John Cochrane on Health Care

John Cochrane (famous Chicago economist) gives an interesting podcast on health care with host Russ Roberts.  You can find more thorough remarks in this paper.  I find myself amenable to both free market critiques and lefty critiques of our health care system, because I think the U.S. is at a local minima.  Moving a long distance toward more market oriented Singaporean health care or a single-payer Canadian health care would both be improvements.

I was hoping Russ would press him on one point I can't comprehend, which is central to Cochrane's argument.  First, we agree that insurance should be long-lived and guaranteed renewable.  Meaning, if a person gets sick, the insurance company can't drop them or raise their premiums.  This makes perfect sense to me.  The reason we buy insurance is to insure ourselves from risk.  In this case, the risk of getting really sick in a way that will cost a ton of money for care.  If I buy insurance that only lasts one year and I get cancer, I'll get the benefit for one year, but the next year when I try to renew my premiums will go sky high.  What good is that?  The answer is obvious.  I need to buy "insurance insurance."  I need insurance against the risk that my premiums rise.  Of course, if insurance insurance isn't long lived, I'll need to insure the risk my insurance insurance premiums rise and this rabbit hole goes on and on.  It's turtles all the way down.  This logic leads to the idea that insurance should be long lived.  Rather than buying an infinite number of insurance contracts, I can buy on contract that never expires.

What I can't figure out is this statement?

Now, the “adverse selection” phenomenon, that sick people are more likely to buy insurance, and healthy people forego it, is a big problem. But the insurance company charges the same rate, not because it can’t tell who is sick – a fundamental, technological, and intractable information asymmetry. The insurance company charges the same rate because law and regulation force it not to use all the information it has. If anything, we have the opposite information problem: insurers know too much.

This source of adverse selection is a legal and regulatory problem, not an information problem, and easily solved. If insurance were freely rated, nobody would be denied. Sick people would pay more, but “Health status” insurance shows how to solve that.

As best I can tell by following his links, health status insurance is the insurance insurance I just discussed.  So John's big idea is the asymmetric information isn't a big deal, the real problem is that insurance companies can't charge sick people higher premiums.  

Suppose that two parents have a kid that is covered on their insurance, until he's twenty-five.  Then he has to go to the market and buy his own insurance.  Now suppose when he's twenty-four, he gets cancer.  In John's world his premiums should skyrocket.  I think he would argue that the parents should buy "insurance insurance" for the kid.  The parents need to buy insurance against the kid's future high premiums, before he gets sick.  Obviously, they can't do that after he's diagnosed.  The "insurance insurance" would be too expensive.  They need to do it earlier.  Perhaps, when he is born.  Though what if we find he has complications?  Perhaps, when he's conceived?  But what if the parents have genetic predispositions to certain diseases?  The kid is more likely to become sick, thus the insurance on his future premiums must be higher.  Maybe they'd be high enough that the two parents wouldn't get married, because of the possible complications.  Oh no, two people who love each other can't get married.  What if the grandparents stepped in and helped out?  They could buy "insurance insurance insurance," they could hedge the risk that their son or daughter grew up wanting to marry someone who wasn't as genetically compatible.

Maybe this sounds convoluted, but I'm trying to get to the notion of complete markets.  Complete markets means that all risk that can be insured is insured.  Since we are risk averse, complete markets make us all better off.  If one of our houses burns down, we'll all chip in $100 bucks to get us back on your feet.  The Amish did it literally, but nowadays we do it through insurance companies.  The premium on home insurance is just the $100 bucks that goes to some unlucky person that just watched their home go up in flames.  

But in a truly complete market, ALL risk is insurable. I could insure against a risk, before I was ever born, before I ever had a medical history.  In a truly complete market, we insure all risks at "time zero," before we even exist.  I picture a random soul in heaven, just like all other souls.  One of the risks those souls want to insure against is sickness.  Maybe being born sick.  Maybe being sick later in life.  Basically, they don't know when it will or if it will happen, but there's some risk they'll get sick.  So they get with all the other souls and agree, we'll all put money aside, and whoever gets sick gets the money.  That's insurance.  My question is how much would each put in.  Well, it's obvious they'd all pay the same.  They are exactly alike in every way.  It's only fair.  

The point I'm trying to make is that in John's system, no matter how you slice it, there will be some choke point along the way.  What if we switched from our system to John's tomorrow?  A lot of healthy people would buy guaranteed renewable insurance, but a lot of sick people would be out of luck and face exorbitant premiums.  If we are in a system where everyone is paying a different price for insurance, then we can't possibly be at the complete markets case.  If we aren't at the complete markets case, either John's policy is suboptimal or there is some friction that prevents us from getting to the complete markets case.  So what is it?

The wrench that I haven't thrown in yet is incentives.  If I have guaranteed insurance before I am born, I'm much less incentivized to put effort into maintaining my health.  I may drink like a fish or eat too much.  I may smoke or do drugs.  Maybe I just won't sleep enough.  We make decisions that affect our health.  This is a "friction."  This is a reason that the complete markets case may not work (as if the having to buy insurance before your born wasn't enough).  Maybe this is the sort of important friction John has in mind, because for conditioning on pre-existing conditons he gives these examples in the podcast, "Fat people don't pay more than thin people; smokers don't pay more than non-smokers.  All sorts of things they don't condition on."  Russ corrects him that they can condition on smoking, which in my understanding isn't that big of a bump in premium.  I don't have a problem with insurance companies conditioning on smoking or charging a higher premium on people like me that eat and drink too much.  It's the all sorts of other things I don't want.  What about something simple like being female?  Women have to pay higher insurance premiums, because women have babies.  In a complete market, women would pay the same premium as everyone else.  They'd buy their insurance before they had a gender (or even parents) and pay the same price as everyone else.

Conditioning on effort is fine to the extent that an insurance company can do it.  But what they really want to do is condition on how sick we are.  People with cancer pay more, and I don't see John distancing from that.  I can't imagine by pre-existing condition he really means "big sweet tooth."

I thought I found a lot to like in the essay.  I think there are lots of regulations that make health care more expensive and that the health care market should be more competitive.  But I was really jarred by this statement, "Romney was pushed on what he was going to do, he said: Well, but of course we can't let insurance companies discriminate on pre-existing conditions. Well, once you've done that, you've swallowed the fly--the old lady that swallowed the fly...And once you do that, you've got most of the ACA."  He's really arguing that my disagreement is irreconcilable with his preferred health care solution.  Which makes sense, if my story is correct then charging everyone the same price and mandating everyone buy insurance sounds pretty close to the preferred solution.  Since in a truly compete market, we'd all pay the same health care premiums.  His preferred solution must be a market frictions story, but its a story I can't understand and he spends a good deal of the podcast and paper dismissing frictions in the health care market. If there is a well-formed second best model there, I'd love to know it.

The EMH Isn't Testable and That's OK - Part II

In Part I, we defined the Efficient Markets Hypothesis and introduced the joint hypothesis problem. I don't want to primarily post on zombie debates, but John Quiggin's book gives me a chance to discuss a little bit about what a lot of modern finance is built on, before I start blogging about whether or not stochastic volatility is a risk factor in a linear factor model (stay tuned!).

I'll let Quiggin start us off with his view:

“But as a string of philosophers of science, being with the late Karl Popper, have shown, a theory that can’t be refuted by any conceivable evidence isn’t really a theory at all…The global financial crisis, along with the earlier dotcom crisis has shown that, on any ordinary understanding of its terms, the efficient markets hypothesis can’t be right…So supporters of the efficient markets hypothesis have sought a redefinition that would make it invulnerable to refutation…This argument in one form or another has been put forward by all the leading defenders of the EMH, notably including Eugene Fama and John Cochrane of Chicago and Scott Sumner of Bentley University.”

Quiggin argues in the chapter that trying to squirm out of irrefutable evidence EMH defenders have changed the theory over time to render it useless. That narrative is completely false. Here is Eugene Fama in 1970 in a seminal paper on the EMH, before he was the “father of modern finance” and was just a young professor trying to sort out the theory, “the theory of efficient markets is concerned with whether prices at any point in time "fully reflect" available information. The theory only has empirical content, however, within the context of a more specific model of market equilibrium, that is, a model that specifies the nature of market equilibrium when prices "fully reflect" available information.”

It’s not nearly as elegantly stated as it is in the previously linked podcast, but that's the joint hypothesis problem in its first formulation in 1970. I am really surprised it isn’t front and center in Quiggin’s account of EMH, because it is certainly front and center in any finance course discussing the testing of EMH. The joint hypothesis problem isn't new, and it isn't something that proponents of EMH have been hiding for the last forty-two years.

Is this a sham? In finance, It's pretty humbling to try to create the "right" theory for prices. The world is complicated and modeling that is hard. How many essential types of risk are there? Can I really model them all? Even the most important ones? What about cash flows? Am I certain I can predict how the growth of the internet and technology will effect firm's various business activities? Is it possible to imagine a world where the dotcom bust doesn't happen, a world with a few more Amazon's, a world where the biotech boom that was so desired actually pays the dividends we dreamed about? Believe me, I'm open to the idea that bubbles can occur. Here is a really good case that the dotcom crash was a classic bubble/mania, but let's admit that the endeavor of diagnosing a bubble even ex post is not simple, much less ex ante. We only observe one outcome of many possible futures.

So I've argued that Quiggin's narrative is wrong. Testing EMH may be impossible, but that isn't something Quiggin discovered. Academics have been discussing the joint hypothesis problem, since the EMH's inception, rather than stuck in a self-erected cell built by constant squirming from critics. In part 3, I'll try to argue all is not lost, if the EMH isn't testable.

Quiggin Responds!

John Quiggin, author of Zombie Economics, graciously engages this post I made in response to his book in the comments. He also points to an interesting and easy to read paper he wrote on the equity premium puzzle. My real critique is that the equity premium puzzle isn't an EMH puzzle it's a macroeconomics puzzle. Let me try to explain the difference.

In Quiggin's book and definition of EMH he is confounding two ideas:

    Efficient Markets Hypothesis - prices fully reflect all available information.

    Market Efficiency - a well functioning market will allocate all resources in the best possible way

The second idea is often strictly defined as the First Fundamental Welfare theorem, which basically says that if you make a bunch of assumptions (that aren't true) like markets are perfectly competitive, markets are complete, no externalities and perfect information, then the market outcome is efficient.  In this case, efficient means pareto efficient, a weak notion that means we can't make one person better off without hurting anyone else.

This confusion explains a lot of odd statements he makes, like, "The Efficient Markets Hypothesis implies that governments can never outperform well-informed financial markets."

The first fundamental theorem does say that (under very restrictive assumptions) and if our notion of improvement is limited to pareto efficiency, but the EMH just says markets adjust in the background.  Let's say there is an negative externality called pollution.  A government may be able to enact a policy to limit pollution and make everyone better off, say a tax on gasoline.  The EMH just says that stocks will adjust to that new policy.  The tax on gasoline will limit the amount of gasoline consumed, so companies like Exxon and BP will see their profits decrease.  People will probably drive less, so Ford's stock will go down.  The EMH just says that security prices will reflect all available information.

The EMH is still not a weak hypothesis.  If we imagine that the government is deciding on whether or not to enact the policy, the market prices must be constantly adjusting to the updating chances that the knew policy will be enacted.  The prices must be the best guess for the properly discounted value of future dividends for every stock in the market, even stocks that will only be barely affected by the law, like a theme park that will lose profits, because it is far out of town and a few less people will want to make the drive.

Digesting Justinian

My last post went after some dumb lessons people were drawing from ancient Rome.  In the spirit of being constructive, here's a better lesson:

So for a long time Rome's legal system had these people called the jurists.  If you were in a lawsuit you would go to a jurist and tell him about your case.  Then he'd write a legal opinion applying the law to your facts (normally favorably), tell you exactly what to plead, etc.  He wouldn't actually argue the case -- advocates like Cicero were for that -- but he'd come up with smart reasons for why you should win, and would grapple in smart ways with any novelties or tough questions of law your case presented.

If a Jurist was particularly smart, his decisions would sort of take on an air of gospel truth, and eventually become law.  And this worked great.  Over time the Romans developed the most important legal system in world history, still the basis of the law in dozens of countries, exactly this way.  But as time dragged on more and more jurists kept writing.  By the middle of the empire, when jurists stopped being a thing, there was a *lot* of gospel truth out there, written by a *lot* of well respected jurists.

So it became a library sciences problem.  And, as they have so often in the past, the library sciences failed civilization.  Romans just didn't have the publishing industry or the filing skills to make sure anyone -- much less hick lawyers out in the provinces -- had access to what every jurist said ever.  So some lawyer in northern France would go on vacation in Spain and come back with a bunch of books he found (authentic? who knows!) from famous jurists.  Suddenly, he's throwing out established legal "facts" no one in the entire province had ever heard before.  Big problem!

So the emperor Justinian fixed all that.  First, he basically pruned the list of people whose writings were considered "canon."  Then, he went through the writings of the people who were left, cutting and pasting, arranging by topic, and throwing a lot of stuff out.  Only what he left in counted as law.  That became the digest, and it's the most important legal work ever in the history of animals.

So what can we learn from all this?  Well, sometimes perfectly good methods for generating law, if left on too long, generate too much law.  And sometimes going through all that big mess of law and throwing out the bad stuff and keeping the good stuff works wonders.

This has a huge bearing on our society.  We don't have jurists, but we do have the common law, and the most unique characteristic of common law legal systems is that judges can make law.  Full stop.  When Americans talk about "the law," they aren't just talking about all the bills passed in all the legislatures, they're talking about every word every appellate judge has said since the 1700's.  And that's a lot of law!

Fortunately, library science has kept up -- who knows where we would be without computers -- but while we are physically capable of managing all that law, you can't help but wonder if all the expense is worth it.  When you hire a lawyer you are paying for him to subscribe to a service that collects and annotates all those cases, paying for him to search through all those cases, and paying for him to try to make sense of all of them and how they affect you.  It ain't cheap!  Multiply that by hundreds of thousands of lawyers and you get a lot of money being thrown after this stuff.

People are cognizant of this  I think, though it's hard to separate complaints that the law is too complicated (in this complex a society, probably inevitable) from the complaint that there is just too much of the damn stuff.  But even though people are aware of it, you almost never hear anyone propose Justinian's solution: let's just throw out a lot of the common law.  People have codified the common law before, but that process, while radical, normally clarifies that anything not intentionally changed in the common law still matters, and normally allows for past common law to interpret the new code, so it's not as radical as what I am suggesting: put together some panels,  decide what cases count and what don't, and move on, the vast bulk of American common law gutted from the system.  Will it be a political process?  Probably.  Will it run into due process and contract clause problems if it tries to be retroactive?  Yup.  Is it still worth doing?  I don't know!  But it's worth thinking about.

I suspect your opinion on the indeterminacy of the law -- how capable the law if of "forcing" outcomes to legal cases on judges and juries -- affects how you think about the Justinian solution.  If you think the law is pretty indeterminate, then all that common law floating around doesn't do much but complicate the process of judges making pragmatic policy decisions.  If you think the law forces decisions on judges, then all that common law floating out there should make decisions more automatic and easy, since so many cases have already been addressed.

Short blogging, I an't good at it.

Interview with Robert Lucas

Noah Smith and Steve Williamson point us to this interview with the famous macroeconomist.

Lucas is not the straw man he's sometimes made out to be.

My favorite bits:

"But the term "Lucas critique" has survived, long after that original context has disappeared. It has a life of its own and means different things to different people. Sometimes it is used like a cross you are supposed to use to hold off vampires: Just waving it it an opponent defeats him. Too much of this, no matter what side you are on, becomes just name calling."

Defending New Keynesian models?

If we accept any version of the Quantity Theory of Money then it seems clear that it does not hold at high frequencies (which is what I think price stickiness means). If we don't accept the Quantity Theory of Money at low frequencies then I guess we should just close up shop. There are some hard unresolved problems to be faced.

Causes of business cycles. This is the first time I've heard any macroeconomist say this explicitly, but it is also my view:

I drew from this the idea that all cycles are probably driven the same kind of shocks. Since I was convinced by Friedman and Schwartz that the 1929-33 down turn was induced by monetary factors (declined is money and velocity both) I concluded that a good starting point for theory would be the working hypothesis that all depressions are mainly monetary in origin.

Ed Prescott was skeptical about this strategy from the beginning...He also thought we needed to have some kind of benchmark theoretical model to give us a start...

As I have written elsewhere, I now believe that the evidence on post-war recessions (up to but not including the one we are now in) overwhelmingly supports the dominant importance of real shocks. But I remain convinced of the importance of financial shocks in the 1930s and the years after 2008. Of course, this means I have to renounce the view that business cycles are all alike!

This is beautiful.

Q: If the economy is currently in an unusual state, do micro-foundations still have a role to play?

Lucas: "Micro-foundations"? We know we can write down internally consistent equilibrium models where people have risk aversion parameters of 200 or where a 20% decrease in the monetary base results in a 20% decline in all prices and has no other effects. The "foundations" of these models don't guarantee empirical success or policy usefulness.

What is important---and this is straight out of Kydland and Prescott---is that if a model is formulated so that its parameters are economically-interpretable they will have implications for many different data sets... This kind of cross-validation (or invalidation!) is only possible with models that have clear underlying economics: micro-foundations...This is bread-and-butter stuff in the hard sciences. You try to estimate a given parameter in as many ways as you can..."Unusual state"? Is that what we call it when our favorite models don't deliver what we had hoped? I would call that our usual state.

EMH

I am going to do my own series on EMH.  This is it.

The EMH Isn't Testable and That's OK - Part I

After reading this feisty exchange between Stephen Williamson and John Quiggin, I wanted to address an argument Quiggin raises against the Efficient Markets Hypothesis (EMH). I read the EMH chapter in his book, Zombie Economics, first, just to make sure I was really seeing the strongest form of his point and not some watered down blog version. While there is much in the book I disagree with, I think Quiggin attempts to grapple with his opponents’ strongest arguments. And he’s a first rate economist (top 1% according to this ranking).

What is the Efficient Markets Hypothesis?

Quiggin gives this definition, “financial markets are the best possible guide to the value of economic assets and therefore to decisions about investment and production. This requires not only that financial markets make the most efficient possible use of information, but that they are sufficiently well-developed to encompass all economically relevant sources of risk.” I honestly don’t know what that means. What is an economic asset? Are there non-economic assets? “Best possible guide for who”? Encompassing all risk sounds like a notion of market completeness, but that isn’t a requirement of market efficiency. Market completeness is just the notion that any risk I have can be insured. This is obviously not true; for instance, I think I'll get a PhD, but I might not. I could flunk out. I'd love to buy insurance against that possibility, but I can't. Does that mean IBM’s stock isn’t fairly priced?

I’m going to use a simple definition given by Eugene Fama in this podcast and seminal paper, and since Fama is one of the major foils in the book, that seems especially appropriate. EMH says, “prices reflect all available information.” This obviously leads to the question, what is the “available information”? Fama broke the EMH into three forms, in order to try to encompass the types of tests people were doing at the time (he regrets this, btw). The forms are weak – the relevant information is past prices, semi-strong – the relevant information is all publically available data (financial statements, earnings announcements…), or strong all public and private data. Quiggin is mostly talking about the semi-strong form, which is standard.

We just have to cover the “prices reflect” part and this is really the crux of the issue. Quiggin argues that EMH implies that prices generated by markets are “right” (scare quotes in the original). The only distinction Fama would make is that they are the best guess, but not necessarily correct. Otherwise they would agree on this statement by Quiggin, “the value of an asset is determined by the flow of income it generates over the period for which it is held and its disposal value. This stream of payments can be converted into a current value by a discounting procedure: [at the] “right” discount rate.” I like this statement. To know what the price should be, we need to know its future cash flows and we need to know what rate to discount the flows.

Here is the crux of the issue. In order to know if the market prices are right we need some theory to tell us what the cash flows will be and more importantly, how to discount them. But how do we know if our theory is correct? In order to test our theory, we have to assume markets are efficient and see if our theory matches market prices. This is called the joint hypothesis problem and has been taught in finance courses for a long time.

This problem really should have been central to the chapter (as it is in Finance courses), because every one of the reasons Quiggin gives in refutation of the EMH is subject to the joint hypothesis problems. Stock prices are too volatile. How volatile should prices be? We need some theory. Is the theory wrong or EMH? Quiggin places great weight on the recent financial crisis, and after every market crash there is always lots of clamoring against EMH. But what theory says markets can’t crash?

Quiggin argues that EMH has been redefined in response to criticism to make it unfalsifiable. As such it isn’t science, but a new sham hoisted on you by the finance community. In Part II, I’ll argue at the very least, it’s an old sham :-). And that maybe there is some hope.