In my last blog, I argued that the private health sector should not always and everywhere be assumed to be efficient. The reasons were market failures because of information asymmetry and uncertainty. Yesterday, Steve Pearlstein (Washington Post, 9/11/2009, (article here)) provided an excellent summary of some of the inefficiencies of private sector financial markets. The inefficiencies he discusses arise because of private incentives to focus on short-term personal gains at the expense of long-term corporate and societal gains.
This is an interesting and long-standing agency problem. Shareholders or owners hire a CEO (their agent) to optimize over several objectives: corporate profits (both short and long-term), market capitalization or firm value (both short and long-term), market share, access to credit, sustainable cash flow, and general financial health are some of the primary objectives.
Back in Adam Smith’s day, most companies were small and privately owned. They were usually managed by their owners, which guaranteed that management objectives were perfectly aligned with owner objectives. The markets in which they traded disciplined them to adopt practices that assured long-term survival. They had to behave somewhat responsibly or, in competitive markets, they would lose customers to competitors. Of course, in the presence of information asymmetries, monopoly, and other market failures, less discipline was forthcoming from the market even back then.
The divergence between management objectives and owner objectives became apparent to owners and investors as firm size increased and ownership and management roles became separated. The current executive pay-for-performance incentives that Pearlstein describes grew out of efforts to realign management objectives with owner objectives. As more companies went public, owner objectives were replaced by shareholder objectives.
While shareholders are technically owners, it is not clear to this child of business owners that shareholders’ primary objective of profits or returns on investment are tempered by considerations of the long-term sustainability of the firm. If all shareholders were long-term investors like Warren Buffet they would optimize over both objectives: ROI and long-term sustainability. However, growth in individual private retirement accounts along with changes to federal regulation of them (all good things) created shareholders, such as fund managers, whose own income depended on meeting short-term performance goals. In addition, as investment in equities became more commonplace, informed, knowledgeable, business-like investors were replaced by individuals who tended to view investing as a form of gaming or short-term reward that tended to reinforce the “casino-like” features of stock markets that Keynes so aptly warned about in General Theory.
As I noted in the last blog entry, most arguments in support of market solutions to market failures have as their underlying premise that private sector markets even at their worst are more efficient than public regulation or public provision of a good, such as health insurance. Pearlstein’s article provides evidence of inefficiencies in financial markets, which are similar to health both in terms of information asymmetry and in terms of uncertainty or risk. Not so surprising since insurance is, after all, a derivative good traded, in effect, in a futures market.
Some try to argue that regulation of executive pay is the force that has distorted incentives. This is a self-serving and short-term perspective that ignores the underlying causes for the regulation: the need to align the interests of two parties with possibly competing objectives: owner/shareholders and managers.
In my opinion, the need for alignment of competing objectives is pervasive in the US and the mechanisms by which it has historically been achieved are faltering. Moreover, there is a prevailing “narrative” that purports to support “free markets” and “competition” but demonstrates little understanding either of markets or of market failures. More importantly, it demonstrates no understanding of the moral and philosophical perspectives that traditionally have supported free markets and competition when they exist.
When Adam Smith described the benefits of commercial enterprise back in 1776, he described benefits both to individuals and to the larger society. The sense one gets on reading Smith in Wealth of Nations (or for that matter in Theory of Moral Sentiments) is that it was the benefits to the larger society that were persuasive for his advocacy. Moreover, one does not get the sense that Smith would have viewed increased national income in the absence of or at the expense of lower and middle-class personal income as a satisfactory outcome. He was quite explicit in his view of the rich and of businessmen who collude to cheat the public. He saw equity and efficiency moving in tandem as commerce spread and pronounced it good.
In many ways, we confront the same tension in health sector markets that financial markets must resolve: the need to align the short and long-term interests of several parties. Equity and efficiency are both compromised if such interests are not aligned. In the case of health markets, it is the interests of insurers, drugs and device manufacturers, providers, the entire health care supply chain, and the US population that must be aligned. The alignment must include long-term as well as short-term convergence. For ethical reasons, even in a perfectly competitive healthcare markets, relative prices would be insufficient. For economic reasons, in our less than perfect heath care markets, relative prices are incorrect and inadequate to accomplish this alignment. The government, through regulation and through alternative means of stimulating competition, such as the public option, is the only entity that can assure a fair outcome.
The real health reform discussion, the one we should be having, is “What must we do to create a health system that is both efficient and fair?” The answer will almost certainly include relegating the private sector to markets where market forces or regulation are effective at aligning short-term private incentives and goals with long-term societal interests. If such markets are scarce or non-existent in health, then the private health sector will be of limited value.