Letter to Krugman

In response to this column, another beauty:

Dear Dr. Krugman,

Splendid column as always.

Part of the reason for the failure to consider the “Iceland strategy” is that, despite its evident failures, we still subscribe to the view that “capital” is a quantity or figure possessed by banks, rather than recognizing that our productive capacity, whatever its nominal value in dollars or any other currency, is comprised of knowledge, social infrastructure, and physical infrastructure. In a crisis, the goal of a government should be to balance risks
of short-term disaster against threats to long term health, i.e., against threats to capital at different time horizons. It is possible that these threats are best addressed by saving banks, but this would be only a special case. In particular, this would occur if and only if banks were seen as having crucial knowledge about risk — whom could be trusted and whom could not — that would be lost if banks themselves were allowed to fail.

Clearly that was not the case here. In fact, bank disbandment might actually improve capital in this case insofar as many banks seem to have institutionalized bad decision-making.

Consider a simple trade-off. Spend $40k to allow one college senior to complete a year of school studying finance at a university or spend $40k to induce a banker who neglects what they learned in finance class 20 years ago and imitates industry trends to stay in their job. Not only is the former spent, rather than placed on a balance sheet, giving it a multiplier effect, it would appear to improve productive capital in the nation’s medium term. This student could conceivably replace the banker-counterpart in 5 years.

I am confident that any number of similar analyses would show that bank bailouts are not only unfair, they are capital depleting.

Best Regards,

Drew Margolin

Back after a long hiatus.

Years ago I worked with an individual who alerted me to the difference between what he called “value creating” and “value claiming.”  I think he may have learned these concepts at Harvard Business School, but I am not sure.  Anyway, I think they are very apropos to many of the issues and debates raised by the Occupy Wall Street movement.

Value creation is the creation of knowledge or wealth.  Value creation includes scientific discoveries and technical inventions, but also the creation of new social relationships.  A salesperson can be a value creator when they help a customer and a company build a satisfactory relationship.  A manager can be a value creator when they help their organization function more smoothly.  There is no domain restriction on value creation.

Value claiming is claiming credit for the creation of knowledge or wealth.  Value claiming includes financial compensation — such as wages, salaries, commissions and bonuses — as well as gains in reputation and authority.  A manager can be a value claimer when they convince others that a useful idea was theirs.  There is no domain restriction on value claiming.

In some circumstances, the value that is created is easy to assign or attribute to those that created it.  In baseball, for example, it is relatively easy to assign credit.  Batters that get hits and pitchers that get outs create more value than those that don’t.  So they should be played more.  Better pitchers are used as starters, better batters play every day and hit higher in the order.   To the extent to which winning generates revenue for the team, they should also be paid more.  In other circumstances, it is much more difficult to assign credit.  In football, for example, it is very difficult to tell whether line players or skill players are responsible for a successful play.  Was it the running back or the blockers that created a 12 yard gain?  Is the quarterback good or is he just getting time to throw and make good decisions?  Often in these team oriented sports there is no meaningful answer.  That is, the contributions are based on the interaction of both, not the creation of an individual.  Tom Brady throws good passes because he gets protection from his line, but he gets protection from his line partly because he inspires them and gives them confidence, audibles to plays where they have a better chance of stopping the pass rush etc.

Because value creation cannot always be accurately or precisely attributed, there is an opportunity for value claiming.  In particular, to the extent to which there is a system by which credit is assigned for value creation, but this system is imperfect, individuals can obtain credit by investing their skills and efforts in meeting the criteria for credit assignment rather than in creating value itself.  For example, in football, pass rushers are rewarded for recording sacks.  This encourages them to pursue sacks even when this means giving up other defensive responsibilities.  In particular, the pass rusher is inclined to give up responsibilities that can be compensated for by others, such as other defensive linemen or linebackers.  So the pass rusher gets more sacks, but another player is burdened with extra responsibilities.  This weakens the team.

The classic tension between value creation and value claiming in business is between sales and production.  Salespeople are evaluated on customer acquisition and satisfaction.  Production processes, and the people who work in and manage them, are evaluated on efficiency or yield.  Sales agreements are constructed around fixed prices.  Production processes are targeted toward fixed, or at least reliable, standards of quality.  Salespeople thus have an incentive give their customers superior quality at the fixed price, what we might call “special treatment.”  Production workers have an incentive to create products that are easy to make, even if they are not desirable, forcing the salespeople to “convince” customers that this product is what they really want.  In both cases, an individual can get “credit,” i.e. can successfully claim value, even when they are doing something bad, i.e., destroying rather than creating value.  The salesperson books a sale by promising a product that is more expensive to make but more satisfactory to the customer.  The production person insists that such a product ‘cannot be made,” and that an easier to produce substitute is the only alternative.

There is no formal, a priori system that can solve  this problem.  That is, the problem cannot be solved by creating a system of categories and incentives tied to these categories.  This is because the problem is based on a fundamental information asymmetry: the salesperson knows what the customer wants better than the production person does, and the production person knows what can be made better than the salesperson does.  This information asymmetry cannot be solved.  First, based on talents, interests, and raw processing capacity it is not possible for every individual to know every detail of every part of a business.  Think about the defensive lineman and the linebacker.  How are they going to know what each other “could” or “could not” achieve on a play?  The complexity of the chaos at the line of scrimmage is too great.  Second, since information asymmetry is a key to value claiming, there is no incentive for individuals to be entirely forthright.  If one individual shares all of their information and another does not, the former will be assigned less value and the latter more.  If production people admit that they actually can make the “special product” for the salesperson, but the salesperson hides their customer’s true preferences, the salesperson can say “yes, that is the only thing they will accept,” when in truth, it is the easiest thing to get the customer to accept.

From these points it should be fairly clear that one can specialize in value claiming and, depending on the circumstances, succeed at receiving credit and resources even without creating much or any value.  For example, a pass rusher who learns when and how to shift responsibilities to other players in order to rush the passer has an advantage over one that does not.  With the same set of skills, he will get more sacks.  Of course, coaches and teammates will monitor this.  But their monitoring will not be perfect.  To the extent to which it is imperfect, their gap may be exploitable.  Furthermore, the opinions of coaches and teammates do not always matter for value assignment.  If a player leads the league in sacks but is disliked by teammates and coaches for being “not a team player,” he may still get signed to another team for a big contract.  The key question is not whether the player was in fact ‘shirking” to get those sacks but the standard by which the player is judged by the other potential employers.  For example, the other team may believe that the player’s “bad reputation” is because he is a shirker who pads his own sack numbers at the expense of team success.  But they may also believe that they player’s “bad reputation” is because of his personality.  This suggests a strategy for value claiming players:  if they mouth off to the media or otherwise look like they have problematic personalities, they may be able to enhance their value.   This is because, even though they may lose some credit because they are seen as “difficult,” this “difficulty” validates their statistical record.  Other teams believe that the player “gets a lot of sacks but is a loudmouth,” and rules out the explanation “the player gets sacks at the expense of his teammates.”  If the salary for high sack, problem personality players is greater than for low sack, shirking players, then there is a value claiming incentive for a shirking player to cultivate the image that he has a problematic personality.  This image will then serve as an explanation for the shirking based complaints.

People specialize in these sort of strategies in business all of the time.  The clearest example was the use of the handle “.com” during the 90’s bubble.  Many CEO’s figured out that, for the purposes of valuing their company, it was more worthwhile to invest resources in convincing other people that they were a  dot-com than in producing a product that had value.  The information asymmetry — the fact that investors did not know exactly what constituted a viable dot-com — invited this value claiming exploitation.  That is, the strategies were too easily available and the value that could be claimed too great.  People invested effort and resources in searching for these strategies, found them, and were rewarded for it.

The preceding has been provided to show that, logically, the value that an individual or company has acquired or been assigned is not indicative of the value it has created.  It is indicative of the value it has created plus the value it has learned how to claim.  In biology, we know this problem as the problem of parasitism.  A parasite is a master value-claimer.  For example, a parasite learns how to look like and act like something that is helpful so that it can gain access to the host.  The host admits the parasite and gives it access to its resources because it is indistinguishable from a value creator.  But it is not a value creator, it is a value claimer.  It sucks resources from the host.

It is important to note that the problem is uncertainty, i.e. information asymmetry.  Distinguishing a parasite from a value creating, symbiotic helper is difficult for the host.  That an organism is in the host and drawing resources does not mean it is a parasite.  It might be a vital organ.  Cancer cells and vital cells look the same to the body.  Indiscriminately eliminating those suspected of being parasites if just as dangerous, if not more so, than allowing parasites to flourish.

Nonetheless, it is important to remember that value assignment is not necessarily indicative of value creation.  To get closer to the topic at had: Some rich capitalists are vital job creators; and some rich capitalists are parasites.  The amount of capital or wealth they have accumulated is insufficient information to tell the difference.  Some people made a lot of money by creating products that people need.  Other people made a lot of money by convincing others they wanted products that are easy to create.  Some people made a lot of money by showing people the value of products they did not understand.  Other people made a lot of money by making junk products that were easy to explain and then invested resources in making further understanding confusing, painful, or expensive.

But the fact that wealth is an insufficient discriminator between value creators and value claimers does not mean that there is no way to distinguish between them, or, more properly, that there is no way to set of a system of incentives that increases the ratio of creators to claimers.  This will be the subject of my next post.

 

Letter to Krugman: Interest Rates

In reference to his column today:

Dear Dr. Krugman,

This may be a naive point of view.  It seems to me that, in the long run, the economy is a function of the knowledge accumulated and distributed within the society.  Growth occurs because new techniques are learned and disseminated.  The economy suffers when bad techniques are learned and dissseminated.

Of course, we don’t know which techniques are good or bad until we’ve experimented with them a bit.  It seems to me that interest rates are a rough marker of our tolerance for experimentation.  When interest rates are high, we trust few new ideas, i.e. we don’t give them very long to prove themselves.  When interest rates are low, we trust many new ideas and give them a lot of leeway.

From this perspective, there is a set of superior (though not necessarily uniquely optimal) interest rates.  These rates match the distribution of ideas currently in the economy by locally maximizing the discriminatory power of lenders.  That is, they minimize the # of false positives (bad ideas that get funded) and false negatives (good ideas that don’t).

Appropriate monetary policy in this perspective would be evaluated in terms of deviation, short term and long term, from these maxima rather than strictly in terms of the risks of inflation/deflation in the consumer sphere.

For example, rates have been low for at least a decade.  This means it’s very likely that the market is flooded with bad ideas, because we’ve been favoring false positives over false negatives.  To correct this imbalance, we need to raise interest rates, not to curb inflation for businesses and consumers, but to re-direct capital to well thought out projects.

Sincerely,

Drew Margolin

Accounting Tricks

Here is another example of an accounting trick whereby:

1) Corporations get taxpayer money for no good reason

2) It turns out that health care was already paid for by the government but just funneled through corporations.

Here’s the main point…

To encourage corporations to continue the provision of prescription drugs to retirees under their retiree health plans, rather than dumping the outlay into the lap of the new Part D Medicare program, the [Medicare Modernization Act of 2003] granted corporations a federal subsidy equal to 28 percent of their outlays on prescription drugs for retirees….

Suppose a firm in, say, 2009 spent $1 billion on prescription drugs for retirees and received from the government a $280 million subsidy toward that outlay.

Should the firm be allowed to deduct from its taxable income only its net outlay of $720 million on prescription drugs for retirees (Option A), or should it be allowed to deduct the full $1 billion (Option B)?

The Bush administration and the lawmakers in 2003 chose Option B ($1 billion in our illustration), in effect allowing corporations to deduct from their taxable income an expenditure actually made by the general taxpayer.

Evidently the Obama administration and its allies in Congress disagree with that decision, for included in the recently passed health-reform bill is a provision allowing business firms to deduct only their net outlay on prescription drugs for retirees (Option A above — $720 million in our illustration).

In other words, the taxpayer subsidizes these health care expenditures by more than 28% of the cost.  If the top corporate tax rate is 35%, a company with $1 billion in prescription drug outlays would pay $350 million less in taxes.  If it were only able to deduct $720 milion, its taxes would be $252 million.  So this provision is worth $98 million or 9.8 % (35% of 28%).  In other words, the subsidy is not 28% but in fact 37.8%.

Thus, taxpayers are already paying 38% of prescription drug benefits for retirees with corporate pensions.

It might be argued that the fact that this subsidy is executed via this apparent loophole is inconsequential.  The real question, it might be argued, is whether  28% or 38% is the right level of subsidy.  That is, what matters is the effective degree of subsidy, the net dollars, rather than the means.

This position is wrong for two reasons.  First, this particular means is not neutral in its impact.  In particular, it favors corporations that pay higher tax rates.  If, for example, a corporation only pays a 15% tax rate, the extra subsidy is worth only 4.2% rather than 9.8%.  And how is the tax rate assigned?  Based on the total size of a company’s profits.  Company’s with bigger profits pay a higher rate.  In other words,  this subsidy favors large companies over small companies.  While it is true that, in this case, larger companies are more likely to have qualifying pension plans, the point is still that the means of the subsidy has an impact over and above its level.  If we accept the “only effective rates” matter logic, then we should assume it is used in many other circumstances in which the effects are more significant.

More broadly, this means is problematic because it is overly complex.  As the complaints over the reversal of this policy under the new health care bill show, every time you effect a policy through an extra step or trick, you make the impact of additional changes more far-reaching and thus more objectionable.  More things have to change to get things working the way you intend, which means change is more difficult, which means it is less likely, which means your system is on the path to being outdated and under-performing.  If you want to subsidize 38% of retiree prescription drug benefits, write a check for 38% of the cost.  Don’t mix and match a thousand rules that each contribute .038%.

But of course, finding, mixing and matching thousands of .038% rules is exactly what politicians tend to do.  It’s easier for them because it’s harder for people to figure out that this is what’s really happening.

It’s ok, I’m sure Lehman Brothers is the exception

The NYT reports that Lehman used accounting tricks to appear solvent while their bad mortgage holding ate away at their balance sheets.  Specifically, they used repurchase agreements to temporarily move bad loans off their balance sheet just in time for quarterly reports.  After the quarter was over and the numbers on which the report is based are set, Lehman would accept the bad loans back:

Repos, short for repurchase agreements, are a standard practice on Wall Street, representing short-term loans that provide sometimes crucial financing. In them, firms essentially lend assets to other firms in exchange for money for short periods of time, sometimes overnight.

But Lehman used aggressive accounting in its Repo 105 transactions: it appears to have structured transactions such that they sold securities at the end of the quarter, but planned to buy them back again days later. These assets were mostly illiquid real estate holdings, meaning that they were hard to sell in normal transactions.

The effect of the accounting was to artificially and temporarily lower the firm’s debt levels to hit certain targets, making the firm look healthier than it really was.

The revelation of Lehman’s Repo strategy now makes at least 3 firms in the last decade that have experienced sudden collapses following financial chicanery (Lehman, Enron, Tyco).  Is this a coincidence?  No.  It is exactly what theory predicts should happen.

Theory predicts that managers can and will exploit information asymmetries to fool shareholders into allocating more capital to them than they deserve (See work by Oliver Williamson).  But since there are limits to this information exploitation, there comes a point at which it is no longer sustainable.  Mis-allocations are not sustainable in the long run, only the short run. By extension, if the short run price is biased high and the long run price is accurate, corrections will come in the form of steep drops (which are collectively bad for the market).

The underlying logic of this process is fairly simple.  By manipulating their books, these firms  allocate their “bad news” into the future.  They take advantage of the fact that most news is somewhat indeterminate.  Sometimes, news that looks bad is actually meaningless because other factors intervene.  So when they get bad news, such as “our loans are performing poorly,” they invent concepts or categories that neutrtal-ize the news contingent on as yet unknown information.

For example, the loans may be under-performing because they are bad loans, or they may be under-performing because some random factor, such as unusual weather, has biased the defaults to come early.  In other words, these are a regular set of loans, but because of the weather, the bad ones reported default early.  If this is true, these bad ones won’t report default later, so in the end it will be a wash.  So the firm can create a category called “March-June timing losses” and book the loans as performing regularly and book the under-performance as a “timing loss.”  Then they can argue that the “timing losses” average zero over time because they are due to seasonal factors.  The trick works because of the information asymmetry regarding what comprises “timing losses.”  If shareholders knew that timing losses are simply regular loan losses, put in another category and assumed to average zero, the fraud would be obvious.  But by giving the category a separate name, the firm suggests that “timing losses” have an independent history, an independent ontology as it were, and so statements about the performance of this category are subject to an independent debate. So it becomes plausible that “timing losses” average out over time even though it is implausible that bad loan losses average out over time.

Of course, this solves nothing, it only kicks the problem down the road.  The implicit commitment of this strategy is that timing losses will average out (to zero) over time.  But of course, if timing losses are simply allocations of bad loans, that is not going to happen.  So after 12 months of timing loss accumulation, shareholders will again become concerned.  But there is a way around this, too: keep changing the name — don’t call them timing losses every reporting period.  If they’re timing losses in Q1, call them “reprobate contingency” in Q2 and zero out the timing losses.  Claim that reprobate contingency is a general category that you only use rarely.  Then, in Q3, put the same losses back in timing losses.  Voila!  Timing losses oscillate around zero, just like you said they would, and you churn them through a variety of meaningless, but rarely used, categories so they don’t accumulate in any one place.

The key to this logic is that solid inferences require the accumulation of compatible data.  So the firm can obscure bad news by splintering and scattering bad news so that it is difficult for outsiders to re-assemble into a compatible set of information.  It is because of this logic that this trick works in the short term, and it is also because of this logic that this trick is not sustainable in the long term.

In the short term, any given piece of bad news can be splintered and scattered.  But in the long term, the splintered and scattered bad news accumulates.  It accumulates in the places where it is easiest to hide it.  Much like sweeping dust under the rug eventually leads to a rug with a weird, unsettling and obvious hump.  The news, like the dust, has not gone away, it’s just accumulating in a place that is difficult to see.  But every time news is put there, it becomes a bit easier to see.  At some point, the task of splintering and scattering the news such that it cannot be observed with compatible information is greater than the firm can undertake — it involves calculations that are too complex or aligning incentives that are too disparate or costly.  So the bad news accumulates and the shareholders notice.  But when they notice it, they don’t just notice the most recent bad news, they notice all of it.  It is the accumulation of all of it that makes any of it apparent.

I first observed such a process when I was a consultant to Campbell’s Soup in the mid/late nineties (mainly 1997).  Campbell’s knew that what Wall St. cared the most about was top line revenue growth.  Campbell’s was seen as a company with “flat growth” in a market that wasn’t expanding.  To get their share price up, they needed to both promise and deliver on growing sales.  So it was absolutely critical that Campbell’s met its quarterly sales volume targets.  But, sadly, the demand for soup was not growing very much.  So to make their quarter end sales numbers, Campbell’s used to call their customers (major supermarkets and big box stores) and ask them if they wouldn’t mind placing their orders for next month now, right before the end of this quarter.  They called it the “quarter end load,” because what they were doing was “loading up” their customers.

Of course the problem with this is fairly obvious.  If you “load” your customers at the end of this quarter, your sales will dip next quarter (in the first week or so), and so you’ll be playing catch up at the end of next quarter.  But this is, of course, the short term/long term trade-off at the heart of the scheme.  Today, your share price stays strong.  Tomorrow, it is likely to be weaker.  But tomorrow is a ways off (3 months in this case).  Lots of things can happen.  Maybe soup demand will finally take off!  Maybe (the individual salesman thinks) “I won’t be in this job in 3 months.”  Maybe (the CEO thinks) “I won’t be in this job in 3 months.”

And once they started thinking creatively about this, they didn’t need to be confined by a 3 month window.  At some point, somebody had the brilliant idea of using trucks as carriers of phantom orders.  Rather than try to convince Ralph’s to take extra soup before they wanted it, they placed orders for Ralph’s and put them on trucks.  Then, when the next quarter started, they let Ralph’s cancel the orders.  So the trucks just come back.  You just pay a little extra in freight.  Of course, freight costs go up, but that’s ok because freights costs are influenced by all kinds of factors, including energy prices and various complexities having to do with order sizes and what not.  In other words, even if freight costs consistently go up because of quarter end loading, it is going to take a shareholder a really long time to figure this out.

But such charades cannot continue forever.  Eventually, the phantom growth in soup sales is too great for all the trucks and all the stores that might discretely carry excess inventory.  So what to do?  I wasn’t at Campbell’s long enough to see how they handled it, but I know the general corporate strategy.  Find an event that permits you to “credibly” take losses and then write-down all of your bullcrap in one fell swoop.  If all of your dust is accumulating under the rug, you wait until the plumber has to come fix something, then you kick out all the dust and say “that plumber sure brought in a lot of dirt!”  For example, any shock to the market that legitimately reduced soup demand could be used to absorb the accumulated losses.  Rather than demand being down 5% they could claim it was down 15% and write-off all of the accumulated cancellations in one stroke.

This is just one example.  And, as it should be apparent, if these kind of tricks can be played with a product as simple and concrete as soup, one can imagine how it could be done with “financial services” products.

A Healthcare Solution

As I’ve written about in several posts, the current health care system is built on flawed premises.  It mis-applies market principles.  Technically speaking, it assumes that doctors and health insurance companies are “suppliers” and that patients are “demanders” who have an independent preference function.  This is wrong.  In healthcare, patients only demand what the suppliers tell them to demand.  Thus, the system gravitates toward whatever incentives the suppliers have, unchecked by patient “demand.”  The result is:

1. Doctors identify the most lucrative services and organize their practices around delivering those
2. Insurers identify ways to minimize the dollars they pay out.  They try to attract healthy people and dump sick people.

The only thing that holds this process in check, concealing its absurdity, is the fact that doctors have an ethical conscience and the larger scientific community provides some checks and balances on absurd care.  But these balancing factors have limited power.

There is no independent consumer demand, but we do know what consumers want — long term health.  They want to live as long as possible.  Thus, we don’t actually need consumer preferences to set up an incentive system.  A proper incentive system would simply reward suppliers for making people healthy.

This incentive naturally exists in a single-payer system.  By making people healthy when they are young, the single-payer has lower costs when they are old(er).  Another way to do this is to try to use centralized judgments about “best practices” and mandate that insurers follow these (the current Medicare system).  But this system, as we know, is open to gaming and runaway costs.  The current “private system” simply lacks this incentive.  Since people can switch their plans at any time, private insurers are not likely to recoup investments in young, healthy customers in the form of cheaper-to-care-for, longer living older customers.

A system of “health co-op shares” might be able to solve this problem.  The key would be that every insured person would not only have a policy with fees and coverage, their policy would have a “value,” similar to a life insurance policy.  The “value” is an estimate of the cost of caring for the individual in the long run relative to the fees they are likely to pay, based on some standard schedule that includes health metrics (age, weight, cholesterol etc.).

Every person is covered and is the responsibility of some co-op.  The co-op tries to make me healthy.  If I stay in my co-op, the co-op earns a return on my long term health.  Thus, it has an incentive to make me healthy when I am younger.  If, for some reason, I want to leave my co-op, the new co-op I go to has to “buy out” my shares from my old co-op.  The shares would be valued by a standard formula based on my medical history, age, weight etc.  The government, or an independent board, could be the clearinghouse.

The upshot is that my co-op gets a return on its investment for making me healthy regardless of whether I stick with them.  If I stick with them, they get the low costs in the future.  If I switch, they get a payment rewarding their efforts, as they have made me a “high value” client.

There are likely to be important weaknesses to this approach.  I am somewhat wary in the way that it tries to re-apply market principles just because this is what is popular, when a single-payer system is a less convoluted way to achieve a similar result.  That said, a workable co-op system would avoid the major disadvantage of a single-payer or otherwise centrally run system: the only incentive for innovation is in bureaucratic exploitation.  In a co-op system, shareholders could do better if their co-op found a way to make people healthier.

A Healthcare Problem

I had an experience recently that demonstrates the flaw in our for-profit healthcare system.  As part of the prenatal care for my wife’s pregnancy, our doctor recommended that I take genetic screening tests for diseases that have elevated frequency amongst Ashkenazi Jews.  Even though my wife is not Jewish, the doctor suggested this was worth doing.  She suggested that if I came up positive on anything they could then test my wife for only that condition(s).

I mentioned that I was unsure whether my USC student health plan (provided by Anthem Blue Cross) would cover these tests.  Our doctor told us the tests would cost around $250.  We decided to go ahead with the tests.

When we received the explanation of benefits I noticed something odd.  The tests did indeed cost about $250, but I was not billed $250 directly for $250 worth of tests.  Rather, the explanation of benefits showed that the tests cost about $2500 — or roughly 10 times what my doctor had suggested and what I finally paid.

Of this $2500, approximately $1400 was knocked off for “patient savings.”  In other words, it appears that Anthem has a deal with Genzyme, the testing company, such that Anthem subscribers pay a substantially discounted price.  The remaining $1100 was then the amount that Genzyme was to collect.  I paid $50 to cover the remainder of my deductible, leaving $1050 to be paid.  They paid 80% of the remainder and I was to pay 20% as co-payment.

All’s well that ends well, right?  I paid what I thought I would pay ($250).  No, actually.  While I ended up paying a fair price for this service, the way this price was calculated indicates a significant source of unfairness in the system.  Specifically, it is very likely that Anthem paid little or nothing on my behalf for these tests.

Anthem and Genzyme have an ongoing relationship that includes a contract and numerous transactions.  This makes it possible for them to manipulate the pricing of services such that patients pay the bulk, if not the entirety of the actual costs.  Furthermore, in our for-profit healthcare system, it is a responsibility of these companies to engage in this kind of price manipulation.  Since price manipulation allows Anthem to avoid paying claims, they are doing a disservice to their shareholders if they do not engage in this practice.

How does price manipulation work?  It’s pretty simple.  Let’s say the cost of the tests really is $250.  That is, Genzyme wants $250 to run these tests — that is the price at which they supply the tests.

Without price manipulation (and excluding the $50 deductible to make things easier to calculate), payments would work like this:

• Total Cost = $250
• Anthem pays 80% of $250 = $200, leaving $50 to pay
• I pay the $50.
• Thus Genzyme receives $250, I pay $50, Anthem pays $200

But if Anthem is innovative and looking out for its shareholders, there’s an easy way for them to increase profits by avoiding having to pay the $200.  Anthem can create an arrangement with Genzyme as follows…

Genzyme declares the cost of the tests to be much larger than the actual cost, let’s say $2500.  This is the “sticker price” of the service.  This sticker price is arbitrary but uniform across all insurance plans offered by Anthem or any other company.  The sticker price is “arbitrary” in that since no one ever pays it, it can be set anywhere.

For each insurance plan offered by Anthem, Genzyme and Anthem negotiate a “discount” to the sticker price such that Genzyme’s actual price, $250, is what Genzyme ends up receiving from me, the patient.  Thus, if my plan asks me to pay 20% of the total cost, subscribers to my plan receive a “discount”off the sticker price such that the billed cost is equal to 5 times ( 1 / 20%) the actual cost.  In other words:

• Actual cost = $250 (what Genzyme wants)
• Genzyme gives a discount such that 20% of the billed cost = the actual cost, 20 % x billed cost = $250.
• Working backward, 20 % x billed = $250, so $250/20% = billed cost = $1250
• So they want the bill to show $1250.  So they set the discount such that the arbitrary sticker – discount = $1250
• So $2500 (sticker) – $1250 (discount) = $1250 (billed).
• This $1250 (billed) x 20% = $250 (paid by me).
• So all told, Genzyme receives $250, I pay $250, Anthem pays $0.

This can easily be calculated for any plan.  For example, if according to a different Anthem plan the patient only pays 10%, then there is no discount — the billed cost is equal to the sticker price ($2500).  Take 10% and the patient’s responsibility = $250.  Again, Genzyme gets $250, patient pays $250, Anthem pays $0.

Thus, with some elementary math and a bit of foresight, Anthem can avoid paying any money for a portion if its claims.  This scheme will work for any service which I, the patient, will not reject on the basis of the price I have to pay.  As long as I am willing to pay Genzyme’s price, there is no need for Anthem to pay anything.  Thus, for any service or procedure that is non-elective, Anthem does not have to pay and the service provider will get their desired price.  And for any procedure that is elective but not too expensive, Anthem does not have to pay and the service provider will get their desired price.  Anthem will only have to pay when there is an elective procedure that the service provider charges more than I would pay.  In these cases, I won’t buy the service unless Anthem makes up the gap.

Using such a scheme is basic, rational economics.  Any executives who are earning their bonuses ought to have already implemented such systems.  Thus, if Anthem is being competently run, they should be paying for only a small portion of the total claims.  They should be collecting fees but not providing insurance.

This may suggest a potential glitch.  If Anthem is not paying claims, won’t this show up in their books?  I pay $250, Genzyme gets $250, but the bill was for $1250.  How do Genzyme and Anthem account for the $1000 that Genzyme claims Anthem owes but that Anthem doesn’t really pay (because Genzyme doesn’t really want it).  Wouldn’t this come up in auditing?  In other words, it appears that this would look illegal.  There’s a “phantom charge” of $1000 that never gets paid.

These appearances can be easily reconfigured to be perfectly ok.  If Genzyme pays Anthem a general, scheduled “fee” to be a participant in Anthem’s plans, then Anthem can “pay” Genzyme by deducting the phantom charge from this fee.  Let’s say Genzyme agrees to pay Anthem $50,000 a year to be a participant.  When I order my test and Anthem is required to pay $1000 by virtue of the calculations above, they simply book the $1000 against the $50,000.  That is, Anthem tells Genzyme they have “already paid” $1000 of their $50,000, leaving only $49,000 remaining.  Anthem books the expense against receivables and Genzyme books the revenue against payables.  That is just the most direct way.  There are an almost infinite number of ways to account for such phantom payments through the invention of meaningless categories, departments and programs into which these fees can be allocated.

The key factor facilitating these games is that fact that neither Genzyme nor Anthem needs to exchange any funds.  Genzyme wants their money — I pay it to them.  Anthem wants their money, I (or my employer) pays them.  Since neither party needs money to change hands, the goal of this “participation fee” is simply to account for the phantom fees.  The participation fee is just there to serve as a disguise so that it is not obvious that the entire cost of the service is being passed to the consumer.  Technically, at any given point in time, one of the two companies owes the other company money on the basis of the tally of participation fees.  But this money never needs to be paid.  The balance can just be carried over to the next month, year etc.  As long as this fee is set reasonably close to the expected number of transactions, the fee will balance out over time. If the fees start to accumulate too far out of balance, they re-negotiate.

What I’ve described is hardly novel.  These kind of arrangements are common in industries where one company is a broker between an individual consumer and another company.  Such arrangements exploit the “information asymmetry” between the consumer — who is receiving a service for the first time and likely only one or two times in their life — and the companies — who have a regularized relationship that persists over numerous transactions.  In these cases, the consumer will believe almost any quoted price, regardless how distorted, provided what they actually have to pay is not too high.  Meanwhile, the “distortion” of the quoted price can be balanced against a second distortion (the participation fee).  Since the two companies have many repeat transactions, they can set these two distortions against one another and they will balance out over time.

Furthermore, given that this information asymmetry exists, it is the responsibility of publicly traded corporations to exploit it.  That is, if the executives of Anthem are earning their bonuses, they ought to be doing this.  If they’re not, they’re not maximizing profit.  They’re missing an opportunity.

In sum, I hope the preceding has made plain three things people should be concerned about:

1) If you are a consumer, i.e. you have private health insurance: your insurance company might be making you pay for the full, or a very large portion of the full, cost of the services you receive while pretending to insure you against phantom fees.  Thus, you might be over-paying.

2) If you are a shareholder, i.e. you own stock in a private health insurance company: your insurance company might not be making its customers pay for the full, or a very large portion of the full, cost of the services they receive while pretending to insure them against phantom fees. Thus, you might be under-earning.

3) If you are an American citizen: your healthcare system has a contradiction.  Either consumers are over-paying or shareholders are under-earning.  That is, the market conditions (information asymmetries) insist that insurance companies collect revenue without providing services.

This is just one example.

Next Letter to Krugman — Bankers are Wrong

Fantastic column.  The explanation for this whole mess is as hidden and obvious as the purloined letter:

The prevailing economic model is wrong.  The market is not always self-regulating and it does not possess the tools to distinguish when it is from when it isn’t.

When decision makers subscribe to a model that is wrong, three outcomes are to be expected:
1. Their decisions will lead to bad outcomes
2. They will be surprised by these bad outcomes (because their wrong model provides no plausible connection between their decisions and these outcomes)
3. They will deny the possibility that their decisions caused the problem (because, again, their wrong model provides no plausible connections).

In other words, it is as though a majority of the world’s financial resources were tied up in a belief in the geocentric model of the universe.  The earnesty and self-confidence of the true believers is beside the point.  Their predictions (and thus their bets) will be wrong and will continue to be wrong.

Krugman on Banking Incompetence

Since this belief is almost completely unfalsifiable, please indulge me the fantasy that my e-mail to Krugman (here) had some influence on his column today (here).

Letter to David Brooks — Any Reform is Good Reform

I wrote this in response to this column by David Brooks.

The argument in your column today is based on the assumption that a “bad bill” — one that does not address the fundamental incentive problem — is worse than no bill.  Moderate conservatives argued from a similar assumption in justifying their opposition to the cap and trade bill.

This assumption is false.  It neglects the benefits of any bill that jostles the system.  More specifically, it fails to account for the fact that the current system’s stability is part of what makes it difficult to change.

The current system is failing for two reasons.
1. The incentives for health care provision are perverse — they encourage expensive treatment with minimal health improvement effects
2. The incentives for health care system advocacy are perverse — they encourage providers, drug companies, and insurers to defend the status quo.

Most people recognize that #2 influences #1:  the provision incentives are locked in place because if the advocacy incentives don’t recommend change.  Less obvious is the way that the advocacy incentives are influenced by the provision incentives.  Specifically, because the provision incentives are locked in place, the advocates all know exactly what behaviors and policies are best for them given these incentives.  Thus, they have a strong incentive to organize around and advocate to keep the system as it is.  They resist reform because they know precisely what reforms they don’t like and why.

If providers and insurers were less certain, and more confused, about how to exploit the system to their own advantage, they would be both less likely to engage in such exploitation and less likely to invest themselves in blocking changes to a system they no longer know how to exploit.

Certainly, a “good bill,” one that appropriately re-aligned incentives, would be much better than a “bad bill” which arbitrarily screwed them up.  But a bad bill that creates confusion is better than no bill which, implicitly, increases the investment in what we know does not and will never work.

A bad bill will, almost certainly, send the country into a tizzy over health care.  And it should.  In one year we might have a real debate, and a substantive discussion, about how to fix a system that everyone knows isn’t working and no one can be certain how to fix, rather than the phony debate we’ve had about a system that no one believes is working but too many know how much they stand to lose if it were fixed.