Monday, October 5, 2009

What is and isn't included in health care costs?

Much has been made about the fact that Americans on average spend far more for health care than citizens of other countries and that we still lag those countries in measures of health care outcomes. But there are a lot of questions about what should and should not be counted as health care. One example is cosmetic surgery. This is not covered by health insurance, but it is included in calculations of health care costs. We are paying doctors for breast implants instead of providing health care. Mental Health care costs are also included, as are dental care and elective procedures such as in vitro fertilization. These items are legitimate costs, but their inclusion skews the picture of how much we spend on health care relative to other countries.
Another cost is long-term care. I do not mean to diminish it's importance, but costs could be dramatically reduced if multi-generational households were the norm as they are in many other countries. If I pay $20,000 a year to put my mom in a nursing home, then it is a health care cost. If I give up $20,000 in possible earnings to take care of my mom, then it is not treated as a health care cost. These two situations should be treated the same in order to properly compare health care costs.
American doctors are also paid a lot more than their foreign counterparts. One reason for this is the time and money doctors must devote to their education. In many other countries, medical training is provided by the government, or at least subsidized to a greater extent. in the US the cost of education is indirectly included in health care costs through the higher payments to doctors. In other coutries, these costs are not included in health care costs because they are costs of education.
It may be true that we spend more on health care, but the numbers don't tell the whole story.

Universal Health Insurance

If we really want universal health insurance then we can easily acheive it. I can personally grant every American health insurance right now. It covers anyone at all, there are no restrictions against pre-existing conditions, it is free, it covers anything the doctor and patient want done, and patients can go to any doctor they want. The key is that the plan reimburses the doctor $1 for each patient he sees during the year. So, now EVERYONE has insurance and the problem is solved.
Obviously not. All the talk about the uninsured and the need for insurance reform misses the point that it is health care and not health insurance that matters. No one dies from a lack of insurance, despite the headlines on a recent report, they die from not receiving medical care. There is a difference between health insurance and health care and people would be wise to understand the difference before making reforms.
If doctors won't treat people covered under the insurance plan then no one receives any health care. The government could FORCE doctors to accept patients, which is already occuring with Medicare reimbursement guidelines and will only increase under proposed reforms. The problem with this is that it will lead to a serious shortage of doctors. We alreay have severe shortages in nurses and general practitioners in part due to the reimbursement schedule.
Besides, it is wrong to FORCE doctors to treat patients. Of course, it is equally wrong to FORCE someone else to pay the doctor to treat patients. In both cases, someone is being forced to work without compensation. In one case the doctor is forced to treat patients, in the other case someone is forced to work for free as his wages go to the government in the form of taxes and ultimately to doctors. If you pay 35% of your income in taxes, then you are being forced to work for free 35% of the time.
A fairer system would involve voluntary exchange and would not have to involve government at all. A non-profit health insurance company could be set up that would accept any and all patients and the health care costs would be funded through tax-deductible contributions. If the American public does indeed care about the uninsured and wants to provide health care to everybody, then this is the way to do it.
Will this work any better than my first insurance plan? Probably not. This whole debate isn't about providing health care, it is about power. It is about making someone else do something that people are not willing to do themselves.

Thursday, September 17, 2009

Kinky Health Insurance Reform

In addition to a public plan that covers the basic health care needs of everyone and anyone, Kinky Care also slaps the insurance industry upside the head and directs them back to the risk-sharing purpose of insurance. Although I am opposed to the reforms that turn the insurance industry into a cost-sharing bastard child, the insurance industry is in serious need of reform.

Critics point to insurance companies refusal to cover pre-existing conditions as a problem, but I am fine with the insurance company refusing to insure pre-existing conditions. However, I am opposed to denying legitimate claims in order to cut costs. The denial of claims or cancellation of insurance after a claim is made is referred to as rescission. Rescissions are not necessarily evil because they does have a proper role in combating fraud. If an applicant lies about a pre-existing condition and then makes a claim resulting from that pre-existing condition, then a denial of claim and rescission is proper. Combating fraud helps to hold down the cost of honest customers and the right to rescind a policy is cheaper than requiring a verifiable, complete medical history from each applicant. However, denying a claim due to an honest mistake by the customer should be forbidden. So, how can you tell the difference between an honest mistake and a fraudulent application? First, a rescission can only occur when the claim is related to the error in the paperwork. If you forgot to mention a broken leg when you were a child and make a claim for a heart attack, the insurance company must honor the claim. Second, the rescission must occur within a reasonable amount of time -- I'd choose two years. Even if you have a family history of heart disease that you covered up, if you don't make a claim or if they don't catch you for two years, then you are free and clear. The third issue is intent and this is the hardest to determine. Did the applicant make an honest mistake or was he trying to cover something up? You have a heart attack after 6 months and the insurance company finds out that your estranged father was on medication for high blood pressure. That would be one for the courts or arbitration panel to decide.
An associated reform covers changes in premiums. Even if insurance is not rescinded, premiums could still rise after a customer has a serious illness. The term of an insurance contract and the allowable increases in premiums must be laid out in the initial contract. If you want a ten-year contract with premium increases restricted to 5% per year, then you could get it. A year-to-year contract would also be available with the knowledge that the customer is taking on the risk of premium increases.

The final major reform is the allowance of interstate competition and the removal of federal antitrust exemptions. Insurance companies are currently protected from federal antitrust laws under the 1945 McCarran-Ferguson Act. The supposed reasoning for this exemption is that they are regulated under separate state regulations with a prohibition against interstate competition. This results in individual state markets that are dominated by a single insurance company. Rates among states vary widely largely based on regulations that restrict risk-based premiums or require mandates that customers may not want. A twenty-five year old who doesn't want coverage for mental health care would be charged the same as a sixty-year old who wants his Viagra covered under a state mandate. Moves to repeal the antitrust exemption and to allow interstate competition are already underway and will hopefully pass regardless of the final health care reform.

Health Insurance (as opposed to Health Care) Reform

Alot of the venom regarding health care in the US has been directed at the insurance industry. Nancy Pelosi singled them out as the top villain, town-hall protestors are labeled as industry shills, and the primary evidence of the failure of the current system is the number of uninsured people in the US. In fact, the overall health care reform drive is largely a matter of health insurance reform. But health insurance is not health care and was never meant to be. The purpose of insurance is to spread risk among a large number of people. Unfortunately, the insurance industry seems to have moved away from that goal and I want to institute policies that direct the industry back towards their original purpose. Reformers, however, want to turn the insurance industry into something it was never meant to be.
The principle idea behind insurance is that bad things will happen to some people, but not to everyone. If there are ten people and each one of them has a 10% chance of having an accident that will cost $100,000, then each person has an expected cost of $10,000 and the insurance company will charge each person $10,000 (plus some profit) for coverage. If some people choose not to buy insurance, then that won't affect the expected cost of the remaining individuals. The main point is that insurance should charge each person their expected cost plus profit and each person has the right to either buy insurance or not to buy insurance.
Reformers want to turn insurance from risk-sharing to cost-sharing. Under cost sharing, people are no longer charged an amount based on their own level of risk, they are charged an amount based on the collective level of risk. Suppose you had ten people again and one person had a 91% chance of having an accident while the other nine had a 1% chance. Risk-sharing Insurance would charge the nine people $1,000 (plus profit) each and the other person $91,000 (plus profit). Cost-sharing Insurance would still charge each person $10,000. If one of the nine refuses to buy insurance, insurance would have to charge the remaining nine $11,000 each (expected costs are now $99,000 divided by nine people). If another person drops out, the premium would by $12,250 (98,000 divided by 8). The expected costs would be divided among fewer and fewer people until the one person has a premium of $91,000 that he can't afford and the other nine have no insurace.
In order for cost-sharing to work, everyone must be required to buy insurance with the low-risk people effectively subsidizing the costs of the high-risk people. That is why the reformers push three primary reforms: mandates that force everyone to buy insurance (or pay a fine), guaranteed issue which says that insurance companies can't refuse high-risk individuals, and community rating which means that everyone is charged the same regardless of their level of risk. These changes would be accompanied by subsidies that help poor people pay for insurance and taxes that force wealthy people to pay for those subsidies.
The primary healthcare reform proposals being debated result in redistributions from the wealthy to the poor through taxes and subsidies and from low-risk individuals to high-risk individuals (from the healthy to the sick) in the form of individual mandates, community ratings, and guaranteed issue. As far as I'm concerned, there isn't a lick of difference if this is done through a single-payer system, a public option, co-ops, exchanges, or reform of private insurance. I can understand some people supporting this type of reform. It might even be better than what we currently have. But it still isn't the best system and I don't support it.
The fundamental characteristic that a health care policy has to have in order for me to support it is the existence of different levels of quality of care with the customer paying more for higher levels of quality.

Wednesday, September 16, 2009

The Laffer Curve

Much has been made about President Obama’s efforts to raise taxes on high income individuals in order to fund additional spending programs such as health care, energy, and the stimulus. Critics cry class warfare and complain that the wealthy shouldn’t be punished in order to provide a welfare state. Defenders say that the rich can afford higher taxes without any big impact on their well-being. The bigger concern to me, and one that isn’t getting the attention that it deserves, is this – it won’t work.
Raising tax rates on high income individuals will not raise as much money as expected and may raise even less money than before. The idea behind this is known as the Laffer Curve and it basically argues that work effort is a declining function of tax rates and that there is some tax rate that maximizes the amount of revenue collected. At low tax rates, people work but the government gets very little tax revenue. As tax rates rise, people will work less so that tax revenues will still rise but at a decreasing rate. At some point, tax revenues will begin to fall as the reduced work effort dominates the higher tax rate. At extremely high tax rates, people won’t work and no money will be collected. If you wish to draw it, the Laffer Curve looks just like an arch.
There is some tax rate that would maximize total taxes, but people disagree on what that rate is. Keynesian economists (Democrats) tend to believe that we are below that point so that higher tax rates lead to higher tax revenues. Meanwhile, supply-side economists (Republicans) tend to believe that we are beyond that point so that raising tax rates actually reduces tax revenues.
In reality, the revenue maximizing tax rate depends on income and you can make a strong argument that high income people should be taxed at lower rates than middle class people. The determining factor is whether or not people have a substitute for working. High income people include business owners, professionals, doctors, lawyers, … and anyone in the highest income levels probably has some control over their career and how much they work. They have the option of taking more vacation, retiring earlier, sheltering income, deferring income, or take some other action that reduces the amount of tax revenue that the government takes in. Any reduction in the amount of work done by these people, and therefore their income, will result in lower tax revenues. Meanwhile, middle class people have less flexibility in their job. Employers expect 40 hours per week with two weeks of vacation – no more, no less. Low income people actually have greater flexibility too in that they can receive state support or work in informal (and untaxed) jobs instead of working in a traditional job.
It is politically infeasible to have lower tax rates on high income people, so the government really needs to determine the tax rate that maximizes tax revenues for this group and then set tax rates for middle and lower income people either equal to or below that rate. So, what rate maximizes tax revenues for high income workers? I honestly don’t know, but I have a feeling we are probably already close to that rate. The highest marginal Federal Tax rates are set to go up to 39% plus state and local income taxes and sales taxes means that we’re probably already at about 50%. I really don’t think that higher rates will lead to higher revenues.

Not everyone agrees with this. Tax rates have been significantly higher than they are today – as high as 91% under Eisenhower – and the economy did just fine. Indeed, there is very little correlation between economic growth and the highest marginal tax rate. There are two reasons for this. First, tax rates should affect the level of income, not the growth rate. When tax rates change, there may be short term effects on growth as people change their work habits, but once these habits are set, there is no reason that the growth rate should be affected. Second, changes in tax rates will only affect a small percentage of tax payers. If you raise tax rates on the highest 2% of workers, then they may cut their effort, but it won’t have a huge impact on the overall economy.
Again, some people disagree and say that the tax cuts just help the rich get richer. As proof of this giveaway they point to the increase in income inequality since the 1950s when tax rates were 91%. In actuality, their argument is self-contradictory and shows the Laffer effect. When tax rates go down on the highest income individuals, they have greater incentives to work and invest which causes their income to go up. Lower tax rates lead to higher before tax incomes. Conversely, higher tax rates lead to lower pre tax incomes. As far as the effect on tax receipts goes, it depends on the strength of that relationship. If an increase in the tax rate from 40% to 50% causes income to fall from $100,000 to $80,000, then tax receipts are unchanged. A smaller impact on income, say a decline to $90,000, would result in higher tax receipts while larger declines in incomes would lead to lower tax receipts. Overall, I think that higher tax rates will do very little to raise revenue, but it might reduce income inequality. This might be a worthwhile objective, but it won’t pay for additional programs.

Friday, September 4, 2009

A brief overview of Kinky Economics

On this blog I will outline my views on public policy. The basic principles of Kinky Economics are that everyone deserves a basic quality of life while minimizing the restrictions on people who desire a better life. I also sometimes refer to this philosophy as the barbed wire safety net, it can save your life, but it's not meant to be comfortable. The actual name of Kinky Economics comes from the idea of a kinked Aggregate Demand curve for those of you with a familiarity with Keynesian economics. I am currently focusing on the health care debate due to the current national debate. However, I will sprinkle in some other blog posts at times. It is my objective to pull this together into a book, so you will at times see periods where I focus on taxes, the environment, welfare, regulation, and other topics. I look forward to any comments you may have.

A brief overview of KinkyCare

How should health care be reformed? Well, the Kinky Economist has a plan that provides for both universal health care and the best damn health care that money can buy. Anyone can get health insurance for free through the government. This public plan would be modeled on the VA system where the government owns the hospitals and the doctors and nurses are employees of the government, so members would not be able to choose their own doctor. Employment in the system could be worked into programs for medical school. For example, tuition is free at military academies such as West Point, but students are required to give four years of duty after graduation. The GI Bill will pay for college for soldiers after they leave the service. The federal government could pay for medical school with a requirement that the doctors work in the system after graduation.

The plan would focus on preventative care where annual check-ups are not only free, but you could get paid for a healthy lifestyle. So much of our health care costs, especially diabetes, heart disease, and respiratory problems, are driven by behaviors such as obesity, inactivity, and smoking. By focusing on wellness, these costs can be avoided (although healthier lifestyles do result in higher costs due to increased life expectancy and chronic diseases in old age).

Chronic and catastrophic health care would be rationed by Quality Adjusted Life Years (QALYs). For instance, the government may pay up to $40,000 for treatment that extends a patients life by one year, so the cost per QALY would be $40,000. Yes, health care will be rationed -- it is already rationed. Every scarce resource is rationed. If you don't want the plug pulled on Grandma. then pay for her health care. You shouldn't demand that other people to pick up the tab if you're not willing to pay the costs. If QALYs are used to ration health care, then how much are we willing to pay to save a life? More accurately, how much are we willing to make someone else pay to save a stranger's life? The budget for health care must be limited to a percentage of the total government budget. Once a fixed dollar value has been created, the cost per QALY will depend on how many people are in the government plan and how much health care they need. The government plan is meant for the poor and the sick, not the healthy and the wealthy. If more people get their own insurance, then the available funds can be spread among fewer participants resulting in higher costs per QALY. The plan can also accept contributions from donors that would increase the cost per QALY.

Another focus of the plan is positive externalities of health care. The plan could require patients to be immunized resulting in a reduced likelihood that other people will get sick. The plan could strongly encourage organ donation to help save other lives. The plan could be used for research on new medical techniques and drugs. All of these characteristics result in social benefits.

The final focus of the plan is cost containment. Treatments would be based on comparative effectiveness so that costly, ineffective treatments are avoided. Medical malpractice costs would be eliminated or at least drastically reduced by not allowing patients to sue or instituting a program to resolve these disputes. Generic drugs would be prescribed instead of brand names in order to lower pharmaceutical costs. Finally, the plan would use it's size to negotiate better terms for prescription drugs, medical equipment, and other purchases.

The public plan is not for everyone and most Americans can and should get their own insurance, just as they do today. However, the health care system does have flaws and room for improvements. The primary downfall of the plans that seem to be bandied about is the insistance on a single level of health care resulting in either reduced levels of care and/or higher costs. By recognizing that everyone deserves basic health care but not necessarily Cadillac care, I believe that the KinkyCare framework has the best potential to improve health care coverage and results.

Is US Health Care Broken?

One of the arguments made by proponents of health care reform is that the US system of health care is clearly broken because we pay so much more than other countries for health care and have worse results. Indeed, the overall statistics bear this out. We spend twice as much per capita and have lower life expectancies and higher infant mortality rates. Is this not proof of the need for change? Perhaps not if we look at individual results instead of averages. Suppose both Rich and Joe are dying. It would cost $100,000 in medical costs to extend Rich's life by one year while it would only take $50,000 to extend Joe's life by two years. From an overall statistical perspective, it would make more sense to save Joe's life. But what if Rich has $100,000 and Joe is broke. Rich might prefer to spend his money to save has own life, and the only way to save Joe is to forcibly take Rich's money from him through taxes in order to pay for Joe's treatments. While this might benefit Joe, Rich is now dead and out $50,000.
So, is this reflective of our current situation? Evidence indicates that this does play a role. While our overall spending is high and our overall results are low, if the results are broken down into subgroups the picture changes. Life Expectancy of Whites and Asian-Americans are inline with European and Asian averages while the life expectancy of African-Americans is lower than the life expectancy of other ethnic groups in the US, it is higher than the life expectancy in African nations, although this is not necessarily a fair comparison.
This is the health care debate in a nutshell. Many people I know and respect believe that health care should not be determined by how much money a person has and that it is fair and preferable that health care should be allocated on the basis of need while the costs of those resources should be borne by the people who can pay. Such a system would indeed lower costs and improve overall results. I would take the opposing view that it is an individual's right to allocate their wealth in a manner of their own choosing.

Wednesday, March 11, 2009

The Utility of Wealth Redistribution

How much happiness can someone receive from $100? If you are poor and that $100 is the difference between eating for a week instead of starving, then that $100 might make you very happy. A wealthier person, on the other hand, might receive utility from spending that money on a new pair of shoes. Higher levels of wealth or income are generally assumed to lead to greater utility, but there is also an assumption of diminishing marginal utility in that each additional $100 provides less and less utility. This would suggest that an additional $100 matters more to a poor person than it does to a rich person. That is the basic argument in favor of welfare – that the decine in the rich person’s utility is less than the gain in the poor person’s utility. However, there are many factors associated with utility, and it would be wrong to assume that wealth redistribution would always lead to greater total utility.

The first critique involves the fallacy of interpersonal utility comparison. Money has different effects on different people. Some people don’t care about money and prefer a minimalist, almost monastic, lifestyle. These people may smugly scoff at other people who receive great utility from their conspicuous consumption. Some people are very proud and would lose more utility from accepting a handout than they would receive from accepting that money and spending it. Other people are miserly and greedy and feel the loss of every penny. A transfer of wealth from the miserly and the greedy to the proud and monastic would reduce total utility. I think it’s fairly safe to assume that wealthy people are more likely to place a great value on money in the same way that you assume that someone with a lot of cats probably likes cats. Thus the total utility associated with a transfer of wealth depends on both the level of wealth and the attitude of the giver and the receiver.

Some people could make more money, but they would rather have a life or equate wealth with being a sell-out. Suppose you have two equally able people but one goes into banking because she is materialistic and the other writes poetry because it nourishes his soul. Is it really fair to take money from the banker and transfer it to the poet? Would it be fair to take some of the poet’s soul and give it to the banker? Maybe you think it would be good if the banker had some more soul, but it wouldn’t last. She’d probably just waste the soul to make more money anyways.

The process by which the exchange occurs will also affect utility. Some people may be very charitable and receive greater utility from donating $100 than they would receive from either spending or keeping the money. In the best of both worlds, a wealthy person might gain utility from giving money to a poor person while the receiver gains the utility of $100 worth of food. Now suppose the poor person steals the $100 from the rich person. This has the exact same wealth effect as the charitable donation – the rich person is $100 poorer and the poor person is $100 richer. The utility effect, however, is completely different. The poor person has $100 but may also have the disutility associated with guilt (assuming that the poor person has a conscience). Meanwhile, the rich person has not only lost $100, they’ve lost their sense of security, their power, their independence. In short, they feel violated. Government enforced redistribution of income presumably falls in between the two extremes of theft and charity.
Wealth distribution may also have negative incentive effects. As long as the redistribution involves the fortunate helping out the less fortunate, then it probably increases utility. However, as soon as it crosses that line into punishing the people who made good choices and sacrificed for the future in order to support people who wasted opportunities and ended up poor, then redistribution becomes a utility-reducing activity. Furthermore, it could exacerbate the problem if people become less likely to make good choices and more likely to make bad choices.

This leads to the question of what is done with the money. If the money helps the poor individual get their life on track and eventually out of poverty, then the money is well spent. However, if the money allows them to continue along their current failed path, then the money is wasted.This is not to say that all wealthy people worked hard for their wealth and all poor people are lazy and irresponsible. Some people clearly have better opportunities than others and some people clearly take better advantage of whatever opportunities are given to them. I would personally rather help someone who ended up poor even though they made the most out of their minimal opportunities rather than someone who ended up poor because they wasted the opportunities they had. Unfortunately, it is difficult for government programs to make that distinction. People qualify for help based on their present state, not based on how they got into their present state. Private charity is better able to distinguish among potential beneficiaries in order to determine who most deserves help and who can benefit the most.

Overall, I think these factors cause the utility effects of wealth redistribution to be about half of what a straight analysis would suggest. Basically, you would want to compare the utility loss of $100 of a wealthy person to the utility gain of $50 to a poor person. I have no scientific data to back up this statement, but I’m going to use it as an approximation unless I find reason to change.

Friday, March 6, 2009

The Primacy of Voluntary Exchange

In discussing the role of government in our lives, I am of the opinion that government should try to increase the general happiness (in economic terms we call this utility) of its citizens. But what makes people happy. The government doesn’t know what makes you happy and therefore can’t provide you with happiness. Only you can determine what makes you happy and you display your preferences with your actions. Everything you voluntarily choose to do, you do with the expectation that it will make you happier. Otherwise you would not do it.
Sometimes you make mistakes and take actions that fail to make you happy. Sometimes the actions have both positive and negative consequences. Sometimes the action benefits others as well as making you happy. And sometimes the action harms others while making you happy. Regardless, people voluntarily act in ways that they expect to make themselves happier.
This idea, this Primacy of Voluntary Exchange, is the Hippocratic Oath of Kinky Economics – First, leave people alone. Therefore, any restriction on voluntary behavior, including requirements of involuntary behavior, must be clearly justified, which leads us to the role of government in maximizing utility.
Government, what is it good for? Absolutely nothing. Well, maybe not nothing, but government is the very antithesis of voluntary exchange. It restricts what you can do through laws and regulations and enforces your involuntary support through taxes. Perhaps I am being too harsh. Not everything government does is wrong. Laws that prohibit murder may restrict the voluntary behavior of killers, but they increase the happiness of would be victims. I may not like paying taxes, but I also want services that only the government can provide (or that they can best provide).
Although government does not know what makes you happy, there are some things that government can do to increase overall happiness. Certain responsibilities are clearly the role of government as even the most ardent libertarian will agree. National defense is a government responsibility, although there are differences in regards to the optimal amount of national defense. The legal infrastructure is a government responsibility including both criminal and civil disputes among individuals and legal entities. There is an economic role in providing public goods, adjusting for externalities, and even wealth redistribution. The difficulty is in finding the right role.

Scarcity and the Laffer Curve

Much has been made about President Obama’s efforts to raise taxes on high income individuals in order to fund additional spending programs such as health care, energy, and the stimulus. Critics cry class warfare and complain that the wealthy shouldn’t be punished in order to provide a welfare state. Defenders say that the rich can afford higher taxes without any big impact on their well-being. The bigger concern to me, and one that isn’t getting the attention that it deserves, is this – it won’t work.
Raising taxes on high income individuals will not raise as much money as expected and may raise even less money than before. This top 2% includes business owners, professionals, doctors, lawyers, and anyone in the highest income levels probably has some control over their career and how much they work. They have the option of taking more vacation, retiring earlier, sheltering income, deferring income, or take some other action that reduces the amount of tax revenue that the government takes in. Any reduction in the amount of work done by these people, and therefore their income, will result in lower tax revenues.
The idea behind this is known as the Laffer Curve and it basically argues that work effort is a declining function of tax rates and that there is some tax rate that maximizes the amount of revenue collected. At low tax rates, people work but the government gets very little tax revenue. As tax rates rise, tax revenues will rise but at a decreasing rate. At some point, tax revenues will begin to fall as the reduced work effort dominates the higher tax rate. At extremely high tax rates, people won’t work and no money will be collected. If you wish to draw it, the Laffer Curve looks just like an arch.
The revenue-maximizing tax rate balances the reduced work effort with the higher tax rates. If you are below this point, then raising tax rates will raise tax revenues, but not by as much as expected. If you are beyond this point, then raising tax rates actually reduces tax revenues. Keynesian economists (Democrats) tend to always believe that we are below that point while supply-side economists (Republicans) believe that we are always beyond that point.
I wouldn’t wager a guess as to where we are on the Laffer Curve, but I do know that raising tax rates on the top 2% will not raise the kind of revenue that Obama is hoping for and there is no way to raise more revenue once you are at that optimal tax rate. Therefore, the only way to reduce the deficit is to cut spending, which does not seem to be in the cards given his ambitious plans. The President must remember one thing about Economics – Scarcity exists.

Thursday, March 5, 2009

The Mortgage Shuffle

The current housing market is a mess, at least it is in California, Nevada, and Florida. One in five homeowners owes more than their house is worth and one in eight are either in foreclusure or behind on their monthly payments (a total of 5.8 million homeowners). However, the housing plan currently proposed by President Obama has several flaws, not the least of which is that it rewards people and banks who acted irresponsibly. Banks are "encouraged" to accept lower payments equal to 38% of the homeowners income while borrowers only have to pay 31% with the government stepping in to make up the difference. This ignores how much the house is worth originally or how much it is worth today.
The justification for the plan is that not stepping in will result in further declines in home value for people that are paying their mortgages. Preventing foreclosures and forcing rescheduling of payments through cram-down bankruptcies is not the only solution. A better solution matches owners with homes that they can afford and encourages homeowners to increase, or at least maintain, the value of their home.
There are really two issues involved: how much are homes worth and how much home can a person afford. Both of these factors are important and we must distinguish between them. Homes sell in an illiquid market and it is difficult to measure home values unless there is activity in the housing market. The second issue is how much house someone can afford. Traditional measures suggest that housing payments should be no higher than 31% of income, although that may be adjusted for the amount of other debt and the level of wealth.
One in five homeowners are upside down in that they owe more than the house is worth. This results from some combination of putting little to no money down on their house, having an interest-only loan, and declining home values. Upside-down (or underwater) homeowners that can still afford their house by conventional measures must be encouraged to keep making their payments – any plan that encourages default will only lead to more problems. They also need to have an incentive to maintain the value of their home through general upkeep and maintenance.
If they can’t afford the payments, then they will have to sell the property. Foreclosed homes lose value both for themselves and their neighbors. However, the problem is not the foreclosure, it is the vacancy. Empty homes fall into disrepair, become an eyesore in the community, and discourage current and potential residents. Home values are not independent of the homeowner. Taking care of their property, making needed repairs, and putting on a good face (Sweat Equity) may not turn a home rightside up, but it can keep it from sinking further. Instead of foreclosing on the house, the bank needs to encourage the upkeep and selling of the house, perhaps by hiring a realtor or contractors to assist in repairs. If a $10,000 investment can bump the home value up by $20,000, then everyone wins.
But who is going to buy the house and what is going to happen to the current homeowners (a term I am using loosely)? To a large extent, that depends on how much the homeowner can afford. Suppose a homeowner buys a house for $500,000 that is only worth $400,000. Unfortunately, the homeowner can only afford the payment on a $300,000 loan. The solution is to let the homeowner pay $200,000 (resulting in negative equity of $100,000) for a house that used to be worth $250,000 but was recently vacated by a homeowner who could only afford a payment on a $150,000 house.
Clearly there is a downsizing effect going on here as homeowners leave expensive houses that they can’t afford for cheap houses they can afford. After the fall out, there will admittedly still be expensive houses that remain unsold and poor people left without a home. Some of these losses will be tabsorbed by banks, some by, homeowners, and some by taxpayers. This is much more viable for the government to step into those situations and help out than the massive undertaking it is currently taking (and which will ultimately fail).
Government can assist in this plan by supporting these negative equity loans as long as they conform to the payments are less than 31% of income. I realize that government support of subprime loans through Fannie Mae and Freddie Mac helped to create the situation in which we find ourselves, but a market for these loans can help get us out. The government can go even further in offering loans directly at a fixed rate of 6.5% (or at the current rate) through their soon to be nationalized banks.
A second change is to allow homeowners and or banks to realize a capital loss on the sale of their homes. Currently home sales are considered personal assets and losses are not tax deductible (and gains are generally tax exempt). In reality, homes are the single largest investment for most homeowners and a tax deduction for losses would relieve some of the current pain. Whether or not to change the exclusion on gains is a separate issue.
This solution achieves a few desirable outcomes that are preferable to the current proposal. First and foremost it matches people with homes they can afford. In doing so it creates a market for homes so that they can be fairly valued. It also encourages the maintaining of home values by encouraging people and banks to put in sweat equity in selling their homes as opposed to just walking away or having banks foreclose on the home. Losses are primarily distributed among homeowners who made bad investments and banks who made bad loans with taxpayers only having limited exposure.