Center for Business and Public Policy
at the University of Illinois, Urbana-Champaign

Okay, I admit, I like to watch professional sports.  I grew up in Virginia, so I watch the Washington Redskins.  I also like to watch movies.  Best are the quirky independent films, but I also watch some Hollywood thrillers.

So why does my government discriminate against me???

Other people get their entertainment in other forms, and that’s fine.  Many here at the University of Illinois watch Illini college football (actually, I do too, but what about those not in a college town who prefer professional sports?).  I’m happy for college football fans in Champaign-Urbana, but, why does our government favor this form of football over others?  Some people like to go to church, and I don’t blame them.  They listen, they learn, and they feel better.  For them, it is a form of entertainment as well.  I’m happy for them, but why does our government favor their form of entertainment over mine?

The answer is: no good reason.

But that’s exactly what happens.  To get some really good seats at a professional football game, you can pay a lot, let’s say $10,640 for a pair of season tickets.  The same is true for college football.  But the way you buy the good seats at a college football game is that you first make a $10,000 “donation” (of which 80% is tax deductible).  Then you buy two tickets for $320 each, and that $10,640 will get you two comfortable chairs in the main stands near the 50-yard line.  But it doesn’t cost $10,640.  Getting to deduct 80% of $10,000 is worth $8,000 off your taxable income, and if you are a 30% tax bracket, then it saves you $2,400 of actual Federal income tax.   The real net cost of the tickets is $10,640 minus $2,400, which is only $8,240.  That is a 22.6% discount, provided by the Federal government.

Why should government care whether any particular sports fan watches college sport or professional sport?  They are nearly identical, so I believe that subsidy is not justified.

The supposed justification for the tax deduction is to encourage charitable donations.  But where is the charity?  This “donation” is not going to help the poor; it’s not even going to any educational purpose!  It is going to pay for a fancy new stadium improvement, expensive new practice equipment, salaries of coaches, and all the costs of running a major football program – the same as it does for the Washington Redskins.  The professional team also uses ticket sales to pay for a fancy new stadium improvement, expensive new equipment, salaries of coaches, and all the costs of running a major football program.  There’s virtually no difference.

The point is that the ability to use tax deductions is too widespread, and it makes all the rest of us pay more tax to make up for the discounts given to other people for their own normal expenditures.  Not only that, but it gives a bigger discount to the rich!  Low-income households are in a low tax bracket, or do not even pay tax, so they get no subsidies for their donations.  Only rich folks in high tax brackets get the government to pay for their Illini football tickets.

The same point can be extended to many other “charities”, even religious organizations.  Some people like the whole experience of going to church: the stained glass, the carved wood, the singing choir, the thoughtful sermon, and the whole spiritual experience.  I don’t begrudge their tastes, but they shouldn’t begrudge mine either.  Personally, I’d rather go to a Hollywood movie.  But my ticket is not deductible, whereas their cost of church is deductible.   I would better see the justification for tax deductions of gifts to charities that help other individuals less fortunate than themselves, and some donations to religious organizations are indeed used for humanitarian purposes.  But I just don’t see why my own tax dollars ought to be used to support some rich person’s cost of getting access to stained glass, carved wood, singing choirs, and that whole entertainment experience.

In recent weeks the debate over health care reform has reached a boiling point.  So, I thought I’d use my first posts here to put out what I believe to be two incontrovertible facts about health care in the United States.  First, modern medicine is probably the greatest success in the history of human endeavor.  Second, there’s still a lot of work to be done.

Today, the first point.  Life expectancy at birth in the United States in 1900 was 47 years.  By 2000, it had risen to 77 years.  Since 2000, we’ve added about another year to life expectancy.  Just take a moment to think about that.  Think about everyone you know who is alive and well for those 30 extra years.  Think of all the things you’ve done or hope to do during that period.

But, people are not only living longer, they’re also living better, and the combined gains in longevity and quality of life are significant.  A 2006 study by Kevin Murphy and Robert Topel published in the Journal of Political Economy estimated that the typical American alive in 2000 valued the increase in life expectancy over the course of the 20^th century at $1.2 million, and that the overall gains experienced between 1970 and the end of the century were valued at about $3.2 trillion per year.  To put it in perspective, that’s like increasing GDP by 50%.  If you don’t like statistics or don’t want to focus on mortality, just think of someone you know the month before and the month after a joint replacement.  The ability of medical care to improve well-being is really quite astounding.

Now, to be fair, not all of these gains are due to medical advance.  Some are simply due to increased income.  Even people living with the medical technology of 1900 would live longer if they had been richer, and incomes increased over the 20^th century.  Some of the gains are attributable to advances in public health, rather than medical care per se.  For example, better nutrition and cleanliness were important, and reducing smoking has certainly had an effect.  But, beginning in the middle of the 20^th century, vaccines, antibiotics and sulfa drugs greatly reduced deaths from infectious diseases and extended the lives of younger Americans.  During the later part of the 20^th century, significant progress was made in extending the lives of older Americans, in particular in reducing deaths from heart disease.  (Want to learn more about the causes of mortality?  Check out this paper by David Cutler, Angus Deaton, and Adriana Lleras-Muney.)  For example, Murphy and Topel estimate that progress on cardiovascular disease added 3.75 years to life expectancy between 1950 and 2000.

Not only has modern medicine reduced mortality, but it has also done it in a cost-effective manner.  Rather than quote the results of individual studies, let me instead borrow a hypothetical question from David Cutler’s excellent 2004 book, Your Money or Your Life.  (Much of what I’m saying echoes what David already said in that book.)  Inflation-adjusted per-capita medical spending in the U.S. was about $500 in 1950.  In 2004, it was around $5000.  Raise your hand if you would be willing to return to 1950’s medicine in exchange for $4500.  Life expectancy then was about 68 years; today it is 78.  Any takers?

So, why write this post?  Well, while our system certainly can and should be improved, over the course of the last century it has actually given us, on average, 30 additional years of life.  This benefit, which holds across income levels and racial categories, is the product of the very actors – including drug companies, insurance companies, hospitals, doctors, and even the government – who are being vilified by at least one side of the debate – and often by more than one side – on a daily basis.  Sure, they can do better – often they can do much better.  But, I thought I’d take a moment to give them credit for their accomplishments before I started in on them.  That can wait for next week.

Social Security has been in the news this week due to the realization that – under current law – there will be no cost-of-living increase this year.  This, combined with the fact that Medicare costs continue to rise, is leading seniors and politicians to express concerns about “shrinking Social Security checks.”  (See, for example, the NYT piece.)

But let’s be clear about the facts.  Since 1975, Social Security benefits have been increased each year by applying what are known as “cost-of-living adjustments,” or COLAs.  Each year, the Social Security Administration automatically increases benefit checks by the rate of increase in the Consumer Price Index (CPI-W).  This adjustment is meant to approximate the average increase in prices so that a beneficiary can continue to consume roughly the same basket of goods and services each year.

This past January, benefits were increased 5.8%, despite the fact that consumer prices were falling due to the recession.  This occurred because the COLA adjustment is done with a bit of a lag, so that the Jan. 1, 2009 adjustment was based on the change in the CPI-W from 3^rd quarter of 2007 to the 3^rd quarter of 2008, which preceded the worst of the economic downturn. 

Because of the economic downturn of the past year, consumer prices have actually fallen.  The CPI-W, which stood at 215.495 at the end of the 3^rd quarter of 2008, stood at 209.224 as of the end of 2^nd quarter 2009.  Thus, to hold real purchasing power constant (i.e., true inflation-indexation), Social Security benefits should be reduced.  But the law stipulates that they not be reduced in nominal terms, so the net result will be a zero nominal increase.  But keep in mind that a zero nominal increase in a period of falling prices actually means that beneficiaries will have a “real” increase in benefits. 

The automatic COLA is in place to prevent seniors and other beneficiaries from having the purchasing power of their checks eroded over time by inflation.  In times of falling prices, benefits are not being eroded – in fact, quite the opposite. 

But what about Medicare?  Yes, it is true that most seniors have their Medicare premiums deducted from their Social Security check.  In normal times, Medicare premiums are set so that participants (in aggregate) pay for 25% of Medicare Part B costs.  But as explained by Chuck Blahous in the Washington Post there is even a “hold harmless” provision that ensures that most seniors cannot see their net check decline as a result of Part B.  In other words, Medicare beneficiaries will not even be charged their full share of Medicare costs. (Unfortunately, as Chuck explains, a minority of seniors will have these costs shifted onto them – that small group actually does have something to complain about.)  Also, I don’t believe that Medicare Part D, the prescription drug piece, has this same hold harmless provision (although I need to check on that …).  Even so, let’s be careful about the logic here.  A few years ago, seniors did not have prescription drug coverage under Medicare.  We are now spending billions of dollars subsidizing their drug purchases, so they are better off than prior to Part D.  But because the Part D premium comes out of their SS check we now have to increase SS benefits even more?  In other words, their costs go down, but because we now deduct part of these costs from their check, we somehow have to increase the size of their check?  This strikes me as little more than “more government begets more government.”      

Despite this economic reality, many are calling on Congress to provide an increase anyway.  For example, my former colleague on the Social Security Advisory Board, Barbara Kennelly, who is also the President of the National Committee to Preserve Social Security and Medicare, was quoted in an AP article of suggesting that Congress increase benefits 1%, despite the falling prices.  

Let’s be clear about the implications.  First, it is well known that Social Security already faces substantial long-run economic challenges that will ultimately require that benefit growth be scaled back.  Increasing benefits now just makes the hole deeper.  Second, allowing Congress to start messing with the COLA adjustment is a bad precedent.  Prior to the start of indexation in 1975, Congress handled COLAs directly, and you can only imagine the political grandstanding that took place then.

I’m not unsympathetic to seniors and disabled workers living on fixed incomes.  Like most Americans, I have plenty of members of my own family in those situations.  But, as Chuck Blahous points out the Washington Post piece linked above, we should not use false arguments to make the case for benefit increase.  He states: “Seniors, like all Americans, are feeling the pain of our economic difficulties. If, after due deliberation, Congress and the administration decide that taxpayers should shoulder still more burdens and seniors less, then so be it. But let’s not dress that decision up in the guise of correcting a nonexistent inequity.”

It’s nice to see something you have been arguing is important for years finally make it to the newspaper. The Financial Times did a couple of long pieces Friday (August 21) on the CLS Bank, an institution I’ve been doing research on since before it was founded (see, Carnegie-Rochester Conference Series on Public Policy, Volume 54, Issue 1, June 2001, Pages 191-226 or http://papers.ssrn.com/sol3/papers.cfm?abstract_id=248058 ).

The CLS bank takes counterparty risk (so-called “Herrstatt risk”) out of currency trading. I’ll quote one of the FT articles:

“Since 2002, an increasing number of trades have been settled through CLS Bank. Owned by a group of the largest financial institutions, it runs a daily system for netting payments between it members that dramatically reduces settlement risk. Currencies accounting for about 95 percent of daily trading can be settled through CLS and all big banks use the system.”

In fact the volume going through the CLS bank on a daily basis is mind-boggling. A conservative estimate says that every couple of weeks, the system turns over value equal to annual world GDP, making it—during the day time at least—by far the largest financial institution in the world. (That “during the day time” caveat reminds me of the boast by Memphis International Airport that it is the busiest airport in the world at night—because it’s the hub for FedEx). During the night, once all trades are settled, CLS bank shrinks down to practically non-existent.

The second article in the FT then goes on to argue that CLS bank’s solution for counterparty risk in FX trading should be the basis for reform of settlement systems of all sorts. That’s a little simplistic: FX trading is special is several important ways, and CLS is designed to take advantage of those special circumstances. Moreover, CLS is fundamentally dependent on the support and cooperation of central banks, and it’s doubtful that those central banks would be willing to give the same arrangements to other settlement systems. Still, the design of new settlement systems is one important potential remedy for the fragility we have endured in new financial markets over the past couple of years, and it’s useful to use CLS as at least a partial model for those new systems.

For more on innovations in payment and settlement systems see “Why Pay? An Introduction to Payment Economics” by Charles Kahn and William Roberds Journal of Financial Intermediation
Volume 18, Issue 1, January 2009, Pages 1-23

http://econpapers.repec.org/article/eeejfinin/v_3a18_3ay_3a2009_3ai_3a1_3ap_3a1-23.htm

Oh, I’m sure you think you pay for your garbage collection through your property taxes, or through your fixed monthly fee.  But given those payments, you can put out as much garbage at the curb as you want.  Have another party with paper plates and cups, and then you can put out another couple of bags at no extra cost whatsoever.  But those extra bags still have to be collected, and they still use up valuable space in the landfill.  It’s not only “fair” for you to pay your own costs; more importantly, it can help get people to conserve.  (Save the planet!)

In the U.S., this problem is a big one. Americans generate about 4.5 pounds of trash per person per day, 95 percent more than our neighbors in Canada, 64 percent more than Australians, and 37 percent more than the French. This high per-capita rate, combined with our large population, means that the United States generates far more trash each year than other developed countries. The amount is also much greater than it used to be: in 1970, the average American generated only 3.25 pounds per day.

It is only getting worse, considering more economic development combined with population growth in communities across the United States and around the world.

Recycling and composting do make a dent: in 1970, composting was virtually nonexistent and only 7 percent of solid waste generated was recycled. But by 2005, the numbers had risen to 24 percent, for recycling, and 8.4 percent, for composting. These figures have remained relatively unchanged for the past several years, however. And while some materials have relatively high recycling rates - half of all paper and paperboard is recycled - others pose perennial problems. Plastics are difficult and costly to recycle.  As a result, less than 6 percent of them are recycled. Furthermore, products like cell phones and computers are creating new problems.

What are the key problems that government officials and policymakers need to address with respect to solid waste? And what policy instruments do the best job of tackling those problems?

For local communities, three goals seem paramount: trash needs to be managed properly without the high social costs of litter and other forms of illegal disposal; the amount of legally disposed waste should be reduced to a level that accounts for its own social costs; and particularly hazardous or toxic wastes need to be disposed separately, not thrown in the landfill with other trash.

Policymaking inevitably involves tradeoffs, so furthering one goal may reduce progress toward another. For the most part, developed countries have figured out how to manage solid waste to avoid extensive dumping. Local communities provide trash collection and disposal services - usually through government provision, franchises, or contracts with private companies. Although the number of landfills has fallen in the past 15 years or so, landfill capacity has remained steady. Moreover, landfills are safer than they used to be because of requirements for liners, methane control, and monitoring. What is less clear is how best to reduce the volume of solid waste in the first place. Based on economic analysis, empirical research, and years of real-world experience, I believe there is no “one size fits all” solution. An array of policies can best make the tradeoffs for different locations and different waste materials.

The economist’s typical solution to an externality problem is a Pigouvian tax: charge a tax or fee per pound of trash exactly equal to the social damages imposed by that trash. That would reduce waste in landfills, but it raises two questions. The first is whether the social damages can actually be estimated. Even if policymakers know what to charge, however, the second question is whether any such fee can feasibly be administered and enforced.

Some communities charge for each can or bag of trash, under a system commonly called “Pay as You Throw” (PAYT). Households might be charged one monthly amount for one can a week, or a higher monthly amount for a larger can or two cans a week. But not every can gets filled every week, leaving households with no incentive at the margin to reduce that last bag of waste. A better system, closer to true “marginal cost pricing”, requires households to buy a special bag at the grocery store, or a special tag to use on a bag of garbage of a particular size.

EPA estimates that approximately 7,100 communities in the United States use some kind of PAYT, making it available to approximately 25 percent of the country’s population. The number of communities has risen over time and, in some areas of the country, is quite high. Some states (Wisconsin, Oregon and Minnesota) even have a law requiring that communities use PAYT.

Does it work? Results from the economics literature suggest that demand for garbage collection is relatively unresponsive to prices, but PAYT towns have experienced some reductions. And it is important to keep in mind that even if reductions are small, charging the right price may result in the right amount of garbage disposal. Fixed monthly charges - the norm in many places - set a zero price for an additional bag or can and thus provide no incentive for households to conserve.

The big question for PAYT communities, though, is what households are doing with the garbage they no longer place at the curb. To avoid paying the fee, households can reduce their waste by recycling, composting, consuming less in the first place, or disposing illegally - burning, finding a commercial dumpster, or throwing it by the side of the road. Recycling does increase with PAYT but not enough to account for all of the reduction in trash. Clearly, municipalities can help themselves by providing free curbside collection of a wide variety of materials for recycling and yard waste collection for central composting. Towns also must choose how much to spend on enforcement, and how to set penalties.

PAYT is most effective in small cities and suburban areas but has not worked so well in densely populated urban areas where apartment dwellers use chutes and dumpsters for their normal disposal (and might easily use vacant lots for everything else). PAYT is also not as well-suited to very rural areas where illicit dump sites are similarly easy to find. In general, it is most feasible where we can measure and monitor individual households’ weekly trash and recycling.

Even in towns where a PAYT fee works well to reduce waste amounts without increased dumping, it does nothing special for separate handling of hazardous and other troublesome items like batteries, tires, or used electronic equipment. These products, especially, are candidates for some kind of deposit refund system (DRS). Experience has shown great success with a DRS applied to certain products: beverage containers in “bottle bill” states have recycling rates that range from 60-95 percent, significantly higher than in states without such a program; 96 percent of lead-acid batteries are recycled; and tires in states with a DRS are recycled at a 72 percent rate. But the idea can be generalized, in a “two-part instrument,” a general sales tax on everything at the store - all of which eventually becomes waste - along with a subsidy per ton of waste handled at the recycling center. Products like computer monitors could still be specifically targeted with a special fee, but most items could be treated in bulk, without time-consuming transactions to count or weigh individual items.

Thus the “best” policy is not any single policy. PAYT can successfully be employed in at least some communities, and probably in more than are currently doing so. Other towns, however, need a two-part instrument - a general sales tax on new items at the store, plus a subsidy for recycling. And products that pose special problems may need targeted deposits or refunds. Different circumstances therefore call for different policies, PAYTs, DRSs, or two-part instruments. All of these policies have a key feature in common and one that economists invariably seek in all of their policy prescriptions: they provide the proper incentives to consumers and others to generate a socially desirable outcome.

Given the hundreds of billions of taxpayer dollars that have been handed out to financial services companies, automakers and other companies over the past year, it should not come as a surprise that corporate sponsors of Defined Benefit (DB) pension plans are also coming to Washington looking for a handout.  Admittedly, this issue has not been at the top of the news lately, but given the increasing number of calls I am receiving from policymakers in our nation’s capitol on the issue, it is pretty clear that this issue is on the political horizon.  

The basic story goes as follows: Despite the decline of DB pensions in the U.S. over the past several decades, millions of employees are still covered by these plans.  DB pension plans are essentially promises to workers that they will receive a monthly check for life after retirement, and this promise is supposed to be “made good on” even if the firm that sponsors the plan disappears in the interim.  The way Congress decided to ensure this back in 1974 was to require that companies sponsoring DB plans fund them (that is, set aside assets in a trust fund that would be dedicated to paying future benefits), and then provide participants with a government guarantee (through the PBGC) that their benefits will be paid even if the employer goes bankrupt with an underfunded plan.

For a variety of reasons that I won’t go into here (I’ll leave that for future posts about pension accounting rules and the flaws of the PBGC – the agency that insures the benefits), most DB plan sponsors invest their pension trusts heavily in stocks.  Thus, when the stock market declined precipitously over the past year, many plans sponsors found themselves facing substantial funding shortfalls. This increases their required contributions at precisely the moment when the economy is sagging.  Earlier this year, Watson Wyatt released a study showing that in 2009, plan sponsors would be required to contribute over $100 billion to their plans, up from just $38 billion in 2008, so the numbers involved are quite large.

Thus, the call for “relief.”  Essentially, plan sponsors are asking Congress to allow them to take a pass on meeting their funding obligations (and basically kicking the can down the road to another year).  Doing so, they say, will free up much needed cash to meet other obligations.  The two other uses for the cash most frequently mentioned are to avoid layoffs and to promote investment.  It is therefore argued that funding relief will be an effective economic stimulus.  (Isn’t it interesting how everything looks like a nail when you are holding a hammer?)

On the first question, I am unaware of any empirical evidence showing a link between mandatory pension contributions and employment.  On the second point, there is a very nice paper by my friend Josh Rauh (now at Northwestern University) showing that when firms are required to make contributions to their pension funds, they reduce investment (as measured by capital expenditures).

Despite these rationale, I remain highly skeptical of the wisdom of funding relief.  My skepticism arises for 4 primary reasons.

1. While I accept the notion that freeing up internal cash may be useful during a period in which external financial markets are frozen, it is not at all clear that funding relief is a useful way to go about it. First, there is no guarantee that Rauh’s results will hold up in a period in which “cash is king.”  Instead, firms may just sit on the cash to provide a safety cushion.  Second, DB plan sponsors strike me as precisely the *wrong* set of firms to target for relief.  Why?  Because they almost surely have lower growth opportunities than other sectors (keep in mind these plans are concentrated in “old economy” firms).  And because these are precisely the firms where assets are most tangible (and thus less susceptible to the information problems that are often used to explain the advantage of internal over external financing).  If we think firms are being prevented from taking on good investments due to problems in the credit market, I’d much rather see us take steps to provide access to credit directly, rather than directing towards an arbitrary subset of firms.
2. Even if the firms that are granted funding relief use it to increase investment, this will not necessarily increase the aggregate level of investment.  Why?  Because the money used to fund pensions is not thrown in the ocean.  Rather, it is redistributed by financial markets to those projects with the highest present value.  It is quite possible that funding relief will do little more than redirect funds away from the highest value projects in the overall economy and towards the highest value projects within a small subset of firms.  In short, I am not sure there will really be any stimulus to this stimulus.  
3. This will further increase the risk to taxpayers.  If an underfunded plan sponsor goes bankrupt with an underfunded plan, the benefits are guaranteed by the PBGC.  But guess what?  The PBGC is already underfunded by at least $11 billion (and possibly much higher) and is expected to grow substantially in the coming decade.  At some point, taxpayer money will be needed to fill this gap.
4. Most importantly, this simply treats the symptom, and not the cause, of the funding problems.  What we really need is a major overhaul of the funding rules – more on this in a future post.

In the current campaign to reform health insurance, a major stumbling block is the cost of providing such coverage to 46 million people. President Obama has various tax increases to pay for these proposals, but is especially interested in redirecting funds currently in the health-care system. A change in the tax treatment of employer-provided health insurance fits into this conception and is the single biggest source of funds that might be tapped. But altering this provision is not a slam dunk or a new idea.

Some policymakers want to put a dollar limit on the amount of health insurance premiums that can be excluded from taxation. That approach was actually part of the tax simplifications suggested by President George W. Bush’s 2005 tax-reform panel. Depending on the limit chosen, this change would affect only employees with especially costly health insurance plans. But other policymakers want to reduce the exclusion on a sliding scale based on an employee’s income from all sources, so-called “adjusted gross income.” That change would apply primarily to upper-income employees, at least initially. That is, once this sliding scale feature is in place, Congress could easily lower the thresholds to affect more employees. In fact, if revenue generation is the main concern, the limit might be set fairly low, thereby affecting a significant number of employees and their families.

Health economists and some tax specialists have advocated eliminating this exclusion entirely for years. The previous administration took this very position, as did President Reagan two decades earlier. Their idea is to put Americans on an even playing field in terms of securing health insurance, rather than favoring those persons whose employers arrange for their employees’ health insurance. The concern with the current tax exclusion is that people do not know the cost of their health insurance and tend to overuse health services. Eliminating the exclusion, some contend, would give employees more “skin in the game” and make them more sensitive to the cost of health care.

Interestingly, this tax exclusion historical accident rather than a deliberate policy decision. It originated during World War II as a means of providing employees with additional compensation in the face of wartime wage controls that precluded increases in salaries. I examine this history and some of its impacts on employer-provided health insurance in my article, “Who’s Afraid of Personal Responsibility? Health Savings Accounts and the Future of American Health Care,” available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=805825, specifically pages 537-548.

Politically, this provision may be difficult to alter. Labor unions, for example, have negotiated very comprehensive health plans over the years, with low or no deductibles and very limited co-payment obligations. This strategy makes economic sense when health insurance premiums are excluded from taxable income while higher wages are taxable. But if the tax law is changed, what happens to the workers covered by those agreements? This expectations issue was undoubtedly one of the reasons that candidate Obama opposed changing this tax exclusion during last year’s election campaign. The bottom line is that one cannot change a tax provision that has been in place for more than 60 years without some serious repercussions.

Those opposed to the Obama health care reform initiative should take little comfort in the problems that the administration and its Democratic supporters in Congress are experiencing. This opposition bodes ill not just for Obama’s plan, but for any type of reform of the U. S. health care system—a system that must change at some point to rein in the growth of federal spending in this area. The problem of the projected growth of Medicare and Medicaid is the major source of the long-run fiscal imbalance of the federal budget–far greater than the problem of financing social security.

The public outcry against many aspects of the unfolding plan, as evidenced by the vociferous town hall meetings, may doom the Obama reforms similar to the failure of the Clinton health care reforms in 1993-1994. While the Obama plan, to the extent there is a plan, appears to be a poorly thought out program that, according to Congressional Budget Office estimates, will not effectively contain costs, this is not the real source of most unhappiness on the part of the general public. Neither are the proposed punitive tax increases on high income taxpayers to finance the reform.

Instead, the unhappiness comes from fears, real or imagined, that the Obama plan will result in the rationing of health care and the denial of service for some patients, especially the elderly. This is fueled by stories about long waits for treatment for seriously ill patients in Canada and by rules in Britain that reportedly deny treatments such as coronary bypasses and hip replacements to patients of above certain ages. People are upset that they or their relatives may be denied access to expensive health care options in the future under the Obama plan.

This opposition is coming from the 85 percent or so who currently have access to health care through private insurance or government programs such as Medicare. The problem the administration faces is achieving its goal of extending coverage to the uninsured while keeping those currently covered reasonably happy. This will not be easy because the extension of coverage without cost controls will be prohibitively expensive while measures to control cost appear to be politically unpalatable.

Conservatives may be cheered by the apparent failure of the Obama initiative for the more centralized provision of health care. However, the same forces that seem to be derailing the Obama program also lie in wait for more conservative reform measures. If the goal is to reduce the rate of growth in health care costs, there are basically only two approaches that can be employed—a plan such as Obama’s that relies on explicit rationing and controls or a plan that makes use of prices to achieve a similar end.

A conservative approach to health care reform would make use of prices to encourage people to limit their use of services. This could come in the form of the removal of the tax exemption for expensive employer-paid health insurance to reduce the government subsidy of so-called gold-plated plans. It might also come by asking patients to pay a larger share of their medical costs out-of-pocket through higher co-pays and deductibles to encourage more careful use of services. It might also come in the form of higher costs for some recipients such as premiums based on income as opposed to the Obama soak-the-rich plans.

Are these more conservative approaches to health care reform likely to be received more favorably than the current Obama proposals? The answer is quite likely no. Twenty years ago, Ways and Means Chairman Dan Rostenkowski was chased out of a meeting in Chicago by a group of elderly constituents. They were not upset about the rationing of health care; instead, they were irate about being asked to pay for an expansion of the Medicare program that would have provided some protection against catastrophic medical expenses and offered limited prescription drug benefits under Medicare. Not coincidentally, many of the provisions of the legislation (including the higher fees) were repealed shortly thereafter.

The problem of health care reform and government finance in general at both the national and state level is that the public neither wants to pay for the increasing costs of health nor accept reductions in service. This belief has been encouraged by politicians who are willing to enact programs without proper funding. The Obama plan to insulate 98 percent of the public from the costs of his program is symptomatic of voters being led to believe that benefits come with no sacrifice.

Unfortunately, the voters and their elected representatives cannot avoid an eventual day of reckoning. The question is how this will be handled. Former Council of Economic Advisor Chairman Herbert Stein is credited with formulating what is now known as Stein’s Law: “If something cannot go on forever, it will eventually come to an end.” Clearly, the growth of unfunded health care spending cannot go on forever. However, bringing it to an end will require courage on the part of politicians and discipline on the part of the public that is in short supply. The fulfillment of Stein’s Law may not be pretty.

The law of unintended consequences is a mainstay of economic thinking. Someone with power establishes a rule or regulation of some sort and assumes that people will simply follow it. But people don’t just do what they’re told. Instead, they have desires, objectives, goals. And when the rules change, people respond according to their goals. And sometimes the rule maker doesn’t like the result.

The university makes you change your internet password once a year—and of course their rules about what constitutes an acceptable password are different from those of the bank, the shopping site, and the newspaper site. For these sites, this inconvenience is good: they don’t want me using the same password for fear of cross contamination—as someone snooping at the newspaper gets into my bank account.

But it can be counterproductive: one place where I worked demanded we change passwords once a month, with the result that what the rulemakers thought was a seven character password was effectively a four character password, with everyone using variants of xxxxjan, xxxxfeb, xxxxmar… Bottom line: lots of inconvenience for users; unintended consequence: less protection, not more.

Of course, in the case of Homeland Security, everybody has his or her favorite version of this story: body searches of grandmothers and the like. And of course, some of that criticism is unfair: if a search pattern is established, terrorists will recruit to foil it. And also of course, sometimes the goal of the rulemakers is simply to be seen to be doing something: effectiveness is beside the point.

Probably the greatest example of ineffectiveness of security rules arises in the case of anti-money laundering regulation as applied to drug enforcement. The regulatory burden the rules place on banks is stupendous: the costs and difficulties of opening new accounts has multiplied out of all recognition; the burden of serving foreign customers has become so prohibitive that many American banks avoid the business. And the effect on the market for illegal drugs has been nil. While the compliance costs for the regulation are onerous for the law-abiding, the costs for evaders are negligible.

In this arena, a classic example of unintended consequences arises: the anti-money laundering regulations require banks to report “suspicious account activity” to the authorities. But what constitutes suspicious activities is undefined—it is, to be fair, inherently undefinable. There are penalties on the banks for non-reporting. Result: banks report everything, the system is overwhelmed, and less useful information gets through than would have happened without the rule.

The anti-money laundering programs can point to some notable successes in other fields, in particular in confronting political corruption. This probably says something about the relative profit opportunities of corrupt politicians and drug bosses.

The good news is that the average individual in the U.S. (and in particular the typical newspaper reporter) understands the law of unintended consequences at gut level. The bad news is that when columnists attempt to predict the public responses to new legislation, the analysis is subject to pop psychologizing and all sorts of wishful thinking. I admit that my preferred form of armchair theorizing—economic modeling—is not without its faults. But I would put it up as a superior explanation, particularly for large numbers and for periods of time longer than a particular newspaper article can be remembered.

Deposit insurance provides protection to small, unsophisticated savers and can enhance financial stability by preventing bank runs. However, deposit insurance also can lead to distortions because governments are politically constrained in their ability to assess banks’ risks. The Federal Deposit Insurance Corporation (FDIC) tends to set deposit insurance premiums that are too low, on average. In addition, because the FDIC sets insurance premiums to manage the level of its reserves in the Deposit Insurance Fund (DIF), premiums are raised too high during economic recessions and lowered too much during economic expansions. This practice creates incentives for banks to make loans and investments that have high systematic risk, and it also increases the likelihood of taxpayer bailouts, especially bailouts of banks that are deemed “Too Big to Fail” (TBTF). There are several reforms that would improve the efficiency of the financial system and reduce the likelihood of financial crises. The first is to mitigate TBTF by reducing counterparty risk via centralized clearing (and possibly exchange-trading) of derivatives. The second is to more fairly set deposit insurance premiums by relying on market information of banks’ risks and by requiring collateral to back insured deposits. The third reform would be to either abolish the DIF or use market mechanisms such as swaps that can transfer the risk of managing DIF reserves to investors outside of the banking industry.

Click here, to read the full and latest version of this paper that elaborates the above posting.