Health Care Costs And Worker Opportunity Costs

A comment I posted to "What's Cost Got to Do with It?" by Joseph T. Salerno on the Mises Daily blog:

Two points.

1. Health care costs, direct and insurance, were and continue to be a big issue, but they follow the same pricing principles mentioned. All the economic articles and research I have seen on the topic discuss, analyze, and provide solutions on the cost side of medical services and health insurance especially that costs are higher in the US than other countries and the US spends more per capita for medical services. They ignore the value to the consumer.

Like all other products and services, the price paid is determined by the value to the consumer. The US has very high GDP per capita and very high productivity rates. These factors would make a worker's opportunity costs, on average, high in comparison to other countries.

With a high opportunity cost, one would expect US medical prices would be higher than other countries as long as the higher price lowers the opportunity costs of medical services to the consumer. Delays caused by waiting for doctor appointments, specialist appointments, medical tests scheduling (such as MRIs, etc.), use of less efficient older technologies, use of older less efficient drugs that require re-treatment, lost productivity from the medical condition, etc. have a high opportunity costs for American workers (who often also have to take off work time to care for an ill child, parent, or spouse). Using new, efficient (in the sense of diagnosis time and treatment) technologies and decreasing the total time (and opportunity cost including lost productivity) to the consumer from the first phone call for an appointment to final result is expensive and will result in higher US medical costs. Most looks at other country medical services find the US had shorter wait times, newer technology to speed diagnosis and treatment, newer, more effective (and more expensive) drugs, and fewer doctor visits per year and per medical condition. This is not to say anything about end results, which are often used as a measure of comparative health care. It is about the speed of reaching that end result, the opportunity costs, beginning from a consumer's awareness of the condition (not first doctor appointment, but the wait for the first appointment) to final recovery.

To me, medical costs in the US are high because these services have a high value and lower opportunity cost to Americans. All attempts to directly control medical costs will fail because the value of the service to the consumer will remain high. American consumers will find ways to spend more, under any medical cost regime, to reduce their opportunity costs while receiving medical services.

Medical costs in the US will rise until they are equal to the consumers' opportunity costs and value.

If the value of the medical services were lower to US consumers, the medical establishment would find ways to reduce costs.

2. To all the comments that say costs are factored into price before production are ignoring that many businesses fail, despite adequate business plans, because consumers are not buying the goods in sufficient numbers for the business to remain viable. At a lower price, the business will sell more, but at a loss. Lack of demand kills many businesses.

Businesses I know consider demand as much as production costs and some will even regularly sell items at or below cost, such as loss leaders, in hopes of increasing overall demand and hopefully increase sales of their other goods. If costs were the main or only consideration, then profit margins would be much higher than they are at most businesses. Demand is determined by value and it sets an upper limit on price and profit.

Also see my earlier post, "The Marginal Value Of US Medical Service Is High So Medical Prices Are High" relating to this topic.

Regulatory Arbitrage Did Not Cause The Current Banking Crisis

Banks Need Adjustable Capital Amounts Sensitive To Future Economic Conditions

Regulatory capital ratios capture firm specific events but do not capture economy wide events. Regulatory arbitrage did not cause the current banking crisis and its complete elimination would not prevent a repeat of the current banking crisis.

Regulatory capital is set by lending and investment categories, such as mortgages, but the computed capital ratio is formulaic, static and does not vary by regional or US economic conditions. Additionally, it is in part dependent on outside ratings by credit rating agencies, especially SEC approved NRSROs, which are lagging indicators of changing riskiness and default rates instead of leading indicators.

Holding $100 million of residential mortgages outright or holding the same dollar amount of securitized residential mortgages does not change the risk the institution faces. The regulators compute regulatory capital by form instead of the substance of the asset, and the institution can free up required capital by modifying the form of its holding and use the extra capital to increase its holdings and concentration in that asset, i.e. engage in regulatory arbitrage. Effectively, the increase risk comes from increased leverage and loss of diversification through an increase in a particular asset concentration.

Additionally, since regulatory capital ratios do not change to reflect changing economic conditions, the regulators require banks to hold the same amount of regulatory capital in growth as in recessionary economic times. We know asset default risk is not constant and changes based upon different regional and US economic conditions, e.g. during periods of higher regional unemployment, regional residential mortgage default rates will increase. Similarly, area home values decline during regional economic downturns and the decline in value increases an area's mortgage default rates.

High unemployment rates along with a substantial decline in home values are the cause of the high mortgage default rates. A lingering, worsening recession was the underlying cause.

There are areas of the US where the decline in home values is 20-50 percent from their highs. In many areas of the US, unemployment is at 25-year highs, if not higher. If banks did not arbitrage from direct holdings of residential mortgages into securitized mortgages, banks would still face substantial write-downs. Residential mortgage defaults would still be higher than usual or expected (by capital set aside) due to substantial home value declines and high unemployment.

Weak US and regional economic conditions and their effects severely affected the value of all residential mortgages and their default rates. It is extremely likely that banks would need to raise capital, face heightened regulatory scrutiny and increased risk of government takeover independent of the form of their mortgage holdings. Even if we had restricted the amount of residential mortgage holdings of any form prior to this economic downturn, the banks would have invested their funds in other earning assets, such as credit cards, commercial loans or commercial real estate. All loans face higher default rates in bad economic times and just about all assets lose value.

What we need is a more sensitive, adjustable capital ratio to future economic conditions. Requiring capital based on sensitivity analysis (stress tests) requires banks to hold more capital than necessary in good times, acts contra-cyclically by restricting lending in good economic times, and lowers the earnings of banks.

Since economic forecasting of turning points in the economy is notoriously poor, market based solutions, such as market valued balance sheets, are probably the best but they are not fool proof. Market values of long-term assets, such as mortgages, reflect all expected losses including those several years in the future. The market value accelerates the future expected default into the present. For example, suppose an apartment building has a 20-year balloon mortgage with a constant yearly interest payment. The likelihood of default during the early years of interest payments may be quite low, but the market may have high expectations of default at the end of the twenty years on the final balloon principal payment. The market could easily value the mortgage at 60 to 70 percent of its face value. The discounted value would force the bank to either increase its current capital base or decrease it lending. The bank would feel the effect of the future default now, many years before it would realize the default and be necessary for it to replenish its capital base. Asset based market valuations for long-term assets could affect lending and investment in a counter-cyclical fashion.

One would have to rerun recent banking history under an alternative, proposed regulatory structure and reconstruct a bank's new balance sheet. We could see, based on new, proposed restrictions, prior to going into this recession, if there is anything that would be different now under a different set of rules and if the banking industry could have avoided its current crisis by lending and investing differently.

Home Values Were Not In A Bubble

Houses are like other assets that are bought and sold in a marketplace. The prices of the transactions in the housing market reflect the economic value to the buyers and the sellers and value is based on future expectations about the economic fundamentals of housing.

In the US and worldwide there has been a noticeable decline in the value of homes. Some argue that home prices were artificially inflated due to a "bubble." Others believe in efficient markets and that the decline in home values is a rational response to a change in economic circumstances and expectations.

Houses are a multi-generational asset in that they are a consumer durable that can been passed on from one generation to another. In a rational expectations, efficient market world which is the world economic research finds we live in, house price changes are due to changes in the expectations of the economic fundamentals related to the need, demand and value of houses. Thus, current house prices reflect their true economic value and homes are not undervalued whether due to the unavailability of credit or for other reasons. Arms-length housing market transactions, of which there are still many, occur at the true current price of housing.

Much recent academic work supports the idea that a sharp price rise and decline in "bubbles" is actually a rational economic response and markets are efficient even in so called "bubbles". For example, see the Wikipedia article on tulip mania and a 2004 article in Slate, Bulb Bubble Trouble [Weblink updated].

So, instead of trying to use government money to artificially shore up house prices, a more rational response to the decline in the value of homes, is to ask what is the price change in the housing market telling us about the future value of housing and to see if that is something that is undesirable. If the expected outcome is not what we would like to see happen and is changeable, then we should do the things to change that outcome in our economy.

Some of the possible future scenarios which would decrease the current value of a home are:

1. a significant and long-term decline in household formation.
2. a significant and long-term decline in population growth in the US due to changes in birthrate or immigration policies.
3. an increase in adult children living in their parents home (including after marriage or cohabitation).
4. an expectation of an increase in mortality or a shortening of life expectancy due to war, disease or natural or man made disasters.
5. a change in our preferences so as to prefer multi-family or apartment type dwellings as opposed to single family homes decreasing the need for single family homes.
6. a significant increase in the costs of owning and maintaining a home which lowers its economic value to a purchaser because of the expected increase cash outflow during ownership.
7. a decline in both household income or the expected growth rate of household income.
8. an alternative technology for building homes which will dramatically reduce the costs of building new houses.
9. a change in home related taxation such as a denial of mortgage interest or real estate taxes deductions.
10. a substantial expected increase in real estate taxes.
11. other possibilities that affect the economic value of a home that I have not mentioned.

Some ideas mentioned above are testable. For example, I was going to mention global warming but a recent paper about house price declines in California observed that the decline is greater in central California than along the coast which is contrary to what would happen to house prices along the coast due to rising sea levels due to global warming. See the paper by OFHEO, "Recent Trends in House Price", pages 4 and 5 and note 6 at http://www.ofheo.gov/media/research/pricesandfinancing.pdf [The Office of Federal Housing Enterprise Oversight (OFHEO) no longer exist and I am unaware of an updated weblink to the paper.]

The point of this post is that to most economists who believe in economic value, efficient markets and rational expectations, the current decline in home prices is a rational response to a change in expectations about the value of homes. If there were not this belief that current homes are fairly valued, then buyers would be buying up and warehousing the depressed priced homes, the foreclosed homes and abandoned homes. The fact that buyers are not rushing in shows that the current prices of homes are fair and homes are not undervalued.

Markets Are Efficient But Can Be Wrong

Markets are efficient and the press and the other media often ignore or misstate the concept's meaning and ideas.

A market is efficient if past prices cannot be used to predict future prices. The period to period change in the prices of actively traded assets such as stocks is random and it is this randomness that makes stock efficient.

In an efficient market, as in all other random markets, the best basis for predicting tomorrow's price is today's price plus a gain for the risk of buying the stock. Likewise, the price of the asset traded in an efficient market already reflects the effects of any information that is available whether through announcement, deduction, logic or expectation. Numerous studies over the past fifty years have upheld the efficiency of actively traded markets.

So any statement about the future movement of a stock's price based on its previous stock price movement is hogwash no matter the terminology used such as top, bottom, stochastic, candlestick, capitulation, and many others. Likewise, any statement that a stock price does not reflect announced information or that it will take several days for the stock price to reflect the news is also hogwash.

The concept of efficient markets does not mean that a market's prediction about a stock's price is always correct. The price in an efficient market is the market's best guess based on all knowable information. The market can guess wrong. Just as in any prediction about future events that have not taken place yet, a guess can be wrong or unexpected events can happen. In an efficient market, the price of a stock is fair in that it is just as likely to be too high as it is too low and no historical information about past stock prices or past events can give an investor an edge over a naïve investor who just buys and holds.