Weekly Economics Lesson: The Problem Is Spending, not Deficits

The Wall Street Journal has a column identifying fiscal deficits as the greatest threat to European economic performance. As this passage indicates, many European nations have enormous deficits and debt, much larger than the United States:

Excessive euro-zone deficits now present one of the biggest risks to the global recovery. Several European countries – Greece, Italy and Belgium – already have debts of more than 100% of gross domestic product. Others will join them in 2010. Across the euro zone, the deficit in 2010 is likely to be more than 7% of GDP. ...The snag is that no one knows how far or how fast countries must cut their deficits to retain the support of markets. Government bonds are being artificially supported by central-bank policies. ...Greece and Ireland's bonds already yield close to 5%, around 1.7 percentage points more than Germany's. ...If yields rise too high, deficits will become unsustainable. Medium-term, most countries need strong growth to reduce debt before they are hit by the huge demands on social spending as the baby-boomer generation retires. In theory, rising yields should impose market discipline on wayward governments. But without the traditional safety valve of devaluation, the sacrifices needed to restore competitiveness via wage deflation and falling living standards may be too much to expect from elected politicians. ...The market assumes that if one member state faced a buyers' strike, the others would ride to the rescue, despite the euro zone's no-bailout policy.

The column identifies some key concerns, but are budget deficits really the problem? Would these European nations be better off, for instance, if they imposed massive tax increases? Setting aside Laffer Curve concerns, big tax hikes could close the fiscal gap. Is it reasonable, then, to think that Europe's economies would respond with more growth? That is highly unlikely. Replacing debt-financed spending with tax-financed spending merely changes the mechanism for diverting resources from the productive sector of the economy to the government. Yes, deficits and debt undermine economic performance by draining resources from private credit markets. But higher tax rates also stifle growth by decreasing incentives to work, save, and invest.

The real problem is that government is far too big in Europe. This is the crisis, and it is a problem that America is now facing as a result of the profligate Bush-Obama policies.

Weekly Economics Lesson

While doing research for an upcoming video, I found an excellent study from the National Center for Policy Analysis that explains how "third-party payer" is largely preventing markets from operating in health care. Government policies (including tax distortions) are the cause of the problem, yet the polticians want to expand third-party payments. Here's an excerpt from the paper, and I also reprint below a key chart from the paper that shows how most medical prices rise faster than the overall price level, but the opposite result occurs when consumes are in control (for things such as cosmetic surgery):

Long before a patient enters a doctor’s office, third- party bureaucracies have determined which medical services they will pay for, which ones they will not and how much they will pay. The result is a highly artificial market plagued by problems of high costs, inconsistent quality and poor access. ...Can the market for medical care be different? Interestingly, in health care markets where patients pay directly for all or most of their care, providers almost always compete on the basis of price and quality. And because they are not trapped in a system that pays for predetermined tasks at predetermined rates, providers are free to repackage and reprice their services — just like vendors in other markets. It is primarily in these direct-pay markets that entrepreneurs are creating many innovative services to solve the very prob-lems about which critics of the health care system complain. ...Cosmetic surgery is rarely covered by insurance. Because providers know their patients must pay out of pocket and are price sensitive, patients can typically (a) find a package price in advance covering all services and facilities, (b) compare prices prior to surgery, and (c) pay a price that has been falling over time in real terms — despite a huge increase in volume and considerable technical innovation (which is blamed for increas- ing costs for every other type of surgery). ...In 1960, consumers paid about 47 percent of overall health care costs out of pocket. ...In 2006, consumers paid only 12 cents out of their own pockets every time they spent a dollar on health care.

Government-Mandated "Fairness" Means Unaffordable Health Insurance

As part of so-called reform, the crowd in Washington is seeking to impose policies to bring "fairness" to the market for people who purchase their own health insurance. Yet these policies - community rating and guaranteed issue - have led to a disaster for families seeking health covereage in New York. The obvious lesson is that the government should not interfere with markets in hopes of creating fairness - though the politicians in Washington have decided that this disastrous approach should be imposed on the entire country. A column in the Wall Street Journal provides the gory details:

One of the biggest things Mr. Cuomo did was to impose government mandates called community rating (CR) and guaranteed issue (GI). The former prevents insurers from charging people more based on their health or age, and the latter forbids denying coverage to anyone who wants to buy it. These two mandates are now a central part of reforms advancing in Congress. In New York, enacting them has been a mistake. One of the biggest proponents of community rating and guaranteed issue in the early 1990s was Empire Blue Cross and Blue Shield. With more than eight million customers, Empire was the state's largest insurer. It was also the state's "insurer of last resort" because, as a nonprofit organization, it already had to comply with both mandates. It lobbied to extend CR and GI to every insurer in the name of fair competition. But New Yorkers didn't get a more competitive insurance market. ...Within a few years, Empire and others stopped selling insurance in the individual market in the state. A 2007 report by the respected Seattle-based actuarial consulting firm Milliman surveyed the damage. It noted that "by 1996 GI and CR requirements effectively eliminated the commercial individual indemnity market in New York." While the reforms were supposed to help keep insurance affordable, "premiums for the two [remaining] standard plans increased rapidly," with one researcher noting "insurers increased premium rates 35%-40% in this period." Today, New York's private individual insurance market is among the nation's most expensive and highly regulated. New York City residents buying private, unsubsidized individual insurance coverage pay at least $9,036 a year for individual coverage and $26,460 for family coverage. New York's average premiums in the individual market are more than twice the national average, according to a 2007 eHealth Insurance survey. ...Partly because of the high costs of private coverage, nearly one in four New Yorkers is enrolled in Medicaid. New York's Medicaid program is the nation's most expensive, requiring high local and state taxes to support it. Policy makers rarely mention that state mandates such as CR and GI can drive up prices and drive millions of people away from private insurance. New York has 51 mandates dictating coverage for a wide range of things including hormone replacement therapy (one of four states with this mandate) and drug abuse counseling (one of seven states). Each adds to the cost of insurance. William Congdon at the Brookings Institution and Michael New from the Heritage Foundation have separately done studies that suggest that 40 of the costliest state mandates in the country add as much as 20% to the cost of basic insurance coverage. In 1994, about 4.5% (10.45 million) of the U.S. nonelderly population was covered by individual insurance. Today, that number has grown to 5.5% (14.35 million), a 20% increase. In California, 8% of the nonelderly population has individual insurance. But New York's individual insurance market represents a paltry 0.2% of its nonelderly population. Before Mr. Cuomo's reforms it was 4.7%. ...market-based reforms could make insurance much more affordable, especially if the CR and GI mandates were repealed. Doing that would reduce the number of uninsured by 18% and 19%, respectively (37% combined), and would lower premiums by 42%. We also found that if the state allowed New Yorkers to buy health insurance sold in Connecticut and Pennsylvania, as much as 26% of the uninsured would purchase private policies costing 25% less than similar policies in New York.

The Hidden Cost of Government Intervention

Alex Pollack of the American Enterprise Institute explains how even supposedly benign interventions have negative effects. Using deposit insurance as an example, he explains how the benefits of intervention are often obvious, but the costs are usually hidden and indirect - and generally of a greater magnitude. The politicians get applause for the supposed benefit (in this case, peace-of-mind for despositors) while avoiding any blame for the hidden costs (moral hazard, financial crisis, malinvestment, etc):

On one hand, there is the fervent political desire to make deposits riskless for the public, so that depositors do not need to know anything about or care about the soundness of their bank. But their deposits fund businesses that are inherently very risky, highly leveraged and cyclically subject to much greater losses than anyone imagined possible. The combination of riskless funding with risky businesses is inherently impossible. The attempt is made to achieve the combination through regulation, but this inevitably fails. Governments are therefore periodically put in the position of desperately wanting to transfer losses from the banks to the public, as once again in this cycle. An alternative is to prefund the losses through deposit insurance. But because the losses can get bigger than the fund, it ends up needing a government guarantee, thus bringing the risk back to the public. ...Has government deposit insurance "put a premium on bad banking," as Sen. Bulkley warned it would? Certainly in some cases it did, especially when risky, rapidly expanding real estate-lending banks could fund themselves by rapidly expanding brokered deposits. More generally, did deposit insurance help inflate the real estate bubble, especially in commercial real estate? Without doubt, it did. Leveraged real estate has been the cause of many banking busts. Over the past several years real estate loans of all commercial banks have grown to represent 56% of their total loans. For the 6,500 smaller banks, with assets under $1 billion, this ratio is a whopping 74%. This expansion of real estate risk could not have happened without deposit insurance.