Perverse incentives and unintended consequences everywhere

I’m a big fan of the books Freakonomics and SuperFreakonomics, co-authored by economist Steven Levitt and journalist Stephen Dubner. I especially like them in audiobook form because the reader, Dubner, throws his voice into a high shrill to demarcate when he is quoting someone else. But I digress.

The books consist of a series of anecdotes that are shocking, bizarre and occasionally inspiring. In the prologue to SuperFreakonomics, the authors tie all of the stories together with this theme. “People respond to incentives, although not necessarily in ways that are predictable or manifest. Therefore, one of the most powerful laws in the universe is the law of unintended consequences.”

I firmly believe that government has an important role to play in making society more just, equitable and civil than it would otherwise be. Whether it’s a police force protecting citizens from the threat of crime or Social Security protecting the elderly and disabled from the threat of poverty, the government is in a unique position to solve certain problems that might otherwise go unsolved.

Yet both of these books include story after story of well-intentioned government policies that went terribly awry because their authors did not predict how they would play out in the real world. In a scathing indictment of government intervention, the authors point out that Franklin Roosevelt — the progressive hero who brought us Social Security — chose to donate his personal funds to the private sector research on curing polio while he was sitting in the Oval Office instead of relying on Uncle Sam. Roosevelt suffered from polio himself, so his contributions to the organization that ultimately became the March of Dimes were the ultimate example of his personal health incentives outweighing his incentives for political gain. Even though he did not live to see it happen, Roosevelt bet on the right horse because it was a private sector team led by Jonas Salk that ultimately invented the polio vaccine.

If you’ve spent any time with me at all in recent years (or if you have read some of my other blog entries), you will know that I am particularly passionate about health care reform. Indeed I was quite pleased when the Supreme Court decided to uphold the Patient Protection and Affordable Care Act, albeit by the narrowest of margins. I see this as an issue of justice since more than 50 million Americans have no health insurance, and millions more are underinsured.

Yet I am a person who tries to listen to the ideas of those who do not share my views. And I have heard a lot of objections to the law. The strongest one that I have heard, though, was the law of unintended consequences. Levitt and Dubner made the best case for this when sharing stories of other government policies gone wrong in decades past. For example, the authors demonstrated how the Americans with Disabilities Act actually discouraged employers from hiring disabled people because they feared lawsuits if they were to ever discipline or fire a bad employee who happened to be disabled.

So, if government is not the answer, what is one to do when faced with a difficult societal problem — especially one as complex and emotional as health care? Simply accept the problem as inevitable?

PPACA is undoubtedly fraught with problems. One unintended consequence of the law has already cropped up: some insurers have responded to the law’s prohibition against denying coverage to children for pre-existing conditions by not offering child-only policies at all. (This is a temporary problem since the law prohibits this practice for all ages starting in 2014 — insurers surely cannot stop selling policies altogether.)

But why would insurers make this tradeoff, even in the short term? Why would they stop selling policies to the parents of healthy kids just because they will have to cover sick kids too? Because health care itself is expensive, and the sick children who can now qualify for insurance are really expensive to cover.

This turn of events should not have come as any surprise to smart policymakers because when there is a lot of money on the line, rational humans invariably will game any system. This goes for insurers, hospitals, doctors, pharmaceutical companies, medical device manufacturers and patients. There is no way to make everybody happy. Any meaningful reform will have big winners and big losers.

Many smart patients will likely choose to pay the individual mandate penalty and go without health insurance until they get sick because the penalty is less than the cost of insurance and the insurance companies will be required to accept them regardless of health status. The higher premiums these gamers will create for everyone else will become what economists call anegative externality — a consequence of one person’s actions that is borne by another person. At least the penalty provides some counterweight to that natural inclination.

So why doesn’t the law go harder after making health care itself cheaper so insurers won’t have such a strong incentive to deny coverage to sick children? Sure, there are some provisions in the law like comparative effectiveness research, accountable care organizations, and health information technology investments, but I suspect the real reason for the kid-gloves approach to costs in the system is because politicians respond to incentives too.

When President Obama and congressional Democrats started working on this law in 2009, they knew that they would face a tough political fight. It was made tougher by Republicans who decided it was in their best political interests to oppose the law unanimously, no matter what provisions it contained. Plus, as politicians who run for re-election, everyone owed a sort of legislative debt to whoever contributed to their campaign funds if they hoped to continue raising said funds.

Since we have already established that health care is expensive, any attempt to reduce costs is invariably going to lead to some belt tightening. And, as humans who respond to incentives, everybody wants somebody else to do the most belt tightening. Are health insurance companies earning too much profit? Are pharmaceutical and medical device companies to blame? What about those high-paid doctors and huge hospital bills? Naturally, with that much money at stake, the biggest players were willing to sink millions of dollars into lobbyists and advertising campaigns to protect their interests.

So, President Obama struck deals — some might say dirty, backroom deals — with PhRMA, the American Medical Association and the American Hospital Association by shielding them from deep cost cutting provisions in exchange for their political allegiance. The Republicans were no better — they partnered with America’s Health Insurance Plans, the U.S. Chamber of Commerce and the Medical Device Manufacturers Association to campaign against the law since these players had so much to lose and the Republicans. Rather than making deals across the aisle, both sides drew lines in the sand and built up their arsenals for an ugly, televised fight that included phrases like “death panels” and “pull the plug on Grandma.” No matter what your ideology, the second half of 2009 was a low point in American politics.

This is another important concern — is it possible for anyone on either side of the aisle to do honest policymaking anymore? Won’t even the most well-intentioned bill authored by the most honest legislator ultimately be corrupted by the time it reaches the President by lobbyists who have become so endemic to the political process?

Perhaps the federal government has a role to play after all, but it is not the role that anybody on the left or right expects. It is neither a role of command and control and micromanagement nor a role of laissez faire, but a role of creating the right incentives for people to do the right thing.

Maybe we should offer big incentives for health insurance companies to cover people with pre-existing conditions instead of penalizing them for denying it. Maybe the pharmaceutical industry should be required to prove the cost-effectiveness of their drugs before the FDA along with safety and efficacy data. Maybe the government can issue huge award checks for the best ideas to solve the health care cost problem.

Maybe the federal government can dispense money to each state government (proportionate to their populations), give a few simple constraints on the results they must achieve (like covering 95 percent of their residents and not denying people for pre-existing conditions) and then create 50 laboratories for health reform plus regular workshops so that state lawmakers can learn from each other’s successes and failures. If one state can achieve the results at a lower cost than what has been allocated, they get to refund taxpayers the difference. And if you don’t like what your state is doing, you can easily move to another state.

I don’t have all the answers. Whatever the government does — or doesn’t do — there will certainly be some unintended consequences.