Congress Gets Health Care Wrong by Ignoring Friedman’s Law

To tackle market distortion, let consumers direct their own dollars

TOPSHOT - A wounded Iraqi child who was injured during the ongoing fighting between Iraqi forces and jihadists of the Islamic State (IS) group in Mosul, receives medical treatment at a hospital in Arbil, the capital of Iraqs autonomous Kurdistan region, on November 24, 2016. Iraqi forces have broken into jihadist-held Mosul and recaptured neighbourhoods inside the city, but a month into their offensive, there are still weeks or more of potentially heavy fighting ahead. / AFP / SAFIN HAMED

Nowhere is Friedman’s Law more pronounced and pernicious than in healthcare, which is approximately 20 percent of the economy. Safin Hamed/AFP/Getty Images

As Congress debates the repeal and replacement of Obamacare, the key risk is failing to identify the actual problem, and commensurately the root of that problem. Politicians will obsess over the percentage of insured, only to obfuscate from the real issue we face: cost. The root cause of astronomical price inflation is the exacerbated distance between consumers and producers, which has completely distorted the market.

In Free to Choose, Milton Friedman described a simple classification of spending. Friedman positioned this discussion in the “Cradle to Grave” chapter of the book, making the argument against the inefficiencies of the welfare state. The usefulness, though, is much broader, and can be applied to all markets in what can loosely be defined as Friedman’s Law.  The further the distance between the payer and the consumer, the greater the distortion in the price level.

Friedman placed spending into one of four categories. In essence, he created a matrix. On one side is whose money is being spent. Your money can be spent, or someone else’s money can be spent. On the other is on whom the money is spent. The money can be spent on something you receive, or on something someone else receives. The matrix creates four categories.

Thus, the first category is you spending your money on yourself. You go shopping at a store with your own money in your pocket and you buy goods and services that you want. This is typically the most efficient form of spending.

The second category is you spending your money on someone else. You go shopping to spend your own money on a gift for someone else. You are still incented to spend frugally—or at least efficiently, yet it is the desires of another recipient that you are trying to fulfill. It is then unlikely that what is purchased is completely optimal with respect to wants.

The third category is you spending someone else’s money on yourself. The consumption is likely to be what you want to consume, but the sense of frugality is minimized. You are going on a shopping spree with someone else’s credit card.

And finally, the fourth category is you spending someone else’s money on someone else. You are shopping for someone else, with someone else’s credit card. In that case, you are unlikely to transact optimally. Your purchases are not necessarily in step with the desires of the recipient, nor are you likely to spend as frugally as you might otherwise do.

Friedman’s Law can, of course, be applied to any industry. An industry dominated by category three or four spending is likely to be wrought with inefficiencies and saddled with excessively high prices. Three prime examples are auto body repair, higher education and health care. In all three, the consumer is rarely directly paying for the goods and services received, and also not necessarily choosing which goods and services are received.

Auto body repair fits somewhere between category three and four. This is the case in most industries where an insurance payment covers the cost. In all cases, you are spending someone else’s money—namely that of the insurance company. On whom the money is spent is a blend between you, because you are the owner of the product, and the insurance company, because in theory they are a part owner because of the nature of insurance. The insurance company typically has a set of guidelines as to what it will cover and the replacements that it will allow, which will be part of what comprises the original insurance contract.

The cost of an ER visit is not exorbitant because of the uninsured, but rather because virtually no one who visits actually pays the bill directly.

Auto body repair, unlike typical mechanical repairs and maintenance, are generally the result of an accident which would be covered by insurance. An oil change, for example, would fall in the first category of spending. You own your car, you pay to change the oil, or do it yourself. You determine how often it should be done, possibly taking into account recommended maintenance intervals. It is no coincidence that the cost of ordinary maintenance pales in comparison to that of auto body repair.

Similarly, the price of college education has skyrocketed due to the impact of Friedman’s Law. Lavish campuses and multi-billion dollar endowment funds have become the norm at universities across the United States. Yet massive inflation in the cost of attending college is a major issue. It would seem logical that students and their families put pressure on costs to come down, and that given the apparent excesses on campus, that it would bear results. But because of Friedman’s Law, the market inefficiency persists. Spending on college education sits mostly in category three. Students tend to spend virtually nothing on their own education.

In the case of higher education, the consumer is a static student, while the payer is a dynamic blend of entities ranging from parents to the schools to banks to the government. At each step, the distance becomes greater. A student paying one’s own way through college will cause the most efficient spending. Parents providing for their child’s education will be frugal, but potentially less so. And it gets worse from there. College education, further, provides a glaring example of how the intention of making a product more widely available had the result of forcing its costs to become unaffordable to most.

The turning point was perhaps the concept of need-based financial aid. In such a scenario, a student is admitted to a college without regard to ability to pay. In return for this potentially advantageous methodology, the college would have to assist in paying. On the surface, it could seem like a logical way to ensure an equality of access to higher education, and for an individual university to accept those students it desires without accounting for ability to pay its costs. However, when the economics are considered, the end result is obvious: higher costs for all, with a heavy dose of inefficiency as well.

Consider a restaurant that charged for meals using a need-based methodology. A family comes in for dinner, and at the door provides their prior year’s tax return and most recent pay stub. The price of the meal is fixed at $200, including drinks, dessert and a gratuity. The restaurant determines that the family can afford to pay $50 for a meal out. For the remaining $150, the restaurant “gives” the family a $25 meal credit, the government guarantees a loan from the local bank for $75—to be paid back over a 10-year period at a lower than market rate due to the guarantee, and the remaining $50 is a gift from the neighborhood to provide meals for families. Absent the additional $150, the family would either not eat this meal, or the restaurant would have to lower the price. However, because the $150 can be accommodated, the restaurant can fix $200 as the price. The intersection point between supply and demand is altered from its free market equilibrium, just as it has been for the cost of a college education.

Nowhere, though, is Friedman’s Law more pronounced and pernicious than in healthcare, which is approximately 20 percent of the economy. Economist Jonathan Gruber paved the way for Obamacare by insisting that by reducing the ranks of the uninsured, the cost of healthcare would go down. The premise of Obamacare, and the Massachusetts model that preceded it, was based on the specious concept that the uninsured are driving up costs. Those whose underlying interest was government control of healthcare were eager to indulge this economic fallacy. Mandates drive costs up, not the other way around. What ensued was insurance has become less affordable, though more subsidized, and costs have risen dramatically.

The current system of insurance propagates a discrepancy between the people who receive the healthcare, and those who pay for it. Prices are out of control because almost all costs are paid by someone other than the actual consumer. The cost of a visit to an emergency room is not exorbitant because of the uninsured who visit, but rather because virtually no one who visits actually pays the bill directly. Further exacerbating the problem is that billions of dollars are wasted each year on unnecessary procedures in an effort to stem litigation, in part because the consumer is not actually paying for it anyway.

It is possible, fortunately, to tackle the market distortion in healthcare. The crucial factor is reducing the distance between consumer and payer. The debate must shift from mandates and how many people have insurance to eliminating the artificial barriers that further separate consumers and payers. Insurance needs to return to being insurance again. That is, insurance is a way to mitigate the risk of unlikely and high-cost events. Further, the current distortion in the tax code must be fixed such that all healthcare expenditures are treated equally. Additionally, health savings accounts should be expanded to become the norm. Consumers should direct their own dollars. Healthcare needs to be reformed in a way that gives consumers vastly more control than they currently have. Tort reform must be enacted to not only directly reduce the cost of healthcare, but also to eliminate the wasteful spending that indirectly increases costs.

As consumers take control over their healthcare spending, costs will be contained, and healthcare becomes more affordable. And as prices drop, the ranks of the uninsured will follow. Those who then still cannot afford healthcare can be subsidized by the government. There is little logic in transforming the entire healthcare system into a government controlled program when only a small portion is in need of help—especially as prices fall. If anything, the government needs to vastly reduce its role, as it currently controls roughly half of all medical expenditures. In order to do that, the real issue in healthcare must be properly identified: cost. And that cost is astronomically higher than it needs to be because of the distance between consumers and payers.

Dave Sukoff is an advisor to the investment management community, and had previously co-founded and ran a $500mm fixed income relative value fund. He is also the co-founder of a software company and inventor on multiple patents in the IoT space. Dave graduated from MIT, where he majored in finance and economics.