Dr. Sherry Jarrell

Inflation, Money Supply, and Interest Rates: Learningfromdogs, part 3

Essay One – Inflation – Part Three

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Inflation, deflation, economic crisis and so on, getting to the bottom of meanings.

Inflation – Part three

Sherry writes:

I think we are getting somewhere!

You’ve zeroed in on the key question, I believe: why is there an inflation risk while the outlook remains so grim?

Inflation is a (sustained) increase in the equilibrium price of goods and services.

The price results from the interaction between two completely independent sides of the market: the demanders and the suppliers. Think of money (or a debit card, whatever form money takes) as an enabler of demand — it makes transactions easier, quicker, and thus more transactions result. The higher the supply of money, the more enhanced the underlying demand for goods and services (by consumers, business, and government).

So more money, higher demand. Higher demand, higher prices. Higher prices, higher inflation.

Now, what if, quite independent of the money supply, businesses and industry were competing and expanding and becoming more and more efficient, producing more goods with better technology and fewer inputs?

This would increase the available supply of goods and services in the economy, and would reduce the equilibrium prices of those goods and services.

Now let the two sides of the economy, the demand side and the supply side, co-exist and interact. And think of their interaction as a video rather than as a snapshot. If the demand is increasing at a faster rate than supply, prices rise. If supply increases at a faster rate than demand, prices fall. With the current rate of increase of the monetary base by the Fed, and the current chill in industrial production, price increases are more likely than not.

I quibble with the aside about the banks and speculation, and point #1 above on how money is created needs some tweeking….but we can deal with those in another post if you like!

Sherry

Paul responds:

Thanks Sherry, I think I’m nearly there. Let me try and reflect back what you said to confirm my understanding.

1. More money in the system tends to make it easier for all segments of society to consume. That increased demand tends to raise prices.
2. Despite much weaker demand, you see the twin outcomes of reduced production and ‘easier’ money tending towards higher inflation than we have at present.
3. That does not necessarily mean that hyperinflation (what is meant by that?) is in store.
4. The phase we are in at present is a contraction in both output and demand hence price stabilisation and, in some cases, price declines. These declines will soon (?) find new equilibriums at which point inflation has the opportunity to appear due to the tremendous amounts of printed money in the system.
5. Deflation is a risk if a vicious circle of more unemployment, less demand, less production, more layoffs and so on becomes embedded. Governments are fundamentally very scared of this scenario, hence the policies of increasing the money supply.

Sherry’s response:

Yes, by George, I think we’ve got it!

First, I don’t think we are headed for hyperinflation (which is just excessive inflation), because that requires a much higher degree of uncertainty about the behavior of consumers, business, and government than I think is basically possible for the U.S. economy right now.

I would agree that supply and demand are contracting. And because prices have been fairly stable, that tells us that these two (unobservable) factors in the economy have been contracting at about the same rate. If demand contracts faster than supply for a sustained period, we will have deflation. Price changes — both increases and decreases — always result from the rate of change in supply relative to demand.

Supply and Demand

Deflation is indeed a scary prospect if it is demand-driven because then it is associated with a fall in output, more people out of work, idle factories, and the fear that accompanies all of that.

If prices fall because of massive improvements in the rate of productivity growth, however, we would see increases in output and employment, and that would be a good thing.

In fact, that should be the goal of government policy, in my view: reduce the real costs of production by reducing business taxes, fees, regulations, and paperwork. We would see an immediate and sustained increase in U.S. output, a fall in prices, and a drop in unemployment. The “Golden Bullet” it’s called.

Our current Fed Chairman, Mr. Ben Bernake, does seem to be much more concerned with deflation than inflation, which is consistent with his easy monetary policy over the last several months.

I worry that Mr. Bernake is overly confident in his ability to contain inflation should it arise. The administration’s concern over a rise in unemployment likewise explains the historic expansionary government spending we are currently witnessing.

Fiscal policy, which we’ve assumed constant in the above dialogue about inflation, may be a good topic for future discussions!

Sherry

This concludes the first essay.  Comments most welcome.

Real Time Economics article on Fed's Bond Purchases and Inflation

Fed's Kohn on Lessons from Buying Government Bonds....in Britain

http://blogs.wsj.com/economics/2009/08/22/feds-kohn-on-lessons-from-buying-govt-bonds-in-britain/

By Jon Hilsenrath

JACKSON HOLE, Wyo. — Federal Reserve officials have made it clear that they have mixed feelings about their effort to bring down long-term interest rates by buying long-term Treasury bonds. It hasn’t been clear if the program was achieving its intended goal of bringing down long-term interest rates.

If all goes according to plan, the $300 billion effort will run its course in October. All along, Fed officials have worried than the program would spook investors into thinking they were “monetizing the debt” – which is econospeak for facilitating big, inflationary budget deficits by buying government debt with money the Fed simply prints. Such a perception in the market could make the program backfire and push long-term rates higher instead of lower.

With that background in mind, it’s worth noting a comment that Fed Vice Chairman Donald Kohn made from the audience this weekend at the central bank’s Jackson Hole meetings. He was struck, he noted, that interest rates on British gilts fell earlier this month after the Bank of England re-upped its plans to buy government bonds. The program in the U.K., in other words, seemed to be having its intended effect, evidence supporting its usefulness. “The markets must perceive that there is an effect there,” he noted during a panel discussion on monetary policy.

The Fed has said it doesn’t intend to expand or extend its bond-purchase program. But what if the economy underperforms? And what if evidence mounts that this program, or others like it such as the U.K.’s, actually did have their intended effect? Maybe it won’t be dead after all. The Fed can be expected to keep its options open on the question.

• www.SherryJarrell.com wrote:

Wonderful article and comments! There seems to be some confusion on the facts surrounding the relationship between the Fed’s actions, the demand for and supply of U.S. bonds, and the interest rate. First, the Fed buys U.S. treasuries all the time, and they are only part of the world demand for U.S. instruments. Their plan to buy an additional $300billion in Treasuries within a relatively short window did represent a notable increase relative to their usual purchases, and was intended to raise the price which lowers the yield or equilibrium interest rate on those bonds, assuming these purchases continue to represent a net increase in world demand for U.S. bonds (which requires a fairly stable supply), and assuming inflation expectations remain flat.

There’s the rub: IF the Fed creates money (deposits, reserves) when it purchases these bonds, inflationary pressures do enter the picture. And increased inflation means higher interest rates. Inflation does require a sustained increase in the supply of money relative to underlying productivity of the economy. If money supply simply “keeps up” with productivity, we’d have zero inflation. If there is insufficient money (or liquidity or credit), deflation kicks in — which I believe is the real concern of the Fed under Bernake. There is ample evidence that Bernake is fairly cavalier about inflation, and perhaps overly confident about his ability to counteract inflationary pressures in fairly short order without much volatility in the markets. It’s deflation he wants to avoid at almost all costs.

I wonder if anyone can help me find any reference in the press of the Fed Res bulletins or minutes that clearly state that the Fed is going to create deposits in order to fund their purchase of the $300billion in Treasuries? I’ve looked and cannot find it. It’s important because this is what links the Fed’s purchase of bonds to any concerns about inflation — a source of a great deal of the confusion on this topic. To the extent the Fed uses anything else, like some of the AIG and Maiden Lane assets that they’ve recently purchased (a result of Paulson and Geithner’s borderline-constitutional blurring of the roles of the Treasury and the Fed), to buy some or all of these bonds, the money supply doesn’t increase and inflation worries abate.

There’s an in-depth, nuts ‘n bolts discussion of Inflation on http://www.LearningfromDogs.com that you all might like to see, linked in to my blog at http://www.SherryJarrell.com.

Inflation (Part Two): LearningfromDogs.com

Essay One – Inflation – Part Two

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Inflation, deflation, economic crisis and so on, getting to the bottom of meanings.

Inflation – Part two

Part One was published on the 23rd.

Paul responds

Sherry,

My first realisation is that I don’t really understand what “money growth” really means. In fact I am little uncertain about money, as a concept!

Are we talking ‘growth’ as in more and more money being lent to the US Treasury Department from the [ever increasing] sale of US Treasury Bonds?

If the sale of these Bonds is to banks or institutions outside the US then there is a flow of money coming into the US via the Treasury Department that then comes into the economy via various Government programmes. Is that correct?

But this is money lent to the US. That means that in order for the US to pay it back (plus interest) there has to be the expectation of taxation income in the future sufficient to meet these debts. As my Pension advisor said, “More credit also means more debt.”

I guess that what really hurts my brain is trying to understand the cause and effect in this. It seems to me that while the sale of Treasury Bonds creates more money in the system it is also creating more debt which has a dampening effect to the inflationary effect of the more money in the system.

Over to you!

Sherry replies:

Paul,

Ah! Yes, very good questions. This back and forth is very useful – it helps me to understand what you (and the reader) understand, and what needs to be laid out better.

The “M1″ definition of the money supply is the number of bills (and coins) in circulation plus the deposits in

Values from 2007

non-interest bearing checking accounts, essentially.

Money growth is the rate of change in this level. The money supply increases when the Fed purchases an asset and pays for it with “created” deposits. And I mean “created” in the true sense of the word: out of thin air. The deposit wasn’t there yesterday and, because the Fed says so (by “the stroke of a pen” or, in today’s terms, by a computer entry), it’s there tomorrow.

Most people assume that the assets the Fed purchases are only Treasury bonds, but that is not always the case. Most Treasury bonds are bought by entities other than the Fed, and thus they are not part of the money supply. And if the Fed pays for Treasury bonds with an asset, like foreign currency for example, it does not increase the money supply.

So there is no necessary relationship between the U.S. debt level and the U.S. money supply.

In fact, for a long time, the Treasury endeavored to have minimal impact on the money supply by using the local bank’s “tax and loan accounts” to deposit its tax revenues and to pay the government’s bills. With this economic crisis and this Treasury Department Secretary, I am not at all sure about this any more.

Sherry

Paul replies

OK, that makes it clear how money gets into being, as it were.

So we have two processes going on;

1. The Fed creates money, as in putting it out there, by purchasing cash-type paper assets from banks in return for printed money (as a concept primarily, in practice computer transactions) and then destroying those assets so just the money remains.
2. The US Treasury, in managing government revenues, borrows money from people and countries by selling US Treasuries to fund the government’s programmes, as well as raising it directly from taxation.

It is the first process that has the potential to cause inflation if the growth of that money creation is in excess of the growth in economic output of the nation.

The thing that I’m still having difficulty with is how the money gets ‘used’ and from that how more money being ‘used’ leads to inflation, that being the underlying topic of this debate.

We are, today, in a situation where demand for housing loans is dropping, industrial production is dropping, employment is dropping, retails sales really dropping and so on. There is no sign that any of these indicators is going to turn up soon and by soon I mean before the end of 2010, earliest.

Even outside the US the international scene is just as bleak although the news media do their best to hang on to snippets of less worse news. France is experiencing deflation (July YoY CPI down 0.8%), Germany likewise, the UK unemployment figures are dire and on and on.

Thus the banks don’t have real clients for their increased cash balances so all they can do is to drive stock markets and commodities higher as part of yet more speculation.

Capital Professional Services have a piece on inflation.

M1 shifted 18 mo vs CPI

As you can see in the most recent 6 months the money supply has increased from a growth rate of a couple of percent up to about 10%. Interestingly it is not up to the peak levels of the 2000 run-up. But if history is any indicator we can expect one of two outcomes either significantly higher consumer price inflation or another asset bubble.
From How does M1 relate to inflation by Tim McMahon, Editor (The original article has access to a larger version of that chart, PH)

So there’s the essence of my problem in understanding why there is an inflation risk while the outlook remains so grim.

The relationship between M1 money supply and inflation also seems less than tightly correlated so, as and when, the economy starts to grow what sort of indicators would give a reliable warning that a move from fixed interest investments was sensible.

Paul

Part Three continues tomorrow. Comments most welcome.

Guest Author Post: Inflation (part I) on Learningfromdogs.com

Essay One – Inflation – Part One

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Inflation, deflation, economic crisis and so on, getting to the bottom of meanings.

The background.

Not so long ago there was an exchange between me and Dr Sherry Jarrell about the meaning of inflation.  Dr Jarrell is, in every meaning of the words, a qualified economist so when I had the courage/stupidity/ignorance to query her views I could not have been more surprised to receive this:

You won’t reveal a lack of understanding of economics — there are co-existing opposing points of view on the topic – that’s why it made for an interesting discussion! (My italics)

This got me thinking.  If your author, who is reasonably well-read about many things especially protecting what little wealth he has, can miss such a fundamental point, then there must be a huge number of other people who, likewise, miss the point and, even more important, don’t even realise it!

Dr Sherry Jarrell

Over the last few weeks Dr Jarrell has not only found time to debate with me, she, too, has realised that a more rigorous exploration of what many economic and financial terms mean has real value for readers of this Blog as well her own Blog.

Therefore I am delighted to welcome Sherry Jarrell to the team of authors.

These essays will attempt to distil clarity out of a number of basic economic ideas, starting with inflation. That seems to be a worry widely ‘predicted’ in the general media as well as elsewhere.

The essay is in the form of a debate format, albeit virtually.  We hope it is both informative and educational.  Please let us know by leaving a comment!

Inflation.

Paul starts:

Sherry,

First a huge ‘thank you’ for engaging with me over this.  You are a very busy person and your time is much appreciated.

Here are some definitions of inflation that I gathered from cyberspace:

• (From your own Blog) Inflation occurs when the rate of growth of the money supply exceeds the level of real growth in the economy.
• Inflation is an increase in the price of a basket of goods and services that is representative of the economy as a whole.
• Inflation is an upward movement in the average level of prices.
• Inflation means a sustained increase in the aggregate or general price level in an economy.
• The overall general upward price movement of goods and services in an  economy, usually as measured by the Consumer Price Index and the Producer Price Index.
• In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.
• … define inflation as an increase in the amount of money and credit in relation to the supply of goods and services

So there we are, then.  That’s really clear!  Well to me, as clear as mud!

The challenge is that although all the above definitions appear to cluster around some common meaning (that economists presumably understand) it is of no real help to those of us that just want to monitor the things that matter and then be able to make best decisions with a minimum of risk to our wealth.

Let’s take my own situation.  The bulk of my investments (personal assets and pension) are US Long-dated Treasuries because:

• deflation seems to be a much greater risk
• what other investments are as safe as the US Government and
• securing a decent guaranteed income that remains for the next 25 years is an important plank to funding our old age. (I’m 65 this year.)

But excessive inflation (whatever that really means) and, worse still, hyperinflation (whatever that too means) are the big enemies of a fixed income, however wonderful the US of A is.

Let me turn to a portion from the last Client’s newsletter issued by the firm that manages my pension (a UK SIPP, self-invested personal pension):

All policy levers are related to the amount of credit in economies and the speed at which that credit circulates. The basic relationship is: more credit brings more prosperity but also a risk of inflation. So, last year’s rescues produced inflation stories.

This argument is superficially attractive, but only a small part of the picture.  More credit also means more debt. Debt has expanded to the point where it is close to unaffordable for many people.

The argument goes on to say that if consumers can’t consume more because of debt servicing and financial insecurity and that continues to ripple up the producer chain how on earth can demand start to overtake supply?

Karl Denninger, Market Ticker guy, has been saying that the real risk is a huge collapse in confidence.  Here’s just one example from many on his Blog.  He says, “The recession is not “easing”, it is DEEPENING.”

Well deepening means heading towards deflation, doesn’t it

HELP!

Sherry replies:

Paul,

Okay. Let’s begin with a primer on the facts about economic relationships then move on to opinions about what may happen and how one might protect their wealth.

Fact:when the rate of money growth is faster than the rate of real underlying economic growth of an economy, that economy will experience inflation, but only over the longer term (two to three years). In the short run, an increase in the money supply reduces short-term interest rates and increases interest-sensitive business and consumer demand.

But unless demand outstrips the ability of private production to keep up, inflation will not ensue.

What determines the real rate of productivity or growth in an economy?

Answer – Physical capital, labor (quality, experience), processes, managerial skill, lack of excessive fees and taxes on production from the government, and so forth …the liquidity represented by the money supply is the link between the real “chug-a-lug” economy and the monetary economy.

The engine of growth and prosperity in the economy is private industry – the combination of physical capital, labor,

Engine of growth?

and management — which is simplified and made more efficient with the liquidity provided by the money market.

The real economy can exist without a money supply, but money is meaningless without the real economy. We can’t eat money. So whether the conditions in an economy produce recession and deflation on the one hand, or growth and inflation on the other, depends on the “race” between the real economic growth capacity of an economy, and the growth rate of the Fed’s money supply.

The current level of economic output and the rate of economic growth is driven by supply (private business) and demand (public and private consumers). Supply is driven by the profit motive of companies. Demand depends critically on consumers and their confidence. If confidence is low, current growth is low, and any particular rate of money growth is more likely to outstrip real growth, producing inflation.

At any particular time in the economy, most any relation between the money growth rate and real growth rate is possible. Recall that, in the short run, an increase in the money supply lowers interest rates and expands the economy. In the long run, that same money supply expansion will raise the fear of inflation which increases interest rates, dampens real growth, and contracts the economy.

Which scenario do we see in the near future?

Well, given the expansion of the Fed’s balance sheet from bailing out AIG and others, and the difficulty they will have in getting those assets off their balance sheets, we may experience a significance increase in the U.S. money supply over the next several months and years, increasing the risk of inflation.

Lenders suffer in inflationary periods because they get paid back in dollars with lower purchasing power: the prices of goods have increased and the paid-back dollars buy less. Borrowers benefit because they make interest and principle payments in deflated dollars, increasing purchasing power.

As usual, the change in the price of a good or service, even the interest cost of borrowing and lending with its unpredictable inflation component, has winners and losers with an essentially negligible effect on the overall health and well-being of the market.

Part Two continues tomorrow. Comments most welcome.

The Waste and Manipulation of the Cash for Clunkers Program

So now we hear that the auto industry is increasing production to meet the increased demand for cars generated by the Cash for Clunkers program.  And this is supposed to be good news; evidence that the program is working. 

Not so fast.  This program is working, all right, but not in ways its proponents would like for you to believe.  On the contrary, the Cash for Clunkers program is a perfect example of the waste and manipulation of most government programs, particularly those that invade what should clearly be a purely private, free-market industry.

Let's make sure, first of all, that we all see the Cash for Clunkers program in the same way: 

Step 1. the U.S. private industry and labor force puts in a good day's work to earn income and revenue, Step 2. the government takes a chunk of that income as tax revenues, 

Step 3. the government picks a select group of cars that it wants us to buy that we are not now buying

Step 4. the government gives a select group of people a chunk of those tax revenues to apply toward buying those cars if 

           a.  those people are willing to spend whatever is left of their after-tax income on one of these select cars during a specified time period, or 

           b.  those people are willing to go into (further debt) taking out a loan (I thought that high debt levels is part of what caused the recent credit crisis???), and finally, 

           c.  those people can trade in the kinds of cars that the government says we shouldn't have bought in the first place.  

What is wrong with this picture? Where do I start!  Why don't we skip the obvious, like the enormous wasted resources associated with the development, administration, and implementation of the program.  As I write this, car dealers across the country are complaining about not yet receiving the cash promised them by the government, and the Department of Transportation is scrambling to add people to their ranks to deal with the paperwork.  Where do these people go when the program is over? Likely, no where. We will be paying their income out of tax dollars collected from the private economy for decades to come.

Car manufacturers are gearing up for increased production to meet the demand.  Where are the unsold cars going to go when the program is over? How does it help the economy to produce cars that we don't buy without a payoff from the government?  Why not let the auto industry produce cars that you and I want to buy if left to our own devices?  And if they can't, they should go out of business and stop wasting our precious resources.  Propping up a losing industry just exacerbates the loss to society.  If the auto industry was producing what society wanted, it wouldn't be having financial difficulty in the first place. The Cash for Clunkers program does nothing to fix that fundamental problem.

And what about all the other, more obscure side-effects of this program, the unintended, unmeasured, ignored consequences of this program?   For one, car repair shops are seeing a marked decline in business.  I called my local repair shop for a routine service appointment last week and they told me to come on in! Business was very slow, they said, because several of their customers, rather than pay for a costly repair or service, had chosen to trade the car in for the $4500 in the Cash for Clunkers program.  So the car repair industry has suffered a decline in income as a result of this program.

People won't trade in cars that are worth more than the $4500 allowed in the Clunkers program.  So,the only cars that would be traded in are those that are worth less than the $4500 trade-in value.  By the stroke of a pen, the administration has single-handedly reduced the supply of available used cars and raised the average price of used cars to the U.S. consumer -- not an insignificant cost.

What about all the injuries and deaths that are going to result from accidents suffered in smaller, more fuel-efficient cars?  I bought my oldest daughter her first car this year, a hefty, used SUV.  Why? Because I wanted to keep her safe.  And so far, in this country, that what free people do:  we buy the kinds of cars we want.   So far.  The Cash for Clunkers program moves us ever so slightly away from a free society where we buy the kind of cars we want, toward the kind of society where the government decides what kinds of cars we want, and uses our income to buy them for us.    At least the government doesn't make the cars itself ..... oops! Well...on second thought....I guess they essentially do now, don't they!?  

Careful: The Public Option Head Fake

Sebelius' comments today that, due to public pressure and in the interest of bipartisan progress, the public option for the proposed health care reform may be off the table, reminds me of an experience I had in the courtroom some years ago.  The opposing attorney, who knew how to play very dirty very successfully, asked the jury for damages that were totally beyond reason.  The jury, in its infinite wisdom, ruled against the inflated requests, but then proceeded to award damages that were still outrageous, but only in absolute terms. Compared to what the attorney had originally requested, the award didn't seem so crazy. 

The manner in which the White House has handled the public option reminds me a lot of those courtroom tactics.  I'm not convinced that Obama or his team really thought that health care reform would get through with the public option intact.  But it couldn't hurt to try, right?  What's the worst that could happen if they had to put that part of the plan aside? Why, now the public would see Obama, Selelius and others as "reasonable;" now the public expects the opposition to also "give something up," "compromise," "cooperate" in the interest of political give and take, or risk being labled obstructionist.  

Brilliant.  Sneaky, deceptive, harmful to our country....  but brilliant. 

Healthcare: Government Rationing vs. Market Rationing

Rationing.  First of all, what does rationing mean?  It means that there is a finite or limited supply of a good or service, and that not everyone who wants it will get all that they want.  Rationing can occur through the price that is charged for the good, or through limiting the quantity of the good by some centralized authority. 

Yes, it is true that regardless of whether we get our health insurance from private insurers or from a government program, there will be rationing.   But there is a huge difference between the type and scope of rationing by the market through price, and rationing by the federal government through control.  When the service is rationed by an insurance company, a doctor, a hospital, if we don't like the decision, we have a recourse.  We have options. We have choices.  We can go to a different doctor, a different insurer, a different plan; we can report the company, sue the company, fire the company.

When your health care is rationed by government-sponsored single-payer health insurance, that's it.  If you don't like the rationing decision, you can't get "another government," you can't sue the government, you can't fire the government, you can't pay a higher price to get more services out of the government (not legally anyway).  You have no recourse.  The government decision is the end of the road.

So rationing in and of itself is not the point, is not the problem.  Government rationing is the problem. 

 

Snitch Czar appointed: David Axelrod, White House

Well, I've gotten two insipid, insidious emails from David Axelrod in the last 4 days, sent to an email address I've used strictly for personal communication.  This is just the beginning of the abuse of power we will experience if the White House continues to ignore the Constitution and the limits it puts on the Executive Branch.  

More later.  First, I need to mull over the perfect response to Mr. Axelrod or, since we are now apparently on a first name basis and good enough buddies to be sending emails to personal accounts, Davey-baby.

"It's not Socialism if Government doesn't write the Dr's paycheck?!"

I heard on NPR today the latest in a very long list of novel ways of clouding the Health Care Reform picture.  Apparently, many on the left are now saying that "It's not socialism if the Government doesn't directly write a check to the doctor."  I am not kidding -- this is almost a verbatim quote.  

I am left just shaking my head.  What is there to say except "WHAT???"  But I have to say something because otherwise there are folks who will start repeating this claim as "fact."  But it is fantasy, folks, and not very credible fantasy at that.

Health insurance is a middleman between the doctor and his/her payment for services.  Either you pay the doctor directly when you go for an office visit, or they bill your insurance company for payment. Either way, you pay, either for the insurance that pays the doctor, or to the doctor directly.

Or, if the government funds the health insurance with taxpayer dollars, then either way, the government pays, either indirectly through insurance, or directly to the doctor.

I do not get where the confusion is.  And I don't get what people who say such things are thinking:  where do they think the money the government spends on absolutely anything and everything, including Medicaid and "universal health care," comes from in the first place?  Oh, that's right, the money tree!!!

Health Insurance vs. Health Care

I'm asked to give talks on current economic issues and events of my choosing on a regular basis.  The audiences range from professional women's groups to senior executives in technology and banking.  Over the last ten years or so the only subject I have purposefully avoided is health care. And, as of now, I intend to keep it that way.  Why?  Because it has been so unproductive to try to deliver an objective, factual overview of health care and its related issues.  Most people just can't seem to depersonalize the subject long enough to hear what it is I am trying to say.  

So I'll hide behind this blog for the time being.  And see how it goes here.

The issue for today is the distinction between health CARE and health INSURANCE.  As we all know, they are not the same thing.  But, as we all likely also have noticed, the two are often confused and the distinctions ignored by many if not most in the media, Congress, the White House, and in town hall meetings.  

Health Care and Health Insurance are certainly interdependent. But it helps to first separate the two and take each in turn.  Let's start with health insurance.  And let's think of it first as just any "insurance," like a policy on your house or your car.  What is insurance?  It's a contract that you buy to limit your losses if a bad event happens, even though the likelihood of the bad event occurring is usually very low.  How do insurance companies set the price and the conditions of the insurance policies that they sell to you? And that you can choose to buy or not?  And that we often shop around for until we find the policy that has the right payoffs for the right price?  

Well, the insurance companies are for-profit entities.  The price they set for the policy has to cover their costs.  (and I'm ignoring the messier pricing issues of co-pays, deductibles, details on what is covered and under what circumstances...) The problem is, they don't know their actual costs when they set the price, because they do not know for sure how many claims will be filed over the term of the policy, nor how large they will be.  The likelihood of a policyholder filing a claim is driven by the chance of some natural event occurring (like a flood or a lightning strike) and by the behavior of the policyholder.  The insurance company controls neither of these.  They must devise a policy that reflects their best guess as to the likelihood of the natural event and the risky behavior of the policyholder or their covered dependents.  At the beginning of the policy period, the policyholder is happy to have the insurance.  If, by the end of the period, you had to make a claim and the policy covered your losses, you'd be very satisfied with the service.  But, if at the end of the period, no claims were necessary, you may feel ripped off or feel like you overpaid... which is a really good example of buyer's remorse: "I didn't need that insurance policy anyway!  I should have never bought it." But the whole point is that you are buying a service today that limits your losses from a bad, but very low probability, future event.  

I can't tell you how many times in the last month or so, as I've commented on the health care reform debate on various websites and blogs, I've been accused of being a paid operative for the insurance industry! Well, I'm not.  It is just that the modeling behind the optimal pricing of insurance contracts (and optimal means that it is best for both the buyer and the seller) is very interesting to a nerd like me -- it involves real options pricing, and is much closer to mirroring the actual behavior of the economic players involved than the usual cost-plus or net-present-value approaches.  So I find it very interesting for sure. But that doesn't mean I'm speaking for (or against!)the insurance industry!  

Health care insurance companies face exactly the same pricing issues, except that they often deal with company represenatives instead of individuals.   When they are dealing with company representatives, the information they get on the likely behavior and risk profiles of the employees is necessarily more generalized.  And the policy will apply to future, now unknown employees as well, an additional complication.  But the economic issues are basically the same as above:  the insurance company must set a price (and co-pays, deductibles, lifetime limits, etc.) that covers their actual costs over time because, if they don't, they will go out of business, and the service won't be offered by that company any longer. If no other insurer comes in, then the service is not offered; no one would get health insurance.  If some other insurer does a better job of forecasting risks, of writing contracts that mirror actual behavior, and of offering the types of coverage that customers want and are wiling to pay for, they will enter the industry, make a profit, and survive, continuing to provide a service that people want and choose to pay for of their own free will.  

There's more on the topic -- like how much better off we'd all be if health insurance wasn't offered by employers as part of our wages and benefits -- and how much worse off we will all be if a health care plan with a public option is passed -- but that's for another post.

Sebelius' confusion about health industry competition

Secretary Sebelius paints a very biased, ill-informed picture of the Health Care Reform debate. Her view is unfortunately very clearly clouded by her experience on the Insurance Board, and she is out of her element when she tries to invoke economic arguments.  And she also doesn't seem to be interested in hearing from all the citizens that she is supposed to represent.  I believe that, as a public servant, she should not sweep all those who disagree with the plan under the rug, assuming they've been brainwashed by scare tactics or enlisted by organized protestors. I disagree with the plan, and I'm an economist who's looked at the plan and the industry data. I'm also a single mom who is responsible for providing health care for me and my daughters. And no one is paying me to say the things I say here on this blog.

The most dramatically naive error in logic that Ms. Sebelius has made during this debate is her claim that government- run health insurance would provide more competition than the current insurance industry does! She is right in saying that competition is good -- it increases choice and reduces prices for consumers. But she is flat-out wrong in her suggestion that a public option "competes" in any sense of the word with insurance companies. Consider the following response she gave to NPR's Melissa Block when she asked if Sebelius thought the insurance companies were villains.  Sebelius answered: "This isn't rocket science. It is a lot cheaper to collect a premium and not pay claims than it is to collect a premium and pay claims.  ... The [insurance] companies would also get competition from a public plan..." http://www.npr.org/blogs/health/2009/08/hhss_sebelius_on_whats_been_lo.html#

This is pure fantasy.  The government does not compete alongside other suppliers in a market; it makes up the rules of the game, takes money from one segment of society and spends it on the goods and services in another (ones that it chooses, not us), and rules by law, not free choice. This is the antithesis of competition.