US healthcare prices (costs) have escalated far faster than inflation because the third-party payment system devised to evade WWII price controls got locked in. (Guest post)

[This is John's response to the email forum question I reproduced here. He has a nice historical summary of how we got to where we are. In other communications, John says his main point is that we need to understand why healthcare "prices" keep outpacing inflation and maybe, eventually, go after the root cause of the problem—lack of market discipline.]

To clarify the discussion, it should be emphasized at the outset that the current national debate is not about the health care system – or not much.   The health care system is fair to pretty good, maybe a C+ or B-.    The debate is about the health care financing system, which is seriously broken and is dragging us into national insolvency.    Roger's framing of the issue is correct, "how healthcare is paid for in America and perhaps also how it is delivered," but this must be emphasized since most of the national debate is off the mark.

Put me down as a number 10, "none of the above."   Of course, many of the others are correct, in my opinion, but I think that the most important problem is not clearly spelled out by the other responses.

The most important problem is that there has been very little operation of market forces in the health care sector for the better part of fifty years.   The fact that most health care charges are paid by third parties has eliminated any incentive for the consumer of health costs to seek out and bargain for more economical alternatives and any incentive for the providers of health care to compete on the basis of price.

It is desirable to understand the history of the current health care financing system, to see how we got here, and to think some "what ifs" about other roads we could have chosen.

At the beginning of World War II, in an effort to prevent the inflation which would be expected to follow a scarcity of consumer goods coupled with full wartime employment, the government imposed a series of price and wage controls.   In general, both wages and prices were frozen at a benchmark level.  Early in the war, organized labor clamored for increases in wages, pointing out that the large manufacturers were making unprecedented profits, and that notwithstanding price controls, the CPI was increasing, about 15% from January, 1941 to May, 1942.    The controlling agency, the National War Labor Board, was reluctant to grant concessions, but was faced with credible threats of strikes in critical industries.   In 1942 it ruled that increases in "fringe benefits" not paid in cash, up to a limit of 15% of base wages, would not be considered inflationary.   Thereupon, in the words of the Bureau of Labor Statistics, "As a result of wage restrictions, employers who needed to attract labor resorted to providing a growing range of fringe benefits, such as pensions, medical insurance, and paid holidays and vacations. These benefits were considered non-inflationary, as they were not paid in cash and, thus, did not violate the wage ceiling. Additionally, payments for overtime afforded extra income to workers, without violating the limits on hourly wage payments. During the late 1940s, fringe benefits became more common as part of settlements reached in collective bargaining." (http://www.bls.gov/opub/cwc/cm20030124ar04p1.htm)  Concurrently, tax policy was codified by the Revenue Act of 1942, which imposed taxes of up to 90% on "excess profits," basically any profits higher than pre-war levels.  The Act provided that employer contributions to group health and pension plans were a tax-deductible expense and so were not included in the definition of profits.

Large employers, with the aid and urging of the then-fledgling commercial health insurance industry, began aggressively to offer company-funded health insurance plans.  In part, this move was motivated by the desire to show the company's benevolence independent of the union, to ward off unionization where it did not exist, and to limit the union power where it did exist. Hence, both during and after the war, health insurance became a major bargaining issue between unions and employers. This was a principal reason why a national health care payment system, as attempted in the Wagner-Murray-Dingell bill of 1942, and in President Truman's programs of 1946, never got out of the starting blocks.   The fight became one over who would control the commercial health insurance, and what share, if any, of premiums would be paid by employees. 

In 1948 the National Labor Relations Board ruled that fringe benefits were a subject of collective bargaining, and in 1949 the Wage Stabilization Board ruled that fringe benefit increases were not inflationary.  Fringe benefits, including most prominently health insurance, became the principal subject of collective bargaining.  The number of workers covered by negotiated health insurance plans increased from 1 million in 1946 to 12 million in 1949 (plus 20 million dependents). 

A trend during this period was the growth of "experience rating" by the commercial insurers.  Experience rating means that the "premium" for health insurance, which is paid by the employer, is calculated in arrears, and is simply the total amount paid by the insurer for last year's health insurance costs for that employer, plus a factor for overhead and profit.  At Tosco, our health care insurance was experience-rated.   This had the effect of giving employers to bargain with the insurer for policy exclusions for "pre-existing conditions" and chronic problems.  Blue Cross was, in those days, a non-profit which did not, as a matter of principle, contain these exclusions, and as a result it began to lose business to the commercial insurers.   (Note that market forces will work, no matter how they are hedged about with regulation, but often not in the desirable way.)

A short excursion: what is called "health care insurance" is not really much like insurance in the normal sense.   Casualty insurance, such as fire insurance, is based on the idea that either you or I may suffer a loss which is beyond our individual economic ability to bear; if we agree that each of us and many others will pay into a fund which would reimburse this loss, we have insurance.  The key is that the insured losses must be unexpected and relatively rare, so that the amount we have to pay into the fund is relatively small.   "Health insurance" commonly reimburses a number of costs which are ordinary and routine, and is not limited to "catastrophic" occurrences.   Therefore, it is a blend of a payment agency and a little true insurance, but mostly the former.  From the viewpoint of the employer in an "experience-rated" plan, there is no "insurance" component at all, but only a payment agent.

Returning to the history, the rapid growth of health insurance in unionized industries led public employees to demand the same, and health insurance soon became common among government employees.   With these pressures, employer-provided health insurance gradually became an accepted norm in most employments, but was not anywhere near universal as late as the 1960s. (When I was a young lawyer, I worked for a progressive "Wall Street" law firm in New York, large by the standards of the day with 95 lawyers.  Health insurance was not provided when I started in 1961, but became available a few years later.)

By the mid-1960s, "health insurance" had become the norm, and it was tied to employment.  The elderly retired were not covered by employer plans, by and large, and this ultimately led to the enactment of Medicare during the "Great Society" days of Lyndon Johnson, over the bitter opposition of the AMA and the NAM.

The foregoing account is, of course, oversimplified, but captures the main events.  As a result of these occurrences, the dominant mode of paying for health care became the third party payment system, the payer being either the government or a health insurer (including HMOs, which had their start in the Kaiser Permanente system created in World War II by Henry J. Kaiser to provide health care for the hugely increased number of war workers in California.)

This system eliminated the usual market incentives and forces from health care.   Consumers no longer had any reason to shop for bargains.  (A "consumer" includes a doctor or hospital contemplating the purchase of the latest medical device or gadget, because the cost, no matter how inflated, can be quickly amortized by billing its use to third party payers.)  As a result, the price of health care began to diverge from general inflation and has continued to do so ever since.

Another short digression: it is useless and misleading to talk about increases in the "cost" of health care, or about controlling the "cost" of health care.   What we are talking about is the price of health care.  Since we are all consumers of health care and few of us are providers, it is natural that we think of the payments as a "cost," but economic understanding will be greatly enhanced if we remember that it is really "price" we are considering.  No one has the faintest idea what the "cost" of health care is.

I have not been able to find clear records of the beginning of this divergence, the increase of health care prices relative to general inflation.  I would expect that the trend commenced at least as early as mid-century.   However, the effect is clear in available records from the Bureau of Labor Statistics, for the period January, 1988 to January, 2009, reproduced at http://www.buckconsultants.com/buckconsultants/Portals/0/documents/publications/newsletters/key_indicators/cpi.html

In January, 1988, the CPI-All Urban Consumers (the index most commonly used to measure inflation) stood at 115.7.  The medical care component of this index stood at 134.4.  In January, 2009, the CPI-U was 211.143, while the medical component was 369.83.  Over this period, general inflation measured by the CPI-U was 82%, while the medical care component increased 275%.   (The actual divergence was larger because the medical care component was part of the CPI-U.)

In my opinion, it is the third-party payment system itself which is the principal cause of the serious health care payment problem.  

Let us do a gedanke experiment, a simple little "what if" thought exercise.  Suppose that the War Labor Board and the Revenue Act of 1942 had determined that employer-provided groceries were not inflationary and were deductible expenses to the employer, the theory being that well- nourished war workers were essential to victory.   Instead of "Blue Cross," a national "Blue Plate" would have come into existence, paying grocery chains and farmers alike for food consumed by members of the plan.   Whatever groceries one ordered would be paid for by Blue Plate, which would pass on the costs to employers; the elderly would be covered by the government Nutricare program.   This makes one grin, but it can be argued that while most of us can continue for quite a while without medical assistance, none of us can long survive lack of food.    If this had happened, what do you think a pound of potatoes would cost?

So, I have indicted the third-party payment system itself as the root structural cause of the problem.   What can be done about it?   Well, various things have been tried.   When it became evident that health care prices (usually misidentified as "costs") were outpacing inflation, blame was laid on the health care insurance companies.  They were, it was claimed, paying for inflated charges, fraudulent billings, unnecessary procedures, and so on.   Pressure was put on them to hold down the amounts they paid by fly-specking and nit-picking every bill.  With what result?

Those of us who are older can remember a visit to the doctor's office "back in the day."  The office consisted of the doctor, and one woman who was nurse, receptionist, and bookkeeper.  Today, the doctors' office consists of three or more doctors (who can no longer bear the overhead as sole practitioners) and an army of clerks who are on the telephone haggling with insurers about the details of bills.  At the other end of the line is an even larger army of clerks, trained in the Nancy Reagan phrase "just say no."   Has this stemmed the increase of health care prices?  It would seem that it has had the opposite effect, since an estimated 25% of the American health care dollar goes to administration, far in excess of any other nation.  (Caution, this figure is controversial, and some estimates are as small as 8%.  I find the 25% figure persuasive, and you can research it yourself.)

Turning to the second part of the question, "The best legislative solution would be . . . . ," the answer should now be obvious.   Unfortunately, it is also totally unthinkable and impossible. The best legislative solution would be for Congress to pass a law, to the farthest limit of its power under the Commerce Clause, which would have two sections.  Section One would provide: "On and after January 1, 2015, it shall be a felony for any person, firm or corporation to pay for the medical care of a natural person who is not a dependent member of the household of the party making the payment."  Section Two would provide: "Notwithstanding anything to the contrary in Section One, it shall be lawful for a person, firm of corporation to pay for the medical care of any person, if that medical care is for a catastrophic condition, as hereinafter defined," followed by the usual 2,700 pages of excruciating detail what is "catastrophic" on a means-tested basis.

Bang goes the current system, and health care insurance is confined to true insurance, protection against unexpected but unmanageable occurrences.

For routine health care, consumers would resume bargaining with and shopping for providers. The effect can be seen by studying health care procedures which are not routinely covered by insurance, such as Lasik surgery or dental implants.   There is a lively industry in such areas, advertising and competing on the basis of price. 

This solution is clearly a political non-starter, and won't happen.  Even the most rabid and revanchist let's undo-the-New-Deal right cannot even conceive of life without something much like our current third-party payment system.

Another alternative is a single-payer system, Medicare for all.  Medicare's administrative costs are, by generally accepted estimates, significantly lower than those of private sector health care insurers, and its processing times and "customer service" are faster.   However, while this might be an incremental improvement, it would not be responsive to the basic structural problem.

Is anything left?  Can this problem be dealt with by a legislature?   The answer would seem to be that a lot of tinkering with details can be done, and the current Congressional efforts and administration program would seem to fall into this category.   Electronic record-keeping, for example, could cut overhead and reduce malpractice.   End-of-life counseling might not kill your granny but it could increase the popularity of voluntary do-not-resuscitate orders.  And so on.

All of these things could make a marginal difference.  A limit on deductibility of employer-provided "Cadillac plans" would return to the original anti-inflationary component of the 1942 War Labor Board ruling.   A universal mandate to carry insurance would make the system more like real insurance, because the well, not just the sick, would pay into the fund.

A popular GOP fix is to provide for increased competition among health care insurers by, for example, removing them from the jurisdiction of state insurance regulators, so that any insurer can market its product nationally.  Proponents point out that "intermediaries" between consumer and producer, like Wal-mart, have been powerful forces for moderating price increases.   It seems to me that this analogy is flawed.   Wal-mart wishes to sell as much stuff as it can to everyone who has cash or credit.  A health insurer wishes to sell only to the young and healthy, and to avoid the payment of claims (delivery of the goods) to the maximum lawful extent.  Therefore, such increased competition might well lead to a "race to the bottom."

In conclusion, this problem seems to be extraordinarily difficult of legislative solution.  Given the political impossibility of a comprehensive answer, it would appear that marginal tinkering is the best that can be hoped for.