 1982 after a severe couple of recessions in the early 1980s. Unemployment will probably continue to rise for a while since unemployment usually lags the turn in output. However, it now appears that unemployment will very likely peak below 10.8%, perhaps well below that previous high. In addition, productivity held up better in this recession than in many others.
While this has been a severe global recession, it is very far from resembling the Great Depression of the 1930s. That depression had a peak American unemployment of 25%, and over a 20% fall in its output compared to the few percentage point falls in output during this recession. The many comparisons made to the Great Depression by economists and others during the dark months at the end of 2008 and beginning of 2009 now look kind of silly- and I said so at the time- although admittedly there was then considerable uncertainty about how bad this recession would become.
Although the severity of the world wide financial crisis was unprecedented (aside from the 1930s depression), the real side of the economy followed traditional recession patterns. For example, as usual, durable outputs, such as of cars, tractors, and houses, fell far more sharply than services, especially than education and health.
Much ink was devoted to the many educated employees of the financial sector who lost their jobs, and they did usually have a tough time, but as in previous recessions the least educated were hit the hardest. As of the end of July, the unemployment rate among high school drop outs was 15.4% compared to 9.4% for high school graduates, and only 4.7% for persons with a bachelors degree or higher. In addition, the percentage point increases in unemployment rates during the past year were much higher for the less educated. Similarly, black unemployment clocked in at a 14.5% rate compared to 8.6% for whites, while during the past year black unemployment increased by 4.6 percentage points compared to 3.4 percentage points for whites. The fraction of those unemployed that have been unemployed for six months or longer, at 34%, is one significant employment statistic that is unusually bad during this recession. This is apparently the highest fraction of long-term unemployed Americans for 60 years.
How important were monetary and fiscal policies instituted during the past year in preventing a far more serious recession? Only time and further research will permit more confident answers to this question, but I will give my tentative opinion. Fed open market policies that bought financial assets from banks and others, and created huge amounts of excess bank reserves in the process gave banks a financial cushion that helped dampen their retreat from risk. Decisions of The Treasury under both Henry Paulson and Timothy Geithner have been a mixed bag, sometimes helping banks deal with toxic assets, while at other times adding to the uncertainty by being erratic and indecisive.
The decisions to let Lehman fail but to merge Bear Stearns and force the merger of Merrill on Bank of America will be debated for a long time. I continue to believe that the bail out of GM and Chrysler by the Bush, and especially by the Obama, administrations were serious mistakes that will eventually cost over $100 billion of taxpayers' monies. It would have been far better to let both companies file for bankruptcy in the Fall of 2008, for they would have emerged from bankruptcy court with lower labor costs and considerably slimmer than they are now. To be sure, Chrysler may have closed shop, not a bad development, and sold its Jeep and one or two other strong divisions to other companies.
Not surprisingly, the Obama administration is taking credit for ending the recession. According to the New York Times, President Obama said that his administration had "rescued our economy from catastrophe". The administration in particular is pointing to the stimulus package- the American Recovery and Reinvestment Act- for the relatively good employment report for July. Yet this stimulus package could not yet have had much direct effect on employment since only about $100 billion, or less than 1% of GDP, of the $787 billion in this package has so far entered the economy. And much of that $100 billion has been directed to service sectors that do not have excessive unemployment rates.
As I mentioned, some Fed and Treasury policies helped a lot, but the capitalist American economy continues to have strong momentum as well. Recessions always end and usually change into booms. While this has been an unusually long recession, the incentives of firms to find profitable opportunities, and the desires of consumers to spend, contributed in important ways to ending this prolonged recession.
Where will the world economy, and the American economy in particular, go from here? Most economists are predicting a flat recovery for the United States that will not take off toward robust growth until late in 2010 or even in 2011. It is notoriously difficult to predict turning points and how fast economies come out of recessions. The 1930s had a fast recovery for a couple of years during 1934-36 before it fell back into another severe depression.
One main reason for pessimism about the strength of the recovery is that banks are generally afraid of taking on additional risks since they still hold many assets of dubious value. In addition, companies are also wary of investing and adding to their employment because of the remaining considerable uncertainty about the economy, and because consumers are continuing to rebuild their wealth portfolios after the hits they took from the sharp declines in stock markets.
I am more optimistic about the world and US recovery than the consensus, although I do not expect a sharp expansion during the next few months. My reasons for greater optimism include the robust recoveries in China, Brazil, and some other countries that will boost world output, and raise demand for US exports. The large excess reserves created by the Fed- some $800 billion- will induce banks to look for more profitable investments than the meager interest they earn on these reserves. The working down of the housing and auto stocks during the past couple of years will result in demand for new residential construction and cars that will stimulate these depressed industries. Firms are still hiring in large numbers, although less than the number they are letting go. One indication of the growing strength of the US labor market is that- as my colleague Casey Mulligan pointed out to me- seasonally unadjusted employment has risen during this summer.
Still, I do have some concerns about the US recovery, beyond the overhang of many billions of dollars of rather worthless assets held by banks. Casey Mulligan has been stressing that the federal government is creating many programs, such as reducing student loan repayments and mortgage payments for persons with low incomes, which discourage the unemployed from finding jobs, and encourage the employed to become unemployed. The proposed caps of various kinds on executive pay, especially in the financial sector, the large government debt being created due to huge fiscal deficits that will put upward pressure on interest rates, the European style reorientation of anti-trust policies toward protecting competitors rather than consumers, the enormous excess reserves that have a considerable inflation potential, the federal government's likely incompetent management of two of the three American auto companies and a major insurance company, and the planned creation of a consumer czar that will interfere with the goods and services offered consumers are examples of policies that are likely to discourage business investment and risk taking.
So legitimate reasons exist for concern about the speed and strength of the recovery of the American economy. However, I worry much more about various regulations, spending, and controls being introduced by the present Congress and by President Obama than by intrinsic difficulties in the American economy.

Posted by Gary Becker at 9:47 PM | Comments (27) | TrackBack (0)

It

I see the economic situation somewhat differently from Becker. The least significant of our differences concerns nomenclature. Many economists describe any economic downturn less severe than the Great Depression of the 1930s as a mere "recession." The consequence is to lump together economic downturns of greatly varying severity. The current downturn is far more serious than any of the downturns the nation has experienced since the end of the Great Depression. It is true that unemployment was higher for a time in 1982 than it is now, but unemployment is not the only measure of economic distress. Duration is important as well, but even more important are the political consequences of the downturn. These are likely to be profound, as I believe Becker agrees.

Other economists use an arbitrary benchmark, like 10 percent unemployment or a 10 percent drop in output. Unemployment was 9.5 percent in June, 9.4 percent in July (a drop due solely to the fact that fewer people are looking for work--they have given up hope of finding a job in the near term). If it rises to 9.6 percent next month, will that convert a recession to a depression?

I also disagree with the view that a recession or depression ends when output stops falling. That would mean that the Great Depression ended (though it later restarted, as Becker mentions) in March 1933, when unemployment was 25 percent and output had fallen by a third since 1929. A recession or depression ends, in my view, when output rejoins the GDP trend line, that is, when it reaches the level it would have reached had the economy grown at its average rate of growth, rather than being depressed. At the moment, as I point out in my Atlantic blog entry of August 1, output is 7.2 percent below the trend line, which suggests that the economy will remain depressed for at least the next two years. Distance from trend line seems, by the way (to recur to the discussion in the previous paragraph), a better measure of the gravity of an economic downturn than drop in GDP. If GDP is flat, or rises only very slowly, for years, the gap between actual and trend-line output eventually becomes enormous.

The global economic crisis has exposed many weaknesses, mainly I think in government and in the economics profession, specifically that part of the profession that studies the business cycle. These weaknesses are among the most interesting aspects of the current depression. I attribute the depression mainly to unsound monetary policy by the Federal Reserve under Greenspan and (initially) Bernanke and lax regulation of financial services by the Fed, the SEC, and other government agencies, and to a general complacency concerning the self-regulating capacity of free markets. Government officials (many of them economists), business economists, economic journalists, and academic economists alike were, with rare exceptions, taken by surprise by the bursting of the housing bubble (they didn't realize it was a bubble), the ensuing banking collapse, the stock market crash, the sharp decline in output and employment, the global scope of the crisis, and the onset of deflation in the late fall of 2008 that created fears of a depression comparable to the Great Depression of the 1930s. By the beginning of this year Bernanke and other senior officials, along with many economists, businessmen, and consumers, were in a state of near panic.

A number of macroeconomists and financial economists, including leading figures in these important branches of economics, had believed until last September that there could never be another depression, that asset bubbles are a myth, that a recession can be more or less effortlessly averted by the Fed's reducing the federal funds rate, that the international banking industry was robust, and that our huge national debt was nothing to worry about, nor our very low personal savings rate. All these beliefs have turned out to be mistaken, along with influential versions of the rational expectations hypothesis, the efficient-markets theory, and real business cycle theory.

The rapid increases in housing prices during the early 2000s were a bubble phenomenon (contrary to Bernanke's statement in October 2005 that they were driven by "fundamentals"), and the bursting of the bubble brought down the banking industry because the industry was heavily invested in financing the bubble. The low personal savings rate reflected people's belief that ownership of houses and common stocks was a stable form of savings, so that when the prices of these assets plummeted the market value of people's savings fell steeply. People had to rebuild their savings, and so personal consumption expenditures fell, precipitating a steep decline in output and a sharp rise in layoffs. That in turn created a downward spiral accelerated by the distress of the banks, which reduced access to credit by both businesses and consumers. Our national debt, and the government's unwillingness or inability to prevent it from growing--the Bush Administration having established, contrary to traditional Republican principles, a pattern of coupling extravagant government expenditures with steep tax cuts--complicated the response to the economic crisis by limiting the amount of new debt that the government could prudently take on.

Because economists have yet to achieve an adequate understanding of the macroeconomy and business cycles, I do not think it is possible to fault the government for having acted aggressively--and expensively--to fight the crisis. By flooding the economy with money (in part by purchasing huge amounts of private and long-term public debt, rather than just short-term Treasury notes), and bailing out the major banks (particularly the "nonbank banks" that have become indispensable sources of credit) with government loans, the government placed a floor under the precipitous drop in lending that began last September. Lending has continued to decline, though slowly. The continued decline is due partly to the fact that banks have hoarded most of the money they've received from the government rather than lending or otherwise investing it (because default rates are high and bank capital is still impaired despite the government largesse), and partly to the fact that the demand for loans has dropped as overindebted consumers, and businesses facing reduced demand for their output, have retrenched.

Many mistakes were made in the government's response to the crisis, in part because the possible need for aggressive interventions to stave off economic disaster had not been foreseen (the problem of complacency)--notably the failure to save Lehman Brothers. But on the whole the government's response was--until reccently, as I am about to explain--appropriate, given the risk of an even worse economic collapse.

The most controversial measures taken by the government have been the bailout of General Motors and Chrysler, which began last December, and the $787 billion stimulus (Keynesian deficit spending) program enacted in February. I believe both these measures were justified, though for reasons that do not receive sufficient emphasis. Contrary to what until recently most macroeconomists believed, a capitalist economy, though superior to any other economic system, is inherently unstable because of its potential for adverse feedback effects; hence the need for watchful monetary and fiscal regulation. A severe shock, such as the economy received last September, can, without prompt and effective government intervention, trigger a steep downward economic spiral, with sharply reduced consumer spending, resulting in falling output that precipitates layoffs that result in reduced personal income and so further reduces spending and hence output, which induces further layoffs, which further reduce incomes and spending. As spending falls, sellers reduce prices, which creates expectations of further price reductions (deflation), which induces hoarding, since in a deflation the purchasing power of money rises even if the money is kept under one's mattress rather than being invested; so investment drops. Deflation also increases the burden of debt, which precipitates defaults and bankruptcies and further reduces incomes and spending.

The fear of a deflationary spiral such as I have just described was acute at the end of 2008 and the beginning of this year, and could not be dismissed as unfounded. In that setting, bailing out GM and Chrysler was a prudent measure, since without it both companies would have had to declare bankruptcy and might have liquidated rather than reorganized, because the credit crunch had temporarily eliminated the availability of "debtor in possession" financing, essential to a reorganization in bankruptcy. The auto companies would have run out of cash by the end of December. To continue operating, therefore, they would have had to borrow money. But no bank or other private entity was lending "DIP" money then; it was near the peak of the credit crunch. If the auto companies had been unable to obtain DIP financing, their creditors would have had to force liquidation, which would have resulted in an increase in the unemployment rolls, possibly by millions, within a very short time. That would have been a severe further shock to an already deeply wounded economy.

Similarly, with regard to the stimulus, when Obama took office on January 20 the measures the government had taken to date--the easy money, the bailouts, and so on--had not arrested the economic decline. For the new Administration to have announced that it had run out of ideas for arresting the decline, and we'd just have to tough it out, could have produced a catastrophic drop in business and consumer confidence, which could in turn have increased hoarding, layoffs, deflation, and so forth.

The auto bailouts staved off the collapse and possible liquidation of GM and Chrysler; and the stimulus package, by showing that the President and Congress were determined to react with maximum vigor to the economic crisis, buoyed (I am guessing) business and consumer confidence. In addition, although estimates of jobs saved by the stimulus are bogus, the initial expenditures under the program, consisting of tax credits and increased unemployment-insurance and health benefits, are probably responsible for a slight increase in personal consumption expenditures, which in turn may have had a slight indirect benefit on output and employment.

The much-criticized "cash for clunkers" part of the stimulus, though it will do nothing for the environment, has, at the least, by inducing increased purchases of motor vehicles, increased confidence that the economic downturn is bottoming.

Unfortunately, the auto bailouts of last December have morphed into a huge and possibly quixotic project of revitalizing, rather than just postponing the demise of, two highly inefficient enteprises; and the stimulus package, being poorly designed, is likely to have its maximum impact late next year and in 2011 and 2012, when it may not be needed but will contribute to the danger of a serious inflation. Economic recovery is also being undermined by the Administration's efforts, in the midst of crisis and without adequate study of its causes, to revamp the regulatory structure of the finance industry.

The economy remains imperiled. If the Administration's trillion-dollar health care program is enacted in anything like its proposed form, the costs, on top of the rapidly rising public debt that is the consequence both of the impact of the depression on tax revenues and the costs of the anti-depression programs may create an aftershock to the current depression that will do almost as much harm to the nation as the--I insist on the term--depression itself.

Posted by Richard Posner at 7:30 PM | Comments (21) | TrackBack (0)

August 2, 2009

Health Reform and Obesity--Posner

The biggest problem besetting the Administration's program of health reform is how to pay for it. The heart of the program is extending insurance coverage to tens of millions of people who at present are not insured. This will cost more than $100 billion a year just in subsidies, but the total cost will be higher because demand for medical services will rise. At present, people who are not insured are billed directly for medical services. Often they cannot pay, but then their credit takes a hit, or they are forced into bankruptcy. And emergency rooms use queuing to increase the cost of their services to the indigent. When the uninsured become insured, the marginal cost of medical services to them falls to the copayment or deductible that they are charged; the total price (pecuniary plus nonpecuniary) is now much lower, so more service is demanded, and prices to all consumers of medical services rise because supply is inelastic.

Some advocates of extending coverage argue that it will reduce aggregate medical costs. They point out that people may defer preventive care that might ward off an illness, or a worsening condition, that might cost more to treat than preventive care would have cost. The other side of this coin is that preventive care may keep alive people who would have died, thus ending their demand for medical care. But everyone dies eventually, and a very high fraction of total medical costs are incurred in the last few months of life. Moreover, because of technological progress and the high value that people place on extending their life, medical expenses are growing far more rapidly than per capita income, and, as a result, postponing death imposes disproportionately greater costs on the next generation. A partial offset, however, may be that greater and therefore more costly efforts may be undertaken to postpone death the younger the dying person is.

Preventive care can also be very costly, especially when it takes the form of expensive screening: screening costs are incurred by the healthy as well as the sick.

The most attractive form of preventive care, at least from a government budgetary standpoint (disregarding for a moment nonpecuniary benefits and costs, to which I'll return), is behavioral change: for example, safe sex as an AIDS preventive--or losing weight, or, more realistically, not gaining excessive weight in the first place, to prevent obesity.

Obesity has increased rapidly in the United States, to the point where, at present, more than half the adult population is overweight and 25 percent is obese. A recent study estimates that the average obese person incurs annual medical expenses that exceed by 42 percent the average annual medical expenses of the non-obese; the aggregate excess cost is almost $150 billion a year. Average expense is potentially misleading because of the shorter lifespan of unhealthy people. However, I believe that except in cases of extreme obesity, the effect on lifespan is less than the effect in creating medically treatable conditions such as diabetes, joint problems, complications from surgery, and cardiovascular disease.

The economist Tomas Philipson and I have written about the economics of obesity. We have pointed out that the decline in the price of fatty foods, along with the rise in the opportunity cost of physical activity (work is more sedentary than it used to be, so one has to invest extra time to get exercise, and television and video games have increased the utility that people derive from sedentary leisure pursuits), explains the dramatic long-term increase in the percentage of Americans who are seriously overweight.

It might seem that if people derive greater utility from consuming fatty foods in large quantity than the costs in illness and medical care, the increase in obesity actually is optimal from an economic standpoint. But there are three reasons to doubt this. The first is that the obese externalize part and probably most of the excess medical costs that their condition imposes, because health insurers (including Medicare) generally do not discriminate on the basis of weight. The second reason to doubt that we have the optimal amount of obesity is that high and rising aggregate health costs, because financed to a large extent by government, are contributing to the serious fiscal problems of the United States: the United States has a soaring national debt that may have very grave long-term consequences for America's prosperity. Obesity thus has potential macroeconomic significance.

Third, there is reason to doubt that the obese actually gain more utility from the behaviors that contribute to their obesity than the costs of obesity, which are not limited to medical costs but include discomfort, loss of mobility, discrimination by employers, and social ostracism by people who consider obesity repulsive or believe it signals lack of self-control, gluttony, or low IQ (or all three characteristics).

Obesity is highly correlated with education. Highly educated people are much more likely to be thin than people who are not highly educated. This is partly but not only because highly educated people have on average higher incomes than other people. They can afford more expensive foods, which are low in calories, and the cost of exercise, which can be considerable, as it may require joining a gym or having a personal trainer.

But income is not a complete explanation, because highly educated people in low-paying jobs, as many teaching (including college teaching) jobs are, tend to be thin. But is this because one needs education to realize that eating fatty foods makes one fat and that fat people have medical and other problems that thin people do not? Surely not. It is rather that educated people have better impulse control, or, in economic terms, a lower discount rate (the rate at which a future cost or benefit is equated to a present cost or benefit), than uneducated people do, on average at any rate. To get an education means incurring present costs for future benefits, and that is less attractive the higher one's discount rate. Moreover, intelligent people derive greater benefits from education in terms of present enjoyment and future income than unintelligent people do, and intelligence implies lower costs of foreseeing consequences of one's actions: it is easier for an intelligent person to realize the consequences of indulging one's tastes for fatty foods than an unintelligent person, given that obesity is not an immediate consequence of eating such foods. Low-IQ people (and many high-IQ ones as well) may also fail to realize how much more difficult it is to lose weight than to avoid gaining weight in the first place.

A further problem with people of low intelligence and (what goes with it) low income is poor parenting, as a result of which children grow up with bad eating habits, including excessive consumption of fatty goods; these habits may be difficult to break in adulthood.

If the unintelligent experience greater costs of imagining the consequences of eating fatty foods, that is an argument for providing them with greater information about those consequences, to offset their deficit in understanding. Maybe with full knowledge the unintelligent would be willing to incur the costs, in somewhat more expensive food and in fewer sedentary leisure pursuits, of avoiding becoming obese. So aggregate utility might actually be increased, as well as aggregate medical costs reduced, by an effective campaign of warning people about the consequences of eating fatty foods. I do not think that government should regulate behavior on the premise that it knows better what makes people happy than people themselves do; but controlling external costs is or should be an uncontroversial governmental function.

Such an educational campaign as I have suggested would be a cheap form of preventive care, but would it be effective? The evidence is mixed, but a 2008 review article by Lisa Harnack and Simone French in the International Journal of Behavioral Nutrition and Physical Activity finds that labeling restaurant menus with calorie information does reduce consumption of high-calorie foods. Conjoined with reduced calories in school lunches, elementary- and high-school courses in nutrition, and warnings in food advertising and labeling similar to the warnings in cigarette advertising and labeling, the prevalence of obesity might be reduced at slight cost--possibly to the benefit of almost everyone except the sellers of fatty foods.

One of the health-care-reform bills pending in the Senate would relax legal limitations on "discrimination" by private group-health insurers; that is a step in the right direction, as are growing efforts by employers to encourage their workers to control weight (the motive is to reduce the cost of health insurance to the employer). Medicare could be modified to reduce fees to thin people. In addition, a calorie-based food tax (which would, for example, fall heavily on sugar-flavored soft drinks), would reduce obesity at negative cost to the public fisc. Such a tax may seem "unfair" to people who consume such foods but are thin, but this is just to say that the tax would be at once a regulatory and a revenue tax, and in the latter aspect would be subject to criticism only if it were an inefficient tax relative to alternative methods of taxation.

Posted by Richard Posner at 8:00 PM | Comments (46) | TrackBack (0)

The Growth in Obesity-Becker
The weight of the average male and female began to grow sharply around 1980 not only in the United States but also in all other developed countries. When average weight grows, the rate of obesity-usually defined by a biomass index (BMI) of over 30- grows at a much faster rate. As Posner indicates, two of the important causes of the increase in weight and obesity are the rapid decline in the price of fast and fatty foods that began about 30 years ago, and the growth in sedentary activities, mainly driven by the expansion of television, and the development and spread of personal computers and the Internet.
Posner believes that consumer ignorance of the health consequences of their eating and sedentary activities also contributed significantly-particularly since lower educated persons have the highest incidence of obesity. I am doubtful, however, if ignorance of these effects has been important. Poor information is a last resort crutch that economists are increasingly relying on to explain consumer behavior that they fail to explain in other ways. For example, "behavioral economists" are arguing that many consumers run up large credit card debts in good part because these consumers are not aware of the level of interest payments, and that poorer borrowers took out mortgages during the housing boom years of a few years ago because they could not calculate the difficulty of meeting monthly payments. In both these cases, virtually no evidence is presented to support this thesis. In the eating case, most reasonably well-executed studies find quite small effects on eating patterns of providing nutritional and other information about foods.
Continuing with an emphasis on the relation between obesity and low education, Posner argues that heavy discounting of future consequences induced many less educated teenagers and adults to overeat relative to the adverse consequences on their future health once cheap fast foods became available. Perhaps insufficient attention to future health consequences has been important; although many other possible explanations are available for why more educated persons eat smaller quantities of fast foods and get more exercise.
Another change, however, also emerged around 30 years ago that provides a fully rational forward-looking incentive to pay less attention to the future health consequences of overeating and weight gain. I am referring to the beginning of the age of blockbuster drugs that help control blood pressure, cholesterol, and erectile dysfunction, help treat if not cure various cancers, and provide other protections against some serious health consequences of being overweight. The expectation of even further progress in the future, such as in treating the worst aspects of diabetes, would rationally reduce present concern about weight gain and the future consequences of heavy eating of rich foods and low levels of exercise.
This argument does not presuppose that persons with less education and even the more educated are keenly aware of these developments in drug therapy, or that they could articulate this as a reason for their eating patterns. All that is required is that most people have a loose awareness of the growth of drug therapy for many diseases, and that such awareness helps relax their concerns about gaining weight. To me that is a reasonable presumption that would producen rationally heavy "discounting" of the future health consequences of becoming obese.
Another argument made for public policy to discourage obesity is that obese individuals make demands on the health care system that raise the cost of this system to others. This argument is not persuasive to the extent that it relates to private health insurance. If obesity makes as large demands on medical care as claimed by the Centers for Disease Control and Prevention study cited by Posner, it would be in the self interest of insurance companies to charge significantly higher premiums to overweight persons since that would better align their revenues to the cost of treating obese persons. Moreover, it is easy to use weight as a determinant of insurance premiums since weight is easily measured in any physical exam required to get insurance. That private insurance companies do not use weight as a premium determinant means either that they do not consider the effects of obesity on their cost to be that large, or that they are afraid they will be accused of discrimination if they do use weight as a criterion. Perhaps the health bill in Congress would make it easier for insurance companies to punish overweight persons relative to thin ones.
Since taxpayers finance Medicare and Medicaid, these organizations do not have the same incentives as private insurance companies to penalize overweight persons for their excess weight. The cost imposed by overweight persons on public expenditures has been one of the justifications for taxes on fast foods and soft drinks since these are important inputs into weight gain. However, such a tax would be inefficient, perhaps highly inefficient, because it targets all persons who eat fast foods and drink sodas, yet most of these persons do not become obese. It is akin to taxing the sale of wines and liquor to reduce drunk driving, even though most drinkers do not drive drunk and cause accidents. This distinction between taxing inputs into drunk driving and taxing drunk driving explains the tendency to heavily punish people who are drunk, especially when they cause accidents.
The corresponding approach with regard to weight would be for Medicare to institute surcharges for very overweight persons (or discounts for thinner persons) and for Medicaid to impose various costs on obese persons who use their services, such as requiring them to spend time at educational classes on the control of weight, or to pay a fee for any Medicaid services they receive. Such charges and fees probably would run into strong political opposition, but they point the way to more appropriate ways to discourage obesity that causes medical problems that utilize public funds.

Posted by Gary Becker at 7:32 PM | Comments (28) | TrackBack (0)

July 26, 2009

Mortality from Disease and the American Health Care System-Becker

Many Democratic Congressmen, member of the Obama administration, and others writing about American health care envy the 'European" health deliver system since they attribute Europe's lower mortality rates, despite much lower per capita spending on health care than by the US, partly to the European model of health care delivery. This model involves government domination of spending on medical care that involves extensive government regulation and rationing of access to medical care. Envy of the European model explains why the Democratic proposed "reforms" of the American system involve large increases in government involvement in health care, including a government-run health insurance plan.
In evaluating whether envy of the European approach is justified, it is crucial to determine whether the higher mortality rates in the US than in many European countries is due to defects in the American health delivery system, or to other factors. Mortality rates are affected not only by health care, for they are also very much dependent on personal behavior, such as smoking, eating habits, exercise, stress, how carefully individuals follow the medical advise they receive, and many other kinds of behavior under the control of individuals rather than the medical profession. The US has relatively high incidences of obesity, partly because Americans consume lots of high fat and high cholesterol foods, and Americans were heavy smokers in the past, just to mention a few unhealthy forms of behavior. Perhaps then the higher US mortality rates are due much more to differences in personal habits and personal care than to defects in the US health delivery system?
One way to separate health care from personal behavior is to consider survival from serious diseases, such as various cancers and cardiovascular diseases. In my post on health care on June 7 of this year I referred to a study published in Lancet in 2007 that compares five-year cancer survival rates for the US, the United Kingdom, and the European Union as a whole. The study examines early diagnosis, early treatment, and access to the best drugs, and finds that the United States does very well on all three criteria. As a result, five-year cancer survival rates are much better in the US: they are about 65% for both men and women, whereas they are much lower in these other countries, especially for men.
Early diagnosis helps survival, but it may also distort comparisons of five or even ten-year survival rates since some cancers would be discovered at very early stages. An alternative that avoids this distortion is to compare age-adjusted mortality rates for different diseases. Early detection and other medical care that improved life prospects would show up as lower mortality rates. A recent excellent unpublished study by Samuel Preston and Jessica Ho of the University of Pennsylvania compare mortality rates for breast and prostate cancer. These are two of the most common and deadly forms of cancer-in the United States prostate cancer is the second leading cause of male cancer deaths, and breast cancer is the leading cause of female cancer deaths. These forms of cancer also appear to be less sensitive to known attributes of diet and other kinds of non-medical behavior than are lung cancer and many other cancers.
These authors show that the fraction of men receiving a PSA test, which is a test developed about 25 years ago to detect the presence of prostate cancer, is far higher in the US than in Sweden, France, and other countries that are usually said to have better health delivery systems. Similarly, the fraction of women receiving a mammogram, a test developed about 30 years ago to detect breast cancer, is also much higher in the US. The US also more aggressively treats both these (and other) cancers with surgery, radiation, and chemotherapy than do other countries.
Preston and Hu show that this more aggressive detection and treatment were apparently effective in producing a better bottom line since death rates from breast and prostate cancer declined during the past 20 by much more in the US than in 15 comparison countries of Europe and Japan. US death rate rates from prostate cancer went from about 7% above those of the comparison countries in 1990 to over 20 % below the average of these other countries in recent years, or almost a 30% greater fall in US rates. American death rates from breast cancer declined from about 10% above the average of these other countries in 1990 to slightly lower.
These results suggest that the US health care system does deliver better control over serious diseases than systems in other advanced countries. Of course, American health care delivery is much more expensive, so a natural question would be whether the greater apparent benefits are sufficient to justify the greater cost?
To get a very rough answer to this question, suppose generously that the American health care system adds 1 life year on average to persons above age 50 compared to what they would have with the average health care system in the 15 comparison countries used by Preston and Hu. Suppose also that people over age 50 value each additional life year by $120,00- since this is a ballpark figure often used for the average American, the dollar value may be lower (or higher!) for older persons. Given that about 4 million Americans reach age 50 each year, the aggregate value placed on these additional life years with these assumptions would be close to $500 billion. This is a little over 4% of American GDP, so this assumed improvement in mortality rates, even aside from improvements in the quality of life, could justify much of the additional spending by the US on health care compared to other wealthy countries.
Of course, the assumption that the American health system produces one additional life year for each person over age 50 may be much too generous, and perhaps older people place a much smaller value on an additional year than $120,000. Still, these calculations suggest that America should hesitate without additional evidence of the type I have used before jumping on the European bandwagon, and conducting radical surgery on the American health care delivery system.

Posted by Gary Becker at 9:13 PM | Comments (44) | TrackBack (0)

American Health Care--Posner's Comment

Last December, the McKinsey consulting firm published a report which states that despite the much higher per capita spending on health care in the U.S. compared with peer countries, the longevity of Americans (even if only that of white Americans is considered) is lower than the average of the comparison countries. This is true, according to McKinsey, even though the prevalence of disease is less in the United States than in those countries (with the principal exception of diabetes, a consequence of Americans' obesity). Because Americans smoke less than the people in those countries, smoking-related diseases are actually lower in the United States.

The report attributes to the higher cost of health care in the United States to higher physician incomes, physicans' control over the number of medical procedures and their ownership of testing and other facilities, which drives up utilization, much higher prices for procedures, higher drug prices, and other factors. To which should be added the exemption of employer-provided health benefits from employees' income tax and the very high overhead costs of health insurers.

Against this, the Preston-Ho article that Becker summarizes points out that the more extensive screening and aggressive treatment of selected cancers, notably breast cancer and prostate cancer, in the United States result in lower mortality from those cancers than in the peer countries.

That is an important point, but it does not establish the superiority of our health-care system. To establish (or refute) that superiority would require conducting a cost-benefit analysis. I have my doubts that such an analysis would vindicate the U.S. system. We spend some $2.5 trillion a year on health care. Our peer countries spend about 60 percent as much per capita on health care and this implies that if we spent at the same level as they, our annual health-care expenditures would be $1.5 trillion. The question, therefore, is what benefits are we obtaining for the additional $1 trillion that we are spending? Suppose the additional screening for and treatment of cancer that we do compared to what the peer countries do is $100 million a year (I have not been able to find an estimate of that cost); that would leave $900 million in "excess" health-care expenditures to explain.

A related point is that the causes of the lesser emphasis in the peer countries on cancer screening and treatment have not been explained. Is it simply a lack of money? Or is it a medical judgment? There is some skepticism in medical circles concerning the overall efficacy both of mammography and of screening for and treatments of prostate cancer. Treatments for prostate cancer are expensive in dollar terms but more so in side effects, which often are permanent. Different people, and perhaps different populations, make different tradeoffs among the various factors that affect a decision on screening and treatment.

I also question the Preston-Ho suggestion that the shorter average life span in the United States compared to that in the peer countries should be treated as a completely exogenous factor. Treating it as such results from an artificial distinction between medical care and public health. Obesity is not a disease, but it is a serious public health problem. A rational allocation of health-care resources might require a shift in resources from end-of-life medical treatments to preventing obesity. Such a shift might increase longevity much more cheaply and effectively than more screening for cancer. So might greater efforts to reduce the murder rate, improve prenatal and infant medical care, reduce speed limits, reduce unsafe sex, increase liquor and cigarette taxes, improve education, reduce poverty, and prohibit motorcycles.

It might be argued that the additional costs of health care that are created by obesity have an offsetting benefit: they reduce the cost of being obese and so increase the net benefits of heavy eating. But the higher health costs of the obese are externalized, in part anyway, to the taxpayer (also to the other members of their insurancce risk pool, if health insurance companies aren't allowed to discriminate). I doubt, moreover, that the obese gain more in enjoyment of food than they lose in the health and other costs of being obese. Much obesity is a result of ignorance (both of calories and of the health effects of obesity), bad habits picked up from parents and peers, negligent parenting, and poor impulse control (i.e., very high discount rates).

And speaking of obesity, its prevalence in the United States undermines studies that find that people attach great value to small improvements in quality and quantity of life. The fact that so many Americans eat badly, don't exercise, drink (or "text") when they drive, and otherwise endanger their life and health, implies, since one can eat well, drive sober, and exercise, etc., at relatively low cost, that people don't value small improvements in quality and quantity of life very much--unless the improvements are paid for by someone else!

Even if we are receiving $1 trillion in benefits from the "extra" $1 trillion that we paying for medical care, it doesn't follow that the $1 trillion in extra costs isn't too much. The reason is that we face, in my opinion, a fiscal crisis; something will have to give and maybe it should be some medical care. The national debt this year will almost equal the Gross Domestic Product (true, the "public" debt--debt owed to entities outside the federal government--is lower than the overall national debt, but the debt owed the social security trust fund, for example, is a real measure of likely future fiscal obligations), and it will continue to soar at least until the economy, and with it federal tax revenues, recover. But it probably it will soar beyond that because the Bush Administration established a precedent of $500 billion annual federal budget deficits that the Obama Administration will follow and probably raise. The health-care reform wending its way through Congress will expand benefits without, it now appears, controlling costs. It is a misfortune that Congress didn't begin with trying to control costs, and then consider whether the nation can afford to expand benefits.

Posted by Richard Posner at 8:15 PM | Comments (52) | TrackBack (0)

July 19, 2009

The Drop in University Endowments and What to Do about It--Posner

College and university endowments have taken a big hit from the drop in the stock market and other asset markets. A drop of 20 to 30 percent is common, and there is suspicion that endowments that contain a significant proportion of assets that are not traded on organized markets, such as real estate, have dropped even more, but without "marking to market" their nonfinancial assets.

The effect of a drop in the market value of endowment on a college's or university's finances depends on a variety of factors. I will give a hypothetical example that may help in understanding the issue. Suppose X College has an endowment that before the crash had a market value of $1 billion. In normal times X cashes 5 percent of the endowment each year to contribute to X's budget, 5 percent being a widely used estimate of the average real return of a typical university investment portfolio. Suppose X's total annual budget is $200 million, with a quarter contributed by the income on the endowment (5 percent of $1 billion = $50 million), a quarter by alumni gifts (apart from gifts intended to become part of the endowment), and a half by tuition. In the economic downturn, I'm assuming, the endowment has fallen by 30 percent, to $700 million; tuition net of financial aid has dropped by 5 percent (because of inability of parents to pay tuition, as a result of declines in their income and wealth); and alumni gifts have (for the same reason) fallen by 10 percent. Then College X's income will have declined by 12.5 percent, from $200 million to $175 million, assuming the college continues to treat 5 percent of the (shrunken) endowment as income.

What should X do (other than expelling its suddenly impecunious students and replacing them with affluent ones of less academic promise)? The typical response has been to cut spending by the amount of the drop in income: in my example, that would require X to reduce its spending by 12.5 percent, which it can do in various ways, the usual ones being laying off staff, freezing hiring of faculty and staff, delaying construction, deferring maintenance, reducing staff salaries, and curtailing extracurricular activities.

At first glance, this seems a puzzling response. Why all this dislocation, instead of either spending capital (that is, taking more than 5 percent out of the endowment) or borrowing? Take borrowing first. Unless a dollar is worth less to College X this year than it will be next year (or whenever its income returns to its normal level), why should it spend less when it can spend the same, with modest effect on future spending, by borrowing (in my example, $25 million)? Lending and borrowing are methods by which the marginal utility of income can be equalized across time when total income varies from year to year. Harvard is borrowing more than $2.5 billion, but it is still cutting its budget by 10 percent.

Similarly, although "spending capital" is a familiar example of improvidence, it can make perfectly good sense. In my example, College X is short only $25 million, and if it takes that out of the endowment, the endowment will fall only from $700 million to $675 million. A problem may be that donors of endowment money may have placed limitations on spending, fearing that a gift that they intended to be perpetual would be eaten up if X dipped into the principal of the gift. But not all endowment money is restricted in this way and trustees of trust funds usually have authority to dip into principal in the event of an emergency. However, X may fear that if it does that it will discourage future contributions to the endowment.

Given that last concern, borrowing seems the superior alternative to spending capital, and yet most colleges and universities seem reluctant to use borrowing to fill the entire gap between income and expenditure; otherwise they wouldn't be cutting spending. Granted, credit remains tight, but the elite universities, at least, are fiscally sound and have alumni in positions of influence in the credit industry.

Maybe the reason the colleges and universities are not borrowing more is that they do not expect their income to recover in the foreseeable future. Nonelite colleges depend heavily on state aid, which is likely to be meager for a number of years--state budgets are in terrible shape. And they draw students from the segment of the population that has been hardest hit by the economic downturn. Elite colleges and universities depend heavily on federal research grants, which may diminish as the government tries desperately to control the rapidly mounting national debt, and on donations by wealthy alumni. Many of those alumni have suffered a permanent reduction in their wealth, and many others are facing the increasingly likely prospect of having to pay higher income taxes, which will make it more difficult for them to pay their kids' tuition. Elite universities may have to limit tuition if they want to attract the best students.

A protracted economic crisis has different effects on different industries, because different industries have different vulnerabilities. The current crisis is speeding newspapers, and print media more broadly, to an early grave, and may yet destroy all three Detroit automobile manufacturers. It will not do in the colleges and universities, but it may have a lingering adverse effect on them that may explain and justify immediate measures to reduce expenditures.

Posted by Richard Posner at 3:04 PM | Comments (26) | TrackBack (0)