Econ 101, Hayek, and Why We Are Losing the War against Drugs

Last week The New York Times reported that the drug cartels, after shaking the political and economic structures of Colombia and Mexico to their foundations, are moving into Central America. Just one more sign, as if we needed it, that the United States is losing its endless war on drugs.

No one who has ever taken Econ 101, or read the works of Friedrich Hayek, should be the least bit surprised. The drug cartels are strong because the US strategy in the drug wars makes them strong. Here's why.

First, what we learn from Econ 101. The key concept is price elasticity of demand—the percentage change in quantity demanded associated with a one percent increase in the price of a product. If a one percent price increase reduces the quantity people buy by more than one percent, demand is said to be elastic. If the quantity sold falls less than one percent, demand is said to be inelastic. Elasticity, in turn, determines what happens to the seller's total revenue when the price changes. If the percentage change in quantity is greater than the percentage change in price, demand is elastic, and revenue goes up when the price falls. (For example, suppose you can sell 100 widgets at $1 apiece and 120 when you cut the price to $.90. Your revenue goes up from $100 to $120.) If the percentage change in quantity is less than the percentage change in price, demand is inelastic, and revenue goes up when the price rises. (Suppose you can sell 100 gadgets at $1 and that you still sell 90 if you raise the price to $1.20. This time it is a price increase, not a decrease, that will increase your revenue.)

What is the elasticity of demand for illegal drugs? Intuition suggests that demand should be inelastic. If cocaine, heroin, and the rest are addictive, people who use them will not find it easy to kick the habit just because the price goes up a bit. Econometric studies of the question are hampered by the fact that drug lords don't post accurate price and revenue data on their web sites, but such research as has been done tends to confirm the hypothesis of inelastic demand. For example, one survey of the literature found that a 1% increase in the price of cocaine would tend to reduce consumption by only 0.51 to 0.73 percent, solidly in the inelastic range.

This gives us our first clue as to why the war on drugs isn't going so well. The main strategy is interdiction of supply. To the extent interdiction succeeds in reducing supply, it drives up the market price. With inelastic demand, a higher price means more revenue for the drug cartels.

Note that more revenue for the drug cartels does not necessarily mean more profit, because interdiction efforts also raise suppliers' expenses. However, from a public policy point of view, it is the expenses that do the damage, not the profits. If drug lords just earned profits, they would probably spend them harmlessly on fancy cars and villas. It is not so harmless to see their expenses rise. Those consist largely of salaries paid to thugs who guard shipments and shoot anyone in the way, bribes to officials on both sides of the border, and pay and equipment for more thugs who are assigned to inter-gang warfare, with innocent victims caught in the crossfire. With inelastic demand, a higher price for drugs means more revenue available to finance all of those things. To the extent that is the case, the interdiction strategy on which the war against drugs is based is self-defeating.

The inelastic-demand model of the war on drugs cannot be the whole story, however. In its simple form, it cannot explain the paradox that while drug violence is on the rise, the prices of cocaine and heroin have been falling steadily for decades. How can that be?

One possibility is that demand is elastic in the long run even though it is inelastic in the short run, a pattern that can be observed for other commodities, as well. It is a pattern that accords with the intuition that an addicted user will not forgo the drug even if the price goes up (inelastic short-run demand), but that cheap drugs might, over time, attract new users (elastic long-run demand). For example, one study found that between 1981 and 1995, the price of cocaine fell by a factor of 5 while the number of emergency room admissions mentioning cocaine increased by a factor of 15. (This interesting graph from the study shows the pattern holding for heroin as well as cocaine.)

Although long-run elastic demand could explain why drug cartel revenue has held up in the face of falling street prices, it cannot explain the price decrease itself. The price decrease suggests that some of the cartels' revenue has gone to investments in capital and technology, and that those investments, over time, have shifted the supply curve downward, more than offsetting the efforts of the drug wars to push it upward.

As one example of the willingness of the drug cartels to undertake investment and innovation, consider the development of drug-smuggling submarines. When satellite surveillance and more extensive patrolling raised the risk for surface boats, smugglers began building primitive semisubmersibles that evaded detection by riding just below the surface, but they were not a perfect solution. The next step is indicated by the recent discovery by the U.S. Drug Enforcement Administration, working together with Ecuadoran police, of a 100-foot fully submersible submarine. "The submarine’s nautical range, payload capacity and quantum leap in stealth have raised the stakes for the counterdrug forces and the national security community alike," commented the DEA's Jay Bergman.

The growing viciousness of the drug wars and their destabilizing impact both on the United States and its allies cannot be explained by economics alone, however. That is where some of Hayek's insights come into the picture. In one of his most important books, The Road to Serfdom, Hayek examines the internal dynamics of totalitarian movements. This passage from the chapter "Why the Worst Get On Top" applies to the case at hand with only minimal editing:

Yet while there is little that is likely to induce men who are good by our standards to aspire to leading positions in a [drug cartel], and much to deter them, there will be special opportunities for the ruthless and unscrupulous. There will be jobs to be done about the badness of which taken by themselves nobody has any doubt . . . and which have to be executed with the same expertness and efficiency as any others. And as there will be need for actions which are bad in themselves, and which all those still influenced by traditional morals will be reluctant to perform, the readiness to do bad things becomes a path to promotion and power. 

The point of this is that drug cartels are like normal business in some ways, but not in all ways. If cocaine and heroin were legal products like tobacco and alcohol, their producers' revenue would  still respond to changes in price as predicted by elasticity, and increases in revenue would still be devoted, in part, to innovation and capital investment aimed at expanding supply. But those businesses would not share the extreme badness of the drug cartels. It is not the nature of their products that makes drug gangsters so readily engage in murder, kidnapping, and other forms of mayhem. Rather, the conditions in which skill and enthusiasm in committing acts of violence become a path to promotion and power are created by the very fact that cocaine and heroin are prohibited substances, and those conditions are only intensified the more vigorously the prohibition is pursued.

What is the alternative? A strong case can be made for full legalization of cocaine and heroin, on a par with alcohol and tobacco. (For a sampler, see these items from the Drug Policy Alliance, the Economist, and the Guardian.) Another excellent source of material in favor of legalization is the web side of Law Enforcement Against Prohibition, where you can find the views of former undercover narcs, sheriffs, and judges, all intimately familiar with the unintended consequences of prohibition. Short of legalization, a demand-related approach that treated drug addiction as a public health problem, not a law-enforcement problem, would produce less violence abroad and fewer unintended consequences at home than present US policy. At any rate, that is the answer you come to if you look at the problem in terms of Econ 101 and Hayek.



Follow this link to view or download a short slideshow on the economics of the war on drugs.

Will Central Banks Accommodate the Oil Price Shock?

Inflation rates are rising in the world's major economies. The consumer price index rose by half a percent in the United States in February, equivalent to an annual rate of 6.2 percent. Consumer prices rose at a 4.4 percent annual rate in the UK and a 2.4 percent rate in the euro area. All three central banks have explicit or implicit inflation targets of 2 percent or less.

In all three economies, rising oil prices accounted for a big part of the increase of inflation. That fact poses a dilemma for monetary policy. Should central banks tighten monetary policy to counteract the effects of oil price increases and prevent general inflation? Or should they instead accommodate oil price increases with easy monetary policy, in order to maintain growth of output and employment? Two problems make the choice a difficult one.

The first problem is that nothing central bankers can do will prevent an increase in world oil prices from harming an oil-importing economy. It must either be left with fewer other goods and services after paying for the oil it imports, or learn to live with less oil, or go deeper in debt, or do a little of each. Monetary policy, at best, can only determine what form the damage takes.

The second problem is that central banks have little direct control over the real economy, as manifested in variables like real GDP and employment. By and large, monetary policy can only control the growth of nominal GDP. If it applies its policy instruments correctly, a central bank could, for example, cause nominal GDP to grow at four percent per year rather than 0 percent per year. However, it cannot do much to determine whether that four percent nominal growth will consist of 4 percent greater output of real goods and services, without inflation; 4 percent inflation without growth of real output; or some combination of inflation and real output change that adds up to four percent.

Putting these two problems together leaves the central bank of an importing country with limited options when an oil price shock hits:

1. It can tighten policy to keep inflation from rising. Doing so will cause real GDP to decrease, or at least to lag behind the growth of potential real GDP. The resulting negative output gap will cause the unemployment rate to increase.
2. It can use expansionary monetary policy to try to offset the impact of oil prices on real output and employment. However, doing so will cause nominal GDP to grow faster. Given the negative impact of the oil shock on real GDP, inflation will accelerate.
3. It can compromise by doing nothing, that is, hold the rate of growth of nominal GDP to its previous path, despite the oil price shock. The result will be intermediate between Cases 1 and 2, that is, there will be some increase both in inflation and unemployment.

None of these options is completely satisfactory. None of them fully neutralizes the harm done by the oil price increase. The choice among them depends on the phase of the business cycle at the time oil prices spike, the preferences of the monetary authorities,the legal framework they work in, and the need to coordinate monetary policy with fiscal policy. Those factors play out somewhat differently for the central banks of the United States, the UK, and the EU, so we should expect different policy decisions.

The situation in the UK is shaped by the aggressive program of austerity being followed by the Conservative-Liberal Democrat coalition government that was elected last year. The program proposes reducing government spending by nearly a fifth and cutting half a million government jobs. Austerity is not limited to cuts in discretionary spending. There are cuts to entitlements, including a scheduled increase in the retirement age, cuts to a health-care system that is already relatively austere by European standards, decreases in defense spending, and tax increases.

A case can be made for the UK's austerity program, considering that the budget deficit in 2010 was among the largest of all developed economies. However, it came at a time when the British economy was just beginning to recover from recession. In the fourth quarter of 2010, real GDP actually decreased. That left monetary policy with the burden of preventing a full-blown double-dip recession. The Bank of England, which had already lowered its main policy interest rate to 0.5 percent, undertook further expansionary policy with a program of quantitative easing. The combination of low interest rates and QE was expected to restore real GDP growth in 2011, but only at 1.7 percent, not enough to keep up with the growth of potential GDP.

Given the circumstances, the Bank of England, so far, has opted for accommodation. Despite January and February inflation more than twice the bank's target rate of 2 percent, six of the nine members of its rate setting committee voted to keep rates low at their most recent meeting. To try aggressively to bring down inflation at this point would not only undermine already-weak economic growth, but would also risk failure for the fiscal austerity plan itself, which depends for its success on a growing tax base and a falling unemployment rate.

In the euro area, circumstances would also appear to favor accommodating the oil shock, or at least taking a neutral stance. Real output growth in the euro area, as in the UK, is expected to be weak this year, just 1.6 percent. Inflation in February was less than half a percent above the 2% target rate, a smaller overshoot than in the United States or the UK. The ECB's policy interest rate, unlike those in the UK and the United States, was never cut below 1 percent. Several euro area economies, notably Greece, Ireland, and Portugal, are in the midst of stringent fiscal austerity programs, which could be derailed by a tightening of monetary policy.

Nonetheless, it appears that the ECB will soon raise interest rates. One reason is the uneven pace of euro area growth. Although peripheral members of the euro are struggling, growth in the core economies of Germany and France is strong. More importantly, the ECB is more inflation averse than the Fed or the Bank of England. The treaty that brought the ECB into existence gives the central bank a strong mandate to focus single-mindedly on inflation. Willingness to take that mandate seriously has been a litmus test for appointments to its executive board.

As one token of its hard-line approach to inflation-fighting, the ECB focuses exclusively on headline inflation, which includes all goods and services. Other central banks pay more attention to core inflation, which excludes volatile food and energy prices, and is currently running well below headline inflation. As a result, the ECB's official inflation target of 2 percent, although nominally on a par with those of the United States and the UK, is effectively more stringent.

Also, the ECB appears to give more weight to the issue of credibility. It seems to fear that the slightest sign of weakness would call its inflation-fighting credentials into doubt. Policy makers at all three central banks would agree, in principle, that credibility is important. None of them want to see the emergence of long-term inflationary expectations on the part of firms and households. However, the Fed and the Bank of England are more willing to gamble on public understanding that any present departures from strict inflation targeting are driven by circumstances, and do not justify an increase in long-run inflation expectations. [Footnote: On April 7, the ECB raised its benchmark interest rate a quarter of a percentage point.]

Last, we come to the Fed. In some ways, the case for accommodation seems weaker in the United States than in the UK or the euro area. US GDP growth in the fourth quarter of 2010, at a revised 3.1%, was stronger than in the UK or the euro area, and forecasts for 2011 growth, running at 3% or better, are also higher. January and February inflation, as measured by the month-to-month increase in the headline CPI, was the most rapid of the three economies. The Fed's policy interest rate, set at a range of 0 to 0.25 percent, was the lowest of the three. Finally, as in England, the Fed had gone beyond low interest rates to engage in a vigorous program of quantitative easing.

What is more, the Fed, unlike the Bank of England, does not face the need to maintain easy monetary policy as an offset to tight fiscal policy. On the contrary, US fiscal policy, especially after December's new round of tax cuts, remains strongly expansionary. Neither the administration's budget, nor any actions taken to date by Congress, come close to dealing seriously with a budget deficit that continues at record levels.

Yet, despite these circumstances, the Fed seems least likely of any of the big three central banks to tighten its policy in response to rising oil prices. As in the case of the ECB, both legal and attitudinal factors come into play. Unlike the ECB, the Fed, by law, is tasked with balancing price stability against the need to fight unemployment, which remains very high. Also, the Fed, more than other central banks, focuses on core inflation, and on measures of expected inflation, neither of which is rising as rapidly than the headline CPI.

Unless some strong indications of higher inflation emerge, for example, a sharp increase in long-term interest rates, it seems almost certain that the Fed will keep interest rates low and carry its current program of quantitative easing through to its scheduled completion in June. At that point, if oil prices are still on an upward trajectory, if Congress has still done nothing about the deficit, and if there are signs that headline price increases are spilling through into core inflation and indicators of expectations, a turn to a less accommodative policy becomes likely.

Follow this link to view or download a short slideshow on accommodation of price shocks. The slideshow incorporates simple macroeconomic analysis.

Move Over Ethanol, Market Forces Favor CNG as a Gasoline Replacement

Ethanol is finally getting the bad press (1) (2) it richly deserves. Cracks are even beginning to appear in its once-solid support on Capitol Hill. In April, the Senate Environment and Public Works Committee plans to hold hearings that are expected to skewer ethanol. The Committee is led by Democratic Chair Barbara Boxer and ranking Republican James Inhofe, both committed foes of burning food to run our cars.

However, whether or not Congress has the courage to cut ethanol subsidies, corn-based fuel faces a more fundamental challenge, this one from market forces. Although it has not been widely noticed, the one-two punch of the latest oil price spike and wider development of unconventional natural gas, including shales, tight sands, and coal-bed methane, have pushed the gap between the prices of oil and gas to a record high. Click through to this nice little graphic from The New York Times, and you will see that on an energy-equivalent basis, oil now costs four times more than gas. As recently as 2005, gas was actually the more expensive of the two fuels.

But run your car on natural gas? Isn't that one of those loony ideas from the inside back cover of Popular Science? No, not at all. Compressed natural gas (CNG) is a fully proven, off-the-shelf technology in wide use around the world. Perhaps only its very simplicity and low-tech reliability have kept it from catching the public imagination in the United States.


I first encountered CNG as an automotive fuel several years ago when I was teaching in Bulgaria. You may associate Bulgarian transportation technology with horse-drawn carts and Soviet-era sidecar motorcycles, but in fact, Bulgaria is way ahead of us when it comes to inexpensive, low-emission automotive fuel. My wife and I rented a car from a neighbor to make a weekend getaway to nearby Greece. Very ordinary on the outside and far from new, the car turned out to have two fuel tanks, one for CNG and one for gasoline. In Bulgaria, all the filling stations had CNG pumps, self-service just like those for gasoline, distinguished only by funny-shaped nozzles. CNG was less widely available in Greece, so before the weekend was over, we finally filled up the gasoline tank (at more than twice the price). After doing so, we threw a switch under the dashboard and kept right on driving without noticing the difference.

So why don't we use CNG in the United States? Well, some people do. Fleets of buses and delivery trucks, including many UPS vehicles, are some of the biggest users. Honda sells a CNG-powered version of the Civic, the Honda GX, in the United States. Many major manufacturers sell CNG cars elsewhere in the world. Presumably, they could enter the US market quickly if there were a demand. In addition, several small companies make kits that will convert a variety of gas and diesel cars and trucks to CNG or dual fuel use. NGV America, an umbrella organization for promoting natural gas vehicles, maintains a useful business directory for anyone wanting to jump on the bandwagon.

Of course, there must be a downside to CNG. Otherwise, with a potential fuel price advantage of 2:1 or better and cleaner operation, everyone would be using it.

Limited range is one disadvantage. CNG tanks are bulkier than gasoline tanks. The Honda GX has a range of about 200-250 miles, half that of the gasoline model, and the fuel tank takes up room in the trunk. Still, 200 miles is better than the range of all-electric vehicles like the Nissan Leaf.

Some consumers are also concerned about the safety of CNG, but the industry claims it is safer than gasoline. Gasoline, after all, is incredibly dangerous stuff. The only reason we are crazy enough to drive around every day with enough gasoline in our tanks to blow us to smithereens is that we are used to it. Anyone who is really safety conscious should stick to diesel.

Another barrier to wider use of CNG is a lack of filling stations. There are more than 1,000 CNG filling stations in the United States, but only about half of them are open to the public. There are clusters of public stations in California and New York, but elsewhere they can be few and far between. If you don't have a CNG station nearby, a company called FuelMaker sells a home fueling kit, which connects to the natural gas main in your home. However, unlike commercial filling stations, the home device takes several hours to fill your tank, and the device costs several thousand dollars to purchase and install. Of course, the scarcity of filling stations is much less of a problem for dual-fuel vehicles like the one I drove in Bulgaria. Unfortunately, although dual-fuel is a realistic option for converted vehicles, the Honda GX is CNG only. No one sells a road-ready dual-fuel vehicle in the United States.

Probably the biggest barrier to wider use of CNG in private cars is the high cost, up to $20,000 or more, of converting existing vehicles. At that rate, you might hope to pay off the conversion of a fuel-hungry pickup or SUV, if you drive a lot, but the cost can be prohibitive for a small passenger car.

It turns out that the high cost of conversion is one of the hottest controversies on CNG web sites and chat boards. Evidently, the biggest component of the cost of CNG conversion is compliance with strict EPA regulations and even stricter state regulations in California. Conversion kit makers must go through a complex certification process that costs $200,000 or more, and each certification applies only to a single engine type. Furthermore, you can't just buy a kit and install it yourself. Installers also have to be certified, adding another layer of cost. If you look around on the web, you can find a gray market in uncertified kits made elsewhere in the world. You can install one in your own driveway for as little as $1,000, but that is clearly a buyer-beware proposition. Considering how inherently clean CNG is, it is ironic that the EPA bans uncertified conversions on the grounds that they constitute tampering with an approved emission control system.

In the last Congress, Sen. Jim Inhofe and Rep. Dan Boren, both of Oklahoma, introduced legislation that would have promoted CNG use by streamlining the certification process. Unfortunately, despite
attracting several co-sponsors and the support of Senate Majority Leader Harry Reid, the legislation failed to make it through the Congressional gridlock. Meanwhile, those wanting to pay the high up-front price for an approved conversion can get part of the cost back through the same clean-energy tax credit used to promote electric vehicles. However, first making it unnecessarily costly to convert to CNG and then partially subsidizing those same high conversion costs hardly seems like a shining example of optimal public policy.

That brings us back to market forces. The price gap between CNG and gasoline is now higher than it has ever been. Although the gap will always vary a little, depending on geopolitics and on the number of gas and oil wells drilled each year, it seems likely that a substantial cost advantage for CNG is here to stay. Given that reality, rather waiting for top-down legislation to open the door for wider use of CNG on the highway, a bottom up scenario seems more plausible. Continued low CNG prices will help spread use of that fuel for fleet vehicles and, at the same time, should steadily increase the user base of converted private cars and trucks. It is a classic case where the long-run supply and demand elasticities are greater than short-run elasticities. CNG users, kit manufacturers, installers, and fuel sellers will gradually become stronger as a political force. As they do so, the legislative and regulatory climate for CNG should become more favorable.

After all, our government can't be that inept, can it? Surely, it cannot go on spending billions on fuel-of-the-future pipe dreams like hydrogen fuel cells and budget-busting ethanol subsidies when a cheap, clean, made-in-America alternative is available right off the shelf, right now. Please, tell me it can't.

Follow this link to view or download a brief slideshow on CNG vehicles.

What Can the US Learn from the French Health Care System?

As reported in the first post in this series, the French health care system comes in at or near the top of international rankings, while the US system falls well down the lists. It stands to reason, then, that US health care reformers should have something to learn from the French experience, but just what? There seem to be lessons both for those who are optimistic about US health care reform and those who think reform will be difficult.

On the optimistic side, the French experience clearly shows it is possible to have universal access to health care of the highest quality while maintaining broad freedom of choice both for patients and doctors. French patients have the right to choose their own primary care doctors, and with only minimal restrictions, to see specialists of their choice. French doctors can choose whatever treatments they believe to be appropriate. That includes even use of cutting-edge treatments like the cancer drug Avastin. (Because that drug, which can cost up to $100,000 per year, does not cure cancer and appears to extend life by, at most, a few months, its use is restricted as not being cost-effective by many US private insurers and also by government health care systems in Canada and the UK.)

Freedom of choice is critical to the politics of health care reform in the United States. Opponents of reform love to play the "socialized medicine" card, which, in the minds of many people, means an impersonal, regimented, system where one stands in line at a government clinic for the first available doctor, who then prescribes a course of treatment according to strict regulatory guidelines. The French health care system is far from fitting that picture.

On the critical issue of costs, the lessons are more complex.

The good news is that their highly rated health care system costs the French 11.2 percent of GDP,  compared with 16 percent in the United States, based on 2008 OECD data. In dollars per capita, the gap is even more dramatic. By that measure, the United States spends exactly twice as much on health care as France, with less to show for it.

There is reason to think that some of the cost-saving features of the French system could be incorporated in US reforms.  Lower costs of administering the medical payment system are one example. France does not have a true single-payer system. Not-for-profit insurance funds closely supervised by the government pay most of the cost of care, but people also carry supplementary insurance, similar to Medigap plans, that cover deductibles and co-pays. Still, despite the involvement of multiple insurers, the French system spends less than half as much on administration and marketing than the 7% of health care costs reported for the United States.

Another area where the French save costs is through more aggressive government bargaining with  hospitals, doctors, and pharmaceutical companies. The US government has done less in this area. For example, under Medicare Part D the government is explicitly prohibited from bargaining for lower drug costs.

Medical malpractice is a third area where would-be US cost cutters might learn from French experience. France uses an approach pioneered in Scandinavia, under which cases of alleged malpractice are decided by special review boards that operate outside the court system. This Scandinavian approach is sometimes compared to the US worker compensation system, in that it is less focused on finding fault than on providing compensation to patients who have been harmed by improper care. Payments are made from a national fund, freeing doctors from the burden of malpractice insurance. Costs of administering the malpractice system are lower than those of adversarial court proceedings, and the chances of freakish "jackpot" awards are lower than when juries are involved.

At the same time, other elements of the French cost control experience are are less encouraging for US reformers. One is the fact that despite all efforts, health care costs have been growing faster than GDP in France, as they have in the United States, and are increasingly a cause for concern. The Sarkozy government has made some efforts to tighten controls, but these have met with opposition. For example, a 2009 reform law that was supposed to strengthen the cost control authority of hospital administrators was perceived by doctors as a threat to their autonomy, and brought them out on the streets in protest.

A final factor that complicates any comparison between French and US health care costs is the fact that French physicians earn only about a third as much as their US counterparts. Although doctors in France are respected, well-compensated, professionals, a medical career there is by no means a guaranteed ticket into the top 5 percent of the income distribution, as it is in the United States. The gap in doctors' earnings makes a big difference for national health care costs. About 20 cents of every US health care dollar is paid to individual physicians and clinics, and that does not count staff doctors in hospitals, whose salaries are included in the 30 cents of the US health dollar that goes for hospital services.

One reason that French doctors can get by on lower earnings is that they do not have to pay for medical education. As a result, they do not begin their careers with tens of thousands of dollars in student debt. Another reason, mentioned earlier, is that they do not have to spend more tens of thousands on malpractice insurance. French doctors also seem to complain less about the burden of paperwork than do those in the United States, presumably because of a simpler system for health care payments. Still another reason for lower earnings is that the French government controls a bigger share of the total health care system, and uses that market share to drive a harder bargain on fees. Finally, we should keep in mind that GDP per capita is almost 20 percent less in France than in the United States, so on average, everyone there earns less.

Nonetheless, despite lower earnings, there is no indication that France suffers from a doctor shortage. According to OECD data, France has 30% more professionally active physicians per capita than the United States.

What should reformers make of the fact that French doctors produce such good results while earning less? It would be an oversimplification to draw the inference that across-the-board pay cuts should be a priority element of US health care reforms. Attempts to cut payments to doctors have not always worked well. Low reimbursements have been blamed for difficulties in finding doctors willing to take new Medicaid patients. Fears that the same could happen to Medicare has led Congress to overrides previously mandated cost-cutting formulas.

Instead, the earnings differential would seem to carry implications more like the following:

• First, replication of the main elements of the French system in the United States could very well end up costing considerably more than in its home country. The difference in doctors' earnings alone would probably erase half of the cost differential that the French system currently enjoys.
• Second, doctors' earnings cannot be considered in isolation. The combination of high prospective earnings, high student debt, and the US malpractice system create a risk-reward profile for a US medical career that is quite different from that in France. Over time, changes in policy could plausibly attract sufficient numbers of qualified people to the medical profession even if the package included  a lower equilibrium level of earnings. But to say that is quite different than to say that doctors who are already practicing in the United States would or should accept immediate pay cuts.
• Third, to some extent, the earnings differential between US and French doctors reflects decisions that shift costs from one government account to another without any real saving to the economy. Lower payments to doctors may be at least partly offset by higher government spending on education and costs of administering the malpractice compensation system.

So, what is the bottom line? What can reformers in the United States learn from the French health care system?

On the one hand, the French experience really does make it look like Americans are not getting their money's worth. It shows that the possibility of high quality combined with universal coverage is a reality, not a utopia. Furthermore, such a result can be achieved without sacrificing freedom of choice either for doctors or for patients. In fact, choices of doctors and treatments are in many case less restricted by the French public health care system than by private insurance companies in the United States.

On the other hand, the prospect of replicating the admirable performance of the French system in the United States and at the same time realizing a cost saving of something like 5 percent of GDP seems less realistic. For one thing, as discussed above, there are reasons to think that running the same kind of system in the United States would be inherently more costly than in France, not to mention the fact that costs are rising there, too.

What is more, the politics of cost control are daunting. During the debate over the 2009 US health care reforms a broad variety of cost-cutting proposals were raised, ranging from streamlining the administrative costs of payments and record keeping, to malpractice reform, to striking harder bargains with drug companies. One by one they were rejected or watered down to the point of tokenism. There is a reason that happens. Every dollar of national health care cost represents a dollar of income for someone. Insurers, drug companies, hospitals, medical associations, and other health care providers do not hesitate to deploy the full arsenal of political contributions and lobbyists to defend their interests.

If Americans want a better health care system—they should want one, and they deserve one—they will probably have to pay about as much for it as they pay for their current dysfunctional one, at least initially. Reform is going to require getting at least large parts of the medical-industrial complex on board, and taking a way a big chunk of their revenues is not a good way to start.

As a quid pro quo, however, insurers, drug companies, hospitals, doctors and all the rest will have to accept measures to restrain costs in the future. That includes moving, over time, to a regime in which doctors can expect lower earnings in return for relief from the financial burdens of malpractice insurance, medical school costs and excess paperwork. As part of the same deal, pharma companies should expect harder bargaining from the government, insurance companies should accept measures to cut administrative and marketing costs, and so on. In many ways, those are bargains the French government seems already to have struck.

Follow this link to view or download a short slideshow comparing the French and US health care systems. Thanks to Charlie Janeway for comments on an earlier draft.

How a Price-Smoothing Oil Tax Could Help Make This the Last Oil Price Shock

It must be Groundhog Day. Events in Libya have pushed world oil prices over $100 a barrel yet again. Retail gasoline prices, usually low this time of year, are at an all-time seasonal high. Are we in for another round of the same-old, same-old? A replay of Jimmy Carter pledging, "Never Again!" and then doing nothing? Or is there some way we can make this the very last oil price shock?

Producing countries have already figured out how to cope with the curse of oil price volatility. Over the years, producing countries, from Norway to Saudi Arabia to Russia, have established national wealth funds that build up when prices are high and run down when prices fall. Meanwhile, consuming countries have done next to nothing.

The US Strategic Petroleum Reserve, designed to offer short-term protection against physical interruptions of supply, is not intended to serve the purpose of price stabilization, nor would it be capable of doing so. But there is a way. Now would be an ideal time to revive an old idea, a variable oil tax that would reduce price volatility and, at the same time, offset the national security and environmental harms of oil dependency.



A variable, price-smoothing oil tax would work like this. Congress would establish a floor oil price of X dollars per barrel. Whenever the world market price P fell below X, an oil tax T would come into effect to fill the gap: T=X-P. Whenever the price rose above the floor, the tax would be zero. Nothing could be simpler.

Why would it be a good idea? There are two parts to the answer, one making the case for an oil tax in general, and the second explaining why a variable tax would be better than one with a fixed rate.

The main argument for a tax of any kind is that oil consumption has adverse spill-over effects on third parties—effects that are not taken into account when bargaining between producers and consumers sets the price. Economists call those spillover effects externalities. The two most commonly cited externalities of oil consumption are effects on national security and effects on the environment. Imposing a tax on oil would be one way to mitigate them.

Consumption of oil has a negative impact on national security because so much of the world's oil comes from countries that are corrupt, authoritarian, anti-American, or all of the above. Any increase in US oil consumption pushes up the world price and enriches bad guys in exporting countries. Any reduction in oil consumption undercuts them. An oil tax would insert a wedge between the price paid by US consumers and the price received by foreign producers. To the extent it raised the US price at the pump, it would encourage conservation and investment in alternative energy. To the extent that it lowered the world market price,the tax would take money from the pockets of the bad guys.

An oil tax would be much more effective than the current US oil security strategy, which consists of buying as much as possible from friendly, nearby countries like Canada and Mexico. That strategy does provide some limited protection against a revolution or embargo that might cause a physical interruption of supply, but it does nothing to mitigate negative national security spillovers that operate through prices. The world oil market operates as one big pool. If something sends the price up, as is happening right now, it goes up for everyone. Canada and Mexico are our friends, to be sure, but they are not so friendly as to sell us their oil below its market price. If excess US consumption drives the world oil price higher, it drives it higher for bad-guy producers, too, even those from whom we do not directly buy any oil.

As for environmental externalities of oil consumption, they have been so widely discussed that there is little to add. In recent years, much of the discussion has focused on climate change from oil-related CO2 emissions. But even if you are a climate-change skeptic, don't forget there are other environmental effects, too. Low oil prices and high consumption mean more local smog and more traffic congestion, regardless of any effects on polar bear habitat. To the extent an oil tax cuts consumption, it improves the environment across several fronts.

Of course, national security and environmental objectives would also be served by a conventional, fixed-rate tax. Why would a variable tax would be better?

One reason is that a variable tax would provide an anchor for expectations about oil prices. During episodes of high prices, investments in conservation and alternative energy production become more attractive, but there is also a risk. If oil prices crater again, those investments will not pay off. Knowing that oil prices would not be allowed to drop below a stated floor would make it less risky for consumers to buy energy-efficient cars and entrepreneurs to build plants to produce biodiesel from pond scum. Greater investments in conservation and alternative energy, in turn, would help moderate the next upward movement of oil prices.

Second, a variable oil tax would help mitigate the impact of oil price spikes on the business cycle. James Hamilton has written extensively on that subject. (See here, here, and here.) He points out that most recent oil price spikes, including that of 2008, have been followed by US recessions, and argues that the depth of those recessions has been greater than would be predicted by the effects of higher oil prices acting alone. One reason seems to be that retail gasoline prices have such a high visibility that price spikes disproportionately undermine consumer confidence. Another is that oil price spikes disrupt the automobile market. They not only harm new cars in general, but also shift the mix from large to small cars. Widespread layoffs have followed at US auto companies, which have traditionally specialized in SUVs and light trucks. Finally, says Hamilton, it appears that high oil prices in 2008 exacerbated other factors that were undermining the housing market. As evidence, he cites the fact that the prices of homes in locations that required long commutes fell by more than those with short commutes.

A third advantage of a variable oil tax compared to a fixed one would be political, especially if it were  introduced at a time when oil prices were already above the chosen floor. Right now, for example, a tax with a price floor of, say, $85 per barrel would produce no immediate pain at the pump, but the knowledge that prices would never again fall below $85 would encourage long-term investments in conservation and alternative energy. Introducing a variable oil tax at a time when prices were already high could make an actual virtue of the often-lamented tendency of politicians to operate on a much shorter time horizon than business investors.

The idea of a variable, price-smoothing oil tax is not going to appeal to everyone. Let me close with two preemptive comments addressed to the most likely critics.

First, to those for whom all taxes are bad: Fine, for the sake of discussion, let's stipulate that all taxes are bad. Still, some taxes are worse than others. The worst taxes are those that discourage businesses from investing in the future while encouraging activities with negative spillovers on third parties. The least bad taxes are those that encourage sensible investment and discourage negative spillovers. Given the current state of the budget, even the most fanatical fiscal hawks concede that we need a federal revenue base of 19 or 20 percent of GDP to have any hope at all of averting fiscal catastrophe. So, if we need more than zero tax revenue, wouldn't it be better to replace really bad taxes, like our loophole-ridden corporate income tax, with less-bad taxes, like a variable oil tax?

Second, to the affordable energy crowd: I've said it before and I'll say it again, if there is one thing we can't afford, it's affordable energy. "Affordable energy" is really a code-word for holding the price of energy below its true cost to the economy. If we don't pay for oil at the pump, we pay for it through the back door, in the form of distorted investment decisions, pollution, and reduced national security. Artificially low energy prices make our economy weaker, not stronger. There Ain't No Such Thing as a Free Lunch. Never was, never will be.

Follow this link to view or download a brief slideshow about the variable, price-smoothing oil tax. Thanks to Henry Lee for comments on a draft of this post.