Wednesday, April 7, 2010

Dean Baker: Free Market Mythology

Next time you hear the right-wingers lament interference in the "free market" ask them how they feel about creating markets that drive wealth to the top instead of the middle.

Yes, ask them how they feel about facilitating patent and copyright monopolies instead of focusing on a more egalitarian distribution.

Hey, ask them how they feel about the drug companies sucking 3 trillion in monopoly profits out of us the next ten years. Puts that trillion for health care in a different light, huh!

Economist Dean Baker has some other insights for lefties who get themselves trapped in the talking points of the right.

Progressives have wailed against “market fundamentalism" for the last quarter-century. They complain that conservatives want to eliminate the government and leave everything to the market. This is nonsense.

The Right has every bit as much interest in government involvement in the economy as progressives. The difference is that conservatives want the government to intervene in ways that redistribute income upward. The other difference is that the Right is smart enough to hide its interventions, implying that the structures that redistribute income upward are just the natural working of the market. Progressives help the Right’s cause when we accuse them of being “market fundamentalists,” effectively implying that the conservatives’ structuring of the economy is its natural state.

This is not just a question of framing; although the framing is important. Economic outcomes that appear to be the result of the natural workings of the market will always sound more appealing than the machinations of government bureaucrats, especially in the political culture of the United States. If we label the Right’s interventions as nothing more than the free market left to itself, then we place progressive policies at an enormous political disadvantage.

But the confusion that this misguided war against market fundamentalism creates in designing policy is even more serious than the political damage. Progressives have no reason to look to government to reverse market outcomes. Rather, like our conservative opponents, we should look for ways in which we can structure market rules so that markets have better outcomes from a progressive perspective.

The most obvious recent government intervention to redistribute income upward has been the bailout of the financial industry. Faced with complete collapse in the fall of 2008, Goldman Sachs, Citigroup, Morgan Stanley and the rest did not yell that they wanted the government to leave them alone. No, these financial behemoths insisted that the government lend them money at below-market interest rates and guarantee their assets. Firms like Goldman Sachs even insisted that the government make good on the debts of bankrupt business partners, such as AIG.

Deregulation also increases profitability and has nothing to do with the free market. In other words, the financial industry wants the government to provide “insurance” through the Federal Reserve Board, the Federal Deposit Insurance Corporation and various ad hoc channels, but it doesn’t want to pay for it. It also doesn’t want the insurance to come with any restrictions. In effect, the financial industry wants to run an explosives factory out of its home and pay only the standard residential insurance premium. That’s not the free market.

The demands of the financial industry on government are not qualitatively different from what other sectors get as a result of government interventions in structuring the market. To take another example, the government grants pharmaceutical companies patent monopolies that allow them to mark up the price of prescription drugs by several hundred percent or even several thousand percent above what the same drugs would sell for in a competitive market. As a result of patent protection, many drugs sell for hundreds or even thousands of dollars per prescription. By contrast, if all drugs were sold as generics in a competitive market, the overwhelming majority could be bought for $4 or $5 per prescription.

Patent monopolies do serve an important economic function—they provide an incentive for researching new drugs—but they clearly are not the only way to finance research. The government spends more than $30 billion a year financing biomedical research through the National Institutes of Health, an amount comparable to what the industry spends on research. In principle, we could replace the industry-funded research through direct, publicly funded research. Or, as Nobel Prize-winning economist Joe Stiglitz has suggested, research could be carried on in its current manner, but new patents could be bought out through a prize system. Under this system, a committee would assess the value of new patents and pay this amount to patent holders. This would allow the drugs based on new patents to be sold as generics in a competitive market.

We can debate whether these alternative mechanisms are better for supporting prescription-drug research than the patent system, but the patent system is clearly not the free market, and it is not essential for financing prescription drug research. The proponents of drug patents cannot claim to support a free market.

There is real money at stake. The country spent $250 billion last year on prescription drugs. In a competitive market, the cost likely would have been closer to $25 billion. The difference of more than $200 billion swamps the size of the payments to such programs as Food Stamps, the State Children’s Health Insurance Program (SCHIP) or Head Start.

Furthermore, the drain from this patent monopoly is projected to grow rapidly through time. Prescription drug spending is the most rapidly rising component of health care costs. In 2019 the country is projected to spend almost $500 billion on prescription drugs. Over the course of the next decade, expenditures are projected to exceed $3.5 trillion, implying excess payments to the drug industry of more than $3 trillion, more than three times as much as will be spent on the health care reform proposed in Congress at this writing in early winter.

A similar story can be told about copyrights. Bill Gates is an incredibly rich man because the U.S. government gives him a monopoly on Windows, threatening to arrest anyone who sells it or even gives it away without Gates’s permission. Without the monopoly created by copyright protection anyone would be able to instantly download Microsoft software anywhere in the world at no cost. As with drug patents, copyrights serve an important economic function. They provide an incentive for creative and innovative work, like developing new and better software or producing good movies and music, but we already have alternative mechanisms for supporting this work and can develop new ones.

Copyright monopolies lead to an enormous transfer of income to software and entertainment companies. Microsoft alone pockets more than $60 billion a year in revenue, almost all of which would not be possible without copyright protection. The industry association claims that, taken together, copyright industries accounted for 6.6 percent of GDP. This is more than one-third of the tax revenue collected by the federal government.

I could list more mechanisms and beneficiaries, but the point should be clear. The idea that a “free market” is allowing some people to get incredibly rich and causing other people to be poor or financially insecure is nonsense. The distribution of income is determined by government policies that favor some groups and work against others. If progressives accept the structures put in place by conservatives as the free market and then look to use tax and transfer policy to redress the inequities, we have given ourselves a hopeless task.

We must instead focus on altering the rules that redistribute income upward. There are many different ways to structure markets. We must be as opportunistic and creative as the Right in finding rules that both produce efficient outcomes and lead to better distributions of income.

The health care bill illustrates the need for a fundamentally different approach. It does a good job of meeting the important goal of extending coverage to most of the uninsured. However, it does very little to address the problem of exploding cost growth. As a result, we will have created a system that we know will be unaffordable over the long run. The idea that we can somehow pay for this system in future decades with progressive taxes is absurd on its face. It will almost certainly not be possible politically to raise taxes high enough to cover public-sector health care costs. We will eventually either have to ratchet back the extent of coverage and/or the quality of care or impose substantial taxes on the middle class.

The alternative route is to directly attack the structure of the health care system that leads to such bloated costs. In this context, it is important to remember that we pay more than twice as much per person for care as people in other wealthy countries. As any number of studies have shown, the reason for higher costs in the United States is not the better quality or greater volume of services but rather the higher cost of the services that we get. This can be addressed by changing the markets for these services.

Let’s return to prescription drugs. The current system leads to enormous inefficiencies from any perspective and leaves us with absurd choices that would disappear with a more rational system of financing prescription drug research.

Consider the situation of an 80-year-old woman, in generally good health, who develops a form of cancer. Suppose that the only treatment likely to be successfully is a new, bioengineered drug that would cost $250,000 a year. Should the government be willing to pay this expense?

As our moral philosophers labor over this problem, consider that the drug would probably cost $200 a year in the absence of patent protection. That would be the marginal cost of manufacturing and distributing the drug. Although the drug company may have spent a huge amount of money developing the drug, this is money out the door. We have already paid the research cost (ideally through one of the mechanisms discussed above.) The relevant question is, what does it cost to produce the next dose. In the world where the year’s dosage costs $200 we won’t have to spend too much time debating the treatment.

This is not the only problem with the patent system. When the government intervenes to artificially inflate prices, it creates unexpected perverse incentives. As a result of the enormous profits on its drugs, the pharmaceutical industry spends a fortune marketing them. This causes them to court and even bribe doctors to get them to prescribe drugs. It leads to expensive direct-to-consumer marketing campaigns. It leads the industry to buy politicians to ensure that Medicare, Medicaid and other government programs pay for the drugs. And, it gives the industry an enormous incentive to conceal research results that call into question the effectiveness and safety of its drugs.

Progressives should have been pushing these “free market” arguments in discussing prescription drugs. The amount of money at stake dwarfs the sums at issue with either the “Cadillac” plan tax or the millionaires’ surtax in the health care plans approved by the Senate and the House.

Similarly, we could use a little free trade in health care. Trade policy has been quite explicitly designed to place our manufacturing workers in direct competition with low-paid workers in the developing world. Progressives often point to the loss of manufacturing jobs in the United States and the depression of wages for non-college educated workers as evidence that free trade doesn’t work. This is completely wrong. These outcomes are exactly what the trade models predicted would be the result of the trade policies that the United States has pursued. I would be surprised if there were any other outcome.

However, we can design “free trade” policies that produce different outcomes. In the case of health care, we can start by allowing Medicare beneficiaries to buy into the health care systems of other wealthy countries. Because health care costs are so much lower in Germany, Canada and everywhere else, if beneficiaries opted to move to another country to receive their care, there would be enormous savings that could be split between the U.S. government and the beneficiaries. We recently did calculations showing that a few decades out the projected savings would be tens of thousands per beneficiary each year. This was even after allowing for a substantial premium above costs to the receiving country of treating elderly patients, to ensure that they also benefited from the deal.

In fact, since these countries would be getting a premium above their cost of care, this could be a major source of growth for these countries. The fact is that everyone has a huge comparative advantage in health care relative to the United States. Our health care industry only survives because of the extraordinary protectionist measures that restrict foreign competition. It is easy to devise mechanisms through which foreign countries could provide care for U.S. citizens and use the profits to provide better care for their own populations. An international Medicare voucher system could allow retirees to enjoy a much higher standard of living than would otherwise be the case, while at the same time saving the U.S. government tens of trillions of dollars in Medicare costs over the long term. By reducing demand for health care in the United States, it would also lead to downward pressure on domestic medical costs more generally.

There are other ways in which the government can promote trade in medical services. For example, it can license facilities in other countries to ensure high standards and also standardize rules on legal liability to ensure that people who go overseas for treatment can be assured of reasonable legal redress in the case of malpractice.

Given the enormous gap in costs for health care services between the United States and Europe, not to mention high-quality facilities in places like India and Thailand, there would likely be a huge flow of patients for treatment outside the country, if we created the proper institutional structure.

Of course, it would be much better to reform the system in the United States so that people did not have to leave the country to get decent affordable care. But, if we lack the political power to reform the domestic system, as is obviously the case now, it is absurd to hold patients here as hostages of a broken system. After the forces of market competition have worked their magic, we will be much better able to discuss reform with the domestic health care industry.

It is far more productive to talk about ways to use market mechanisms to fundamentally restructure the health care system than to try to scrape together nickels and dimes in tax revenue to pay to maintain a broken health care system for a few more years. The same approach can be applied to almost any social problems. We can and should push for progressive taxation, but it is even better to change the institutional structures that lead to gross inequality.

CEOs in the United States get paid tens of millions of dollars a year because we have created a corporate governance structure that allows top managers to plunder the corporation for their own ends. This corporate governance structure was created by the government, it did not develop through the free market. No other country allows for the same sort of plundering. Changing the rules in ways that return control to shareholders is not government interfering with the market; it is simply repairing a dysfunctional system. Europe and Japan both have dynamic capitalist economies, but they do not have the huge executive compensation packages of the United States. This is not due to legal restrictions on pay, it is due to the fact that they have governance structures that don’t allow the top executives to pilfer the corporations that they ostensibly work for.

In the same vein, although minimum wages and other direct income supports for less-educated workers are desirable, it is better to restructure markets in ways that increase the relative demand for their services. For example, we should insist that the Fed allow the unemployment rate to fall to low levels, rather than raise interest rates to choke off any possibility of inflation. Former Federal Reserve chief Alan Greenspan made this choice in the 90s (over the protest of Bill Clinton’s appointees to the Fed), allowing the first sustained period of real wage growth for workers at the middle and bottom of the wage distribution since the 60s. More union-friendly laws, such as serious civil or even criminal penalties for employers who violate workers’ right to organize, would also help equalize the distribution of income.

We can also apply some good free market principles to highly paid professionals, such as doctors, lawyers and economists. Easing professional and immigration restrictions that largely protect the most highly educated workers from international competition will reduce pay for those in the top 1 percent to 2 percent of the wage distribution and help to lower the cost of everything from health care to a college education.

There is an endless list of policies that alter economic rules to lead to more egalitarian outcomes. The current rules were not given to us by a deity or by nature, they were written by the wealthy and powerful interest groups who benefit from them.

These people are absolutely not free market fundamentalists, nor are they opposed to a well-working government. No one can mass market unauthorized versions of Pfizer’s latest drugs or Microsoft’s new software.

Even under Republican administrations the government would quickly arrest a large-scale violator of patent or copyright law. The wealthy want and expect a government that enforces the rules that protect their wealth and power. They don’t care about government social programs, but that is because they don’t depend on these programs. No rich person died in Hurricane Katrina.

A serious long-term progressive agenda must move away from a focus on tax-and-transfer policy and instead concentrate on changing the rules that lead to undesirable market outcomes. We must be as aggressive and creative as the Right in designing new rules that redistribute income downward rather than upward. And, we must bury the concept of “free market fundamentalism.” There are no free market fundamentalists in this debate, just conservatives who want to pretend that their rules are the natural working of the market. Progressives should not help them in this effort.

Dean Baker is the co-director of the Center for Economic and Policy Research (CEPR). He is the author of Plunder and Blunder: The Rise and Fall of the Bubble Economy and False Profits: Recoverying From the Bubble Economy.

This column was originally published by Dissent.