Central Planning vs. Medical Knowledge

Why Medicare’s Latest Idea, Accountable Care Organizations, Will Not Work

Accountable Care Organizations (ACO’s) are Medicare partnerships set to start in January 2012 in which relatively large number of local physicians and other local providers of healthcare services will team with local hospitals and Medicare and will attempt to improve quality of care and reduce costs.  The model calls for incentive payments by Medicare based on numeric indicators on quality, clinical processes, patient satisfaction, utilization, costs and outcomes. Medicare would assign a minimum of 5,000 local patients to an ACO and will track these indicators over time. Medicare will develop a baseline consisting of the prior 3 years’ cost information of those patients assigned to an ACO and will adjust it for risk, that is, how sick its patients are. Medicare will also develop a cost reduction target for the population.  An ACO’s performance will then be compared to cost reduction targets and if the yearly per-capita beneficiary costs are below the target specified by Medicare, then the ACO will be entitled to a share of the savings which will be distributed to the members of the ACO. 

ACO’s are a response to the regional variations in Medicare expenditures per enrollee documented by the Dartmouth Atlas group, variations that range from $6,000 (Dubuque, Iowa) to $17,000 (Miami, Florida). Dartmouth Atlas finds that these variations in expenditures are caused by differences in the amount of care given to the population and that the amount of care depends on the supply of medical services available in a particular region. These variations are supported by a Medicare payment system that keeps the supply of medical services fully employed regardless of their capital intensity or their cost to Medicare.  The higher the proportion of hospital beds and specialists in a region, the higher the number of hospital admissions and referrals to specialists and the higher the Medicare total payments in a region. Simply put, the higher the supply, the higher the demand.  

The hypothesis behind ACO’s is that if spending could be safely reduced to the level of the low spending regions, overall savings for the US healthcare system would be in the order of 30%, and that since according to the Dartmouth Atlas data large clinically integrated health systems are able to provide care at lower costs, then ACO’s that emulate these large healthcare systems could serve as the vehicle for provider integration in regions that lack such large scale integration and, if the proper financial incentives from Medicare payment systems are in place, ACO’s will form and will achieve those savings. 

The policy implications of ACO’s are clear: to reduce costs, Medicare will need large organizations of physicians and hospitals with more primary care physicians, fewer specialists, fewer hospitals, fewer hospital beds, fewer capital intensive diagnostic and treatment technologies, primary care physicians who do not refer to specialists and finally, specialists who do not use hospitals or capital intensive equipment.

But Medicare’s and Dartmouth Atlas’ logic is based two intellectual mistakes. Their first mistake is to assume that Medicare’s current payment methods (fee for service) reinforce an already poorly coordinated and expensive medical care and that supply causes demand. The cause and effect relation moves exactly in the opposite direction: we have poorly coordinated and expensive medical care because Medicare’s payment method interferes with the formation of free market prices and we have higher supply of services because under the current sytem, we have an unlimited unchecked demand for services. As Ludwig von Mises pointed out, without prices economic calculation is impossible so managers and entrepreneurs are unable to allocate capital, labor and supplies to the highest valued use and without the constraints on cost to themselves, consumers of healthcare face no limit to their demand. We have explored this argument here. 

Their second intellectual mistake is to assume that the healthcare system can be made more efficient by encouraging and forcing integration. This mistake is caused by Medicare's failure to understand how complex societies transmit knowledge and information. F.A. Hayek answered this question in 1945 in his essay The Use of Knowledge in Society. Sociologist Charles Bosk supports Hayek’s answer in his classic 1974 field study of residency medical education titled Forgive and Remember. The rest of this article follows the logic behind these two works and applies them to the healthcare reform debate. 

The knowledge necessary to improve coordination and reduce costs in our healthcare system is never and can never be concentrated in a central planning organ, be it at the national level with Medicare, or at the local level, with an ACO. To the contrary, medical knowledge is always dispersed in incomplete and contradictory form scattered among million of patients and thousands of health care providers. Medical knowledge is only made present in the individual interaction between a particular patient and a particular health care provider in a particular physical space and time. The problem that Medicare is trying to solve is not what is the best way to allocate scarce healthcare resources in general. Medicare’s problem is infinitely more complex; Medicare is attempting to find out how to allocate scarce health resources when only the individual patient and his physician know the relative importance that those scarce resources have when compared to other alternatives.  

If Medicare could concentrate all the knowledge which is initially dispersed and then convey that knowledge back to individual patients and their physicians so they can make the right decisions, then ACO’s (and central planning indeed) could be successful. But this depends on the type of knowledge that needs to be communicated. If what Medicare is communicating is scientific knowledge, perhaps a body of experts could be assembled to decide on the right diagnostic and treatment protocols that ought to be used--though Medicare would then have to address the obvious questions of who selects the experts, what criteria is to be used for that selection and how those protocols will be enforced across space and time. Indeed Congress has already allocated $10 billion to Medicare to establish a center for innovation in January of 2011 charged with develop innovative models to slow growth and improve quality. 

But Hayek points out that scientific knowledge, is not comprehensive knowledge.  There is knowledge that is unorganized rather than scientific, particular rather than general, bound by time rather than timeless and bound by location and circumstance rather than universal. This is the knowledge that a patient has about his specific symptoms, his history, his physical condition, his emotional state, his subjective level of pain, his spiritual inclination, etc., that can only be voluntarily disclosed if it is to be used by his physician to diagnose and treat the condition that is causing the symptoms. It is also the knowledge that a hospital or medical practice manager has:  knowledge about relative surplus, scarcity and quality of supplies, weather or other conditions that may interrupt the flow supplies, labor and patients, best locations to rent physician offices or build hospitals, how and when to consolidate or expand services or nursing units within a hospital, how to cut costs in this particular department at this particular time without sacrificing quality, when to improve quality even if costs increase, key stakeholder analysis, accountability systems, etc.  

This type of practical knowledge is also characteristic of the clinical knowledge that an experienced physician has. In his field study of medical education Forgive and Remember, sociologist Charles Bosk follows a team of medical residents and attending physicians over the course of 18 months to observe how medical knowledge is transmitted. Specifically, he concentrates on the nature and types of medical errors. He points out that a misunderstanding about two types of medical errors (a reasonable treatment option that is later proven wrong versus a treatment option that is an indefensible mistake) and how physicians make the distinction between the two, leads to incorrect policy recommendations about how the medical profession ought to be controlled. He argues that medical errors are an indeterminate category, similar to beauty or mercy (p.24). This indeterminateness is caused by the dual nature of medical knowledge itself: on the one hand, there is scientific knowledge (or “general knowledge” in Hayek’s terminology) and on the other, there is clinical expertise (or “local knowledge” in both Hayek’s and Bosk’s terminology). Bosk found that when physicians make clinical decisions,  “arguments based on clinical expertise override those based on scientific evidence” (p.85). Local medical knowledge, therefore,  trumps general knowledge, exactly the same conclusion that Hayek reaches. 

Residency programs for medical students are apprenticeships in which an experienced attending physician nurtures and develops through a series of almost choreographed rituals, humor, unwritten rules, stereotypes, hierarchical structure, tension, drama, survival-of-the-fittest character, public display of student’s and attanding’s mistakes and accomplishments, compassion, self-deprecation, team effort, individualism, camaraderie, horror stories, etc., in the inexperienced resident the practical judgment to know when to follow scientific knowledge and when to follow clinical experience. This is the most critical element of medical education.  Residents are expected to study and know the general rules. Attending physicians are expected to teach residents to recognize the exceptions to those general rules. That clinical acumen or clinical eye characteristic of an experienced attending physician, his clinical expertise, “is a charismatic possession, a gift of grace; its exact nature is a mystery“ (p.92). Medical education has evolved over hundreds of years and is structured today as a way for medical residents to appreciate that mystery.  

Bosk points out that the assumption by managed care, and I would add Medicare, Dartmouth Atlas and all medical central planners, that the healthcare system can be made more efficient through centralized decision making far from the bedside clashes with the very system that  clinicians use to grapple with medical errors, understand their cause and implement remedies, and teach future physicians, all part of a process that is “an extreme example of local knowledge” (Bosk’s own terminology in p. xxiii). Bosk concludes that medical “errors are not events that can be counted. Their existence needs to be debated; the discourse over precisely what is and is not an error is necessary to the formation of a sense of professional responsibility.” 

The patient’s knowledge about his condition, the manager’s knowledge about the local conditions of the market, the physician’s clinical knowledge about exceptions to the rule are all knowledge that cannot be counted, aggregated and expressed in statistical format. It cannot be conveyed to Medicare planners. Aggregation destroys the minor differences that are the “bread and butter” of the day to day actions of physicians and healthcare managers at the local level. And even if it were possible to aggregate, this knowledge could not be disaggregated and transmitted back to individual patients and providers of care in time to have any useful meaning to guide action at the local level, especially given the rapid rate with which change at a local level takes place.  

Bosk doesn’t offer any solutions to the quandary facing healthcare central planners, but his study reveals what is the result of centuries of development in the medical education field: an apprenticeship environment at the local level can best impart the practical, local and non-theoretical clinical knowledge necessary for medical students to become effective clinicians. This supports Hayek’s insight that only by decentralizing can coordination be improved.

The challenge faced by Medicare is how to allow decentralization and at the same time impart the additional knowledge to local patients, local physicians and local hospitals that will allow them to make decisions in a way that the overall objectives of Medicare can be met. In this regard, Medicare faces not just a difficult problem, but an impossible task. Almost anything that happens in the world can and does have an effect on the decisions made at the local level. 

The paradox of simultaneously having to decentralize and coordinate in order to achieve common general objectives is solved by the market price system. Hayek states that when free market prices are allowed to function, they coordinate the separate actions of different people in the same way that an individual’s subjective values assist him in coordinating the parts of his own plan, without having to know all the details of the problem to be solved or having to develop all the ramifications of each option. He concludes:  “The mere fact that there is one price for any commodity...brings about the solution which might have been arrived at by one single mind possessing all the information which is in fact dispersed among all the people involved in the process.”

The price system communicates information critical to achieving coordination at the local level and achieves general objectives as if an omniscient central planner instantaneously and continuously provided guidance to everyone. In fact, Hayek states, the marked does it so efficiently that its participants need to know nothing about the causes and ramifications of events affecting a particular local process in order to react quickly and through trial and error approximate the correct action that a central planner would recommend if he were omniscient. 

If Medicare aims to have local patients, physicians and hospitals to reduce costs, improve quality and adapt quickly to local changes, it would seem that the best and indeed only way to make that happen is to allow local providers who are most familiar with those local conditions, local resources and local changes to make those adaptations. Without a market and its price system, however, this is impossible to achieve. Centralization and price controls can only slow down adaptation, reduce coordination, increase misallocation of capital, supplies, and labor and ultimately reduce quality and increase costs. 

__________

¹ Israel Kirzner’s Competition and Entrepreneurship,  Chapter 6 Competition, Welfare and Coordination, helps clarify and augments Hayek’s argument.

Medicare can’t play market

The Journal of the American Medical Association (JAMA) reported June 24, 2010 that Medicare’s program requiring hospitals to reach certain numeric goals that measure the Surgical Care Improvement Process (SCIP) in care of surgery patients do not result in better outcomes: 

“Despite this evidence, hospital-level performance on individual SCIP measures is publicly reported "to assist patients in selecting centers of excellence" for receipt of their surgical care. This publicized use implies that reported adherence on these measures is directly related to improved outcomes. Our findings are unable to support this assertion.”

This is a significant blow to Medicare’s “Value-Based Purchasing.” This initiative is part of a trend that the tax-supported payor program for seniors started more than a decade ago to mimic the free market. The method that has been selected attempts to derive numeric scores in three quality domains: process of care, patient satisfaction and outcomes. From these scores, Medicare will apply a payment formula that will redistribute a pool of funds created by a 2% withholding of hospital Medicare payments. This is designed to provide the necessary financial incentives for hospitals to comply with the program. Hospitals with scores in the top quartile will receive 100% of their contributions into the pool. Hospitals in the bottom quartile will not receive any of their contributions back, and the middle 50% will be paid according to a formula that goes from 100% to 0%. These payment formulas will be phased-in from 2013 to 2017. In an era in which Moody’s “A” rated hospitals have operating margins of 2.2% and Medicare represents over half of that margin, giving up 2% of Medicare payments is the difference between keeping the hospital open or closing it. 

The study from JAMA looked at a subset of measures for the process of care in surgery known as Surgical Care Improvement Project (SCIP). This project was started by Centers for Medicare and Medicaid Services in 2002 to decrease complications and mortality associated with postoperative care in hospitals. Measures include antibiotics given one hour before incision, clipping rather than shaving hair on the surgical site, keeping blood sugar controlled between certain limits, treatment to prevent blood clots, etc., but there are other non-surgical process measures such as pneumonia patients receiving pneumococcal vaccination. Satisfaction measures include doctors and nurses always communicate well, rooms were always kept clean and quiet at night, etc. Outcome measures include mortality and re-admission rates.  Hospitals started reporting in 2004 on 10 measures. Currently they must report on 46 measures. This number is scheduled to grow to 55 in October 2010 and to 90 by 2012.   

Medicare’s hypothesis for Value Based Purchasing seems straight forward: if hospitals attain these goals in process, satisfaction, and outcomes, the quality of patient care will improve, and costly interventions to correct negative medical outcomes, such as additional surgeries, antibiotics, vascular procedures, additional days in the hospital, etc., will be avoided. Moreover, if hospital performance in reaching these goals is reported to the public, consumers will chose hospitals with better scores (and lower costs), hence overall healthcare costs for the program will drop. 

Using the Misesian critique of socialist calculation we have argued in prior articles (The Health Czar Can’t Calculate” and “Why Obamacare Can’t Work”) that it is impossible for Medicare to give any coordinating content to its mandates, that it is also impossible for healthcare agents to rationally allocate their scarce labor and capital resources under Medicare’s cost-based payment methods and that therefore, at best, Medicare will not be able to reign-in healthcare costs. 

The empirical results of this JAMA study point out that even if the socialist calculation problem did not exist, Medicare cannot know with certainty which hospitals offer high quality care and which don’t.  First, in reviewing other studies, the authors of the JAMA article found weak or no statistical significance between adherence to individual process of care measures and improvements in patient outcomes. Second, they argue that without better cause and effect relationships between process and outcomes, it is difficult to justify the massive investment in time and resources needed to track all these measures. Third, complications stemming from hospital care are influenced by a myriad of factors that are independent from the process of care measures. Fourth, public reporting of performance in process of care measures which compare hospitals do not infer quality differences between hospitals. And finally, that implementing financial incentives do not improve hospital quality. 

These empirical findings by JAMA are fully supported by the Misesian critique of the use of the method proper to the natural sciences to the social sciences. One could make the argument that medicine can use the method of the natural sciences effectively. However, medicine is as much science as it is art. Writing a progress note in a medical record, for example, one that successfully communicates to other clinicians the unique medical history, symptoms, diagnosis and treatment for a patient cannot be fully encapsulated in a statistical function derived from the reaction of the same types of patients in clinical trials or in the experience of the physician. But even granting such a concession, when the method of the natural sciences is applied beyond the narrow confines of very specific predictions about patients and their care to the world of hospital management in which social relationships between thousands of human beings such as patients, care-givers, support staff,  management, bond-holders, philanthropists, employers, third party payors, suppliers and competitors influence a myriad of cause and effect relationships that directly and indirectly affect nature of the care given, then the natural sciences method cannot make statistically significant predictions about that care. This is because complex relationships between individuals with their own uniqueness and freedom influence the outcomes that are being measured, and, more importantly, the actions of these individuals many times provoke the very events that Medicare is trying to prevent. 

If the cause and effect relationship between Medicare’s proposed goals for hospitals and overall quality is statistically weak or non-existent, then their connection to cost reduction is also weak or non-existent. Medicare’s Value-Based Purchasing initiatives will not cause a reduction in costs. This, in conjunction with the socialist calculation problem, will continue to confuse Medicare’s central planners as they attempt to encourage patients and healthcare providers to simulate the results of competition. 

A Critique of the Medicare Payment Advisory Commission

The Medicare Payment Advisory Commission released its second annual report to Congress in June 2008. Titled “Reforming the Delivery System”1, the report outlines the change in direction that the Medicare program is likely to take in the coming years. The Commission recognizes that without change, “the Medicare program is fiscally unsustainable over the long run”2 and it believes that under the current Fee For Service (FFS) payment method, in which Medicare reimburses hospitals and physicians for individual units of service, incentives for reform under are limited for two reasons. One, paying for individual units results in a strong incentive to providers to increase volume of services, and two, separate physician fee schedule and hospital prospective payment systems discourage coordination between physicians and hospitals that might result in efficiencies or better outcomes. 3 As a result, the Commission makes a series of recommendations to move Medicare away from FFS payment method toward one that promotes better coordination and accountability.

While these goals are laudable, their fundamental error is that the Commission’s assessment fails to understand the cause of the symptoms it attempts to diagnose and treat. The tell-tale sign of this methodological mistake is encapsulated in one of their reform ideas: the creation of an independent entity to produce information about the relative value of the services for which Medicare pays. By “value”, the Commission means “the clinical effectiveness of a healthcare service compared to its alternatives,”4 which will include cost effectiveness. The report states that while “cost effectiveness is not the primary mission, the Commission does not rule it out,”5 obviously because it recognizes that questions of value cannot be divorced from questions of economic calculation.

However, under Medicare’s central planning authority any rational economic calculation about the relative value of different health services is practically and theoretically impossible. This is the root cause of the inevitable long term collapse of the Medicare program and as we shall explore later the root cause of the inevitable collapse of our entire health care system. Any health care system resulting from central planning is not just of higher cost, lower quality, reduced innovation, uncoordinated, inefficient and ineffective, but literally and truly impossible. Austrian economist Ludwig von Mises in his 1920 treatise “Economic Calculation in the Socialist Commonwealth” developed this fundamental insight about the nature of all central planning.6 I rely heavily on his analysis of the impossibility of economic calculation under socialism to understand the inherent problems in the healthcare system created by the Federal government under the auspices of Medicare.

From a practical perspective, one can imagine a central planner judging the value of health care goods which require very simple production process, such as picking and consuming an orange from a tree in order to replenish the body of needed antioxidants that may aid in the prevention of certain cancers. One can also imagine this central planner valuing goods that are required in a slightly longer production process such as using lumber, a saw, a hammer and nails, to build a ladder to be used to climb a tree to pick fruit more efficiently. This is because in these simple examples, the planner can measure income and expense across the relatively short period of time it takes to build a ladder and pick fruit. But matters get very complicated very quickly when the central planner needs to decide on the level of reimbursement for a chemotherapy agent that took a pharmaceutical company years and millions of dollars to discover, test and manufacture, for the oncologist who supervises the delivery of the drug and who invested thousands of dollars and years of his life to understand the cancer disease process and for the hospital that invested millions of dollars and decades to build the infrastructure within which to deliver the drug.

This type of valuation is quantitatively more complicated because chemotherapy agents, physicians’ intellectual development and hospitals require very long and wide production processes across time and geography and complex interconnections between people, producers, quality, revenue and cost. In addition, to this one particular health product at one particular point in time and geography, the Medicare planner must consider hundreds of thousands of other health care goods and services, tens of thousands of hospitals, pharmacies, nursing homes, surgery centers, diagnostic centers, laboratories, home health agencies, hospices, long term acute care hospitals, ambulances, and millions of patients physicians, nurses, therapists and clinicians, across time and space. The central planner must therefore consider a practically infinite number of permutations in order to correctly allocate half of the healthcare dollar spent in the US.

Some may argue that the advent of the information age will resolve this practical calculation problem. But even if the Medicare planner possessed the most advanced computer information systems, it is only logical to assume that hospitals, physicians and producers of healthcare goods and services will possess similar computer systems as aides in the management their own internal operations and that hence, together, they would be capable of generating more information than the Medicare planning computer could absorb and process meaningfully. So paradoxically, information technology actually makes the economic calculation problem for Medicare more difficult to resolve.7

The Medicare planner must also consider two additional exacerbating factors.8 The first one is that like all goods, healthcare resources by their very nature are to a greater or lesser degree substitutable for one another. This is the phenomenon that the Commission is attempting to resolve by creating another commission to study the relative value of different health care services. For some types of breast cancers, for example, chemotherapy, radiation therapy and surgery may be substituted or complemented with one another. The challenge for the Medicare planner is to discover and approximate the myriad of natural substitutability of all healthcare goods and services in accordance with the exchange relations that an unhampered healthcare market economy would take place automatically and instantaneously.9

The second factor exacerbating the calculation problem is that since time is a scarce resource, capital can be accumulated and invested in order to lengthen any process of production and improve the efficiencies and quality of any healthcare good or service. This further multiplies the permutations required to evaluate alternative plans for the allocation of capital for the production of not only health care goods and services that Medicare patients consume, but also of capital required to manufacture the goods and services used by producers to fabricate the goods and services that hospitals and physicians purchase. For example, hospitals may decide between investing their capital in robotics for pharmacy or the operating room in order to improve the productivity and accuracy of pharmacists and surgeons or they may hire additional pharmacists or more experienced surgeons, or varying combinations between all or none of the above. Simultaneously, the manufacturer of robots would need to decide to invest capital to develop either pharmacy, operating room, radiation therapy or automobile robots and varying combinations between all or none of the above, and so on and so forth up the production chain of producers of software, research, education, parts, raw materials, financial services, etc., etc. So another challenge for the Medicare planner is to discover and approximate the natural substitutability of all alternative production chain possibilities that an unhampered healthcare market economy would discover automatically and instantaneously.

The infinite complexity of actual and potential relationships among producers, suppliers, providers and patients require precise calculations of income, expense, assets and liabilities across time in terms of a medium of exchange, i.e., money. Monetary calculation under conditions of private property and freedom of exchange, allows all consumers and all producers in very complex and long production processes to simultaneously solve the economic calculation problem detailed above by what Mises calls an “intellectual division of labor.” 10 This process is twofold. On the one hand, each and every consumer makes monetary bids for goods and services based on his individual subjective valuation resulting in objective money exchange ratios for goods and services (i.e., market prices for goods and services). On the other hand, every producer seeking to engage in production and seeking to maximize profits, bids against one another for the factors of production (labor and materials) resulting in objective exchange ratios for labor and materials (i.e., wages and prices for materials). In this way, Mises points out, not only end products ready for consumption but all intermediate goods used in the production of those end products “receive a position in the scale of valuations in accordance with the immediate state of social conditions of production and social needs.”11

When prices in the health care market are not the result of unhampered exchanges between economic actors but are mandated by a central planning agent, the capital structure of health delivery systems is distorted. This is because the prices of goods and services set by Medicare create different profit expectations in the minds of hospitals, physicians and the rest of the producers of healthcare goods and services up and down the various chains of production than the prices that would have been created by the free market. For example for years Medicare has handsomely rewarded hospitals and physicians who set up ambulatory radiation oncology programs. This preferential pricing not only encourages the proliferation of radiation centers and the associated stimulation of demand by patients, but also affects each and every intermediate step in the entire production chain necessary to build and operate a radiation center. This includes, for example, the production, marketing and distribution of linear accelerators, the programming of software to design treatment plans and control the accelerator, the production of CT scanners that feed patient’s anatomical information into the treatment planning and accelerator navigation systems, education facilities to train radiation technologists, physicians, physicists and administrators to diagnose, plan, treat and manage the accelerator, the production of lead, aluminum, steel, plastics and other raw materials needed to build and produce all of the physical components of accelerators, facilities and supplies needed, etc., etc. The length and scope of this production process alone and hence the capital structure required to bring about thousands of radiation treatment centers across the nation is as deep as it is wide.

All of these intermediate industries are interrelated using hundreds of thousands pricing signals. By making pricing decisions on the reimbursement of radiation therapy services based on criteria other than the subjective valuation of patients and producers, the Medicare planner affects all the pricing signals throughout the production process of each intermediate industry; however, the central planner, by definition, will never comprehend or have the means to comprehend and test how his pricing decisions cause changes in the structure of health care production, because the only rational way to test these cause and effect relationships is via the monetary calculation made possible by exchanges between patients, providers and other producers of healthcare goods and services in a free market.

At the outset of the Medicare program, its central planners were able to set their prices as parasites of the then existing competitive private health care price structure, just like their Soviet Union counterparts unable to resolve the economic calculation problem were forced to copy and use the price structure of Western economies to direct Soviet production processes and subsist for 80 years, albeit at inefficient and meager levels. This strategy was recommended by the Medicare Payment Advisory Commission in it’s first Report to Congress in March of 1999 which argued that Medicare’s primary payment system objective is “to establish payment rates that approximate the competitive prices that would prevail in the long run in local health care markets.”12

But as the proportion of Medicare expenditures continue to grow as a result subsidization and unintended stimulation of demand, as additional Medicare programs are brought on line, such as prescription coverage, as the proportion of Medicare eligible population increases relative to the rest of the population and as additional government programs such as Medicaid grow faster than the private sector, the percentage of the health care economy under the control of the government expand and central planners crowd out the fewer pricing signals produced by a diminishing private sector. If to this one adds the already existing inadequacies of the pricing signals produced by the private health sector, such as the distortions produced by a tax policy that encourages employer provided health insurance arrangements, the mixing of both uncontrolled risk (e.g., family history) as well as controlled risk (e.g., eating habits) in health insurance risk pools, is it any wonder that health costs are out of control and that unsubsidized members of society have been priced out of the market for health services?

In addition to facing the practical calculation problem outlined above, the labyrinthine payment methods created by Medicare totally misunderstand the theoretical nature of prices and hence do not recognize the theoretical impossibility of its attempt. Unlike the weather forecaster who faces a technical problem that can be ameliorated by the use of better satellites and faster supercomputers, the Medicare planner simply cannot determine the market prices for the services that it reimburses because by definition health care prices can only be arrived by the free and unencumbered interaction between patients and providers.

There are two reasons why it is theoretically impossible for the Medicare planner to arrive at a rational pricing structure for healthcare. The first, prices of goods and services are not determined by their costs of production. Prices are determined by the instantaneous valuations made by consumers bidding for goods and services. By a process of imputation that flows from the consumer to the producer, prices of goods and services impute value to the factors of production necessary to make the goods and service that consumers demand. This imputation of value occurs when producers and entrepreneurs bid for the factors of production (labor and materials) in response to expected future profits and which sets wages for labor and prices of materials.

For more than two decades now, Medicare planners have come up with alternative valuation methods that unsuccessfully attempt to arrive at a rational price structure for health services. Despite the Commission’s assertion that cost-based payment methods (in which reimbursement is determined by allowable costs supplied by providers) are being phased out because “they are complex, they result in unpredictable payments and spending for providers and Medicare, and they weaken provider’s incentives for efficiency”13 and that they are being substituted for prospective payment methods (in which an initial operating and capital payment base rate is adjusted by wage indexes, case mix, medical education costs, charity burden, short or long lengths of stay, etc.), payment rates are still determined by cost information. This is because the initial operating and capital payment base rate that prospective systems use is determined by “the operating and capital costs that efficient facilities would be expected to incur in furnishing covered” health services.14 “Operating payments cover labor and supply costs; capital payments cover costs for depreciation, interest, rent and property-related insurance and taxes.” 15 Despite the fact that this initial base rate is later modified by wage rates, geographic differences, case mix, etc., the initial rate is still cost based. Again, the first reason why it is theoretically impossible for Medicare to rationally set prices is that prices determine production costs and not the other way around. When the Medicare planner tries to use cost information to arrive at a price, he has the economic cause and effect relationship backwards.

The second reason is that prices in a market economy are continually, instantaneously and simultaneously being created, destroyed and recreated by the individual subjective valuations of consumers and producers facing the passage of time and hence changing expectations, economic conditions, wants, needs, technological advancements, etc. This information about valuations is not created until after consumers and producers place their respective bids in the intellectual division of labor process outlined above, so it is impossible to transmit it before it is created. Before bids are made, all you have is a universe of possibility in the minds of each economic participant that do not constitute information. But once bids take place and information created, transmitted to the central planner, processed and returned to the market place in its original or distorted form, it is old and useless information that cannot have rational guiding content. Moreover, if the information returned by the planner is coercive in nature, bids do not take place and future pricing information cannot be created.

As a result, all the Medicare planner does, to use Mises’ phrase, is grope in the dark. The Medicare planner may know exactly what final health care goods and services are needed to meet the needs of Medicare patients. Indeed, in the Commission’s own words, “Medicare’s primary goal is to ensure that its elderly and disabled beneficiaries have access to medically necessary acute care of high quality.” 16 But as Mises points out, this is only one of two simultaneous equations that are needed to resolve the economic calculation problem. The second equation is the valuation of the means of production to ensure that those needed goods and services are produced. Without market derived pricing signals, hospitals, physicians and producers of healthcare goods and services up and down the production structure (and the Medicare planner) are all left without the bearings of economic calculation. The Commission’s greatest concern, therefore, should not be that “the Medicare program is fiscally unsustainable over the long run,” as worrisome as that is, but that our entire healthcare system, including the capital structure needed to support a wide array of lengthy production processes, is unsustainable over the long run, being left, to quote Mises, “floundering in the ocean of possible and conceivable economic combinations without the compass of economic calculation.” 17

It is highly unlikely that the arguments advanced here will slow the accelerated movement toward the complete socialization of the healthcare delivery system in the US. Most supporters of socialized medicine do so for aesthetic, moral, political or religious reasons. But at a minimum, it is my hope that the above ideas will be a warning to those who expect a rational system of economic calculation that will guide consumers and producers of healthcare services to come out of command and control Medicare reimbursement systems.

Ludwig von Mises warned Marxists economists in the 1920’s that economic calculation in a command and control economy was literally impossible. In the end, the collapse of the Soviet Union and the rest of the Eastern Block caught unaware the great majority of Western economists. It is not just that these economists were unable to play their expected role and spare humanity of all of the grave errors committed by the planned economies in the East, but that on the contrary, economists encouraged the very same policies that caused untold misery and human suffering in the East. Sadly, Western economists instead of openly manifesting profound regret for their failure and instead of rethinking the theoretical underpinnings of their science, to this day continue to study their science and make policy recommendations as if nothing had happened.

In blindly following the advice of health economists who practice within a bankrupt theoretical framework and in suggesting that Medicare central planners can come up with rational pricing and payment methods for health services, the Medicare Payment Advisory Commission makes exactly the same intellectual error that Soviet planners made 90 years ago. One can only qualify as overbearing arrogance the Commission’s presumption: that Medicare central planners in the US are smarter than their Soviet counterparts.



1 Medicare Payment Advisory Commission, “Report to Congress Reforming the Delivery System, June 2008” http://www.medpac.gov/documents/Jun08_EntireReport.pdf

2 idem, p. xi

3 idem, p. xi

4 idem, p. 107

5 idem, p. 108

6 Ludwig von Mises, “Economic Calculation in the Socialist Commonwealth” http://mises.org/pdf/econcalc.pdf.

7 Jesus Huerta de Soto, “Socialismo, Calculo Economico y Funcion Empresarial”, p. 105,

8 See Joseph T. Salerno, “Poscript: Why a Socialist Economy is “Impossible”.”, p. 35 http://mises.org/pdf/econcalc.pdf.

9 Mises, p. 9.

10 Mises, p. 15

11 Mises, p. 15

12Medicare Payment Advisory Commission, “Report to Congress Medicare Payment Policy, March 1999” p. 5 http://www.medpac.gov/documents/Mar99%20Entire%20report.pdf

13 idem, p. 4

14 Medicare Payment Advisory Commission, “Hospital Acute Inpatient Services Payment System”, October 2007 p. 3 http://www.medpac.gov/documents/MedPAC_Payment_Basics_07_hospital.pdf

15 idem, p. 3

16 Medicare Payment Advisory Commission, “Hospital Acute Inpatient Services Payment System”, October 2007 p. 4

17 Mises, p. 15-17

Why health insurance does not work

The object of insurance is to cover a large loss to the policy holder triggered by an event that is outside one's control. The probability of the loss caused by this uncontrolled risk and the cost associated with it must be calculable in a large group of random policy holders so that in exchange for an affordable premium, the insurance company can pay for the loss and make a profit.

Sickness combines both controllable risks and uncontrollable risks born by the policy holder. Breast cancer, for example, occurs at predictable rates in large groups of females and is beyond the control of the policy holder; therefore, it can be insured against. But routine diagnostic tests, for example, follow patterns that are influenced, at least in part, by the individual choice of the policy holder and are hence a type of risk controlled by the policy holder. The more that diagnostic tests are covered by insurance, the more that the insurance contract encourages their use and the higher the costs to the insurance company. This is the phenomenon of “moral hazard” in which the actions of the policy holder change the value of the insurance contract. Facing this type of uninsurable risk, insurance companies react by increasing premiums, copays and deductibles. There comes a point in which premiums, deductibles and copays become so large relative to the protection offered, that the covered group faces “adverse selection” and becomes non-random as healthier policy holders chose to drop out and only high cost individuals remain insured.


The only sensible system to cover risks controlled by the patient is in an environment in which fee for service dominates the market, similar to the car maintenance model. This is, of course, what we had in the US prior to the hospital and physician sponsored Blue Cross and Blue Shield and HMO plans of the 1920’s and 1930’s. These plans were the first ones to introduce first dollar coverage for risks controlled by the policy holder and, while they may have attempted to manage the business consequences of moral hazard and adverse selection, they did not understand the negative economic and political consequences that their business model would cause decades later. These consequences (enumerated below) were exacerbated by two factors. One, the prevalence of employer provided health benefits resulting from the wage and price controls imposed by the US government during WWII and the tax code which forced employers to compete for qualified personnel not via wages but via tax deductible benefits such as group health insurance. Two, the introduction of Medicare and Medicaid, modeled after Otto von Bismarck’s Health Insurance Act scheme implemented in Germany in the 1880’s. Bismarck’s plan was the first one to ever attempt compulsory social insurance. Lenin and Stalin in Russia, Mussolini in Italy, Franco in Spain, Hirohito in Japan, Hitler in Germany, Castro in Cuba, Peron in Argentina and FDR in the US, have all followed Bismarck’s model: welfare payments mandated by the state and paid for through taxation, government debt and inflationary monetary policy.

The economic consequence to the manner in which private health insurance and socialized welfare medicine are structured in the US is obvious to everyone: over utilization, high costs, high taxes, poor outcomes, rationing, price controls, adverse selection, large pools of uninsured, etc. The cause and effect mechanisms that result in these problems all stem from a pricing structure that is not the result of the free exchange between patients and providers, but the result of government intervention. Without the clear guide of prices, patients, hospitals, insurance companies and physicians cannot rationally plan their actions. The details of these mechanisms are beyond the scope of this article, but some of them are explored by this author here and here. The political consequence of this structure in the healthcare market is that industry, welfare, professional associations and business interest groups continually call for more government regulations and more medical socialism and that politicians of both parties effectively respond to those calls. Practically nobody is seriously challenging the flawed assumptions of the existing healthcare model. If anything, in the hopes that more government intervention will help save the current system, movement towards medical socialism has accelerated in the past two decades.

A sensible step towards reform away from medical socialism would be the deregulation of the private health insurance industry and allow individuals and families to deduct individual policy premiums from their income tax. Such a deregulated environment would encourage individuals to take responsibility for their controllable risks, would bring back a fee for service environment for a small but significant portion of the healthcare market and would allow insurance companies to:

1. Insure primarily against uncontrollable risks
   
2. Not insure against controllable risks, which result in moral hazard and adverse selection
3. Underwrite individual policies, the practice of determining how much coverage the policy holder should receive and determining the premium
4. Move away from community rating, the practice of charging the same premium to healthy people and to sick people
   

These reforms will re-introduction a rational pricing system for at least small but meaningful sectors of the medical market that can guide the actions of patients, physicians, hospitals, other healthcare providers and entrepreneurs.

Outline for a critique of HillaryCare II

The Clinton Campaign unveiled their health care plan this week. It features a mixed bag of carrots and sticks that are to end the cost spiral and give universal coverage for all Americans (see note 1 below for summary). HillaryCareII will be financed by increasing taxes for the rich and reinvesting the savings from running a more efficient system. Efficiencies will be gained by promoting the adoption of information technology to cut costs, research and promotion of best practices for providers and paying for prevention rather than acute care.

HillaryCareII features the “Principles of Shared Responsibility”:
1. Drug companies should offer fair prices
2. Insurance companies should cover everyone regardless of pre-existing conditions, expectations of illness
3. Providers should collaborate to provide quality care
4. Employers should contribute to health coverage, large firms required to provide insurance; small business should take advantage of tax credits
5. Government will make insurance affordable through tax credits, provide a safety net so that insurance is not a financial burden, and will end cost spiral.
6. Individuals required to buy insurance

It is easy to see that while HillaryCare II may reach universal coverage for all Americans, it will not solve the problems of the current health system, including the cost spiral. This is because HillaryCareII does nothing to question the paradigm under which the current system rests: that government can rationally design the reimbursement mechanisms and set payment rates for provider services, the same governmental comand and control tactics that have failed int he past.

Democratic and Republican reform initiatives leave untouched Medicare’s command system of setting prices for health services based on costs of production. The prices of healthcare services (or any consumer good for that matter) are NOT based on the costs of labor, supplies, rent, capital, etc. Medicare administrators and their supporters in academia and government have the cause and effect relationship between prices and costs exactly backwards! Costs of production do not cause prices. Prices are set by the subjective judgments and valuations of individual producers and consumers exchanging goods in a free market, irrespective of production costs. In response to these prices and expected profits, entrepreneurs and business managers bid up the prices of factors of production like labor and supplies. That in the long run or that in perfectly competitive markets prices equal costs of production plus the interest rate is irrelevant. What determines the price of a service here and now is the short run adjustment mechanisms that allow producers to bid for factors of production to meet a consumer need and make a profit.

When Medicare tells providers what they will get paid for a heath service, it sends a signal to providers to bid up the prices of labor, supplies and equipment to meet the new price level. The result is a feedback loop between Medicare and providers, out of control costs, distortions in labor markets for physicians and nurses and a capital structure for health services ready to break down. The solution to the government induced mess in healthcare is as simple as it is politically incorrect: get the government out of the healthcare financing business, privatize Medicare and let the free market rationally allocate capital, labor and other resources based on consumer preferences.


Theoretical problems with HillaryCare II from an economic perspective:

The problem of the imputation of value
The problem of calculation
The problem of dissemination of knowledge Hayek
The problem of entrepreneurship P 698 Human Action
The problem of disruptive technology p. 706-707
The problem of the allocation of capital . p 704
The problem of allocation of the factors of production without prices
The problem the computation of profit and loss without prices in P 701
The problem of changes in consumer tastes p. 706


Note 1: Key carrots (+) and sticks (-) of HillaryCareII are:

For Individuals:
+Individuals can keep their current health plan.
+The congressional private health plan menu is expanded to the general population
+Medicare expanded to the general population as an additional choice.
-Limit tax free employer provided insurance to the average government menu, tax the excess benefits.
+Expand Medicaid to all low income individuals
+Expand health plan menu to fill the gap for early retirees before qualifying for Medicare
-Repeal Bush tax cuts and redirect revenue to fund program.
+Limit premium payments to a % of income yet maintain consumer price consciousness in choosing plan

For Insurance Companies:
-Medicare overpayments to HMO’s phased out.
-Guaranteed issue, automatic renewal
-No rating based on age, gender, occupation…
-No excessive profits or marketing costs
-Cannot deny coverage or renewal, unfair prices, excessive premiums
-Cover preventive care
-Cover chronic illness care management
-Promote prevention

For pharmaceutical companies:
-Pharmaceutical companies regulated to control their relationship with providers, cut prescription drug ads, prohibit direct to consumer ads.
-Medicare is allowed to negotiate directly with pharmaceutical companies to cut prescription drug costs

For providers:
-Disproportionate Share payments phased out.
+Apply technology and clinical best practices to improve quality, reduce errors, eliminate waste via technology, care coordination, best practices
-Align Medicare payment with performance, reduce geographic variation in care, information to consumers,
-Expand pay for performance based on outcomes

For employers:
+Tax credits for small businesses
+Employers expected to provide health insurance to their employees
-Limit tax free employer provided insurance to the average government menu, tax the excess benefits.

For more details on HillaryCareII go to http://www.hillaryclinton.com/feature/healthcareplan/

Medicare Rx

The fundamental flaw with Medicare’s system of paying for healthcare services is that it attempts to find out what it costs to produce medical services. These costs are then used to set provider fees using complicated cost-plus-profit methodologies (RVU, DRG, RUG, etc.). Medicare collects these provider costs through various vehicles that include requiring providers to submit cost reports (See http://www.cms.hhs.gov/CostReports/ for a summary of these reporting regulations).

The basic assumption of Medicare's complex approach is this: that the price of a healthcare service is based on the costs of producing that service. But Medicare administrators and their supporters in academia have the cause and effect relationship between prices and costs exactly backwards! This is the same mistake that Karl Marx and his predecessor Classical economists David Ricardo and Adam Smith made in their unsuccessful attempt to explain how prices are supposed to be a reflection of labor costs and other factors of production costs like land, supplies, capital, etc. Costs do not cause price! The price of a product is set by the subjective judgments and valuations of individual suppliers and consumers exchanging goods in a free market. And it is this price that then determines costs of production! This takes place through a process of "value imputation" that flows from the consumer back to the factors of production. This "value imputation" happens when entrepreneurs and managers bid up the prices of factors of production in response to expected future profits.


Let us first illustrate the complexity of Medicare's attempt to collect cost information and then set prices. Medicare uses the following formula to determine the fees paid to physicians:

Work RVU x Budget Neutrality Work Adjustor x Work (GPCI)+Practice Expense (PE) RVU x PE GPCI+Malpractice (PLI) RVU x PLI GPCI= Total RVUxCY 2007 Conversion Factor of $37.8975= Medicare Payment

The three Relative Value Units or RVU's in the formula represent the value assigned by Medicare to the various resources needed to provide each physician service. The RVU's are supposed to reflect the work effort, skill, time, intensity and risk required of the physician depending on his specialty, his expenses in providing each service adjusted by a geographic practice cost index (GPCI), liability insurance costs (PLI), a "budget neutrality" cap on total Medicare payments to physicians mandated by Congress and the "conversion factor" which translates each RVU into a dollar amount.

RVU's were developed by the good folks at the Harvard School of Public Health in the mid 1980's when Medicare administrators awarded them a contract with the intent of establishing a rational, equitable and distortion-free approach to physician fees. Additional help was provided by KPMG Consulting who was charged with the development of the liability insurance cost factors. For a more detailed account of how those liability factors are determined go to http://www.ama-assn.org/ama/upload/mm/363/pliwhitepaper.pdf. And later still, more help was provided by experts in econometrics at the Urban Institute who developed the geographic practice cost index. Go to http://www.urban.org/publications/900540.html for fascinating account from one of its developers.

To coordinate the whole process, Medicare also enlists the help of the American Medical Association, the American Osteopathic Association and the major national medical specialty societies, all of whom participate in an advisory group ( RVS Update Committee http://www.ama-assn.org/ama/pub/category/16401.html) responsible for compiling data obtained from physician surveys to determine the time spent in performing the medical service and ranking the service relative to existing services.

There are over 10,000 values for each of the above three RVU categories, hundreds of GPCI's and PLI's adjusting each of those 30,000 RVU's resulting billions of potential combinations for physician fees. In the near future, Medicare will adjust this formula to reflect each physician's clinical outcomes or quality, which will result in another exponential increase in the number of potential combinations for fees. And this is only for the professional component of physician reimbursement. Physicians also receive Medicare payment for the facility components of certain procedures performed in their offices.

If one adds to this already mind-boggling array of physican fees calculations more layers of complexity represented by fees to hospitals, home health agencies, hospices, Medicare HMO's, ambulances, nursing homes and pharmacies, each with their own assigned methodologies for Medicare reimbursement, and one adds the mechanism by which the AMA and the government manipulate the supply of medical education (http://www.cogme.gov/) and hospitals and some state governments influence the supply of hospital beds through certificate of need regulations, one can only begin to appreciate the mammoth size and the power of the bureaucracies needed to attempt to centrally manage our healthcare system.

I wrote earlier that unlike what Medicare administrators assume, prices determine the cost of production. Let us illustrate the correct causal relationship between prices and costs with an example. Diamonds are expensive not because they cost a lot to produce, but because high demand and low supply forces prices to be high, which then allows producers to engage in the very expensive process of discovery, extraction and commercialization of diamonds. When diamond entrepreneurs are wrong in anticipating the price at which they will sell diamonds and their production costs are higher than the market price, their companies go out of business. When they are right and their costs are lower than the price at which they sell, they make a profit and prosper.

The higher their profits, the more other diamond entrepreneurs will enter the market, which bids up the prices paid to the factors of production or increases the quantity produced until, in the long run, the market for diamonds and the market for the factors of production of diamonds may approach equilibrium. It is only then that price of diamonds equal the costs of producing them. And it is then that casual observers are deceived into thinking that the price of diamonds is caused by their cost of production. This is because we tend to experience only the resulting price and costs of those companies that survive the competitive process. When we erroneously conclude that the value of a product is inherent in the costs of the inputs of the production process, we ignore the more vital and essential role played by the short run process of adjustments.

Theoretical work by the Austrian School of Economics since the 1870's has clearly refuted the incorrect theory of value that we inherited from the Classical school and Karl Marx and that economists and policy makers, including Medicare administrators, continue to use to this day. For an account of the Austrian approach and the theory of value imputation, see Ludwig von Mises' "Human Action" Chapter XVI, pp. 328-347 http://www.mises.org/humanaction/chap16sec2.asp:

"Attempts to establish cost accounts on an "impartial" basis are doomed to failure. Calculating costs is a mental tool of action, the purposive design to make the best of the available means for an improvement of future conditions. It is necessarily volitional, not factual. In the hands of an indifferent umpire it changes its character entirely. The umpire does not look forward to the future. He looks backward to the dead past and to rigid rules which are useless for real life and action. He does not anticipate changes... Profits do not fit into his scheme. He has a confused idea about a "fair" rate of profit or a "fair" return on capital invested. However, there are no such things... In a changing economy profits are not determined with reference to any set of rules by which they could be classified as fair or unfair. Profits are never normal..." pp. 346-347

The key insight of the Austrian approach is that not only are prices of consumer goods subjective, but that production costs are also subjective and determined through voluntary exchanges in a free market through a proces of value imputation that flows from consumers to producers to owners of factors of production. The collapse of the Soviet Union's economy has shown us that a centrally planned socialist approach based on an erroneous theory of value does not work in practice. This collapse has vindicated the work of many Austrian School economists who have shown since the 1920's that economic calculation under a centrally planned economy is theoretically impossible (for a devastating attack on central planning, see Ludwig von Mises' 1922 "Socialism" http://www.mises.org/books/socialism/contents.aspx).

Attempts by a central bureaucracy to use costs to set prices are not just difficult or "thorny" practical issues to resolve. Bluntly put, it is theoretically impossible for a PhD economist or a Medicare bureaucrat to figure out healthcare costs and therefore impossible for him to figure out the correct reimbursement rates for any healthcare service anywhere at any time. Only an unregulated free market where patients and physicians and other providers of healthcare services can voluntarily make exchanges can correctly solve the puzzle. The market for healthcare is not an exception to this inexorable and axiomatic economic law.

With the government sector accounting for more than 40% of healthcare spending (http://aspe.hhs.gov/health/costgrowth/) and with insurance and managed care companies and individual patients following Medicare's methodologies, the overwhelming majority of players in the healthcare market in the US are following a centrally planned socialist approach. The process and the results are disastrous and inevitable. First, Medicare compiles observed production cost data to calculate reimbursement rates or prices. Then healthcare providers take this price and it's implied expected future profit to bid up the price of the factors of production. The following year, these factors of production are then fed back to Medicare as costs to be used to determine the new reimbursement rates, and so on and so forth, into an ever ending negative feedback loop.

Is it any wonder that we have a collapsing healthcare system with ever increasing costs, misallocation of capital, meaningless prices, shortages, cues, rationing, cherry picking and fraud? Is it any wonder that a significant and ever increasing portion of patients are being priced out of the market and turning up in our emergency rooms as uninsured? Is it any wonder that patients, physicians, insurance companies and hospitals are pitted against one another with missaligned incentives in a battle to maximize Medicare dollars? Is it any wonder that Medicare taxes and deficit spending are causing an unprecedented inter-generational transfer of income from younger working poorer uninsured Americans to older, retired, insured and wealthier Americans?

CMS administrators should recognize that they are using a mistaken socialist economic theory to set their fees that will inevitably continue to bring the healthcare system to its knees. Physicians and hospitals should recognize that with this approach in which their own professional societies have actively participated, they have have lost complete control of their practices and hospitals and have simply become instruments of the state. And patients should recognize that their beloved Medicare has eroded the patient-physician relationship beyond recognition, one in which physicians can no longer respond to patient needs but to a bureaucracy in Washington.