The Becker-Posner Blog

Should the Government Use Its Monopsony Power to Reduce the Price of Drugs? Posner

One of the controversies swirling around the movement for health-care reform concerns the use of “buying power” by the federal government to reduce drug prices; the government is a huge indirect purchaser of drugs since it finances the Medicare and (with the states) Medicaid programs, in addition to providing medical care to military personnel and veterans and medical insurnance to the government’s civilian employees. A related issue (which I do not discuss) is whether the government should finance the importation of drugs from countries in which drug prices are lower.

 

The technical issue is the use of monopsony power. Monopoly power in economics refers to restricting output in order to push price above the competitive level, which is the level at which a further increase in output would cause price to fall below the cost of producing that additional output. A price above that level will deflect some buyers to substitute products that cost more to produce but are cheaper because they are sold at a competitive price. For example, if the marginal cost of product A is 5 and its price is equal to marginal cost, most buyers will prefer it to B, a similar product that costs 6 and is sold at 6. If now A is monopolized and its price rises to say, 7, some buyers of A will switch to B, and therefore will be buying a product that actually costs society more to produce. This deflection is a social cost of monopoly, as is also any costs that sellers incur to obtain monopoly power, such as costs of collusion or of obtaining government protection from competition. In addition of course there is a transfer of wealth from consumers to producers if products are sold at monopoly prices, though this does not reduce economic welfare unless consumers derive greater utility from a marginal dollar than producers (their shareholders, etc.) do.

 

Monopsony power is parallel. It refers to a situation in which a buyer reduces its purchases of an input in order to reduce its costs. Most products have an upward-sloping supply curve, meaning that the larger the quantity that is produced, the higher the unit cost of production, because the producer or producers have to bid more resources away from other producers. So one way a company can increase its profits is by buying less of an input, though this will work only if the company buys a large fraction of the quantity of the input that is produced, as otherwise its reduction in quantity purchased will not have a substantial effect on the quantity of the input that is produced and therefore on its price.

 

Monopsony is inefficient, like monopoly, because it reduces the output of the monopsonized product below the competitive level; the monopsonist produces below that level in order to reduce his input costs. In the drug setting, the government, purchasing or (more commonly) controlling (acting in effect as an intermediate buyer) the purchase of such a large fraction of total drug sales could reduce by some arbitrary amount the drug prices that it is willing to reimburse or permit the reimbursement of doctors, pharmacies, and hospitals for.

 

The drug companies in turn would reduce their output, though not immediately. The reason is the structure of drug costs. The cost of developing and obtaining FDA approval of a new drug, all of which cost is incurred before the drug is sold, is a large percentage of total costs. Once the drug is on the market, the cost of actual production is very low. The sale price of the drug is dominated by the presale development costs. The effect of the government’s pushing down the sale price would therefore be to reduce the development of new drugs rather than the production of existing drugs. (As Becker points out in his comment, this analysis does not apply to generic—unpatented—drugs, which generally are sold at a price close to marginal cost. To those drugs, the normal monopsony analysis would apply: the government would pay a price that forced the producer to move down his supply curve, reducing output.)

 

Slowing the development of new drugs would be politically attractive because the reduction of government-financed drug costs would be experienced immediately but the cost in slower development of new drugs (because they would be less profitable) would be deferred, and indeed would be invisible because no one would know how much faster the development of new drugs would have been had it not been for the government’s exercise of its monopsony power. In addition, the cost savings to the government from reducing the price of drugs could be used to reduce the deficit that the health-care reform program soon to be adopted by Congress will create.

 

Complicating analysis is the fact that expenditures on medical care are not well aligned with social benefits. Because beneficiaries of government health-care subsidies do not pay the full cost of health care, including the full cost of drugs, health care is overproduced from the standpoint of economic efficiency. This overproduction is exacerbated by the immense marketing expenses of the drug industry, which appear to exploit the ignorance and desperation of the sick. Particularly objectionable in my opinion is television advertising of prescription drugs, which is designed to bypass physicians’ exercise of professional judgment by appealing over the heads of the physicians to the patients, who pester their physicians to prescribe drugs that the patients have seen advertised on television.

 

There is no doubt that many people derive great subjective utility even from new drugs that do not do much for them—that are not significantly superior to old drugs and produce only slight extensions of life. But if they are misinformed or, more likely, do not bear the cost of the new drugs, there is no presumption that the provision of these drugs is utility-maximizing in an economic sense. If I am correct that government subsidies and patients’ information costs have resulted in an overproduction of drugs from an efficiency standpoint, there is an argument for the government’s using its monopsony power to reduce the price of drugs. If drug production is above its optimal level, the economic objection to monopsony—that it reduces output below the optimal level—withers.

 

An objection likely to block any such measure is that it amounts to government’s rationing medical care. It does. But if government is to be the (indirect) provider of care, it has to ration it; otherwise the costs of medical care will strangle the economy.

Government Demand for Drugs and Drug Prices-Becker

In determining whether governments should use their monopsony power-defined well by Posner- to reduce drug prices, it is essential to distinguish between generics and drugs that are still protected by patents. Generics are produced under competitive conditions because they typically become available only after patents on drugs expire. The production of generics would be inefficiently low if the government used its buying power to force down prices to the government, and to patients, to levels where demand for drugs by patients exceeded the supply of these generics.

Even a government monopsonist can avoid causing such an inefficiently low output of generics if it bought generics at competitive prices, but required generic drug producers to give them upfront payments in order to get their business. This is called two-part pricing in the literature on monopoly pricing, and applies fully not only to government monopsonists, but also to unions that set wages along with employment of their members. However, successful two-part pricing is delicate to achieve, and if used unwisely on generic producers it could force some of them out of business in the long run because they cannot obtain a decent return on their capital investment.

The wisdom of the government’s using its economic power to lower the prices of drugs it buys is even more questionable for drugs under patent protection. The whole purpose of patent laws is to give drug innovators monopoly power for a period of time in pricing their drugs in order to encourage the R&D research that leads to these innovations. The government would be taking away with one hand what it gave with another hand if it then used its buying power to take back some of this pricing power.

A different version of two-part pricing might help even with patented drugs. The government could arrange to pay producers of patented drugs a certain amount upfront if they sold units of the drugs to them at the cost of producing these drugs. Such upfront payments would help offset the large spending on R&D required to discover successful drugs. The major difficulty in this approach is in determining the size of these upfront payments to drug companies, especially when the media and members of Congress would be quick to claim a sell out to powerful drug lobbies.

One reason why companies and researchers in the United States are greatly overrepresented in the development of new diagnostic and therapeutic drugs compared to say Europe (see, for example, the paper by Whitman and Raad “ Bending the Productivity Curve: Why America Leads the World in Medical Innovation”, November 2009, Cato Institute) is that prescription drug prices are about 50% higher in the United States than in Europe. Another factor is that almost half of all pharmaceutical sales are in the US.

Posner recognizes that especially persons under government Medicare and Medicaid are encouraged to buy an excessive amount of drugs relative to their medical needs because their co-payment rates are only a fraction of the total cost to the government. Posner also believes that advertising and other promotion of drugs induce consumers to buy more drugs than they really “need”. Perhaps that is true, although I am doubtful. Stil, both these considerations suggest that the government should force consumers to pay more for drugs under Medicaid and Medicare. Higher consumer prices could induce consumers to eliminate any “excessive” use of drugs. Whether the government could politically get lower prices from pharmaceuticals and yet force many consumers to pay more is surely questionable.

A different reason why investments in developing new drugs may be excessive is that it is hard to deny the use of new drugs once they are developed, even when new drugs are only slight improvements over existing drugs. The difficulty in denying their use may arise from political pressure by the elderly and others who benefit, even if only by a little, from the new drugs. In addition, children who help their elderly parents pay for their medical care may feel “guilty” in not allowing them to consume the latest drugs, even when they add little to their parents health and longevity.

Other considerations, on the other hand, suggest that drug companies may not spend enough on developing new drugs. One is that even elderly people appear to be willing to pay a lot of their own resources for small extensions in their life- see the various Rand experiments on demand for medical care. Persons with serious diseases believe or hope that if they can extend their lives even for a short while, new drugs will come along that will greatly improve their life prospects. This happened during the 1990s for persons with Aids since Aids cocktails developed then that greatly extended lives of persons with Aids. Very sick patients with these expectations would be willing to spend a lot for relatively small initial extensions in their life expectancy.

Another reason why too little may be spent on developing new drugs is that companies with blockbuster patented drugs collect only a fraction of the total benefits to patients, despite the high prices they charge. This is partly because similar drugs are often developed prior to the expiration of the patents of the original drugs.

The net outcome of all these forces is that the American government would be unwise to use its economic power to force down drug prices, unless it used sophisticated forms of two-part pricing of drugs. I believe that in the long run major drug discoveries lower rather than raise medical spending by reducing the need to rely on lengthy hospital stays and expensive surgeries to treat serious diseases.

Failure in Copenhagen-Becker

Relative to initial expectations, and given that the heads of almost all leading nations attended, the recently concluded United Nations climate change summit in Copenhagen was an embarrassing failure. The final accord was only a statement of intention, and had no binding pledges on actions to reduce greenhouse gas emissions, although the majority of attending nations did agree to ''take note'' of a vague last-minute compromise document by President, Barack Obama, and the leaders of four major emerging powers: China, India, Brazil and South Africa.

The most important issue on the initial agenda was to reach agreement on major worldwide cuts during the next several decades in greenhouse gas emissions. Yet the final Copenhagen document removed from an earlier draft a proposal to target a 50% cut in world greenhouse gas emissions by the year 2050. The final document does acknowledge the need to limit world temperature rises to less than 2 degrees centigrade above pre-industrial levels, but it does not include any way to enforce achieving this goal.

The second major aim of the US, Europe, and other rich countries was to get agreement from China, Brazil, India, Russia, and other important developing countries to greatly reduce their greenhouse gas emissions during the next couple of decades. China has become the world’s largest producer of carbon dioxide, supplanting the US, now in second place. In return for agreeing to large reductions in emissions, developing countries hoped to receive substantial aid from the rich countries. This effort also failed. The only firm deal on aid in the final accord is for developed countries to provide a paltry $30 billion to help developing nations cope with the effects of climate change from 2010 to 2012, although the rich nations indicate that they will try to jointly provide $100 billion year to developing countries by the year 2020.

It is easy to see why the fundamental difference at the Copenhagen meeting was between the developed and developing world (the second most important difference was within the developed world, where Europe and Japan wanted more aggressive emission cuts from the US). A well documented finding by development economists is that as per capita income grows in the course of economic development, countries become more concerned about both local and global pollution, such as global warming. This is why the BRIC countries-Brazil, Russia, India, and China- and other developing countries feel it is unfair to ask them to take actions that the developed countries themselves did not take when they too were much poorer.

This fundamental conflict is the reason why rich countries were willing to discuss possible aid, or “bribes”, to developing countries if they undertook large cuts in their carbon dioxide emissions (see the proposal along these lines in my post in December 2004 on our old website Becker-Posner-blog.com.) This explains the goal of providing $100 billion of annual aid by 2020.

$100 billion is a lot of money, but it is paltry compared to the GDPs of the most important developing countries, and even to their industrial output base. For example, China, the largest of the developing countries, has a GDP of about $8 trillion, adjusted for purchasing power parity, compared to the $14 trillion of the United States. Since China is the world’s largest exporter of goods, its industrial sector- where carbon emissions are concentrated- accounts for almost half its total output. Even if we suppose, unrealistically, that China receives a full half of the proposed aid, or $50 billion annually, that is only 5/8 of one per cent of its current GDP. So China would be economically much worst off if, in return for this $50 billion, China had to cut emissions enough to reduce its growth rate by only a little. For example, if cuts in its carbon dioxide emissions reduced China’s annual growth rate for the next decade from 8% to 7.37%, the lose in GDP from the lower growth in the first year would just offset the $50 billion in aid. However, in later years, China would lose much more than the aid from rich countries since its GDP base would be much larger due to its rapid economic growth.

The difficulty in reaching agreement on enforcing compliance was a major obstacle to getting rich countries to agree to large amounts of aid. China and other developing countries argued that monitoring of their compliance with their pledges to reduce emissions of greenhouse gases infringed their sovereignty as independent nations. Yet without serious monitoring of compliance, such agreements are of dubious value since developing countries, especially non-democratic ones, may accept aid from rich countries, and then fudge their published records on degree of compliance.

The rich countries of Europe, Japan, and the United States may still implement further steep cuts in their own carbon emissions. But that is likely to have only a modest effect on worldwide carbon emissions if the BRIC countries and the other almost 200 countries are not included. A major reason why the 1997 Kyoto Protocol failed is that it exempted developing countries from any targeted cuts in emissions. Large cuts by rich countries alone would speed up the already rapid shift of economic power to Asian and other developing nations. Some companies in Western countries would transfer much of their most polluting outputs to developing countries, and industrial companies from China and elsewhere would grow at the expense of American, European, and Japanese companies.

So my conclusion is that either rich nations have to pony up a lot more money to get developing countries to agree to large cuts in their greenhouse gas emissions when monitoring of compliance would be limited. Or rich countries have to go it alone in cutting their emissions, and then accept a much smaller impact than they would like from their own cuts on worldwide emission reduction. Even the strongest proponents of immediate sharp cuts in world emissions of greenhouse gases –which I am not- have to recognize the implication from the failure of the Copenhagen meeting that large worldwide reductions in emissions are not achievable in the near future.

 

The Copenhagen Debacle: Where Do We Go from Here? Posner

I agree with Becker that the Copenhagen conference on global warming was an embarrassing and total flop. As he explains, there is no prospect in the foreseeable future for an international treaty that will limit emissions of carbon dioxide. A different approach is required.

 

And desperately required; for I believe that the threat of global warming is very serious, and that it is not merely a long-term threat. (If it were, there would be no urgency about taking measures to slow it, for normal technological progress will eventually solve the problem at low cost.) The particular danger which concerns me, and which I emphasized in my book Catastrophe: Risk and Response (2004), is that of abrupt global warming. The climate equilibrium (like the economic equilibrium, as we have discovered) is unstable, in part because of feedback effects. For example, as the Alaskan and Siberian permafrost melts, methane, a potent greenhouse gas, is released into the atmosphere, causing surface temperatures to rise, which in turn accelerates the release of methane. And also as surface temperatures rise, the amount of water vapor in the atmosphere increases—and water vapor is a potent greenhouse gas, and so increasing it accelerates the warming trend. The ocean’s capacity to absorb atmospheric carbon dioxide is limited, so that as emissions increase, more remain in the atmosphere longer. Similarly, the destruction of forests to make way for agriculture increases net carbon emissions because trees absorb more carbon dioxide (during the day, in photosynthesis) than they emit (at night, when they are breathing oxygen and exhaling carbon dioxide).

 

The effects of rapidly rising concentrations of greenhouse gases in the atmosphere in heating the earth’s surface could produce such catastrophes as the melting of the Greenland and Antarctic ice caps, which would raise the level of the oceans by several feet, and the melting of the Arctic ice cap, which by diluting the salt in the North Atlantic could shift the Gulf Stream from northeast to north, which would give Europe, because of its northern latitude, a Siberian climate. These are catastrophes that could occur within the next one or two decades.

 

No probabilities can be attached to abupt global warming, so no expected cost can be calculated that would enable a cost-benefit analysis of preventive measures. But when the likelihood of an immense disaster cannot be estimated, yet does not seem negligible, there is an argument for taking preventive measures, at least if they are not prohibitively costly.

 

The free-rider problem is defeating efforts to limit carbon emissions. Emissions limitations even by a major emitter (the two biggest emitters are China and the United States) would have only a slight effect on the concentration of carbon dioxide in the atmosphere. It would not reduce the concentration; it would not keep it from increasing; it would just slow the rate of increase slightly. The major effect would a transfer of wealth to any country that did not limit its emissions; that country would have a competitive advantage because it would not bear the cost of reducing emissions. As other countries reduced production because of higher costs, the free-riding countries would increase their production (because they would have a comparative advantage)--and with it their carbon emissions.

 

The free-rider problem would not be serious if the cost of reducing emissions by significant amounts were low; but it is high. Given existing technology, it requires a substantial reduction (whether brought about by emissions taxes or by quotas) in the use of motor vehicles, in the generation of electricity (other than in nuclear reactors), and in the clearing of forests for agrcultural and other uses. What is needed to make a solution to global warming feasible is cheap technological fixes. One is actually at hand, though strongly resisted by environmentalists (I am tempted to put “short-sighted” in front of “environmentalists”), and that is to inject sulphur dioxide, a potent sun-screen gas, into the atmosphere. This solution (called “geoengineering”) is resisted because sulphur dioxide in the atmosphere causes acid rain; but acid rain is a far less serious problem than global warming.

 

Other possible technological solutions include injecting carbon emissions from electrical power generation underground, cheap battery-driven motor vehicles, and artificial “bacteria” that would devour carbon dioxide in the atmosphere. All of these solutions would require large investments in research and development to achieve feasibility at low cost. The benefits, however, would include not only reduced carbon emissions but also reduced dependence by the United States, Japan, and many other countries on foreign producers of oil and natural gas, which include unstable countries and countries hostile to the United States and its allies.

 

The United States and other nations are financing the development of carbon-limiting technologies, but at low levels relative to the need. I favor carbon taxes to increase the incentives for private R & D by producers who would be affected by such taxes and by firms interested in supplying emission-reducing technology to such producers. Private innovation is anyway likely to be more efficient than government-sponsored R & D. Emission taxes would have painful allocative effects in the short run, and their imposition should be deferred until the economy improves significantly. But when imposed they would generate tax revenue as well as affecting R & D incentives, and we shall need additional tax revenue to control our immense and growing public debt.

Should We Jettison GDP As an Economic Measure? Posner

This past September, the “International Commission on the Measurement of Economic Performance and Social Progress,” which had been appoined by French president Sarkozy and was chaired by the well-known economist Joseph Stiglitz, issued a report of almost 300 pages criticizing Gross Domestic Product as a measure of social welfare and proposing a variety of alterations and alternatives. Such criticisms are nothing new, but Stiglitz relates them to the deficiencies of GDP as a measure of our current economic situation, and this makes the report especially timely. For U.S. GDP (and that of many other countries) grew in the third quarter of this year, leading a number of economists and journalists to declare the end of the recession that began in December 2007 and that dramatically intensified in the financial collapse of September 2008.

 

There are three types of objection to the GDP as a measure of welfare. The first is that it is defective even from the narrowest economic perspective. GDP is the market value of all goods and services produced in a year. It thus explicitly excludes nonmarket values. But its treatment even of market values is defective because it excludes depreciation. Suppose the calamitous effects of Hurricane Katrina on New Orleans and other parts of the Gulf Coast had caused (it probably did cause) a surge in the output of various services such as emergency relief, building repairs, and construction. The market value of those services would be counted as part of GDP, without subtraction for the depreciation of the value of property that the flooding triggered by the hurricane caused.

 

Another objection to GDP as a measure of economic welfare, also a criticism based on economics though now viewed a little more broadly, is failure to adjust for monetizable, but not monetized, economic values. An obvious example is household production, which can be valued in money terms by estimating what the household producer would earn in the market; that is only a lower-bound estimate, but it is better than nothing. Leisure, which is also a value, can be monetized similarly.

 

Quality is another economic dimension that can be monetized, as is recognized in calculating the consumer price index; without an adjustment for quality change, the rate of inflation would be greatly overstimated. More to the point, it would be wrong to conclude that if the cost of making a product declines and competition forces the producers to cut price, there has been a loss of value. A great deal of the modern increase in the standard of living is due to improvements in product quality that do not result in cost increases commensurate with the improvements, and often result in lower costs. A dramatic example is modern dentistry. A possible further example is increased longevity, which can be monetized; the problem is relating increased longevity to the enormous expenditures on health care.

 

Turning to bads, economists can and do estimate the costs imposed by crime, pollution, and traffic congestion, but these costs are not subtracted, in the calculation of GDP, from the costs of police and prisons, costs of pollution control, and costs of dealing with congestion—all those costs (except a loss of production from congestion delays) are included in GDP. Put differently, the monetizable value of investments in police, pollution control, and reducing congestion does not enter into GDP.

 

Even with all the suggested corrections made, GDP would be an imperfect measure of economic output, because government provides many services that are difficult to value: expenditures on the military and on foreign and domestic intelligence and counterintelligence are conspicuous examples. It would be odd to say that the “market value” of a bomber that costs $100 million to build and is sold only to the U.S. Air Force has a market value equal to the purchase price. Its market value in a meaningful sense would depend on its contribution to reducing the expected costs of foreign threats to U.S. security.

 

Which brings me to the third and broadest problem with GDP as a measure of welfare--that even if improved along the lines I have just suggested it would not really measure happiness or well being. Market value is a function mainly of cost. The value that people derive from goods and services is better measured by what they would pay for them if competition did not reduce their price to or near the cost of production; but that value (“consumer surplus”) is difficult to estimate. Or consider—coming closer to current events that have sharpened traditional concerns with GDP’s adequacy as a measure of welfare—the anxiety that people who are involuntarily unnemployed experience.

 

The second in command at the international commission was the economist Amartya Sen, a pioneer (along with the philosopher Martha Nussbaum) in attempting to develop measures of human “capabilities” and ranking countries according to their ability to equip their citizens with such capabilities (long life, adequate nutrition, education, etc.). The United Nation’s Human Development Index attempts such a ranking, and some might think it a candidate for replacing GDP.

 

So should GDP be changed or abandoned or supplemented or supplanted? I think not, for three reasons. The first is that even the adjustments that every economist would favor in principle, such as subtracting depreciation from market value, involve contestable judgments (there is a measure called Net Domestic Product that subtracts normal depreciation from GDP). If private economists want to make such adjustments and offer up their own estimates of the economy's output, fine; but GDP is an official government statistic, and to avoid the suspicion and perhaps reality of political interference it is essential that government statistics be calculated in a thoroughly objective, uncontroversial manner. An extreme example is the U.S. census, which would be a lot cheaper to conduct if it used sampling, rather than trying to count every household and individual in the United States. But the loss of credibility would be damaging.

 

The objection to adjusting GDP would grow with every adjustment. And adjustments that were not monetizable would require controversial decisions on weighting. That is a standard problem with multicriteria rankings.

 

Second, crude as it is, unadjusted GDP is at least roughly correlated with adjusted measures of welfare. In the international commission’s report, adjustments for leisure and other nonmonetized but monetizable values boost France’s GDP from being 66 percent of America’s to 87 percent. In another words, France is poorer than America, though not by as much as the unadjusted GDP figures suggested. Anyone who knows something about France knows that it’s a wealthy country, though not so wealthy as the United States, and that the French don’t work as hard as Americans.

 

Third, except at extremes (Norway versus Zimbabwe, say), the significance of GDP lies not in its use as a method of ranking nations, but its use as a method of measuring the business cycle in an individual nation. A chart of U.S. GDP oscillates around a trend line of about 3 percent per annum; there is a big dip in the Great Depression of the 1930s and a smaller though still significant dip since 2007. The oscillations in GDP since 2007 provide a rough but serviceable starting point in appraising the performance of the economy—a sharp drop of GDP in the last quarter of 2008 and the first quarter of 2009, a smaller drop in the second quarter, an increase (of 2.8 percent) in the third quarter, which still leaves GDP well below its trend line.

 

But it is necessary to emphasize that it is just a starting point. I disagree with economists who say the “recession” ended in the third quarter. The depression (as I think we should call it if only because of its enormous potential political consequences) has caused massive unemployment with all the associated anxieties and hardships, has greatly reduced household wealth, has caused private investment to turn negative, has cost the government trillions of dollars in lost tax revenues and recovery expenditures (TARP, the fiscal stimulus, the mortgage-relief programs, the auto bailouts, etc.), has undermined belief in free markets and altered the line between government and business in favor government, and is threatening a future inflation while deepening our dependence on foreign lenders. To view a change in GDP from negative to positive as signifying the end of a depression (by which criterion the Great Depression ended in 1933 and again in 1938) is to misunderstand the utility of GDP as a measure of economic activity.

We Should Amend, not Discard, National Income Accounts-Becker

The justification economists give for concepts of national income, such as Gross Domestic Product (GDP) and Net Domestic Product (NDP), is that the price of a good measures both the utility households gain from consuming that good, and under competition price also measures the cost to sellers of producing the good. This interpretation of the value of goods sold in terms of both utility and production costs helps justify not only concepts like GDP, but also helps link consumer price indexes to the cost of producing a given level of utility to the average consumer, and also ties producer price indexes to the cost of producing given amounts of output.

A tremendous achievement of the 1930s was the construction of early measures of GDP and NDP by pioneers in national income accounting, like the Nobel-winning economists Simon Kuznets and Richard Stone. They recognized from the outset that their national income accounts only very imperfectly measure what is produced each year, let alone consumer utility. Despite these limitations- I discuss in detail a couple of these shortly- these national income accounts have proved very useful in quantifying changes over time in the real value of what is produced in numerous nations and regions of the world. They have also provided useful measures of changes in the degree of inflation at different time periods.

For example, measured real GDP shows clearly that the worldwide Great Depression of the 1930s was far more severe in its effect on production and incomes than the world recession of the last couple of years. The growth in real GDP during the third quarter of 2009 strongly suggests that this recession ended during that quarter. Data on the growth of GDP per capita also clearly indicate that China and other rapidly developing countries during the past couple of decades significantly reduced the gap between their own standard of living and that of the wealthy Western countries, although cross country comparisons of real GDP typically make additional price adjustments to national income accounts  for differences in purchasing power.

Similarly, indexes of changes in consumer and producer prices unambiguously show that the middle and end of the 1970s were periods of substantial inflation in the United States and Europe, that Japan had significant deflation during the 1990s, and that many countries experienced mild deflation in prices during the recent recession.

So despite their various limitations, measures of aggregate changes in real output and prices, and other concepts related to the national income accounts, have been valuable tools for policy-makers, economists, and others. Although the United Nations Human Development Index (HDI), which tries to rank countries by their level of “human development”, has the virtue of incorporating improvements in life expectancy-I return to this subject later- in all other dimensions it is far inferior to national income accounts. In constructing the HDI for different countries, this index gives equal weight to measures of their life expectancy, education level, and GDP. Since education is an important source of improvements in life expectancy and GDP, the HDI involves serious double counting by including education as an independent variable on an equal footing with these other variables. Moreover, even aside from the double-counting problem, the 1/3 weight attached to life expectancy, education, and GDP are completely arbitrary, and not based on any analysis of either consumer utility or costs of production.

Although national income accounts are far more useful than the HDI and other suggested alternatives, these accounts have serious omissions and other limitations.  Posner discusses many of these, so to avoid too much duplication I will concentrate on only two. GDP and other output measures do not include work in the household (neither does the HDI), such as time spent on child rearing, preparing meals, and other valuable household activities. These activities have traditionally occupied much more of the time of women than men, so that GDP and related measures of output exclude very important production mainly by women.

New national time use surveys for the United States and other countries allow this omission to be corrected, at least to some extent.  Time use surveys give the amount of time spent on child rearing and other forms of work in different households, and also the time spent on leisure. Other data sets provide evidence on the hourly earnings of women and men in different households when they are working in the labor force. By multiplying the time spent at household work, and perhaps also the time spent on leisure, by measures of their actual or potential hourly earnings, one can derive an estimate of the cost of household time that is conceptually similar to measures of the cost of producing market work.

Such measures of total output or income adjusted for household time would be imperfect, but they would be superior to income measures like GDP that exclude the value of household work. For example, when increases in economic development and education raise the time married women spend in the labor force mainly by reducing the time they spend working at home, national income accounts exaggerate the increase in total output by failing to subtract reductions in output produced at home.

National income accounts do not incorporate improvements in life expectancy, which is a major limitation because of the magnificent advances in health and declines in mortality during the past 100 years throughout the world. The HDI has the virtue of incorporating life expectancy into its measure of human development. However, this index ignores modern economic research that provides a method to use consumer and producer behavior to combine changes in national income with changes in various types of mortality risk into a single index of what is called “full” income. This method calculates the "statistical value of life", which measures how much individuals are willing to pay for various reductions in mortality rates (see the fuller discussion in my post on Dec.15, 2007).

The concept of “full” income combines changes over time in GDP with estimates of the value placed on reductions over time in mortality risks (or increases in mortality, as in some African countries in recent years due to the Aids epidemic). Such full income measures combine changes in life expectancy and in ordinary income not in an arbitrary way, but by extending the willingness to pay concept used in national income accounting to valuations of changes in life expectancy.

A common finding is that the usual measures of per capita incomes grew only a little more rapidly during the decades 1960-2000 in poor and less developed countries than in richer countries, even after accounting for the rapid growth in the world’s two most populated countries, China and India. That finding on changes in world inequality is greatly altered when comparisons are made not of GDP per capita but of full income per capita. Phillipson, Soares, and I construct such measures of full income for about 100 countries for these decades (see our "The Quantity and Quality of Life and the Evolution of World Inequality" The American Economic Review, March 2005). Since mortality declined more rapidly in poorer countries than richer ones, adding the value placed on declines in mortality to measure changes in full incomes have a much greater effect on adjustments for poorer countries than for richer countries. The result is that the growth rate in full incomes are generally much more rapid in poorer countries than in richer ones, which implies that inequality in full incomes per capita declined greatly across nations during the past several decades, even though inequality among countries in GDP per capita did not change much.

 

Despite all the limitations of national income accounts, they are still the best available way to measure changes over time in the amount of production in an economy, and even for comparisons of real output per capita among different countries. Nevertheless, these accounts can be made even better by including the value of time spent at home, and the value of improvements in life expectancy. A demonstration that such changes in national income accounting are feasible would encourage serious efforts at including some of the other improvements in national income accounts discussed by Posner and others.

 

 

Should the Fed Remain Independent? Becker

Neither former Fed Chairman Alan Greenspan nor the present Chairman Ben Bernanke anticipated the financial crisis that erupted in 2008. In addition, Greenspan helped keep interest rates low for several years after the 9/11 attacks on the United States that contributed to the boom in housing prices, the stock market, and other asset prices. For these and other reasons there is considerable anger and disappointment toward the Fed in Congress and among some economists.

This hostility explains the grilling that Bernanke received this past Thursday in the hearings before the Senate Banking Committee on his nomination for a second term as Chairman. It also explains the drive by many members of Congress to have Congress exercise greater control over the Fed’s behavior, and to take away from the Fed its power to supervise banks. As part of this Congressional pressure, Republican Congressman Ron Paul of Texas has introduced a bill to have the policies of the Fed audited by the Government Accountability Office (GAO).

The problem with these attacks and proposals is not that the Fed behaved perfectly either during or before the crisis-far from it- but rather that closer Congressional supervision and oversight is likely to make matters much worse rather than better. For example, although the Fed is criticized for not foreseeing the financial crisis and for its low interest rate policies, at the time there was no outcry in Congress against these policies. In addition, few, if any, Congressmen warned that a financial crisis would develop unless the Fed tightened up its supervision of banks, and also raised interest rates.

Members of Congress also directly contributed to the unsustainable housing boom. Barney Frank, one of the most knowledgeable Congressmen about financial matters, urged banks to increase their mortgages to subprime borrowers. The Community Reinvestment Act of 1977, extended further in 1995, also basically forced banks to increase their mortgage lending to consumers in poorer areas who were not likely to be in a financial position to meet their mortgage payments.

The Fed clearly made some serious mistakes as it struggled to cope with a financial crisis that was far more serious than Bernanke and other members of its governing Board had anticipated. By not letting Bear Sterns collapse, the Fed probably raised expectations that it would do the same for Lehman Brothers and other major investment banks if they got into serious trouble. All hell broke loose in financial markets when the Fed then let Lehman go under.

 Perhaps too the Fed should not have put so many resources into saving AIG, the major commercial insurance company that also became a major insurer in the credit default swaps market. Other decisions by the Fed can be legitimately questioned, but there is little support for the view that the Fed would have behaved better if Congress had been more closely supervising Fed policies. In any case, Congress already has considerable supervisory powers over the Fed. This central bank has to produce an annual report on its activities, and the Chairman must testify at least twice a year before Congress. During this testimony, he has to explain what actions the Fed has taken, and to justify them when questioned by members of Congress. The minutes of the Board’s eight meetings each year are made publicly available-with a lag- so that everyone can see what the members are discussing, and any disagreements.

Central Banks in many countries have fought over decades and even centuries for the type of independence in their decision-making that the Fed enjoys. The problem usually with dependent central banks is that they engage in considerable inflationary printing of money under the urging of the executive or legislative bodies that control them. The increased money supply is an inflation tax, with the revenues used to finance greater government spending that would not have been feasible with the income tax and other tax revenue raised from companies and households.

The potential for inflation in a few years in the United States is considerable because of the Fed’s extensive and unprecedented open market operations as it tried to shore up the financial system. These operations created over a trillion dollars of banks excess reserves. When the upswing in the economy gains momentum, banks will use these reserves to lend much more to companies and households, a process that will increase currency and demand deposits, and thereby inflate prices. In order to subdue this inflation, the Fed will have to sell many of the securities that it purchased in open market operations, and find other ways to withdraw reserves and some of the inflationary potential from the American banking system.

Such Fed actions will raise interest rates, and put downward pressure on the economy’s growth, and contribute to increased unemployment.  History shows that such inflation-fighting actions are far less likely when central banks are not independent, and legislative or executive branches control their policies. Even the oversight that Congress already has over the Fed is likely to induce the Fed to rein in its inflationary fighting policies. It would be an unpleasant and ironic prospect if increased Congressional control of Fed policies led the Fed to engage in more of the “easy” money policies that many members of Congress are rightly criticizing this central bank for promoting during earlier years of the decade.

Should the Fed Remain Independent? Posner

I agree with Becker; no matter how badly the Fed performed in the run-up to the financial collapse of September 2008, stripping it of its political independence could only make things worse.

The Fed indeed performed badly, and Bernanke himself—not just Greenspan—must (though he’s refusing to) shoulder a significant share of the blame. Bernanke approved of, and may even have played the key role in advocating, Greenspan’s policy of pushing interest rates way down beginning late in 2001, keeping them there, and promising that when the Fed started raising rates it would do so gradually and would use monetary policy to prevent asset prices from diving in consequence of higher rates (that is, it would push down interest rates, which would firm up housing prices because houses are a product bought mainly with credit). These actions by the Fed nourished the housing bubble.

The Fed not only mismanaged monetary policy, but was notably lax in regulating the commercial banks and bank holding companies, ignored warning signs of a coming financial collapse, and prepared no contingency plans to deal with such a crisis even after Bear Stearns’ collapse signaled the existence of potential solvency problems in a wide range of banks and “shadow banks” (such as Bear Stearns, a broker-dealer rather than a commercial bank). The Fed was blindsided by the collapse of the other dominoes in September 2008 and blundered gravely in failing to bail out Lehman Brothers, a failure that precipitated a run on the other shadow banks.

   

These failures have shaken confidence in the Fed, and provide I think a strong argument against giving the Fed additional powers. But the failures do not provide an argument for reducing the Fed’s political independence. The critical reason is Becker’s: looking back at the behavior of Congress in the years and months (and weeks and days) preceding the financial collapse of September 2008, there is absolutely no reason to think that, had Congress exercised more control over the Fed, the financial collapse would have been averted or its gravity diminished.

 

The reason is related to the principal argument for the independence of a nation’s central bank: that without it there would be much more inflation. Politicians want low interest rates because they stimulate economic activity and thus create at least the illusion of prosperity, for which politicians want to take credit. But if inflation is already high or expected to be high, low interest rates create a serious risk of more inflation. The reason is that the way a central bank reduces interest rates (to simplify) is by buying Treasury securities; the cash it pays for them increases bank balances and therefore reduces interest rates and stimulates lending. The more lending, the more spending, and the more spending the more money there is in circulation relative to output and therefore the more inflation there is, since inflation is determined by the ratio between the amount of money in circulation and the amount of goods and services available for purchase.

 

Congress would undoubtedly have wanted interest rates to stay low throughout the past decade and thus would have fought the Fed had the latter heeded warnings of a housing bubble and raised interest rates. In fact there was inflation—asset-price inflation, the assets being houses and common stock, and at times oil and other commodities. The Fed should have raised interest rates higher and earlier, and probably would have done so if it had realized that there was asset-price inflation. But had it done so, it would have caused a slowdown in economic activity, and Congress would have intervened had it not been for the Fed’s independence. Elected officials have short time horizons.

 

The Fed isn’t really that independent because, unlike the independence of the Supreme Court from the other branches of government, the Fed’s independence is not based on the Constitution but merely on statute, and Congress can change a federal statute at any time. Because of this the Fed cannot ignore political pressures entirely. But if the “reformers” get their way, the political pressures will operate directly, and inflation will be an even more serious problem.

 

The hostility to Fed is in part a hostility to “Wall Street,” especially to firms like Goldman Sachs which have made enormous profits this year while most of the country was suffering from the economic downturn. The combination of the government’s having bailed out Goldman and the other big banks, thereby signaling that it will not allow such firms to fail, and the Fed’s current interest-rate policy, which has pushed short-term interest rates down almost to zero, has enabled Goldman to borrow capital at very low rates and lend or otherwise invest it very profitably because the distress of other banks has reduced aggregate private lending and investing.

 

Because private banks elect two-thirds of the members of the board of directors of each of the 12 regional federal reserve banks, and five of the presidents of those banks serve on a rotating basis on the Federal Open Market Committee—the body within the Fed that sets monetary policy and thus interest rates—there is suspicion that the Fed is a tool of Wall Street. That impression would be dissipated, to a degree anyway, by cutting the private banks out of any role in determining the governance of the federal reserve banks. Such a change might reduce the political pressure to reduce the Fed’s independence.

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