Time To Stop Worrying And Learn To Love Baumol’s Cost Disease?
Look beneath the surface of our polarized political debate over budgets, taxes and the size of government and what you’ll find is that it is largely driven by the seemingly inexorable rise in the cost of providing health care and education and other necessary services.
For conservatives, these rising costs are the inevitable result of too little competition, too much subsidy and regulation and too much power in the hands of public employee unions.
For liberals, the problem is not so much the higher costs as the inability of ordinary Americans to pay for them, because so much of the national income is now captured by the rich.
There is some truth to both arguments. But what if the more important explanation for our current predicament is that “goods” such as medical care and education, public safety or social work suffer from the fact that they are so labor intensive. It’s hard, if not impossible, for them to be produced more efficiently.
This is the famous “Baumol’s cost disease” argument. Productivity in one part of the economy raises wages on average. But less-productive sectors need to compete with the more-productive sectors for labor, so costs in those sectors rise inexorably even if there is no improvement in quality. If those sectors produce non-essential goods and services, then the market may shrink. If those sectors are essential – as health-care and education are – then the sectors will chew up an increasing proportion of the spending dollar.
For these, Mr Baumol offers his most intriguing prediction: although their costs will grow alarmingly high, they will remain affordable. In a way, the disease produces its own cure. If America’s economy grows by 2% per year (its long-term rate), it will be eight times bigger in 100 years. In addition, goods and services in innovative sectors will become much cheaper. In 1908 the average American had to work for around 4,700 hours to earn enough to buy a Model T Ford. A century later, a typical car can be had for only 1,365 hours of labour. This means that, even if health care really did eat up 60% of the pie, there would still be much more to spend on everything else (see right-hand chart).
The real problem is not the cost disease, Mr Baumol argues, but knee-jerk reactions to it. The most likely response to spiralling budgets for publicly provided medicine and education is to shift provision to the private sector. But that will not cure the underlying disease. High costs could also lead to excessive rationing, slowing development over the long term. If it happens, such a reaction rests on a mistaken premise: that the rising costs in the stagnant sectors make people poorer. In fact, buying power is growing much faster than medicine, education and the arts are becoming dearer.
I’m pretty well sold on Baumol’s cost disease as a major driver (though not the only driver) of increasing health-care and education costs. But this “don’t worry; we can afford it whatever it costs” line strikes me as myopic. I plan to read the book to see if it feels that way when I’ve heard the full argument, but here’s my instinctive reaction.
The argument, if I understand it, is that rising wealth due to productivity increases in certain sectors of the economy is what’s driving the rising cost of labor in sectors that haven’t experienced that increase in productivity. And therefore, the rising cost of labor can’t outstrip that increase in wealth. Hence we can afford the increasing cost of health-care and education, provided we don’t freak out about the price tag and remember how cheap everything else is.
But this analysis breezily ignores distribution effects. “We” may all be able to afford lots of education and health care – but who’s “we” kemosabe? If the gains to rising productivity go overwhelmingly to the upper quintile, and even more disproportionately to the top 1%, then “we” will be able to afford less and less of the most essential services, even as we have no particular trouble affording flat-screen televisions and more calories than we ought to be eating. Which is precisely what has been happening.
Moreover, distribution effects show up on the service side as well. Live music keeps getting more and more expensive. That doesn’t mean nobody goes to concerts anymore – far from it – but the market gets more and more segmented because at the prices tickets go for these days you have to really want to attend to pony up. But think of that dynamic being applied to education, or to health care, and it’s less clear how you “segment” effectively – except by gradations of quality.
I find it very implausible that people will happily pony up 50 or 60 cents of every dollar they earn to ensure that everybody will get equally high-quality health care and education. Rather, at every point on the income spectrum there will be pressure to make sure that money isn’t being redistributed downward – and the only way to assure that is for the “basic” guarantee provided by the government to be revised into a less and less generous service.
The only way out of this dynamic, it seems to me, is to actually achieve productivity gains in education and health-care – which means figuring out how to leverage high-value individuals more through technology. There are some ideas about how to do that – distance learning, for example – but right now they are still pretty peripheral. But that’s the challenge. If we can make those gains, then a “basic” package can remain relatively affordable while still being of relatively high quality, and the “premium” package will continue to rise in price without resulting in enormously superior outcomes. If we can’t, then rational self-interest on the part of anybody above the median is going to push inexorably for less redistribution, which will mean a deterioration in quality of the “basic” package, and a deepening entrenchment of social inequality.
That’s what I fear anyway. Now I have to read the book to see of Baumol and his co-authors have already anticipated and answered those fears.