Since the document laying out the President's financial reform package is 88 pages, I will concentrate my evaluation on a few basic issues. 1) Do the reforms rely mainly on regulatory discretion or on new rules? 2) Is there adequate attention to the issues raised by financial institutions being "too big to fail"? 3) Is it proposed to micromanage the operations of financial institutions and individuals? 4) Most important, are these reforms likely to greatly reduce the likelihood of another financial meltdown? I take them up in turn, but my overall grade for the plan is no higher than a B-, and perhaps as low as a C.
During this crisis, regulators of banks and other financial institutions generally did not use the authority they already had to rein in the asset expansion and various excesses of commercial banks and other financial institutions. This is not at all surprising since regulators usually get caught up in the same "exuberance" as bankers, and no more see the looming risks to the system and to individual banks than do bank executives. Moreover, examples from many industries show that regulators frequently get "captured" by regulated firms, and tend to support the interests of these firms. This occurs even when the actions of firms are contrary to the public interests, and when regulated firms do not bribe or exercise other improper influence on regulators.
For these reasons, any new regulations should mainly operate automatically through rules rather than relying on discretionary decisions of regulators. Unfortunately, although the plan does contain new rules, they rely too much on discretionary choices of regulators. For example, the plan advocates creating a mechanism that allows regulators to take over large, failing financial firms, and to decide how to fix them, but it does not specify how the regulators should fix banks, or even when they should take them over. The plan encourages the Fed to monitor systemic financial risk, but it does not indicate how the Fed should determine whether systemic risks are excessive. My overall grade on the place of rules vs. discretion in the proposed changes would be no higher than a B-.
Countries tend to bailout large firms more often they should, including large and/or highly interrelated banks and other financial institutions. Nevertheless, big and complex financial institutions that appear to be failing will often be bailed out in the future, especially in light of the perception that the failure of Lehman Brothers triggered a sharp worsening of the crisis, and a dramatic retreat from risk. In order to reduce the likelihood of the need for such bailouts, large banks should be required to have especially high capital requirements (see my post on March 9). Perhaps they should also be forced to have much of their capital in liquid forms. The President does propose that the Fed should more heavily regulate and supervise large financial firms- possibly including special capital requirements- but the proposals appear to give the Fed much more discretion than is desirable. Overall, the grade on the too big to fail proposals is a B or B+.
Abundant evidence from the US experience and that of other countries indicates that governments do badly when they attempt to micromanage firms and individuals in the financial and other sectors. Nevertheless, the government proposes to have regulators issue guidelines on executive pay, with the intent of "better" aligning pay with stockholder value. It also wants to "better" relate the compensation of financial firms to the long-term performance of their loans, and to require non-binding shareholder votes on executive compensation.
Another proposal would prevent "unsophisticated" individuals from trading derivatives "inappropriately". Others would ban or restrict mandatory arbitration clauses, and would regulate bank overdraft provisions. Still other parts of the plan would mandate that some employers offer automatic IRA plans to employees, and the government proposes to regulate closely the investment choices made by holders of these plans.
The degree of micromanagement of company and individual behavior in these and other provisions is distressingly high (see our posts on the case against controls over executive pay on June 14th). This is why the overall grade on the proposed degree of micromanagement of financial institutions and individual behavior is no higher than a C.
Would the changes embodied in President Obama's financial plan greatly reduce the likelihood of another major financial crisis? An honest answer is that no one really knows because it is not yet clear which of the myriad aspects of the American financial system were the most important causes of the crisis. For example, some discussions blame the generous compensation packages provided to executives of banks and funds, especially the close dependence of total executive compensation on current profits and the value of their stock holdings. However, Japan had a terrible financial and economy wide crisis throughout the 1990s, even though Japanese executives are paid much less than their American counterparts, and Japanese executive pay is much less dependent on profits and stock prices.
Others have claimed consumer ignorance is responsible for the sharp growth in subprime and other mortgages, and for the great expansion of credit card debt. Yet who could blame poorer families for buying homes when they received great deals in the form of low interest rates-partly due to the Fed's policies! - and very low down payment requirements. Low down payments and low interest rates might have been mistakes of the lenders, and of government policy that encouraged such loans, but they hardly indicate that consumers were fooled into taking out these mortgage loans. Similarly, lower income consumers like to borrow on their credit cards because that debt is often the cheapest and most flexible form of credit available to them. Small print on credit card contracts and fast-talking mortgage salesmen were just not important forces in determining what happened in mortgage and other consumer credit markets.
A basic problem is that when little is known about the likely effects of new financial regulations, they are more likely to harm rather than help the financial system. Suppose, for example, that regulation of pay of financial executives appears to have a 1/2 chance of improving the efficiency of the financial sector by 25%, and a 1/2 chance of reducing efficiency by the same 25%. The average expected impact of such pay regulation on efficiency would be zero, but it would increase risk by raising the expected variance in the efficiency of outcomes. Therefore, when there is sizable ignorance about the consequences of new regulations, governments should only introduce those financial reforms that are much more likely to improve rather than worsen the performance of the financial sector.
When the government's financial proposals are evaluated from the medical principle of "do no harm", they cannot be given better than a C grade. The lesson from this low grade is not to stop reforming the financial sector, but to go slowly, and introduce now only those changes that seem quite likely to reduce the prospects of another crisis. For example, higher capital requirements, especially for larger banks, seem to be justified even though the precise role in the crisis of high and growing leverage of bank assets is not clear. Similarly, central counterparty exchanges for derivatives are often desirable, although the benefits are likely to be greater if traders are induced to participate in these exchanges rather than mandated to do so.
The case for other changes in financial markets may also be strong. However, most of the proposals in the President's plan should be put on hold until much more is learned about the causes and possible cures for this and future financial crises.
I have blogged at considerable length about the July 17 report, see http://correspondents.theatlantic.com/richard_posner/, and also written a short op-ed on the subject, published in the New York Times on July 25 ("Our Crisis of Regulation," p. 21). I have emphasized both what seem to me fundamental failings in the report and weaknesses in particular proposals. The fundamental failings include prematurity, one-sidedness, and overambitiousness, and let me dwell for just a moment on the first of these, or rather one aspect of the first, and that is the Administration's determination to revamp financial regulation in light of the financial crisis of last fall before the causes of that crisis have been determined. In other words, first the sentence, then the trial to determine guilt, specifically the guilt of the finance industry (of "banking" in a broad sense that includes other financial intermediaries--the members of the "shadow banking" system, of which more shortly).
Without pointing to evidence, the report asserts that the financial crisis was the product of irrational decisions both by lenders and borrowers and of major gaps in the structure of financial regulation. Ignored is the role of error and inattention by the regulators, notably including the Federal Reserve and the Securities and Exchange Commission; the deregulation movement in finance; lax enforcement of the remaining regulations; and failures of understanding by the economics profession. And thus the role of the Fed in forcing interest rates too far down, and keeping them too far down for too long, during the early years of this decade, and in neglecting growing signs of housing and credit bubbles (caused by low interest rates), goes unmentioned. Since senior economic officials in the Administration were implicated in these failures of regulation, and since the thrust of the report is that we need more regulation, it is not surprising that the report should give regulators a pass.
It should be a rule of regulatory reform that before the regulatory structure is changed, which is likely to be a time-consuming endeavor with at least some unanticipated consequences, the government make sure that the regulators are employing their existing powers to the full. And indeed just last week the SEC announced that it is imposing reserve and capital requirements on money-market funds, requirement that had they been in force last September would have reduced the systemic consequences of Lehman Brothers' collapse (see below). Had this rule been honored by the authors of the report, there would have been much less emphasis on structural reform, as in the proposed creation of new regulatory entities and the proposed expansion in the powers of the Federal Reserve.
The centerpiece of the Administration's proposal, and the only specific proposal in the report that I will discuss in this comment, is the proposal to authorize the Federal Reserve Board to regulate any financial enterprise that creates "systemic risk." The Fed would designate the enterprise a "Tier 1 Financial Holding Company," and having done so would have the same (perhaps even greater) powers that it has over commercial banks that are members of the Federal Reserve System. Its focus would be on "macroprudential" regulation--that is, on assuring that a failure of the Tier 1 FHC would not imperil the financial system as a whole. The Fed would be expected to limit the leverage of these firms (the debt-equity ratio in their capital structure) and take other measures to reduce the risk of failure, for example by forbidding them to engage in proprietary trading (that is, speculating with their assets). To prevent the gaming of this new regulatory power by firms that would go up to the very edge of whatever line was chosen to separate Tier 1 FHCs from other nonbanks, the Fed would have a broad discretion in so classifying financial firms.
Financial firms that are not commercial banks are now significantly larger sources of credit than banks, and they can create systemic risk. An example is (or rather was, because it is now defunct) Lehman Brothers, a broker-dealer. Lehman, among its other activities, was a dealer in the commercial paper and money-market markets. It would issue its own commercial paper (short-term promissory notes) to money-market funds and use the money it borrowed in this manner from the funds to buy commercial paper from (that is, lend to) nonfinancial firms with sterling credit records, such as Proctor & Gamble, that finance their day-to-day operations by issuing commercial paper. When, last September, Lehman Brothers became insolvent because of losses in other parts of its business, it could not repay its loans from the money-market funds or lend money to issuers of commercial paper. The commercial-paper and money-market funds froze, contributing to the credit crisis. Lehman was not among the largest nonbank financial enterprises, but because of its interdependence with other participants in the overall credit market its sudden collapse had serious repercussions.
Although the Federal Reserve claims that it lacked the legal authority to save Lehman from collapsing by lending it the money it would have needed to stave off bankruptcy, the claim is unpersuasive. Section 13(a) of the Federal Reserve Act authorizes the Federal Reserve to lend money to a nonbank provided the loan is "secured to the satisfaction of the Federal reserve bank." Lehman did not have good security for the loan it needed, but, in the emergency circumstances of a collapsing global financial system, the Fed could, it seems to me, have been "satisfied" with whatever security Lehman could have offered. If this interpretation seems a stretch, Congress could amend the statute easily enough to add "in the circumstances" or "in the sole discretion of the Federal Reserve Board," after "satisfaction," or it could delete the reference to security altogether.
But the fact that the Federal Reserve, has, as it seems to me, all the power it needs to prevent a nonbank that poses systemic risk from failing, and in failing carrying part or all of the entire financial system with it, is not a rebuttal of the Administration's proposal, because the government would like to be able to prevent the collapse of such enterprises rather than having to spend tens or hundreds of billions of dollars to save them. The first question to ask, however (it is not addressed in the Administration's report), is whether these enterprises that are not banks but might create systemic risk are already regulated. I mentioned money-market funds, which are regulated by the SEC, as are broker-dealers. One might think that closer liaison between the SEC and the Fed would go far to minimize the "macroprudential risk" posed by broker-dealers. Most important, if the Federal Reserve simply identified the firms that it believes pose systemic risk, a combination of market forces, public and legislative opinion, and the implicit risk of regulation would probably impel the firms to take steps to reduce the systemic risk that they pose. This possibility should at least be explored before the Federal Reserve is given enhanced regulatory powers.
After all, the principal reason--or so at least I think--for the financial collapse last September was that the regulators were asleep at the switch. They are now awake, indeed insomniac. If the Federal Reserve needs some additional staff, and perhaps authority to require financial information from financial enterprises that it does not at present regulation in order to identify the firms that pose systemic risk to the financial system, and perhaps some minor tinkering with the Federal Reserve Act to clarify its existing authority to deal with nonbank banks, these modest reforms can be adopted without restructuring the entire system of financial regulation, as the report proposes.
Warren Buffett, who is a wit as well as a multibillionaire, said with reference to the fact that Bernard Madoff's long-running Ponzi scheme came to light during the financial collapse of last fall that until the tide goes out, you don't know who's swimming naked. A year ago Becker and I blogged about the decline of the newspaper industry. A year later the decline has accelerated. The economic crisis has hurt the newspaper industry as it has so many industries. The question is whether it will recover (or at least rejoin its slower downward path of last year) when the economy as a whole recovers; or has the economic crisis merely revealed the terminal status of the industry.
I am pessimistic about a recovery by the newspapers. One reason is the current economic situation. A serious, protracted economic crisis can result in changes in consumer behavior that persist after the end of the crisis. A change in consumption, even in some sense involuntary, can be a learning experience. People make what they think will be merely temporary adjustments in their consumption behavior to reduce financial distress but may discover that they like elements of their new consumption pattern; and businesses too, which have reduced their newspaper (and other print-media) ad expenditures drastically. They may never go back.
Newspaper ad revenues fell by almost 8 percent in 2007, a surprising drop in a non-recession year (the current economic downturn began in the late fall of that year), and by almost 23 percent the following year, and accelerated this year. In the first quarter of 2009 newspaper ad revenues fell 30 percent from their level in the first quarter of 2008. This fall in revenue, amplified by drops in print circulation (about 5 percent last year, and running at 7 percent this year--and readership is declining in all age groups, not just the young), have precipitated bankruptcies of major newspaper companies and, more important, the disappearance of a number of newspapers, including major ones, such as the Rocky Mountain News and the Seattle Post-Intelligencer. Falling revenues have led to layoffs of some 20,000 employees of the remaining newspapers. Print journalism has come to be regarded as a dying profession. Online viewership and revenues have grown but not nearly enough to offset the decline in ad revenues. Even the most prestigious newspapers, such as the New York Times, the Wall Street Journal, the Washington Post, and USA Today, have experienced staggering losses.
News, as well the other information found in newspapers, is available online for nothing, including at the websites of the newspapers themselves, who thus are giving away content. The fact that online viewing is rising as print circulation is falling indicates a shift of consumers from the paid to the free medium. The economic downturn has doubtless accelerated the trend, but economic recovery is unlikely to reverse it. To repeat my earlier point, many of the people who have switched under economic pressure to the free medium may find themselves as happy or happier and hence will not switch back when their financial condition improves.
Moreover, while in many industries a reduction in output need not entail any reduction in the quality of the product, in newspaper it does entail a reduction in quality. Most of the costs of a newspaper are fixed costs, that is, costs invariant to output--for they are journalists' salaries. A newspaper with shrinking revenues can shrink its costs only by reducing the number of reporters, columnists, and editors, and when it does that quality falls, and therefore demand, and falling demand means falling revenues and therefore increased pressure to economize--by cutting the journalist staff some more. This vicious cycle, amplified by the economic downturn, may continue until very little of the newspaper industry is left.
So what will happen to news and information? Online news is free for two reasons. First, in the case of a newspaper, the marginal cost of providing content online is virtually zero, since it is the same content (or a selection of the content) in a different medium. Second, online providers of news who are not affiliated with a newspaper can provide links to newspaper websites and paraphrase articles in newspapers, in neither case being required to compensate the newspaper.
As newspaper revenues decline, newspaper content becomes thinner and thinner--but by the same token so does the linked or paraphrased newspaper content found in web sites that have no affiliation with a newspaper. If eventually newspapers vanish, online providers will have higher advertising revenues (because newspaper advertising will have disappeared) and may decide to charge for access to their online news, and so the critical question is whether online advertising revenues will defray the costly news-gathering expenses incurred at this time by newspapers. Imagine if the New York Times migrated entirely to the World Wide Web. Could it support, out of advertising and subscriber revenues, as large a news-gathering apparatus as it does today? This seems unlikely, because it is much easier to create a web site and free ride on other sites than to create a print newspaper and free ride on other print newspapers, in part because of the lag in print publication; what is staler than last week's news. Expanding copyright law to bar online access to copyrighted materials without the copyright holder's consent, or to bar linking to or paraphrasing copyrighted materials without the copyright holder's consent, might be necessary to keep free riding on content financed by online newspapers from so impairing the incentive to create costly news-gathering operations that news services like Reuters and the Associated Press would become the only professional, nongovernmental sources of news and opinion.
According to data compiled by my colleagues Matt Gentzkow and Jesse Shapiro, the number of daily newspapers in the United States has been declining for more than 90 years, from a peak of about 2200 to its present level of about 1400. The decline started with the advent of radio, accelerated with the growth of television, and continued of course as the Internet became more popular. The likelihood is that many more newspapers will disappear during the coming decade, and that dailies no longer will be a major source of information and news. This has already happened to evening newspapers: their circulation went from about five eights of the circulation of all dailies in 1940 to only about 12% at present.
A free press has been a foundation of democracies because the press spreads information about political and other developments. This is why one of the first moves totalitarian and other non-democratic governments make is to suppress the press. For example, the Iranian government has closed virtually all newspapers that are openly critical of the government. Nevertheless, I do not believe that the decline in the number of dailies, even if it rapidly accelerates, poses a major threat either to the viability of democracies, or to the spread of political and other information.
The main reason for this belief is that the Internet is far more efficient than newspapers in providing news, information, and opinion. This is obvious with respect to sports, financial developments, and weather since online updates are much more frequent than is possible even for the best papers. During the past 10 days of the Iranian election crisis, my wife and I turned mainly to the Internet for the very latest news and pictures on what was happening in Teheran and elsewhere in that country. These sources certainly included online editions of several newspapers, but also important were various online accounts by observers of and participants in the protests.
That the Internet is a more efficient provider of news and opinion than newspapers is seen in the fact that hardly anyone under age 40 now reads papers. Readership is also declining among older persons, but many of them continue to read papers- we subscribe to 3 daily and 2 Sunday editions- primarily because they built up strong habits of reading papers at breakfast or at other times. The lack of newspaper reading among younger persons is in small part a lifecycle effect, but mainly it is a strong predictor that the market for papers will continue to fall sharply.
The best newspapers, like the New York Times, Wall Street Journal, Financial Times, and Washington Post, not only present the latest news, in depth analysis of events, and selected opinions, but they certify the accuracy of what they are reporting through reputations built up over many years for objectivity, and care in checking sources. To be sure, they sometimes slant which facts to emphasize, or select stories that fit in with their particular points of view. Polls do strongly confirm that the great majority of journalists are liberal. Nevertheless, readers can usually have confidence in the news and other reports in the eminent papers.
Do online reports have a similar accuracy? I confess to being surprised by the huge numbers of men and women (including Posner and me!) who want to use the Internet to present their opinions and describe events they witness. Many millions of bloggers regularly report on everything from what they had for dinner to major political developments. Although the quality of these discussions varies greatly, many of them have gained reputations for rather accurate and unbiased reporting and analysis. A good example is the open source encyclopedia, Wikipedia, which has millions of entries that are continually updated. I have not read enough articles in Wikipedia to have an overall assessment, but I have been favorably impressed by most of those that I have read and can evaluate for their accuracy.
Although the printed newspaper industry is doomed, and will be missed by those of us that remember newspapers in their heyday, they are being replaced by good substitutes in the form of blogs, social networks like Facebook and Twitter, online news gathering by various groups, including newspapers, and other electronic forms of communication. People in democracies will continue to have access to independent and often quite accurate, reports on events in their own countries and most other parts of the world. In fact, the populations of undemocratic countries now have much greater access to what is happening in the world than they had in the past because it is far more difficult to suppress access to the Internet and other electronic forms of communication than it is to suppress newspapers.
This week the Obama administration, acting through Secretary of the Treasury Geithner, appointed a pay czar to review, reject, and possibly set the pay of companies that received large amounts of federal assistance during the financial crisis. No appeals will be allowed from his decisions. The Czar, Kenneth Feinberg, will have broad authority over compensation for the top executives and 100 top employees at Bank of America, Citigroup, American International Group (AIG), General Motors, and a few other companies that received large federal bailout monies. This is surely one of the more preposterous ideas to come out of Washington.
The title of my post, "The Fatal Conceit", is taken from the title of a book published in 1988 by Friedrich Hayek. In this book Hayek attacks socialists for "the fatal conceit" that government officials can effectively determine prices and production through various forms of central planning without having the incentives and information available to firms in competitive markets. A closely related conceit is behind the belief that someone sitting in Washington can determine the pay to hundreds of executives and other employees.
The social purpose of competition and private enterprise is to provide quick responses to constantly changing market conditions. These responses include determining and changing the salaries, bonuses, and stock options of employees and top executives. Companies get into trouble and even fail when their decisions, including decisions on the quality of employees and their compensation, are less effective than decisions of their competitors.
All the companies that will have the pay of top employees under the control of the Czar compete against companies, both domestic and foreign, that will be free to set the pay of their employees. If these companies offer higher pay than the Czar allows for companies under his jurisdiction-whether this higher pay takes the form of bonuses or other forms, or whether fully justified or not-the controlled companies will lose their best employees to competitors, and they will have trouble attracting employees who are highly capable. The Czar could even be making serious mistakes if he just allowed the pay of companies under his control to match the pay offered by competitors. For it is plausible that companies in hock to the government may have to pay more than competitors to entice capable persons to take on the task of resurrecting these companies. This is especially likely since Congress and the Treasury will be calling them to testify and second-guessing their decisions.
The background of the Czar, Kenneth Feinberg, is not reassuring in these respects. A lawyer, he first worked for the federal government, and then during the past several decades headed a law firm based in Washington. Since he apparently has never been an employee of any company other than the government and Washington law firms, how can this background prepare him to set the pay of large companies, such as AIG or GM, that are in highly competitive industries?
In recent interviews Mr. Feinberg claimed that excessive risk-taking fuelled the crisis, and that this risk-taking also led to excessive compensation. Surely, risk-taking has essentially nothing to do with the problems of GM and Chrysler, two of the companies under his wing. Growing leverage by banks of their limited capital base did contribute to the crisis, and perhaps that also greatly increased the pay of bank executives. However, even if this claim is entirely correct, I do not see how that can help him efficiently determine the pay of the (fortunately) few companies under his jurisdiction when their competitors can set the pay of their employees much more freely.
Defenders of the selection of Mr. Feinberg point to his almost three years spent as a pro bono Special Master of the fund that compensated victims of the 9/11 terrorist attacks. I do not know how well he carried out these duties, but determining compensation of victims is entirely different from what is required to set compensation of executives. As Special Master he had to assess the value of losses due to wrongful deaths and injuries. Although that assessment is not easy- it depends on lost earnings and other aspects of the so-called statistical value of life- it really has little to do with determining employee pay in a few companies engaged in highly competitive and changing industries.
The same fatal conceit behind the setting up of a pay Czar is also responsible for the belief that members of Congress and Washington officials are capable of steering GM and Chrysler toward profitable directions. This is behind the government pressure on these companies to shift toward small fuel-efficient cars, even though GM and Chrysler have been best at producing trucks and larger cars. Perhaps they will be able to make this shift, but it is far more likely that Honda, Kia, Toyota, and other foreign auto manufacturers that have been making small cars for decades will eat their lunch.
I agree with Professor Bebchuk of Harvard, and others, that there is a problem with the compensation of top executives at publicly held corporations (that is, corporations in which ownership is widely dispersed), so that control resides in the board of directors. The problem is that the individual directors do not have strong incentives to limit the pay of the CEO and other top executives. By limiting his and their pay, the board would narrow the field of selection, and if the company got into trouble they would be criticized for having been penny wise and pound foolish in resisting their "compensation consultant's" advice to pay top dollar. In addition, the directors often owe their lucrative directorships, and their continuation in them, to the CEO. The movement toward "independent" directors (as distinct from directors who are officers of the corporation) does not cure the incentive problems, but rather compounds them by making the board less knowledgeable about the corporation.
So there is a basis for concern with the compensation of top management in publicly held corporations, but it is not a momentous concern and costly measures to ally it would not be justifiable. Modest measures, such as making it easier for shareholders to replace directors than under the existing, Soviet-style system in which shareholders vote for or against the slate proposed by management, and requiring full disclosure and monetization of all forms of compensation paid CEOs and other top executives, may be sensible; but nothing more should be attempted.
The solving of the overcompensation problem would have little if any effect on risk taking by bankers and other financiers, so probably any efforts to solve it should be postponed until the economy recovers from its present sickness.
A distinct problem is that of compensation of executives of firms that are owned or controlled by the federal government, such as General Motors, American International Group, Fannie Mae, and Freddie Mac, and (or) that are recipients of federal bailouts. These are troubled firms, and the concern is that management may try to funnel the federal moneys that the firms have received into dividends and bonuses so that shareholders and executives will be protected should the company fail completely. The danger in other words is that when a firm is teetering on the edge of bankruptcy, management may stiff the firms' creditors by funneling some of the firm's remaining assets to managers and shareholders. The time to deal with this problem, however, is when the bailout is made; suitable conditions can be attached to it. To instead appoint a "pay czar" to deal with executive salaries of bailout recipients on an ad hoc basis creates all the problems that Becker discusses.
These problems are especially grave with regard to General Motors and Chrysler, as these are fast-failing firms that need to be able to offer high salaries to attract able executives. Between efforts by the "pay czar" to limit these companies' flexibility in compensation, and the efforts by Congress to limit the companies' ability to import vehicles and close plants and dealerships, the government is doing to best to minimize its chances of ever recovering its $60 billion investment in the two firms. This is called shooting oneself in the foot, or, alternatively, politics as usual.
Still another distinct problem is that of compensation practices of banks and other financial intermediaries. Here the problem is not the compensation of top management, but the compensation of traders and other investment officers at the operational level. The concern is that compensating them on the basis of the profitability of the individual deals that they make motivates them to take excessive risks. Suppose a deal has a positive expected value, but there is a 1 percent chance that it will fail in a way that imposes heavy costs on the corporation, and perhaps, because of the chain-reaction effect of the failure of a major bank (as we saw last September, when Lehman Brothers went broke), on the financial system as a whole. The trader who makes the deal may not worry much about that risk, because a 1 percent annual risk of disaster is very unlikely to materialize in the short run; the probability that an annual risk of 1 percent will materialize in 10 years is only 10 percent (actually a shade less).
Financial firms that worry as they should about such a catastrophic risk (since the firm makes many deals, which multiplies the risk of disaster), typically try to reduce it by employing "risk managers" who review proposed deals. Because this method of limiting risk failed to avert the financial collapse of last September, there are suggestions that it be supplemented or replaced by rules limiting the cash bonuses paid to traders, instead compensating them in restricted stock of the corporation, which they cannot sell for a number of years, or authorizing the corporation to "claw back" any bonus they receive should the risk involved in one or more of their deals later materialize and reduce or eliminate the profit that the corporation made on the deals.
It might seem that top management would have all the incentive it needed to prevent its subordinates from taking risks that would jeopardize the solvency of the company. But that is not true, because the private cost of bankruptcy is truncated by limited liability (the shareholders cannot be forced to pay the corporation's debts), but the social cost, as we have learned, can include a devastating global economic shock.
An external cost is a conventional justification for regulatory intervention--in principle. But the specific suggestions for curbing risk taking by traders are problematic. There are many influences on the value of a corporation's stock besides the outcome of a particular deal, and a claw-back possibility can greatly reduce the present value of a bonus, as well as complicating the recipient's tax and other financial planning. I conclude that it is premature to start regulating compensation practices in the banking industry; there are other ways of reducing financial risk that are less problematic.
Notice that this problem has nothing to do with boards of directors' inability under existing rules to control the compensation of top executives, because traders are not top executives. Management has no incentive to overpay its subordinates! Nor has this problem anything to do with government ownership or control, or a risk of insolvency that might induce top management to try to appropriate a firm's remaining assets.
Any monkeying by government with compensation practices, especially below the top level of management and especially in financial firms, will impair the ability of American firms to compete with foreign firms. The banking business is thoroughly international, and unless all countries act in lock step with the United States in regulating compensation practices, many of our ablest financiers will be lured to foreign banks.
One can only hope that the appointment of a "pay czar" is merely a sop to ignorant public and congressional opinion, and that Mr. Feinberg will be suitably restrained in the exercise of his powers. Secretary of the Treasury Geithner seems unenthusiastic about the government's imposing more than cosmetic changes on corporate compensation. practices. More power to him.
It is understandable why there is widespread concern with the American system of health care. The nation spends about 15 percent of its very large Gross Domestic Product on health care, which is almost twice as much per capita as the nations that we consider our peers spend, yet outcomes, at least as measured by longevity, are no better in the United States than in those other nations, or for that matter in many much less wealthy nations. We provide much greater health care to elderly people at the end of their life than other nations do, though without much to show for it in increased longevity. Some 45 million people--15 percent of the population--have no health insurance, either private or public. They are either charity patients, or pay the full price of any medical treatment they receive--or at least are charged the full price, for a common sequel to an expensive medical procedure for an uninsured patient is the patient's declaring bankruptcy in order to wipe out his medical debt.
The Administration wants every American to have medical insurance. The details are unclear, but the thrust of the Administration's plan is those who can afford to buy medical insurance, either directly or through their employer, would be required to do so and that those who cannot would have their insurance subsidized. The cost to the government alone of the Administration's program is estimated by the Administration itself to be $120 billion a year. How it will be financed remains up in the air, along with many other crucial details. Probably part of the cost will be defrayed by limiting the tax deductibiliy of employer-provided health insurance. But most of it, at least in the short run, will simply be added to the government's huge budget deficit--so huge that amounts like $120 billion are beginning to seem like small change.
The Administration claims that in the long run the aggregate cost of health care will actually fall. Indeed, the hope is that the $120 billion annual cost will not have to be funded at all, but instead will be offset by various reforms that the Administration proposes, including digitization of health records, allocation of greater resources to preventive care, and evaluating the performance of hospitals and other medical providers more carefully, to determine which medical procedures are really useful, and limiting reimbursement to providers accordingly.
I don't think the program makes fiscal sense. If enacted in anything like the form that the Administration is urging on Congress, it would be immensely costly and would thus add significantly to our national debt, which is already growing at a fast clip because of the decline of tax revenues as a result of the current depression and the immense government expenditures on trying to speed economic recovery.
Ignored in estimates of the cost of the health care program is the effect of insurance on the demand for medical services. When people, because they lack health insurance, have to pay for medical services or encounter long queues in hospital emergency rooms, they have an incentive to economize on medical treatment. If they have health insurance, the marginal cost of treatment in excellent medical facilities falls to the cost of a deductible or copayment; and it is the marginal cost that the insured consumer of medical services confronts--the cost of the health insurance premium itself is a fixed cost, which is not affected by how much treatment the insured receives. Because the supply of medical services is not highly elastic, an increase in the demand for those services will increase average as well as total cost.
I would not object if a program of universal health insurance could be financed by reducing or eliminating the tax deductibility of health insurance. But only a modest reduction, if that, in its deductibility is politically feasible. The reforms that the Administration contends will not only pay for the program but also reduce the aggregate costs of health care in the United States are probably pie in the sky. Digitization of medical records does increase efficiency: it makes it easier to change doctors, track health histories, and coordinate medical services. But the net savings are likely to be modest or even negative, because anything that lowers the average cost of a given quality of health care increases demand, just as broadening insurance coverage does.
Preventive care--another efficiency measure touted by health-care reformers--is potentially very costly, because by definition it provides health services to people who are not yet ill. Advances in preventive care are not limited to telling people to exercise and eat healthful foods, but increasingly are dominated by massive and costly programs of screening and follow-up. Such programs, and the treatments that ensue for persons found to have a treatable condition, may extend life, but often this means keeping alive very sick people who will require expensive care for the remainder of their prolonged life.
An effort to create a form of benchmark competition between hospitals and between doctors, by careful evaluation of outcomes and by using the results of the evaluation to calibrate reimbursement by insurers so that the best-performing health-care providers will be rewarded and the worst punished, is likely to founder on the difficulty of adjusting for differences in outcomes that are not attributable to the efficiency of the health-care provider.
In addition, efforts to limit treatment by limiting reimbursement, especially efforts by government to do so, are deeply unpalatable both to patients and to doctors and hospitals. A patient convinced by his doctor that a particular treatment is his only hope for continued life will not be reassured to be told that in the opinion of the government's experts, the treatment would not be cost-justified because it is very costly and is unlikely to be successful. Insurers, and employer health-benefits plans, try to do this kind of financial triage now, but their lack of success is reflected in the enormous annual cost of American health care.
A deep problem is the replacement, in the medical profession as in the legal profession, of a professional model of service with a business model. In the professional model, the service provider is assured a good but not extravagant income by limitations on competition, and in exchange he is expected to avoid exploiting the ignorance of patients as he could do by performing unnecessary or low-value procedures. In the business model, the service provider endeavors to maximize his net revenues. In the case of medicine, the disparity of knowledge between provider and patient, coupled with the fear and desperation that serious illness (or just the possibility of it) engenders, enables the profit-maximizing provider often to convince the patient to undergo costly low-value treatments. Certainly the profit-maximizing health-care provider will be very relucant to refuse to provide a treatment that the patient insists upon, his insistence being made convincing by the fact that insurance will pay all or most of the cost. Insurers do try to limit their costs by refusing to approve low-value procedures--but in the face of combined pressure by provider and patient, the insurer is often forced to back down.
To return to the initial puzzle of why our peer nations are able to provide what seems, judging by outcomes, a level of health equal or superior to that of Americans at far lower cost, the only convincing answer is that the health-care providers in those nations limit treatment. I am not sure of the explanation, but the possibilities include: the professional model is more tenacious in societies less committed to free markets and a commercial culture than the United States; more of their hospitals are public and more of their doctors are public employees, who are therefore salaried rather than entrepreneurial; and Americans, being less fatalistic than most other peoples, have a more intense demand for life-extending procedures. These are reasons why a national health plan modeled, as the Administration's appears to be, on the health plans of peer nations with much lower aggregate health costs is unlikely to work well, or at least to generate net cost savings.
Of course if people value extension of life very highly--and there is evidence that, in the United States at least, most people do--a very costly health care system may be cost-justified, in the sense that the benefits exceed the costs. Yet the benefits seem rather illusory, since the extra money we spend on health care does not seem to produce better outcomes. But international comparisons of health that are limited as they largely are to differences in longevity are crude. They ignore health benefits unrelated to longevity, such as the benefits conferred by cosmetic surgery and the possibility that the additional costs of health care in the United States enable people to live more dangerous, strenuous, or self-indulgent lives and by doing so confer utility.
The best way to evaluate America's expensive health care system would be to estimate the effects of different kinds of healthcare on the quality and quantity of health for individuals of various ages, incomes, races, and other categories. To my knowledge, no researchers have come close to doing this. Instead, the American system has sometimes been found wanting simply because life expectancies in the United States are at best no better than those in France, Sweden, Japan, Germany, and other countries that spend considerably less on health care, both absolutely and relative to their GDPs.
Life expectancy is surely one supremely important measure of health since individuals in rich countries are willing to pay a lot even for small increases in their probabilities of surviving different ages (see the studies in the book "Measuring the Gains from Medical Research", ed. By Kevin M. Murphy and Robert Topel, 2003). Studies show that an additional year of life is worth over $120,000 to the typical American adult, apparently also including older adults, where "worth" is measured by willingness to pay for a one-year improvement in length of life. One can easily see without a lot of fancy calculations that the large sums Americans are willing to pay for improvements in health imply that they would pay a considerable fraction of their incomes in order to achieve significant improvements in their life expectancy, and also in their quality of life. Similar conclusions apply to other countries since the willingness to pay in different countries for an additional year of life varies approximately proportionately to their per capita incomes.
Although such calculations show that improvements in life expectancy are worth a lot to most people, national differences in life expectancies are a highly imperfect indicator of the effectiveness of health delivery systems.for example, life styles are important contributors to health, and the US fares poorly on many life style indicators, such as incidence of overweight and obese men, women, and teenagers. To get around such problems, some analysts compare not life expectancies but survival rates from different diseases. The US health system tends to look pretty good on these comparisons.
A study published in Lancet Oncology in 2007 calculates cancer survival rates for both men and women in the United States, the United Kingdom, and the European Union as a whole. The study claims that the most important determinants of cancer survival are early diagnosis, early treatment, and access to the best drugs, and that the United States does very well on all three criteria. Early diagnosis helps survival, but it may also distort the comparisons of five or even ten-year survival rates. In any case, the calculated five-year survival rates are much better in the US: they are about 65% for both men and women, while they are much lower in the other countries, especially for men. These apparent advantages in cancer survival rates are large enough to be worth a lot to persons having access to the American health system.
Several measures of the quality of life also favor the US. For example, hip and knee replacements, and cataract surgery, are far more readily available in the US than in Europe. The cancer survival and quality of life advantages enjoyed by US residents indicates that Americans get something for the large amount they spend on health care, but they do not indicate that the bang for the health buck is greater in the US, or even that the US health delivery system is reasonably efficient. Indeed, the American health system has several characteristics that may considerably lower its efficiency.
The American system ties medical insurance to employment by allowing company spending on medical premiums to be fully tax-deductible. Companies introduced health benefits during World War II in order to get around wage controls to be competitive in attracting employees. It was maintained as income tax rates increased during subsequent decades. This employer-based system is partly responsible for the high number of Americans who have no insurance coverage, since many small companies do not provide insurance to their employees. In addition, the system favors persons with high earnings since tax deductions for insurance premiums are worth more to them. A much better approach, so far opposed by President Obama, would provide a certain number of dollars each year to every person-perhaps $2500- as tax credits to be used only to buy health insurance and pay for medical care. Unused amounts in any year would be folded into health savings accounts (see my discussion of these accounts and other health care issues in posts for April 15, 2007 and January 13, 2008), and unused balances in any year would be carried over to spend in later years. This approach gives the same tax incentives to everyone, and it would encourage individuals to economize on their health care spending since unused balances would be available to spend in the future. It would also induce many persons without health insurance to get some since otherwise they lose access to this tax credit.
Health insurance is expensive in the US partly because most states mandate coverage of various health expenditures that have little to do with insurable risks. For example, the majority of states require insurance companies to cover the medical costs of all birth deliveries, even though these deliveries are mainly planned, and the expenses are known beforehand. The proper insurance approach would cover only unusual birth expenses caused by complications in the delivery and post delivery stages. By getting rid of unnecessary mandates, health insurance would become much cheaper, especially in states with the more onerous mandates.
The President wants to establish government-run health insurance companies to compete with private companies. This is a bad idea because experience from government-owned enterprises in other sectors conclusively shows that that they are run inefficiently, in good part because of political interference. Moreover, government enterprises do not compete fairly since they generally are subsidized, often generously and in hidden ways. Private health insurance companies in the US compete very strongly, although they are hampered by mandates and other regulations that frequently have nothing to do with effective and honest coverage of health needs.