Let’s start with the obvious debating points. There is a lot of fat in both programs. CMS just acknowledged that as much as 10 percent of spending in Medicare and Medicaid is “improper.” This does not include spending on defensive medicine, unnecessary services demanded by fully insured patients, unwarranted variations in practice, and all the other usual suspects. Nor does it reckon with all the waste due to poor health behaviors, although eventually the grim reaper will have his say and dying is usually very costly no matter how well you have pampered your body along the way.

The obvious solution is to find ways to cut the fat. By some estimates, tort reform could cut spending by a few percentage points. Shifting everyone on Medicare into high deductible health plans could do the same. Cutting “excessive” salaries of pharmaceutical and insurance company executives might shave off another point or two. If we do all of this we may save ten percent on total spending, although we had better cut with a sharp scalpel lest the unintended consequences cost more than we save. Maybe we can save even more if we moved everyone into private insurance, but the argument about the relative efficiency of public versus private health insurance is mostly philosophical rather than empirical.

This is the easy part of the debate. Everyone wants to see CMS eliminate fat, although it has not been particularly effective at doing so. I imagine that CMS will redouble its efforts to cut fat. If it does not make the effort, then taxpayers have every right to demand fundamental reform.

Now for the hard part of the debate – the part where philosophical divides will show. Suppose that CMS does make the effort to cut fat. Better still, suppose that CMS finds enough fat to cut ten percent off of Medicare and Medicaid spending. Although this would be welcome news, at historic rates of inflation it will take just two years for Medicare and Medicaid spending to return to the pre-fat cutting levels. Finding another ten percent gives us just a four year respite. It is not sufficient to cut the baseline level of spending. CMS has to cut the rate of spending growth. (Fat cutting will affect the growth trend only if fat has been trending faster than lean. If anything, I suspect the percentage fat is trending slightly down.) This means that CMS has to confront the ever growing lean, or the day of reckoning must eventually arrive. A few years later, perhaps, but with consequences that are just as devastating.

That day approaches because Medicare and Medicaid programs have built into them the seeds of their own destruction. These programs do not promise to spend a given amount of money on beneficiaries. Instead, they promise to provide all beneficiaries with access to near state-of-the-art medical care. Unless there is a dramatic and unforeseen change in the nature of innovation in medicine, a change large enough to offset inexorable changes in demographics, this is a promise that will be increasingly costly to keep. For Medicaid, the financial obligations for keeping those promises fall on current wage earners. For Medicare, the obligations are fulfilled from a trust fund that increasingly relies on the contributions of current wage earners. Even if there is no fat in the system, the cost of keeping that promise, and the resulting burden on current taxpayers, will inexorably increase.

So any debate about the long term solvency of Medicare and Medicaid must eventually answer one simple question: Do we want to keep our promise?

One can make a very good argument that the benefits of costly new technologies have outweighed the costs in the past, and conclude that the promise is worth keeping. One might also argue that failing to keep this promise will create a two-tiered health care system in which most citizens are denied access to services available to wealthier Americans. But keeping the promise threatens to wreck the entire economy. The alternative is to convert Medicare and Medicaid from entitlements to certain levels of access to entitlements to certain levels of spending.

Congressman Paul Ryan’s Medicare reform plan goes down the latter path, converting Medicare from an access entitlement to a spending entitlement. If you support Ryan’s plan, you no longer believe that we can keep our promise about access. If you support Ryan’s plan, you either believe that it is worth sacrificing the nation’s prosperity to fulfill this promise, or you are willing to take a leap of faith that healthcare spending inflation is going to reverse a 100 year long march towards infinity.

I will finish by pointing out one irony. The cost of keeping the access entitlement for Medicare and Medicaid strongly depends on the level of technology available to the privately insured. HMOs, which tended to limit access to technology, thrived until baby boomers spurned them in the name of unfettered access and physician autonomy. If HMOs had survived the backlash of the 1990s, private sector health spending would be much lower, and CMS would need to spend lot less to assure Medicare and Medicaid beneficiaries equal access. As baby boomers move into retirement, their demands for gold plated medical care when they were young may be precisely what dooms them in their dotage to be second class citizens in a two tiered medical system.

1) With the economy on a slow but steady road to recovery, Republicans will resurrect health reform as a key issue in the fall election. They run a controversial ad showing a patient named Debbie getting diagnosed by her iPhone’s Siri. In response, Democrats show Debbie filing for bankruptcy because her insurance refused to pay for Siri’s consultation fee.

2) The Supreme Court will uphold the purchase mandate in the Affordable Care Act. Lobbyists for every major industry flood Congress with requests for more purchase mandates.

3) Healthcare continues to be a bright spot in a sluggish labor market. As a way to simultaneously address persistent unemployment and the growing needs of the elderly, Nancy Pelosi proposes a new law mandating that all baby boomers purchase a caregiver for their parents.

4) CMS will release new revised rules for ACOs. The new rules discourage ACOs from only covering patients in good health by reducing reimbursements for patients who are able to lift the new 1200 page ACO rulebook.

5) After eight seasons, Hugh Laurie announces that he is leaving House. Princeton-Plansboro Hospital’s malpractice premiums fall by 50 percent.

6) In the latest deficit reduction agreement, Congress proposes to cut Medicare payments to physicians by 20 percent. Interim CMS director Hugh Laurie announces that unlike the previous seven announced reductions, this one will not be rescinded.

7) CMS introduces 60 new quality guidelines for the treatment of ear infections. The guidelines are so simple that young children are almost able to treat themselves. But few are willing to do so, because the reimbursement rates are so low.

8) Healthcare spending will slow down to a rate of inflation not seen since the 1990s. Republicans will claim that this proves that competitive health care markets can reduce costs. Democrats will point out that per capita spending in the U.S. is still double that in Canada and Europe. Health economists will search in vain to find competitive health care markets.

Happy New Year!

“Secretary of Labor Hilda Solis recently commented that the healthcare sector continues to be a bright spot for job creation. How is the nation to reconcile the desire for “job creation” with the desire for cost containment?”

First, some background. Secretary Solis is correct – the healthcare sector is a jobs engine. In just the past year, healthcare has added about 325,000 jobs, accounting for perhaps a third of total U.S. job growth. By way of perspective, the rapidly growing energy sector creates about 100,000 jobs annually. Job growth is great, but more jobs in health care means more spending on health care. Despite the technological imperative that propels the system, healthcare remains a labor intensive business. Half or more of hospital spending goes to labor, not including physician expenses. Labor expenses dominate home health and long term care. It is nigh on impossible to reduce healthcare spending without reducing labor spending. Thus, job creation and cost containment are enemies.

I put the ball in the hands of the panelists: do you favor job growth or do you favor spending cuts? The panel punted.

All four panelists invoked the“efficiency mantra.” You know what I am talking about: “It is our responsibility to find ways to make healthcare more efficient.” The efficiency mantra is always followed by the “we are making a difference incantation”: You know this one too: “Skeptics will tell you that it cannot be done, but we are committed to this and we are already making a difference.” Then they throw out the “mystery statistic”: “We are saving millions of dollars while simultaneously improving quality.” What is the mystery? If every hospital is saving millions of dollars, then why does healthcare spending continue to increase?

Let’s take the CEOs’ at their word. Suppose that their hospitals are saving money by preventing unnecessary hospitalizations and eliminating unnecessary tests and procedures. Suppose further that they are keeping their local communities healthier through prevention, early detection and early treatment. I am all for it. After a century of unabated growth, the healthcare system would finally shrink. Hospitals could downsize. Outpatient surgery centers would go wanting for patients. Demand for long term care would finally trend down. And the nurses, technicians, aides, and all the others who staff these facilities would be looking for new jobs.

I haven’t mentioned the booming business in healthcare facilities construction. Right in my backyard, Rush University Medical Center just built a $673 million facility. Children’s Memorial is building a new hospital in downtown Chicago to a tune of nearly a billion dollars. That pays for a lot of tradesmen. Slow down health spending and the wherewithal to build these magnificent facilities dries up.

So the CEOs really did avoid the central question. (One CEO offered that we could save money by replacing high wage labor with lower wage labor. Fortunately, Crain’s Business Breakfasts do not attract many union activists.) What could they have said, besides the usual platitudes? If I had the rare talents required to be a hospital CEO and the moderator laid this trap for me, here is how I would have responded:

“I do not see any inconsistency. Yes, healthcare spending is high and we need to eliminate waste. But on average you get more for your healthcare dollar than on anything else you can buy. There is no greater gift than the gift of health, and our hospital teams help people live longer, healthier lives. As we move forward, we will continue to eliminate inefficiencies but we must also be responsive to the needs of an aging population. We will continue to promote wellness and prevention, but we must also be prepared to take advantage of medical breakthroughs that will allow us to better cope with cancer, heart disease, and the many other afflictions that we must all eventually face. The question should not be whether we are spending too much or too little on healthcare, but whether we are spending our money wisely. If we are – and I believe we are making major strides in that direction – then we will have the appropriate labor force to meet our community’s needs. An efficient healthcare system that grows in response to community needs – that is my vision, and it is one that generates jobs without wasting dollars.”

Okay, so I have thrown in a few platitudes of my own. But the fundamental tradeoffs are there for all to see. Even if you strip away all the inefficiencies, healthcare is still expensive and becoming more so. But we get so much for our health dollars that we have to be careful in our zeal to cut spending not to throw out the baby with the bath water. If and when our providers can make the case that they are serious about efficiency, no one would begrudge their growth.

The Health Insurance Exchange is an idea that economists have floated for more than three decades and thanks to his hard work, that idea has become a reality in Massachusetts and perhaps the rest of the nation, provided that the Supreme Court doesn’t block this fine bit of economics. Unfortunately for supporters of the exchange (including myself) the health insurance purchase mandate – an essential element of any economically viable exchange – might be unconstitutional. God forbid that the U.S. Constitution might interfere with beautiful economic theories.

There is a solution. I am almost too modest to say it but I proposed this idea in my book Code Red long before Barack Obama put his hand on the bible to be sworn in as Regulator-in-Chief. The beauty of the solution is that it respects, nay, was inspired by Jon’s work in Massachusetts, and is constitutional to boot! The solution is in its own way conservative, because it does not mandate a single approach to health reform. Congress should have given each state a block grant conditional on expanding health insurance coverage. The states could have chosen how to proceed. The U.S. Constitution might prohibit a federal mandate to purchase insurance, but it says nothing about what the states may do.

Some states might have chosen to adopt their own versions of the Massachusetts Health Plan. A few states may have centralized insurance, creating their own versions of single payer systems. Others may have given individuals vouchers and encouraged the growth of private insurance exchanges. This would be the closest to a free market solution, keeping the government out of it, except as a vehicle for transferring wealth. Perhaps all of these ideas would have been better than the status quo. Perhaps states could have learned from each other. Even Jon Gruber might have learned something new! Through this experimentation, we could have rapidly expanded health insurance coverage and also put lots of theories to the test. I still think this is a terrific idea. But in 2009 when politicians and economists huddled together to write the Affordable Care Act, no one invited me to the party. Alas.

When it comes to research, the best economists are rather conservative. We put our own findings under the microscope, trying every which way to prove ourselves wrong. We cannot publish unless several peers have given our work the same scrutiny. But when we are given the opportunity to make policy, we often abandon this conservatism. Perhaps this is because we are so rarely given the chance to make policy. Economists like Jon Gruber were privileged to have substantial input into the future of the health care system, and may have thought that their work was done when Congress embraced their models. But that was never the end of their work. The Constitutional challenge to the insurance purchase mandate is part of a process that should have been anticipated from day one. There are no surprises here.

P.S. Jon Gruber has stated that he cannot understand why Mitt Romney is disowning the Affordable Care Act when it is modeled on the Massachusetts Health Plan. Perhaps Romney believes that the Massachusetts Health Plan is good for Massachusetts, but might not be so good for other states. I know I believe it.

The mystery this week is “what is a life worth?” We cannot ignore this question because it seems unthinkable. As will discuss, coverage decisions by public and private insurers depend on the answer. Some payers are rather explicit about they think a life is worth.

Before I try to solve this mystery, let me acknowledge that we should not spend money on health services that are of zero value (or worse.) But what about expensive health services that might prove to be of some value? How much should we spend on these?

Let us accept the reality of insurance. When we “purchase” health care, someone else foots the bill. Perhaps insurance should contain big deductibles, but even big deductibles are quickly exhausted if we need surgery or have a chronic health problem. If we are pooling our resources to pay for medical care, then we will probably want to reach some sort of collective decision about what drugs and treatments we will pay for. The alternatives would be to invite massive moral hazard. (Let me repeat for those who bang the drum loudly for big deductibles – deductibles are quickly exhausted when serious illness strikes and moral hazard again rears its ugly head.)

Now imagine a new cancer drug that offers a small prospect of survival to patients who have no other choices. Suppose that on average, patients who receive this drug can expect to live about another three months and that there are no downsides to this drug. If the drug company offered to give the drug away for free we would surely want patients to have access to it. If the drug company asked $100 million a dose, we would probably agree to spend the money elsewhere.

There must be some price under $100 million that would cause us to stop and think this over. Should we pay for the drug if it costs $500 per patient? What if it cost $100,000?

At some point we must answer the unthinkable question. In this case, we must determine how much should we be willing to spend to offer individuals three more months of life? Regulators in many countries have already given their answer. For example, the UK recently refused to pay for the skin cancer drug ipilimubab because the cost per “quality adjusted life year” was between £54,000 and £70,000. The UK uses a threshold of about $100,000 per year of life, a threshold that is accepted in most developed countries. But is that really what a year of life is worth? By all accounts, this threshold is based on past spending norms, adjusted for inflation. What was once seat of the pants policy, driven purely by budgetary needs, has become the gold standard for measuring the value of a life.

This all seems rather ad hoc. Rather than accept a valuation that was seemingly pulled out of thin air, academics have sought to value life by looking at how people actually behave. Some researchers have asked people what their lives are worth. Carefully constructed surveys generate values for a year of life well in excess of $100,000.

Such surveys are notoriously unreliable. If we could observe people spending their own money on health services, then we would truly know what they think their lives are worth. But insurance means that we only see people spending someone else’s money. Here is where economists have gotten rather clever. Workers are often confronted with tradeoffs between relatively safe jobs and relatively riskier jobs that pay more money. (Controlling for skills and experience, the data definitely show that riskier jobs pay more.) Assuming that employers do not pay higher wages out of the goodness of their hearts, they must be paying higher wages in order to convince workers to take on more risk. Led by Harvard’s Kip Viscusi, economists have looked at the data and determined that workers can expect to get paid an extra $5000-$10,000 to take on a job that has a heightened mortality risk of 0.1 percent. This adds up to $5-10 million for every additional death, or well over $250,000 for every year of life lost. If workers insist on getting paid $250,000 extra to compensate for the prospect of losing a year of life, then they must hold their lives very dear.

So is a year of life worth $250,000 to the average worker? Many people criticize Viscusi’s work, in part because it makes strong assumptions about what workers know about job risk and about worker mobility. Some economists observe that these calculations do not take into consideration the importance of hope. But if we try to correct for any resulting biases, the value of a life would probably be even bigger! One bias might work in the opposite direction – we might insist on receiving a lot of money to take on additional risk, but be unwilling to give up the same amount of money to reduce risk.

My mother always told me that “if you don’t have your health, you don’t have anything.” She held life very dear. So do I and so do most people – more so than the UK and other regulators want to believe.

Everyone is concerned about rising medical costs, and for good reason. At some point we may spend so much on medical care that we will no longer be willing to give up so much money to live longer or better, preferring to spend the money on food and shelter. And in today’s tough economic environment, perhaps quite a few of us have reached that point. But in our zeal to cut spending, let’s not throw out the baby with the bath water. Effective medical care remains one of the greatest bargains, even when that means spending tens of thousands of dollars to save just one year of life.

I first learned about CLASS when I was asked by a senior economist in DHHS to provide a strategic assessment of the business prospects for CLASS. DHHS officials were appropriately concerned that the low price/limited benefit plan would almost surely suffer from adverse selection and end up losing money. So they wanted to know whether CLASS could offer additional LTCI plans to cover the losses in the base plan. I persuaded Cory Capps (a former colleague and partner with BatesWhite, an economic consultancy) and Leemore Dafny (my current colleague at Northwestern) to help with the analysis. We shared ideas with economists working within DHHS.

We viewed this as a traditional market analysis. Anyone can enter a market and lose money – the base CLASS plan would be a poster child for this obvious point. We wanted to understand whether there were any opportunities to turn a profit in the LTCI market. We also wanted to understand why, if there are profits to be had, private insurers had not already exploited these opportunities?

What we found was a rather strange market. There are lots of LTCI sellers, mostly crossovers from the life insurance market. This makes sense, because the main purpose of LTCI is to help enrollees preserve their retirement savings. The same customer who buys life insurance to make sure their next of kin are well taken care of would therefore also want to buy LTCI. These customers trust life insurers, most of whom have been around for a century or longer and can be counted on to pay out future benefits. At the same time, LTCI products are remarkably (perhaps unnecessarily, and likely strategically) complex, so customers rely on their insurance brokers to explain their options. These features helped mute competition among LTCI insurers and possibly pose entry barriers to new sellers.

We were reasonably convinced that CLASS could rely on the reputation of the federal government to assure future payouts. (We would have been more convinced a few years ago.) And the CLASS Act provided DHHS with a chance to work around the broker market – employers would be given the option to offer CLASS LTCI to their employees, although it was not clear if employers would be eager to participate. So it seemed that DHHS could overcome the two main barriers to entry.

With the wind in our sails, we addressed the most critical questions: What products would DHHS sell? How would it penetrate the market? Could these products survive competitive forces? We immediately rejected the idea of offering the same products sold by private LTCI firms. If DHHS sold the same products that were already on the market, private insurers would surely match on price and the market would have to expand to accommodate CLASS insurance. This was a risky prospect, as private insurers had been trying to grow the market for years with very limited success.

Putting on our strategy hats, we wondered if DHHS could come up with new product features, thereby attracting a broader base of enrollees. Exchanging ideas with DHHS economists, we came up with quite a few suggestions: tontines (where enrollees enjoy rebates of premiums if they don’t end up needing LTC), extended vesting periods before coverage began, “short term” LTCI and others. We laid out the advantages and disadvantages of each feature and we asked a critical strategy question: If these features are so promising, why aren’t private LTCI insurers offering them? For some features, such as the extended vesting period and the tontine, we were reasonably sure that DHHS could secure a profitable niche in the market. Even so, we wondered how these ideas would be explained to consumers. LTCI insurers relied on brokers. Who would get the word out for CLASS?

On balance, we were rather optimistic about the potential success of some of the “new” LTCI features that could be offered through CLASS. Many uncertainties remained, however, and we were unable to project the profits that these products would bring in. This came with the territory; we were essentially viewing DHHS as an entrepreneur bringing new products to the market, and entrepreneurship is fraught with uncertainty. When it came time for DHHS to perform the mandated 75 year projection of CLASS profitability, the unpredictable profits from the new products could not offset the certain losses from the base plan.

In retrospect, perhaps this was the best outcome. I could imagine DHHS succeeding as an entrepreneur in the LTCI market, but I would have misgivings. The federal government as business entrepreneur – it almost makes me shiver. Even so, I came away from this experience feeling a little more optimistic about our government. Editorials in the Wall Street Journal and elsewhere applauded the demise of CLASS, arguing that the act was politically motivated and made little economic sense. I will not comment on the political motivations, but I will say that when it came to our contribution to this matter, DHHS officials remained focused on the economic realities.

1) Hospital charges are not the same as hospital costs or hospital prices.
2) Hospitals need to do a better job of cost accounting.
3) Hospitals need to redesign their work flows to improve efficiency.

These themes are correct and Porter does a fine job explaining why they are important. But if anyone wants to learn about them in more detail, I suggest they look to the work done by faculty at another not-too-shabby business school. In 1991, the year I joined the Kellogg faculty, I published an article in Medical Care entitled “How Fast Are Hospital Prices Really Rising?” (My coauthors were my Kellogg colleague Mark Shanley and Will White who was at the University of Illinois.) The article made all the points that Porter made and then some, even documenting how reported medical price inflation, which was based on charges, was overstating the rate of inflation of actual prices. The consumer price index was soon revised to use actual prices rather than charges.

I learned about the myriad problems with hospital cost accounting when working on several cost benefits studies and I contributed a chapter describing the issues in the book Valuing Health Care, which was published in 1994. My Kellogg colleague Bala Balachandran hasn’t just been complaining about this problem. For the past 20 years, he has been helping hospitals adopt activity-based cost accounting.

I can forgive Porter for not citing the Dranove canon or about Balachandran’s “on the ground” efforts to change the system. But I am surprised that he ignored Steve Shortell’s work on process improvement. Shortell, currently the Dean of the UC Berkeley School of Public Health, is on the short list of “most prominent academics in the field of health management.” When Shortell was a Kellogg faculty member he published several papers, trade books and a textbook all around the theme of transforming medical care delivery. The redesign of care processes through continuous quality improvement is a constant theme in Shortell’s work.

I suppose we at the Kellogg school should thank Porter for his efforts. It is always nice when famous people acknowledge that the work that we have been doing for two decades

Northwestern University is one of Blue Cross of Illinois’ largest customers. Suppose that premiums for all BC plans are expected to increase by 10 percent, but NU is able to force Blue Cross to accept a 5 percent increase. Would you expect Blue Cross stick McDonalds with a 15 percent increase in order to cover the shortfall from NU? I wouldn’t, for two reasons. First, McDonalds would probably threaten to take its insurance business elsewhere. Second, the scenario I have described is inconsistent with profit maximization by Blue Cross. After all, BC’s ability to stick McDonalds with a 15 percent increase surely does not depend on the price paid by NU. Any negotiator whose willingness to stick it to McDonalds is conditional on the price charged to NU is leaving money on the table and probably would have been fired a long time ago.

We might never expect BC to raise prices to some customers to make up for shortfalls from others, so why do we believe that hospitals do this all the time? It is impossible to discuss Medicare and Medicaid payments without someone invoking the mantra of cost-shifting. The theory of cost-shifting is deeply ingrained in the minds of healthcare decision makers and the policy implications of the theory are profound. Consider that if hospitals cost shift, then the burden of Medicaid cutbacks falls on privately insured patients, not on Medicaid patients and the hospitals that serve them. This calls into question whether the cutbacks will result in any savings for taxpayers and cause any harm to Medicaid beneficiaries. It also makes you wonder why hospitals that serve low income communities struggle to survive. Couldn’t they just cost-shift their way out of financial difficulty? A cost-shifting zealot would conclude that the managers of these hospitals are incompetent.

I must confess that I perpetrated one of the best cited papers providing evidence of cost-shifting. I studied what happened at hospitals in Illinois in the early 1980s after a substantial cut in Medicaid fees, finding that hospitals did raise prices to privately insured patients by enough to make up about half the Medicaid shortfall. But things were different back then, and I don’t believe that evidence can be used to describe what happens today. For one thing, there was essentially no managed care in Illinois, so insurers had to accept the prices set by hospitals. Insurers are far more powerful today than they were back then. Second, all of the hospitals in Illinois were nonprofits and, as far as I could tell, most placed mission above profits. So it is possible to believe that prior to the Medicaid cutbacks, hospitals really were leaving private sector money on the table. With all the empire building that hospitals are engaged in today, it is hard to believe they would ever leave insurer money on the table. This makes it equally hard to believe that they would need the excuse of government cutbacks before sticking it to insurers.

Cost-shifting may be a flawed theory, but there may still be a disconnect between theory and practice. Hospitals might cost shift because, well, that is what they think they are supposed to do. So what does the modern evidence show? Will White and I published another paper about a decade ago that tracked what happened at hospitals in California after large Medicaid cutbacks. We found that hospitals that experienced large Medicaid cuts also experienced relatively slower increases in private sector payments, the opposite of what would have occurred under cost shifting. There are quite a few other studies showing that the quality of care delivered to Medicaid and Medicare patients suffers when government payments fall. This would not occur if hospitals could cost-shift.

Unfortunately, there are a lot of more stylized analyses that seem to show that cost shifting is alive and well. The typical analysis finds that profits from privately insured patients are negatively correlated with profits from government-insured patients both in the cross-section and over time. This is cited as conclusive evidence of cost-shifting.

There is alternative explanation that, unfortunately for the cost-shifting zealots, is quite consistent with the institutional facts. To motivate the explanation, consider an industry in which all firms earn zero profits, but the firms’ accounting systems are somewhat arbitrary and assign costs to different customer groups in a somewhat haphazard fashion. If a firm in this industry has two groups of customers, it may appear to be profiting from one group due to the way it allocates costs. Because the firm earns zero profits overall, it must appear to lose money from the other group. Thus, reported profits will be negatively correlated between customer groups.

Now suppose that one group of customers got its act together and demands lower prices. This would have no impact on the price paid by the other group in the short run. In the long run there would be exit, because some firms were losing money. This would drive up prices and again create a negative correlation in pricing both in the cross-section and over time. But this would not be cost-shifting as it is commonly discussed. (Nor would it require arbitrary cost-accounting.)

If we relax the assumption of zero profits but instead suppose that profits are constrained to a fairly narrow band, then we would still get the same negative correlation in both the cross-section and over time, provided there is a fair degree of arbitrariness to cost allocation. And this, I believe, pretty well describes the hospital sector, where most hospitals have profits in a range of plus or minus 5 percent, and cost allocation is speculative even in the best institutions.

So I can explain away the stylized evidence without invoking the mantra of cost-shifting. But that does not make my explanation correct. Cost-shifting is so deeply engrained that CFOs might do it even though it is not profit maximizing. I think I could even construct a game theoretic model in which hospital CFOs use government cutbacks as a kind of focal point for passing along tacitly collusive price increases, so that cost-shifting is profit-maximizing in a strategic sense. My point is not to deny cost-shifting so much as to point out that there are good reasons to question both the theory and evidence. Whether or not hospitals cost-shift remains one of the great mysteries of health economics.

I was in my second or third year as an Assistant Professor at the University of Chicago when my brilliant senior (but still young) colleague Dennis Carlton asked me to explain how medical providers set their prices. I told him that we needed to throw the traditional textbook economics model of pricing out the window. This wasn’t a market where price sensitive consumers chose among homogeneous sellers, with the result that prices in competitive markets converged towards marginal cost. Instead, consumers had insurance that paid for all or nearly all medical bills. Moreover, patients were loyal to primary care physicians and their referral networks. As a result, patients rarely shopped around for the best price. This was when Dennis asked me why prices weren’t infinity. The question stumped me! I supposed that insurers would only pay usual, customary, and reasonable rates but that didn’t prevent providers from asking for infinity and occasionally getting it. Perhaps providers didn’t want to appear unseemly or were bound by ethical constraints. Or perhaps, as I ultimately responded, medical prices were inflating so rapidly that they would soon reach infinity.

The conversation ultimately led me to examine all sorts of pricing puzzles. Why did prices seem to be higher in more competitive markets (in violation of the traditional price/concentration relationship?) Why did specialists make so much more than generalists? Do any of the rules of pricing apply to medicine?

Economists have solved some of these puzzles. The seeming violation of the price/concentration relationship for hospitals was partly a statistical artifact resulting from a failure to control for quality and severity of illness. And once managed care took over, the traditional price/concentration relationship firmly established itself. The violation for physician pricing could be explained by simple economic forces in monopolistically competitive markets (i.e., markets with many slightly differentiated sellers each of whom has some loyal customers). If some factor causes prices to be higher in some areas than in others, physicians will tend to gravitate towards the high priced areas in order to share in the higher profits. It is not difficult to imagine what factors might cause prices to differ – socioeconomic conditions, culture, the willingness and ability of patients to shop around. Health services researchers offer an alternative hypothesis – that physicians in concentrated markets “induce demand” in order to drive up prices. But this hypothesis had little empirical support beyond some old studies with major statistical flaws. And even these old studies found modest inducement effects at best – not enough to explain the data. Besides, the inducement hypothesis fails to explain why some markets are more concentrated in the first place. The market forces explanation is consistent with the data with the added virtue of explaining the variation in concentration.

Economists will be hard pressed to explain the pricing data that was just reported in Health Affairs. Laugesen and Glied find that U.S. physicians earn far higher incomes and charge far higher prices than their counterparts in other developed nations. The pricing gap is larger for specialists than for generalists. These price differences cannot be explained by differences in costs, including the cost of medical education. Economists often suggest that entry barriers protect physicians against competition that might drive prices down. But it is more difficult to become a specialist in Europe and Canada than in the United States. Moreover, Laugesen and Glied provide further data suggesting that U.S. physicians are not working at capacity; excess capacity is one of the surest predictors of price competition in almost any market, even hospitals. So why not physicians? And the specialist/generalist pricing gap has not been explained to anyone’s satisfaction, especially when there is excess capacity.

Policy makers seem likely to use the Laugesen/Glied findings as an excuse to slash physician payments. But until we understand why physician fees are so high, we will never be able to accurately forecast the impact of fee reductions. Unfortunately, after 30 years of trying, we are no closer to explaining these pricing patterns. During this time, prices have climbed inexorably closer to infinity.

Everyone seems to agree that the U.S. spends too much money on healthcare. This has led many to embrace machete policies: Slash payments to doctors. Slash payments to hospitals. Slash payments to drug companies. Slash the number of specialists. Slash, slash, slash.

There is abundant research that past machete policies directed towards healthcare providers have adversely affect healthcare quality and access. There is also abundant evidence supporting the view that machete policies would curtail medical innovation. Medical providers and drug companies cite this evidence whenever they are threatened with payment cuts, proclaiming that any reductions from current levels would be disastrous for the American public. (This is not to deny that a lot of spending is inefficient; unfortunately, no one has devised the machete that only slashes inefficient spending.) As I will explain in a moment, we are in no position to assess such claims. But note first that if cutting healthcare spending would be disastrous, the implication is astonishing: increasing spending would be wonderful. (I suppose it is possible, by sheer happenstance, that we are spending exactly the right amount of money on doctors, hospitals, and specialists, but the odds of that are about the same as the odds of getting a royal fizbin – astronomical.)

Unfortunately, health services research has taught us just enough to be totally confused about this issue. As I mentioned above, research tells us that if we follow a machete policy, quality and access will fall. But research does not come close to telling us everything we need to know about this tradeoff before we can reach a sensible policy decision. (Congressional Republicans deny the existence of this tradeoff and refuse to discuss it. This makes it easy for them to take out their machetes.) To determine whether we should slash, slash, slash we need to know two more things. First, exactly how much will quality and access suffer per dollar saved? Second, is too much?

Economists have produced interesting answers to the second question. Studying things like the tradeoff between wages and job safety, economists have concluded that we need to save at least several hundred thousand dollars to offset the loss of just one quality adjusted life year. The exact dollar amount remains open to considerable debate. Remarkably, this is the easier number to pin down.

We just don’t know how much quality will be harmed by a machete policy. We have some strong evidence that further reductions in Medicaid payments will cause substantial harm for patients with certain conditions such as heart disease, but those are cutbacks from levels that are already low and might not apply to other medical conditions. We cannot say whether these results will translate for Medicare or the privately insured. There are a few studies of Medicare cutbacks and while the results again suggest that there will be quality and access reductions, the standard errors are large enough so that all we can say is that the reductions will be anywhere from small to large. To make matters worse, these studies do not focus on physicians or distinguish among specialties, and are silent about cuts to home health care and other providers. And for the studies of medical innovation, we are quite sure that if drug profits fall, we will see fewer drugs. A lot fewer? We don’t know. Nor do we know if we will see one less statin drug or if we will never see the drug that cures Alzheimer’s. About all we can say, based on research by Harvard’s David Cutler and his colleagues, is that new medical technology is worthwhile in the aggregate (the health benefits of an entire generation of medical technology exceed the costs). But even the estimable Professor Cutler cannot identify the marginal impact of a machete policy on technological change.

When I started plying my trade, health care spending accounted for 10 percent of the GDP. Most people thought that was too high, but they could offer no logical reason why. It just felt that way. Today, spending stands at 17 percent of a much higher GDP. Nearly everyone thinks this is too much though a logical explanation is still elusive. It just feels like we are spending too much. Yet hardly anyone is proposing that we return to 10 percent though no one can state what the right number is. What will we be saying thirty years from now?

The bottom line when it comes to assessing health care spending, we don’t know much about the bottom line. We publish papers showing that some specific policy had some specific outcome, which is all well and good. At least we know that Congressional Republicans are putting their collective heads in the sand. But beyond that all we can do is make conjectures. The Congressional Budget Office is charged with making these guesses for federal legislation, but they have little to go on. They can project cost savings with a tiny degree of confidence. But no one has asked them if the savings are worth pursuing, which is just as well, because they cannot possible answer that question.

In a nutshell: When it comes to healthcare spending, we do get what we pay for. If only we knew how much we wanted to spend.