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January 11, 2010


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Dear Dr. Jarrell,
Your analysis is indisputable and quite to the point. I find that direct rhetoric such as this rarely enters the debate. The reason for this phenomenon is the subject of another posting. I wish to comment on another point of economic reality that has not found its way into this discussion, the cost of capital.
One of the primary arguments made by those favoring government run health care is that programs like Medicare have lower overhead or administrative cost than private insurance plans. On the surface this is true Medicare reports a 5% administrative cost compared the administrative costs of private insurers which are purported to be as much as 30% according to the argument. I will not delve into the cost accounting issues that should be questioned in this analysis for there are many significant details such as cost accounting standards and the accounting for losses and incorrect payments that should be analyzed. I wish to focus on one glaring omission in this comparison; the cost of capital formation.
Private enterprises compete among investors for capital in the bond and stock markets. These markets are vast and quite diverse. Basically, conservative investors typically purchase bonds whose cost to the corporation which issues these instruments is the interest rate that is enough to give this kind of investor the returns they seek. The corporate borrower must offer a rate that is sufficiently appealing to induce the bond purchaser to invest their funds in the instrument. This rate is influenced by the financial strength of the corporation relative to other businesses of a similar nature seeking to acquire funds from like minded investors.
Some investors are interested in a greater return on their investment than bonds can offer and are willing to assume greater risk to receive that return. These investors may wish to purchase stock in the corporation. Again the stock is valued to some degree on the financial stability of the corporation and similarly it is in competition with other businesses engaged in similar activities. The return offered by stock is typically in two forms; dividends and future earnings potential as viewed by the investor’s analysis of the competitive position of the business and its management. Future earnings are important because they give the corporation funds to spend on product innovations or to make their business operations more efficient.
The Federal Government is a little different because it has essentially two sources of revenue; taxes and debt. If a new program cannot be funded by taxes then it must be funded by debt. That sounds simple but another role of the Federal Government then comes into play, the Central Bank. No Fed bashing which seems to be all the rage these days will be written here. The Federal Reserve Bank is important because through the Federal Reserve, the Federal Government can print money and it has the ability to create enormous sums of capital, the cost of which is more difficult to identify than that of its counterparts in the private sector, but a cost just the same.
First we must recognize that taxation is not simply the act of earners making payments to their Government. Taxation is displacement of scarce resources that could be used for consumption or investment. This money is used for the administrative cost of our country, its government entities. The dollars spent on taxes do not meet the test of free market choice, nor do they return growth and re-investment like those dollars spent and earned in the private sector. The foregoing is a fundamental reason why we separate Gross Domestic Product (private spending) from Gross National Product (all spending including that of the government). It is the reason why one of the bellwethers of the total Federal Debt is to measure it against Gross Domestic Product. In essence, taxes are a drag on the economy. And too much drag results in stagnation.
A more incipient issue in the creation of capital is the second way the Federal Government can raise money; by issuing debt and its effect on the aforementioned private bond market. Because the Federal Government has the power to print money it can never fail to pay back those investors from whom it borrows. If the money is not available it can just print more. Seen this way, the supply of money is endless, but the supply of willing investors is limited. So an insurance company for instance, which is competing for investor capital must compete against an entity that can print money. When the Federal Government borrows, it saps resources from the pool of investor money; please refer back to the previous paragraph about taxation. Printing more money is also problematic because if too many dollars are printed their supply can quickly exceed demand and then we have real problems; high interest rates and inflation (does anyone remember 1976?). In this realm there is another complication, the value of the dollar against other currencies. The depreciation of the value of the dollar began before the recent financial crisis, and as we issue more government debt that trend will continue. The result is that goods and services from other countries require more dollars for their purchase which causes the flow of more dollars out and exacerbates the problem. Once again we have difficult choices but higher interest rates will certainly follow. It is these forces make the cost of capital creation an integral part of the cost of “administration” of a program like Medicare which is to say that a simplistic comparison of the cost of Medicare administration to that of a private firm is not only incorrect, it is misleading. That is an indisputable fact, just like the shift in the supply curve that is illustrated in your graph.
So if I this comment is sensible to you, one point is clear; government programs like health care require capital creation in their own form. It is the vague nature of that capital formation and its slippery cost that makes it seem so inviting. But let the buyer beware; if something seems to be too good to be true, it usually is.

Hello EP,

So many issues you've raised! Your key observation about the (opportunity) cost of capital -- that determined in a competitive market for capital, not by accountants assigning overhead! -- is so very important. I think back over many of the posts here and on www.LearningfromDogs.com and, indeed, a running theme is the cost of capital, which is fundamentally a return to lenders generated by the profits of the use to which the lent funds are put. And the profits are what enable the continued borrowing, i.e. capitalism. The intersection between private industry and the federal reserve in the capital market is a very interesting one, indeed, and needs to be better understood. One way to understand this relation is to think of the cost of capital to a business or an industry as a bunch of levels stacked upon one another: the bottom is the risk-free rate of interest as determined by the t-bill rate of the U.S. economy. That rate is as much driven by real underlying productivity of the U.S. economy as anything -- this is one reason that higher interest rates are a good thing. The second layer would be the expected inflation rate, driven by the monetary policy of the Federal Reserve. This is a reason that higher interest rates would be a bad sign. The third layer is the additional risk that the lender may not receive their principal plus interest at the maturity date, which depends on many firm-specific, industry, macroeconomic, international and political factors both within and across economies.

Two things: we don't want to confuse debt with the U.S. money supply. There is a very tenuous, varied "association" between the two. I don't even thing I'd go so far as to call it an accepted "model." Two, the way that the Fed buys treasury bonds is by creating money, by injecting more money or liquidity into the economy, not spending it, which may seem backwards to some. It did to me, at first. Another clarification: as money supply increase, the near-term interest rate falls. But if money supply increases cause Aggregate Demand to outstrip inherent growth in Aggregate Supply inflation will ensure. So it's a complex subject, made infinitely more understanding and therefore information by substantive discussions such as these. Bravo!

Why would they start another tax increase and since the health care system is currently a big issue, I doubt that this will have a positive effect.

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