The Origins of the Long-only Index Funds

Several months ago, a friend handed me Matt Taibbi’s best selling book, Griftopia, and said, “read it and tell me what you think.”  I don’t normally read muckraking books written in a contemporary style that is both “over the top” and crude.  However, after skimming a couple of chapters, I realized that Taibbi is a bright guy with some interesting things to say.  I was surprised when I turned the page and came to Chapter 4—“Blowout: The Commodities Bubble”—in which Taibbi discusses the long-only index funds (see particularly pages 132-141) that now dominate the futures markets.

Taibbi makes two main points about the origins of the long-only index funds.  First, Goldman Sachs and other big banks obtain at least 17 semi-secret letters from the CFTC—starting in the early 1990’s—that allowed them to ignore the existing limits on speculative positions and begin a profitable campaign of selling long-only commodity index funds to investors.  Second, the “Uniform Prudent Investor Act of 1994” was passed.  This Act, “some form of which would eventually be adopted by every state in the union,” ended the prohibition on investing in commodities by pension funds and trusts.  In fact, they are now “duty bound to diversify as much as possible” and that mean including commodity funds in their portfolios.  As I was reading Chapter 4, I received a call from the bank that manages the financial assets of a small trust I’m involved with.  The bank wanted to increase the Trust’s holdings of commodity funds—even though the Trust’s main asset is wheat land.  I had wondered why commodity index funds were starting to appear in the Trust’s portfolio.  After finishing the chapter, I understood.

For those interested in the origins of long-only index funds, Chapter 4 of Taibbi’s book is worth a look.

Taking Advantage of the “Long-only Index” Funds?

In my last blog post, I explored how the dramatic growth of “long-only index” funds has affected the Chicago futures market.  These funds focus on worldwide inflation forecasts in making their investing decisions and have maintained their long positions irrespective of what is happening in the wheat market.  Accommodating this huge new semi-permanent demand for long positions requires attracting many more short sellers.  “Long-only index” funds must make the short positions of hedgers—farmers and grain handlers—more attractive and profitable, so they will hedge and store wheat that normally would be sold on the cash market. The higher the futures price is above the expected cash price (i.e. the more negative the basis), the more attractive hedging becomes.  This difference is the “fee” paid by the “long-only index” funds to maintain positions unrelated to the basic supply and demand for wheat.

After some worry, I’ve come to the conclusion that farmers can safely take advantage of this market distortion.  When futures prices are above expected cash prices, hedgers will normally make money and the “long-only index” funds will lose money.  Farmers will lose only if they must close out their hedge positions during a period when the funds are building their long positions and causing the basis to widen.

A New Way of Viewing Basis and Chicago Futures

Farmers in my area are increasing their use of base-price contracts to sell their current and (especially) future soft white wheat (SWW) crops.  Until 2007, the SWW basis (the Portland cash price of SWW minus the nearest Chicago futures price) fluctuated around 44 cents and was usually positive sometime during the early fall.  Since 2007, the basis has fluctuated erratically and spent most of the time in negative territory.  Since a strengthening basis (i.e., a basis that becomes more positive or less negative) adds to the net return from a base-price contract, understanding why the basis has been staying so negative has been a topic of considerable interest to my neighbors and me.

Two years ago, I discussed this issue in one of my first blog entries.

I explain why the basis should average 44 cents in this article.

In trying to understand why the basis has been negative for so much of the time since 2007, I’ve focused on the “convergence problem” problem in Chicago futures.  The futures price has often remained above the cash price of SRW wheat when futures contracts expire.  This isn’t supposed to happen and could contribute to the negative WW basis.  After several years of study, the Chicago Mercantile Exchange has failed to correct the “convergence problem” and I was beginning to wonder whether they really were serious about dealing with it.  However, I now think this lack of convergence is largely irrelevant in explaining our persistent negative basis.

My thinking changed in late October when I attended a U.S. Wheat Associates Board meeting in Minneapolis.  I attended a panel discussion including Mike Ricks, a senior manager for Cargill.  Listening to Mr. Ricks caused me to start thinking about basis in a new way.

A New Way of Thinking About Basis

The classic theory of futures markets argues that their main function is to facilitate hedging.  Normally, short hedgers (farmers and grain elevators) outnumber long hedgers (grain buyers and millers) so the market needs to attract long speculators to buy the extra contracts that short hedgers want to sell.

The Chicago wheat futures market began to change the way it functions  around 2006, when “long-only index” funds started building their positions in the wheat market.  These funds hold wheat futures contracts as a hedge against possible “food price inflation.”  They aren’t concerned about the current price of futures or short-run changes in the supply and demand for wheat—they just want to be long futures.  Shortly before each contract expires, they roll their positions to the next available contract month.

“Long-only index” funds now hold a huge and dominant position in the Chicago wheat futures market.  They hold contracts for at least 1.2 billion bushels—more than five times the size of this year’s soft red wheat crop.  Just as hedgers previously had to attract long-speculators to offset their net short positions in the market, the “long-only index” funds now need to attract short sellers to hold the other side of their huge long positions.

How do you attract new sellers willing to take short positions totaling 1.2 billion bushels?  Attracting the necessary supply of short-speculators might be difficult—since naked short speculation is risky when inflation is a worry.  However, new hedgers can also be attracted into the market to take the necessary short positions.  As the futures price rises above the cash price of wheat (i.e., the basis becomes more negative), hedging by owners of physical stocks of wheat looks more and more profitable—giving grain handlers and farmers an incentive to delay selling the crop so they can store and hedge more wheat.  Because hedgers hold a long position in the physical wheat, their short position in the futures market seems less risky than the position of a short speculator.  By being willing to take the other side of the futures contracts that the “long-only index” funds buy, hedgers have indirectly allowed the funds to accomplish their real desire—to hold physical wheat.

Can the Basis Return to Normal? 

One of the reasons hedging has looked attractive is because the basis has been unusually negative.  In calculating their expected profits, many hedgers are assuming that the basis will not stay unusually negative and will eventually return to “normal” levels.  Can basis return to “normal?”  What happens if basis narrows, i.e., cash prices rise (converge) to the level of futures prices?  If basis narrows, maintaining hedges will look less profitable and hedgers will start lifting their hedges by buying futures and selling their stored wheat.  This will cause the basis to widen again.  As long as the “long-only index” funds insist on maintaining their huge long positions, no big players in the market will be willing to sell contracts to exiting hedgers.  Futures prices will keep rising until hedgers stop wanting to buy futures — because hedging looks profitable again.  Hence, the situation may be unstable—the necessary amount of hedging will be done only if basis is expected to return to “normal,” but basis can’t return to normal if “long-only index funds” insist on maintaining their positions.  I now think I understand why the CME is having such difficulty forcing “convergence.”

Why Do Futures Prices Move with Cash Prices?

If “long-only index” funds are focused only on inflation and if hedgers are focused on the basis, what causes movement in the futures price and how are futures prices related to the supply and demand for cash wheat?  As argued above, the “long-only index” funds have caused an increase in U.S. wheat carryover and this has at times reduced exports.  As Mr. Ricks mentioned in Minneapolis, the index funds are causing the U.S. wheat carryover to reach levels that rival the size of the burdensome government stocks in past years.

Since about half of U.S. wheat is exported and must be priced competitively on the world market, the cash price of wheat is still predominantly determined by world supply and demand.  If the cash prices rise, the basis narrows and hedgers start lifting their hedges and buying futures.  This causes futures prices to rise along with cash prices and by enough to keep the necessary number of hedgers in the market.  Similarly, if the cash price falls, basis widens and hedging increases.  The resulting sale of futures contracts by hedgers causes futures to decline along with cash prices.

How Will All This End?

Mr. Ricks indicated in Minneapolis that Cargill had been giving lots of thought to the question, “How will all this end?”  I believe that until “long-only index” funds start liquidating their huge positions, the basis must remain wide and hedgers expecting the return of a “normal” basis may be disappointed.  When the “long-only index” funds start reducing their positions by selling their future contracts, the futures price will decline and the basis should initially narrow, i.e., become less negative.  Hedgers should then be able to liquidate their hedges at profitable basis levels.  As they do, they will sell their stored wheat and cash prices should decline along with futures.  If “long-only index” funds liquidate their positions quickly, the cash price of wheat could crash along with futures—as our large carryover stocks are dumped on the market.

Why Federal Healthcare Vouchers?

Our American Farm Bureau Deficit Task Force spent several two-day meetings in Washington, D.C. discussing healthcare reform with leading experts.  All the experts agreed costs are rising at an unsustainable pace and quick action is urgently needed.  What disappointed and surprised us was that none of the experts provided us with a solution—a comprehensive approach to reforming our current system.

The Task Force’s charge is to find ways to reduce the looming federal deficits.  We could not finish our work without recommending a way to deal with the most important cause of future deficits—soaring healthcare costs.  After much discussion, we decided the best approach is federal healthcare vouchers:

… the federal government should provide each citizen with a voucher sufficient to purchase a bare‐bones, private health insurance policy. These health care vouchers could be used only for insurance plans that incorporate the reforms necessary to reduce the growth in health care costs. To encourage innovation, the requirements that health insurance plans must meet to be eligible for voucher financing would be determined on a regional basis.

I believe we were all surprised by our vote to support vouchers—I certainly was.

I voted “yes” last May for two main reasons.

1. Vouchers offer the best hope of getting key reforms implemented quickly enough to avoid a government takeover of our healthcare system.

Health insurance premiums in the U.S. more than doubled between 2000 and 2009.  According to the Kaiser Family Foundation, the cost of a family health insurance policy now averages $13,375 per year.  When out-of-pocket costs are included, the total is close to $16,700.  Since median family income in the U.S. is approximately $60,000, total healthcare costs are now a quarter of family income!

This year, employers paid on average $9,860 of the $13,375 cost of health insurance for a worker and his family.  Many workers with employer-provided insurance believe they don’t need to worry about rising healthcare costs because their employer is picking up their tab.  These workers are suffering from an illusion.   Good evidence exists that employers recoup the rising cost of health insurance by reducing future wage increases—so workers do ultimately pay the full cost.  Over the last twenty years, output per hour in U.S. businesses has increased by over 150%.  Hourly wages in manufacturing (adjusted for inflation) have declined slightly.  Productivity growth should cause wages to rise, but rising health insurance costs are siphoning off all the extra income.

If healthcare costs continue to grow at their current rate for nine more years, the average cost of health insurance for a family is projected to be $38,000 or ½ the family’s income.  Our current system of private insurance, mostly provided by employers, will self-destruct before that happens.

Our market-based healthcare system has many strengths—including patient choice, rapid innovation, and competition among private insurance companies, hospitals and doctors.  As I discussed previously, its inability to control costs stems mainly from an over-reliance on fee-for-service payments.  Fee-for-service payments—combined with a physician’s dual role as a provider of both diagnoses and of treatments—encourages too much ineffective and costly treatment.  How can doctors’ and hospitals’ incentives be changed quickly without direct government regulation, while still preserving the good features of our current system?

Our recommendation is to have the federal government offer all citizens a voucher redeemable for a bare-bones health insurance policy from one of many competing private insurance companies.  Additional coverage could be purchased and added on if desired.  The tax deductibility of health insurance would be eliminated.  Insurance companies would be required to accept all applicants, but would receive a bigger voucher payment for covering an applicant with a pre-existing condition.  Medicaid would disappear.  Senior citizens currently on Medicare could stay in the Medicare program.  However, younger citizens would stay with vouchers and private insurance when they turned 65 years old.  Hence, Medicare would phase out over time and all citizens would eventually finance their basic healthcare with vouchers.  Finally, the most important change—to be eligible to accept vouchers, insurance companies would be required to change the way they pay hospital and doctors.  Fee-for-service would be phased out and new methods introduced to encourage better outcomes and discourage costly, ineffective treatments.  For example, insurance companies would be required to increase the use of bundled payments, capitated payments, electronic medical records, and self-monitoring by doctors in each local area (Accountable Care Organizations).

2. Vouchers would establish a national healthcare budget and allow the U.S. to control the growth in healthcare spending.

 

The AFBF Deficit Task Force didn’t make a recommendation on how the healthcare vouchers should be financed.  I’m convinced that financing should come from a new dedicated consumption tax—i.e., a value-added tax  (VAT) or a national sales tax.  The level of the tax would depend on how “bare-bones” is defined.  Martin Feldstein recently argued that the federal government could provide everyone with a high-deductible health insurance policy by using only the extra $220 billion in tax revenue gained by eliminating the tax deductibility of employer provided insurance.  However, if deductibles are set too high, the poor would still need Medicaid and many low and even middle income Americans would need subsidies to pay their deductibles.  One of the great attractions of the voucher idea is that income-based subsidies aren’t required.  Subsidies that vary with income (such as those included in all the healthcare bills now working their way through Congress) are complicated. They also dramatically increase the marginal taxrate faced by those who receive them and would have bad effects on incentives.

Emanuel and Fuchs provide details on the funding of healthcare vouchers.  They estimate that a 15 percent VAT would be needed to provide all Americans, including the elderly who would now be on Medicare, with a voucher for health insurance coverage similar to the plan now covering members of Congress.  Adding a 15 percent consumption tax would represent a significant increase in federal taxes.  However, healthcare vouchers would provide important other benefits:

 

1. As Medicare phases out and seniors transition to vouchers, the VAT rate would need to increase from “10 to 12 percent to approximately 15 percent.”   However, the 2.9% Medicare payroll tax would be eliminated.

2. The federal government currently spends about $220 billon on Medicare above what is collected by the Medicare payroll tax.  Medicaid also costs the federal general fund about $200 billion. The tax deduction for employer-provided health insurance reduces federal revenue by about $220 billion.  Vouchers would eliminate the need for all three. The federal government would have approximately $600 billion that could be used to reduce the federal deficit.

3. State budgets are currently under severe strain due to the rising cost of Medicaid, SCHIP and employee health insurance premiums.  These programs currently take up approximately 20% of state budgets.  Vouchers would eliminate these state expenditures and should cause a reduction in state and local taxes.

4. Employer-provided health insurance would be eliminated and individuals would pay only for “add-on” coverage above what their voucher provides.  Since an employee must now accept his employer’s choice of a health plan, vouchers would give individuals more choice and increase competition in the private insurance market.  As employer-provided health insurance phases out, wages should start rising again in line with productivity growth.

5. Since vouchers would be financed by a dedicated tax, the U.S. would—for the first time—have a national healthcare budget.  If healthcare costs increased faster than the growth of the economy, either the VAT tax would be raised or changes would be made in our healthcare delivery system to reduce the growth in costs.  Since everyone would bear the cost of a tax increase, our nation would finally have an incentive to deal with the hard choices that we must eventually make—how much to spend on end-of-life care, when to pay for very expensive new medical equipment, how to modify the fee-for-service payment system, etc.

6. Finally, by replacing Medicare and Medicaid with vouchers funded by a new, dedicated tax, the U.S. would eliminate almost all of the federal deficits projected to be such a problem over the next fifty years.  Vouchers would also eliminate the need for large future income tax increases.  Vouchers funded by a dedicated tax would, by themselves, solve the problem that caused our Deficit Task Force to be created.

 

References:

Ezekiel J. Emanuel and Victor R. Fuchs, “A Comprehensive Cure: Universal Health Care Vouchers,” The Hamilton Project, The Brookings Institution, July 2007.

Laurence J. Kotlikoff, The Healthcare Fix—Universal Insurance for All Americans, 2007

Malpractice Reform and Higher Deductibles Are Not Enough

When I discuss the rising cost of healthcare with my neighbors, they always bring up the need for tort reform to reduce malpractice insurance costs and the importance of expanding the use of high-deductible health insurance policies in combination with “health savings accounts.” Expanding the use of high-deductible policies would give patients added incentives to economize on medical services by forcing them to pay more of their medical costs “out-of-pocket.” I strongly support both ideas and both should be part of any reform proposal. However, neither is likely to slow significantly the long-run growth in medical costs.

Medical Tort Reform

Our laws governing medical malpractice are a mess. Less than 3% of patients who are injured by medical negligence ever get their cases heard in court and the desire to avoid frivolous lawsuits causes doctors to order unnecessary tests and treatments—driving up costs. David Leonhardt summarizes the evidence in this article.

He writes “[malpractice] jury awards, settlements, and administrative costs … add up to less than $10 billion a year. This equals less than one-half of a percentage point of medical spending.” The cost of the “defensive medicine” practiced by doctors because they fear malpractice suits is much greater and has been estimated at up to $60 billion a year. However, this is still only about 3% of healthcare costs in the U.S.

Tort reform that capped excessive jury awards and provided better protection for doctors who follow “best practice” guidelines would reduce the cost of malpractice insurance and the incentives for unnecessary tests and treatments. However, a successful campaign to reform malpractice laws would be unlikely to reduce overall healthcare costs by more than 3 percent.

Higher Deductibles

Increasing the share of medical expenses paid “out of pocket” would cause patients to think more seriously about whether they should seek medical care. They’d be more likely to object if their doctor ordered low-value tests and treatments. In listening to the discussions of my friends on Medicare, I’ve been surprised by how often even the $30 per visit co-pay causes them to postpone an additional visit to their doctor.

Unfortunately, increasing patients’ co-pays is limited as a way to control costs because of the unique characteristics of the doctor-patient relationship. When a consumer goes to purchase a car or refrigerator, he knows what he wants to buy and can determine whether the value of additional features on more expensive models is worth their higher price. When a patient seeks medical treatment from a doctor, he usually doesn’t know what treatment he needs or its value. In at least 70% of doctor visits, patients don’t go to buy a medical treatment. They go for advice about what treatment they need. The more serious the illness, the more likely the patient is to rely on his doctor’s knowledge and advice. Even with a $5,000 deductible health insurance policy, a patient who receives a cancer diagnosis will usually do what his doctor prescribes, even if the treatment turns out to be very expensive.

Since doctors will be making most of our treatment decisions even when patients are paying the full cost “out of pocket,” the focus of any effort to reduce costs must be on doctors and especially on modifying our fee-for-service payment system so doctors have less incentive to prescribe unnecessary tests and treatments.

Using Less Treatment

Up to one-third of medical treatment does little or no good for the patient [see the end of my blog entry “Slowing the Growth of Medicare and Medicaid Cost”].  Several accounts have recently become available illustrating our healthcare system’s tendency to overtreat.  For example, see the Atul Gawande’s article at

http://www.newyorker.com/reporting/2009/06/01/090601fa_fact_gawande

or the radio program available at:

http://www.thisamericanlife.org/Radio_Episode.aspx?episode=391

 

Why do doctors order treatments that don’t benefit their patients?  There are at least four reasons:

1.  Profit seeking – Doctors spend their long medical education learning how to treat patients.  Our fee-for-service payment system then gives doctors a strong incentive to use this training and provide additional services.  Medicine is slowly changing from a healing profession to a business.  Read the Gawande article.

2.  Ignorance – In many cases, doctors don’t have adequate knowledge about the cost-effectiveness of different treatment options.   Without clear guidelines, they often will, in good conscience, order the procedures they are trained to provide that earn them the most income.

3.  Patient demands – Patients often ask their doctors to treat ailments for which there is no cost-effective treatment.  They sometimes demand treatments that their doctor knows are not likely to be effective.  These requests are more likely when a patient has insurance and doesn’t have to bear the cost.  Doctors often have a difficult time saying no, especially when their income increases if they give in.

4.  Malpractice lawsuits – To protect themselves from malpractice lawsuits, doctors may order additional tests and treatments.

The best way to reduce healthcare costs and improve the quality of care in the U.S. is to change doctors’ incentives so they will stop ordering ineffective treatments.

I will devote the next blog entry to discussing the last two reasons listed above and will argue that, while they are important, they are not a primary cause of the high cost of healthcare.  Profit seeking and ignorance are the primary causes of over treatment.

 

Actions to reduce ineffective treatments

A. Improving Payment Methods and Encouraging Self-Monitoring by Groups of Doctors

Dr. Arnold Relman has written a book, A Second Opinion, and many articles, e.g.,

http://www.nybooks.com/articles/22798

in which he argues that medical costs in the U.S. will be reduced and patient outcomes improved when more doctors start practicing as salaried members of privately-owned, multispecialty groups.  The Mayo Clinic is probably the best known such group.  The cost of care at the Mayo Clinic during the last six months of life is half the cost of such care at, for example, the UCLA medical school.  Several group practices similar to the Mayo Clinic exist around the U.S., including the Cleveland Clinic, Kaiser Permanente, the Billings Clinic and the Health Group in Seattle, and all have been successful in lowering costs.  For a video examining these groups, watch

http://www.pbs.org/newshour/bb/health/july-dec09/billings_08-12.html

As a salaried member of a group practice, a doctor’s income depends less on ordering unneeded treatments and he has more opportunity to discuss and coordinate care with his colleagues.

Making group medical practice the norm will take many years to accomplish.  In the interim, two intermediate steps should be taken now.

 

1. Accountable Care Organizations

Doctors in an area should organize into “Accountable Care Organizations” (ACO).  ACO’s would hold regular meetings at which the member doctors review how medicine is being practiced in the local area and provide feedback to doctors who are either overtreating or undertreating their patients.  The ability to review local practice standards would be facilitated by the widespread use of electronic medical records.  The formation of ACO’s could be encouraged if Medicare and private insurance companies shared part of any cost savings with hospitals and the doctor members of ACO’s.

2. Increase the use of “capitated” payments and “bundling” of payments

Medicare and private insurance companies should move away from fee-for-service payments and pay part of a patient’s care with a single yearly payment to the group of doctors providing his care (“capitation”).  With part of a patient’s care covered by the fixed payment, reimbursement for routine tests and procedures could be reduced—reducing the incentive for extra treatments.  “Bundling” of payments would provide hospitals and doctors with a lump sum in advance to provide care for a particular medical condition.  “Bundling” would encourage doctors and hospitals to improve quality since repeated treatments or readmissions to the hospital would not be reimbursed.

 

B. Providing Doctors with Better Information about Treatments

For a surprisingly large number of illnesses, doctors currently have inadequate guidelines about the most cost-effective treatments.  Prostate cancer is a good example. Many treatments for prostate cancer are available, including radical prostatectomy, several types of external radiation, brachytherapy (radioactive seed implants), and “watchful waiting.”  The cost of these treatments varies enormously—from very little for “watchful waiting” to over a hundred thousand dollars for newer types of external radiation treatment.  For early stage prostrate cancer, no consensus exists on whether one type of treatment is any better than another type.

http://www.nytimes.com/2009/07/08/business/economy/08leonhardt.html

Another example of our failure to provide doctors with adequate information is medical devices (e.g., defibrillators and artificial hip joints).

http://www.nytimes.com/2009/11/05/business/05device.html?scp=3&sq=Barry%20Meier&st=cse

Healthcare costs in the U.S. could be significantly reduced by funding more research on the effectiveness of different treatments and by giving doctors clearer guidelines on which to base their recommendations.

 

Pet Peeve

Please excuse me while I take a short break from healthcare and blow off some steam.

As a farmer, I’m often sent surveys from the government and from ag suppliers.  These questionnaires ask where I get the expert knowledge necessary to make important farming decisions.

  • Who scouts your fields for diseases and pests?
  • Who determines the amount of fertilizer you apply?
  • Who decides the chemicals you should use to control weeds and insects?
  • Et cetera
  • Et cetera

These questions always annoy me.  “I DO” is almost never one of the choices on the long list of government agencies, ag suppliers and outside experts.  The implication seems to be that I’m a stupid farmer who isn’t competent to make decisions affecting my farms.  I should be relying on someone else.

As a farmer, my profession is to scout my field and make decisions about fertilizer rates and chemical applications.  If I lack this key knowledge necessary to run my farm, I should get another job.  I also believe I am more motivated and competent to conserve the soil and water on my farm than is any outside expert (although I do appreciate the technical advice provided by the NRCS and SWCD in designing conservation practices).

Given the events of the last year, maybe the federal government should be shifting more of its survey efforts into finding out where the leaders of Wall Street and our big banks get their advice — since their ineptitude almost destroyed our financial system.  The farmers I know are competent professionals.

Slowing the Growth of Medicare and Medicaid Costs

Without major changes, the federal deficit will explode and U.S. national debt will reach dangerous levels within the next twenty years. Any realistic plan to balance the federal budget must include two main elements.

1. A significant reduction in the growth rate of federal healthcare costs — primarily Medicare and Medicaid.

2. An increase in taxes.

The more we can slow the growth of Medicare and Medicaid costs, the less we will need to increase taxes.

Medicare and Medicaid cost growth can’t be slowed without similar changes in the private healthcare system

Attempts by Congress to slow the growth of federal healthcare costs have been unsuccessful primarily because Medicare and Medicaid are so closely linked to the rest of our healthcare system. All doctors and hospitals treating Medicare and Medicaid patients also have private patients. If Medicare and Medicaid payments are cut much below the standard charges to private patients, healthcare providers will stop seeing the poor and elderly. If the government restricts treatments available to Medicare and Medicaid patients, Congress will quickly receive complaints that it has created an inferior healthcare system for the poor and old. Consequently, slowing government healthcare costs in the long run is not politically possible without reforms that also apply throughout the U.S. healthcare system.

Slowing the growth of healthcare costs

Between 1975 and 2005, per capita healthcare costs grew much faster than costs in the rest of the U.S. economy — 2.4% faster for Medicare, 2.2% faster for Medicaid, and 2.1% faster for private patients. Rising costs are now threatening to bankrupt not only the federal government, but also many businesses and private patients. How can the growth of healthcare costs be slowed? That is now the $64,000,000,000,000 question.

There are three main approaches to reducing healthcare costs: reducing the need for treatment, paying less for treatment, and using less treatment.

Needing Less Treatment

The U.S. is currently suffering from an epidemic of obesity and diabetes. Getting Americans to eat better diets and exercise would reduce chronic illnesses now and in the future. However, we all will eventually get old and die, so the main effect of healthier lifestyles is to delay healthcare costs. The studies are inconclusive about long-run savings and, unfortunately, finding ways to motivate people to change their lifestyles is difficult.

Paying Less For Treatment

Congress has passed and rescinded many laws to reduce Medicare and Medicaid payments. Government efforts to pay less have so far been unsuccessful in reducing cost growth. Increasing competition among providers might reduce charges, but is very difficult to implement because of the special characteristics of the doctor-patient relationship (I’ll have more on this in a later blog entry.) More competition among insurance companies could reduce costs and this is one of the reasons the Task Force supported a voucher plan. However, unless government takes over the healthcare system, it is unlikely that the growth in payments per treatment can be slowed enough to solve our problem.

Using Less Treatment

This is where the hope (if there is any) lies. Evidence from two sources indicates that about one third of medical treatments have little if any benefit and, in some case, may harm the patient. For twenty years, researchers at Dartmouth have been examining Medicare payment records and have published the data in the now famous Dartmouth Atlas of Health Care.

Large variations exist in the cost of healthcare in different parts of the U.S. — with some areas spending twice as much as other areas. The surprise is that patients in high cost areas don’t do any better than those that receive less treatment in low cost areas.

The second source comes from international studies of healthcare. The U.S. spends about a third more of its GDP on healthcare than any other advanced country and other advanced countries usually have as good or better outcomes. See this report from the White House, particularly the discussion starting on page 9.

Our healthcare system seems to be surprisingly inefficient. If we can make better treatment decisions, we should be able to reduce costs without affecting the quality of care. How can this be accomplished? I’ll discuss this in the next blog entry.

Is the U.S. going the way of G.M.?

My first Deficit Task Force meeting took place at the American Farm Bureau headquarters in Washington, D.C. last December 17th — the day I turned 65 and became eligible for Medicare. I was the oldest Task Force member and the only one close to actually experiencing Social Security and Medicare.

Our first presentation was from the “Fiscal Wake-up Tour” — three experts on the federal deficit representing the Concord Coalition (non-partisan) , the Heritage Foundation (conservative) and the Brookings Institution (liberal). They were unanimous in their message — without major changes, the federal deficit would explode and bankrupt our country over the next thirty years (or less). They certainly got our attention.

As I mentioned in the previous post, I came to the meeting with the mistaken belief that the looming retirement of the baby-boomers and the resulting increase in Social Security payments were primarily responsible for the deficits.

Social Security

The Social Security Trust Fund is projected to run out of money in 2043. However, Social Security payments are currently equal to 4.4% of GDP and it is taking in payroll tax receipts equal to 4.8% of GDP — so the Trust Fund is growing and will be for the next decade. If nothing is done, SS payments are projected to grow to 6.1% of GDP in 2033 and then stabilize. A .5% of GDP increase in revenue or a cut in expenditures now would bring SS back into actuarial balance. This could be done by increasing the payroll tax from the current 12.4% to 13.7%. The required increase in the payroll tax would be less if combined with an increase in the “full retirement age” (the Task Force favored automatically increasing the “full retirement age” as longevity increases) and/or a increase in the cap on earnings subject to SS tax ($106,800 in 2009).

Social Security has a serious long-term funding problem that must be faced soon. However, since Congress controls both the revenue and expenditure sides of the Trust Fund, many options exist that will bring SS back to solvency. Only the political will is lacking.

Medicare and Medicaid

The government now pays directly or indirectly for well over half of U.S. healthcare. The biggest contributors to government costs are the Medicare and Medicaid programs and the tax revenue lost by not taxing employer-provided health insurance. Government costs are rising rapidly because healthcare costs are rising much faster than inflation in the rest of the economy. I’ll have much more to say about this in future posts.

Unless dramatic action is taken, steadily rising healthcare costs are projected to bankrupt the federal government. The Congressional Budget Office (CBO) has projected that the combined cost of Medicare and Medicaid will increase from 4.9% of GDP in 2010 to 10.6% in 2040 (an increase three times bigger than the increase in SS). During the initial meetings of the Task Force, we saw two graphs from the CBO that dramatically illustrate this point.

Notice that the top graph excludes interest payments on the national debt. If nothing is done and interest payments are added, the federal budget is projected to grow to 43% of GDP in 2050 with interest payments on the skyrocketing national debt alone costing 16% of GDP (and these estimates were done before the current recession). Federal tax revenue has averaged about 18% of GDP for the last 30 years. Hence, without a very large increase in taxes, the federal deficit in projected to explode in the near future — mainly due to rising healthcare costs.

Why worry about the federal deficit?

We’ve been hearing dire warnings about federal deficits at least since the 1980’s when the Reagan tax cuts caused the yearly federal deficit to jump to unprecedented levels. However, none of the predicted bad effects has materialized yet. Interest rates have stayed low. Buyers have lined up to eagerly buy our Treasury bonds. Interest payments as a share of federal outlays have actually fallen from 14% in 1985 to a projected 7% in 2009. Why is action so urgent now?

I believe the situation we currently face is different in two fundamental ways. First, the size the projected long-term deficits is much larger than we have ever experienced in peacetime. See the graphs on page 4 and the title page of the CBO’s most recent “Long-Term Budget Outlook.”

Second, our government is now selling most of its debt to foreigners. After the waves of currency crises that swept around the world between 1996 and 2001, many countries decided they needed to increase their reserves of U.S. dollar assets. By purchasing U.S. bonds, foreign governments caused the U.S. dollar to rise in value relative to their currencies and this promoted a rapid growth in their exports. Maintaining an undervalued exchange rate turned out to be a spectacularly successful development strategy — one that China and other other developing countries have been reluctant to give up. China now has accumulated over $1.5 trillion in U.S. debt and knows it will suffer large capital losses on this debt as soon as it stop buying dollars and lets the Yuan appreciate.

During the last decade, the U.S. has not experienced rising interest rates and the other negative consequences of its large federal deficits because foreigners have willingly accumulated U.S. dollars. They now have more dollars than they want and may soon start selling rather than buying. Interest rates will soon rise dramatically.

Because more than half of U.S. Treasury debt is now foreign-owned, foreigners have also gained a powerful foreign policy tool they can use against us. Sudden large sales of foreign-owned U.S. Treasury bonds would dramatically raise U.S. interest rates and disrupt our financial system. The U.S. threatened this financial weapon against the British an French governments and forced them to withdraw from the Suez Canal in the 1950’s. The Chinese could now do the same in a conflict with us.

Are we going the way of G.M.?

For sixty years, G.M. was the largest and strongest car company in the world. Because it was so powerful, G.M. could delay facing up to its mounting losses during the last decade. Neither management nor the unions stepped up to make the painful changes necessary to confront G.M.‘s problems and save the company. G.M. ended up bankrupt. Unfortunately, the U.S. faces a similar situation.

A final complication

A federal budget deficit for a year or two is not necessarily bad. During our current severe recession, the federal deficit has ballooned to an unprecedented $1.5 trillion. This deficit is due partly to the additional spending from the stimulus package, but mostly to a decline in tax collections. Both lower taxes and increased government spending are stimulating our economy at a time that stimulus is sorely needed. There is no doubt that the debt we are accumulating is adding to our long-term problem. However, large deficits are necessary until the recession ends. As soon as the economy gets back on it feet, the federal budget must be balanced.