Can’t repeal economics — health insurance

1 Mar

How does health insurance work? Individuals (or an organization on behalf of the individual) pay a premium to a company. If the individual falls sick the insurance company pays for health care. Sounds simple, but what is the insurance company’s business model here?

Healthy people pay premiums. That is the insurance companies revenue stream. When they fall sick the insurance company pays for healthcare — that is (along with administrative expenses) the insurance companies costs. Profits = Revenues – costs. The insurance company has an incentive to keep costs low and revenues high.

Notice that for the insurance business model to work healthy people are necessary as a revenue source. But what sort of person would prefer not to buy insurance? Well healthy people of course because they don’t think they need it. By the same token sick people would want insurance. This dynamic is not good for the insurance companies bottom line. That is why insurance companies would like to charge more for older people or sicker people (for example those with preexisting conditions) though ideally it would be best to not have these high risk categories on their rolls at all.

Older Americans are covered under government run Medicare since they add to insurance companies costs. Before ACA insurance companies could refuse coverage to people with preexisting conditions. Now they cant. Healthy people therefore cross subsidize people with preexisting conditions and as a result high risk people have a lower premium than they would otherwise have while healthy people have a higher premium. This is a risk pool and left alone it is not stable. Healthy people are paying more than they want to so they quit buying insurance. This reduces revenues and profits for insurance companies. So they raise premiums. This makes more healthy people leave. And the insurance company goes out of business. Healthy people are needed to cover expenses for sick people and a little bit more. But for everyone — both sick and healthy — to be covered healthy people have to be “incentivized” to buy insurance. In any case, any policy to add more people to insurance rolls implies that sicker people are more likely to apply while healthy people will not. This unraveling of the risk pool destroys the insurance business model. The only way to get around that is to “incentivize” healthy people to join the insured ranks.

The ACA does that by penalizing people who do not have health insurance. The various replacement plans floating around seem to want to give tax credits for those who join. They are essentially the same thing. Consider someone who has to pay a $1 penalty if she does not buy insurance. That $1 of her money she does not have — a penalty she can avoid by buying health care. Now consider the $1 tax credit. If she does not buy the insurance she loses $1 of her own money as taxes — a penalty she can avoid by buying insurance!

Can’t repeal economics. Sigh!


“Border Adjustments” Tariffs Whatever

19 Feb

I do not understand why Mr. Trump and his GOP want to raise taxes on the American people.

Mr. Trump wants to hike import tariffs. His congressional Republican lackeys call it a “border adjustment.” Either way this tax will make goods and services more expensive for American consumers while their touted “benefits” are murky.

For example, a fall in the trade deficit is touted as one such “benefit”. However, this fall will ALWAYS be balanced by a fall in foreign capital investment in the US. Thats just how national income accounting works. Well that’s also fewer American jobs.

Another effect might be a devaluation of the US dollar because of a fall in demand for US assets. That makes our exports more competitive while making imports more expensive. Since many of the goods we make in the US have foreign inputs the net effect of all of this on American jobs and wages is murky.  Moreover, a fall in demand for US assets like T bills puts upward pressure on interest rates. Higher interest rates translate into less US capital investment and fewer American jobs. These higher interest rates could be neutralized by asset purchases by the Fed. But that could end up being inflationary.

Supporters of the “Border adjustment” claim that any inequity in the border adjustment will be negated by a rise in the value of the dollar. Well thats not so certain given the possibility I raise above. In fact anyone who claims they know exactly what will happen to exchange rates is at best wildly optimistic!

Advocates also keep talking about the border adjustment as “trade neutral”. Thats a lie. The whole argument for the border adjustment is that it helps import substitute and export industries while penalizing American businesses which use imported inputs. In fact even advocates say that prices of all goods will rise (see Which of course it would! In other words it is a tax on the American people.

Of course, US tariff increases will be matched by other countries. This trade war will impoverish everyone.

Not so long ago Republicans understood that government intervention in business decisions was a bad idea because the economy is complicated. As a result, policies have complex and often unintended effects. This was one argument for small government that did not promote grandiose policies with ever cascading unintended consequences. Republicans need to remember that idea. Executive orders or even legislation cannot repeal economics.

How about a flat destination based corporate income tax without any border adjustment? That would encourage American businesses to relocate to the US. It would increase demand for American goods and American workers. And all without the inevitable price hikes from so called “border adjustments.”

Political Economy of Trump’s “jobs” policy — A scenario.

17 Nov

President elect Trump says he wishes to “Prioritize the jobs, wages and security of the American people” ( But what would his restrictive immigration policy do for jobs? The question is complex but the most obvious analysis suggests that it would not help unskilled workers or workers with outdated skills.

Let’s start in the labor market. Immigration restrictions will reduce the supply of labor. That should raise wages for American workers. However, that wage rise will also impact how American businesses hire workers. A higher wage might make labor relatively more expensive than capital. Businesses would then substitute capital for labor where they can. Such substitutions may be harder in agriculture (machines have a harder time picking fruit without bruising them) than in say automobile manufacturing (already quite capital intensive). Nevertheless that kind of substitution would be incentivized by the rise in the price of labor relative to capital. Of course, these higher wage jobs would also require specific skills since employers will pay higher wages only to more productive workers. Thus workers with low or outdated skills may continue to be unemployed.

A President Trump has also promised higher infrastructure spending. So that will also spur the growth of construction and construction jobs. But here too higher wages (increase in the demand for labor) will also require higher productivity. In short these jobs will require specific skills since these jobs will be part of a capital intensive production process. Once again, folks with low or outdated skills may not see the benefit they hoped for.

In fact President elect Trump’s  desire to reduce the trade deficit could further complicate matters. Reducing the trade deficit through high tariff barriers would of course have long term negative effects on innovation and growth. But even in the short term a reduction in the trade deficit would imply a reduction in foreign investment into the US and foreign lending in the US’s capital account. Keep in mind the US’s national accounts have to balance so a reduction in the trade deficit will also result in a reduction in the capital account surplus. This process will be correlated with a stronger dollar and higher US interest rates. This also suggests less investment in the future, lower exports, and generally a higher cost of capital.

To conclude, as both wages and the cost of capital rise in a US protected from both foreign workers and foreign capital, US economic growth and power will diminish in the medium to long term. Of course, the reader will note that there are many moving parts to this scenario. It assumes for example that other countries will not react to US policy changes or that there will be no internal changes in the skill distribution in the US. Nevertheless, the analysis above is pretty straightforward and seems loaded against unskilled workers or workers with outdated skills.


Why Nations Fail

9 Feb

I recently wrote a review of Acemoglu and Robinson’s newest book “Why Nations Fail.” The review is available behind a pay wall for the journal Public Choice (here). But here’s the gist:

Why Nation’s Fail is an ambitious and worthwhile attempt to understand the origins of power, prosperity, and poverty. It provides a succinct narrative for how institutions may diverge. The many examples that show this divergence are entertaining and informative. However, Acemoglu and Robinson’s unwillingness to incorporate the well-established toolkit of public choice economics hobbles their analytical narrative. Ultimately, they fail to make their case – and make no mistake it is an important case to make – because they ignore the individual and they ignore history.

The impact of Republican intransigence on passing the budget and raising the debt ceiling

4 Oct

It should come as no surprise that our country finds itself in yet another internecine squabble regarding questions about how much to, or maybe even if we should, fund governmental operations.  It is a source of national embarrassment that the United States hasn’t passed a full slate of Appropriation Bills since Fiscal Year (FY) 2008.  Looking back to FY 1977, there have been 17 funding gaps of at least one day or more (Congressional Research Service). The funding gap in Fiscal Year 1997 was, until now, the most highly publicized funding gap.  In FY 1997, the U.S. Government shut down from 15 December 1996 until 6 January 1997.  While our current shutdown commands the attention of the vast majority of the press, the effects of a shutdown are mostly temporary; they do not extend much past the lost productivity of government workers. There may be very real impacts in specific sectors of the economy. Closed national parks may affects tourism related businesses, closed Headstart facilities would affect the working poor, and closed licensing authorities may affect whether businesses get certain permits or not. However, this could be balanced against the economic activity created by people who substitute their vacation dollars away from national parks or by depending on friends and family for daycare. Moreover, the impact of the shutdown will begin to be felt – even in these sorts of affected sectors – only if the shutdown drags on. Thus, it is hard for us to get overly excited about another crisis of artificial proportions.

The bigger issue associated with yet another game of brinksmanship played by two kids who can’t play nicely on the playground, is the issue of a possible link between this fight and the yet-to-be-had fight over raising the debt ceiling.  Even without the current intervention by the Federal Reserve, the United States dollar enjoys reserve currency status, which allows the U.S. to borrow at very low interest rates.  Certainly artificially low interest rates hurts U.S. savers, but it is a boon for the U.S. in terms of lessening the burden of servicing the fast-growing U.S. debt.  Now, though, we are quickly approaching the date when all extraordinary financial measures will be exhausted and the U.S. will default on its legal obligations.  This date is widely believed to be 17 Oct (side note – just approaching the debt-ceiling deadline in 2011 caused the U.S. to suffer a downgrade to its heretofore sterling credit rating; an actual default will potentially have long-lasting implications, as it will most likely raise borrowing costs substantially and it will make asset valuation harder because treasury bonds will not be risk free anymore), but the first large, default-inducing payment comes on the 1st of November when benefit checks are due.  Currently there are no indications that countries are actually worried about a default; in fact, the yield on the 10-year U.S. Treasury bond closed unchanged on the first day of the shutdown, which suggests there isn’t any panic selling as of yet.  But let’s do some back-of-the-envelope calculations to get an idea of what may transpire.  As of 31 August 2013 (latest data available from, there is $16.7 trillion of total U.S. Treasury securities outstanding.  The average interest rate now is 2.4 percent; this equals about $400 billion a year in interest payments.  Assuming that a simultaneous credit rating downgrade and a limited default causes a one percentage point increase in the average interest rate from 2.4 percent to 3.4 percent (a rate last seen in August 2009), interest payments will increase by $170 billion a year.  To put this in perspective, last year’s Fiscal Cliff deal is projected to raise $617 billion in new revenue over 10 years; all of this new revenue will be subsumed by increased interest payments in less than four years.

A less obvious but more pernicious consequence is the uncertainty that results from nearly five continuous years of partisan gridlock.  Businesses and individuals cannot plan if they do not know whether a law will exist or not. This puts a damper on economic activity and job creation. Moreover, to the extent larger businesses have more resources to deal with uncertainty, partisan bickering serves as a tax on small job creating businesses.

— Commentary provided by me and Jeff Smith.

Tenure: A meandering path to serfdom!

15 Mar

Tenure is part of the compensation package for college professors. However, college administrators view this as a privilege. In fact, the AAUP (effectively a professor’s union) tacitly agree because they make the case for tenure as an institution necessary for academic freedom with no connection to compensation.But let’s concentrate on the idea that tenure is about compensation. How should professors react when tenure is not part of a compensation package?

Consider what tenure does. It is part of a compensation package designed to reduce mobility. It is a barrier to exit in the college professor employment market. Thus it reduces bargaining power for the professoriate effectively by reducing any holdup costs. Professors cannot make a very credible threat to leave if they feel their working conditions are bad or wages are too low. This lack of credibility translates into reduced bargaining power when it comes to wages. This is, of course, a big reason behind the wage compression we see among professors relative to assistant professors. And if there is no way to bargain for higher wages or better working conditions why should the professoriate innovate? After all they cannot retain the fruits of their innovations. So what would happen if tenure went the way of Nineveh and Tyre?

The end of serfdom – similar to tenure insofar as it reduces the bargaining power of labor by restricting mobility – in medieval Europe may provide an object lesson. The reduction in the labor force wrought by the plague had differential impacts in Western and Eastern Europe. In Western Europe small institutional variations led to the end of serfdom as labor became more scarce. This jump started a secular increase in the share of output going to labor. Of course mobility and other institutional changes also promoted innovation and economic growth. In Eastern Europe, however, the problem of scarcity of labor was met with a strengthening of serfdom! The results are obvious and persist to this day.

In other words, removing tenure, like the end of serfdom, should increase the likelihood that the professoriate will innovate to keep themselves competitive and increase their wages. Of course there may be other problems based in agency theory. How will administrators gauge the productivity of the professoriate given the inherent information asymmetry that exists between the professoriate and college administrators? But that’s another post. Watch this space!

Gerrymandering and the failure of the US political market.

27 Jan

Acemoglu and Robinson in their book “Why Nations Fail” argue that Venice — the global superpower of its day — became a museum because inclusive institutions like the “commenda” were slowly replaced by extractive institutions which led to the “La Serrata.” Venice effectively became a hereditary aristocracy because the election system was rigged to favor incumbents and their families.  Congressional districts in the United States are often redrawn in a way that favors incumbents. Only people belonging to a certain “family”  — political party — can get elected from these districts. This restriction of political competition has echoes of Venice! So will the United States become a pretty museum? Probably not. But it may lose its economic superiority by ignoring inclusive founding principles.

Taxes and…..

28 May

Alan Simpson told Fareed Zakaria that any one who thinks that the current deficit problem can be solved without raising taxes (in some form — either directly or indirectly through inflation and/or high interest rates) has rocks instead of brains. I like the salty rhetoric. But is it true? I suppose it depends on beliefs about the short and long run.

By and large most economists would believe that economies where the government has a light touch — creating and protecting basic institutions that promote economic freedom — are more likely to generate prosperity. Low taxes are part of this mix since taxes are how governments extract rents from creative individuals. Of course there is an optimum amount of taxation necessary to protect the aforesaid institutions. But this is a long term view. As of now we have increasingly an extractive political economy. Rising inequality in the US does not help. Some inequality is of course good since it provides an incentive to work (as a recent book by a Bain Capital colleague of Mitt Romney’s rightly claims). But as inequality increases it enables a class of wealthy individuals to capture the legislative process to their favor. This is a fundamentally anti capitalist process which starts a vicious cycle that reinforces both extractive political and extractive economic institutions (Acemoglu and Robinson make this case in their recent book “Why Nations Fail”). At any rate, the rising deficit also extracts wealth from the economy and the ROI on this deficit spending is at best unclear. But taxation is an extractive process as well. One obvious solution is to get rid of all transfers (social security, medicare, etc.) and gut military spending. But this appears to be politically unfeasible. Another solution is to raise tax REVENUES by simplifying the tax code and cut spending at the same time. This would reduce the power of extractive economic institutions. This is effectively the Bowles Simpson approach and the approach that President Obama claims as his own. Then there is the Mitt Romney approach — cut taxes on his first day in office and do very little for spending. Cutting taxes may appear to be a blow against extractive economic institutions. But runaway spending will continue. Remember that even Paul Ryan’s so called revolutionary plan merely limits the GROWTH of spending! Thus the deficit may be expected to rise. In other words the rise of extractive institutions will in fact be abetted by tax cuts! Current, stated, Republican policy may appear to disfavor extractive political institutions (the tax cuts) but in reality will increase their power (by doing very little for the deficit). Why?

One answer may be that the Republican party has been captured by wealthy interests who wish to capture the legislative process and jumpstart a system of extractive political and economic institutions. In other words, its not a question of rocks instead of brains. This is very intelligent rent seeking at work. I think I disagree with Mr. Simpson. Republicans are not stupid.

The Evolution of Institutional Mechanisms

21 Apr

Looking at our current economic catastrophe one might wonder why none of the theoretical safeguards of neoclassical capitalism lead to a self correction. Leftists would argue – what safeguards of neoclassical capitalism? Rightists (I hate the moniker “conservative” — what are they conserving? certainly not energy!) claim that it was precisely the lack of capitalism — too much government regulation — that negated any hope that the safeguards of neoclassical capitalism would work. Fair enough. But my question is the following: If untramelled free markets are so wonderful then why don’t they develop organically and then persist as permanent institutions? Why do we have societies like Somalia? It is not enough for economists to claim that there are institutional differences between societies. They still have to explain WHY these differences develop and then why they persist. This is what this blog will investigate.

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