The Simple Macroeconomics of Health Reform

Posted by Nolan Miller on Mar 5, 2010

Filed Under (Uncategorized)

As part of my teaching duties, I include a couple of lectures on macroeconomics in my financial economics course. Now, many of the choices I’ve made in my life can be traced back to a desire to avoid studying macroeconomics. But, my brief foray into the area this fall taught me an important lesson that is applicable to many areas, including the quest to reduce the cost of health care.

One of the first diagrams presented to macro students is the so-called “circular flow diagram” that depicts how money and goods and services flows up and back between households and firms. On the output side, firms send goods and services to households and households send money back to the firms in exchange. If this were all there were, firms would quickly end up with all the money, and the economy would grind to a halt. However, there is also another side to the diagram. In order to produce goods and services, firms need inputs like capital and labor, and these are supplied by households. So, households supply capital and labor to firms, and in exchange firms send money back to households in the form of wages, interest, dividends, profits, etc. This last is a critical and often overlooked point. Firms don’t enjoy profits – their owners do. So, if you think that health insurers are earning excessive profits, what you’re really saying is that the returns to people who own health insurance stocks are too high. Anyway, the point of the circular flow diagram is that, in equilibrium, these flows are all the same. In particular, the total expenditure on goods and services must equal the total income to households.

There’s the rub. Applied to the context of health care, the circular flow diagram says that total expenditure on health care – including payments to insurers, doctors and hospitals, etc. – must equal total income from health care related activities – including total wages paid to health care workers, profits to health care firms, etc. Thus, if you are concerned about reducing the rate of expenditure on health care, this is the same as saying that you are concerned with reducing the rate of income from health care. In other words, reducing either wages of health care workers or profit to health care companies. And, while many people would like nothing better than to stick it to the big corporations, the ones who really bear the brunt are the owners of these corporations. And, the populist call for windfall profit taxes on health insurers sound quite different when you realize that it is simultaneously a call for a tax people’s 401k returns!

So, the lesson from Macroeconomics 101 for health reform (or any other reform for that matter) is that expenditure is just another way of expressing income. So, reducing expenditure necessarily means reducing somebody’s income. Seen in that light, it is not so surprising how difficult it has been, and will be, to reduce the rate of expenditure growth in health care.