WHY MEDICARE PART D IS BAD POLICY

The following commentary was delivered by Professor Michael Meeropol on WAMC radio in December of 2005

WHAT’S WRONG WITH MEDICARE, PART D?


As I speak, Medicare recipients are deciding whether to sign up for the new prescription drug plan. I want to focus on the most serious shortcoming of this controversial program. The program does not permit Medicare to use its purchasing power to negotiate for discounted prices on the drugs sold under the plan.

When Medicare reimburses hospitals and doctors it tries to reduce medical cost inflation by slowing the rate at which provider compensation increases. But the law does not permit it to do the same with prescription drugs.[1]

Drug prices are high in large part because of government granted patent protection. Patents give the owners monopoly rights. If you want a specific drug, you pay what the company charges. There are no competitors.[2]

If Medicare could use the power of its large volume purchasing to force drug companies to cut Medicare a deal, the result would partially compensate for the price advantages the drug companies have due to government enforcement of their patent monopolies.

So why did Congress explicitly forbid Medicare from doing what, for example, the Veterans Administration does on a regular basis, namely bargain for discounted prices in exchange for large volume purchases?

One could be cynical and assert that the Pharmaceutical Industry is very generous to people running for Congress and that the industry gets what it pays for.

However, let’s let one member of Congress speak for himself. At the time of the vote, one member of Congress who strongly supported the prohibition against price bargaining said on NPR that when government uses its purchasing power to force a lower price on the market it’s just another word for PRICE CONTROLS.[3]

This was the sum of his argument. In other words, if the government uses bargaining power to force a seller who has a monopoly to sell at a discount, that is the SAME THING as the government actually SETTING THE PRICE to begin with!

To show how irrational this argument is, we need only look at REAL government price setting. Regulated public utilities can only sell to their designated customers at the price determined by the regulators. The only recourse they have when they believe they are being forced to charge too low a price is to try to persuade the regulators to change their minds.[4]

By contrast, if Medicare were to use its deep-pockets purchasing power to induce pharmaceuticals to make discounted deals with the program, [PAUSE] every one of those companies could “pass” on the opportunity and continue to sell drugs to other consumers. Those companies who would make deals with Medicare would do so because it makes good business sense.

Meanwhile, IN THE PRIVATE SECTOR we have countless examples of high volume purchasers getting bargain prices from suppliers.

Wal Mart, for example, charges the lowest retail prices in the country on average, in large part because it is such a large purchaser. It can in effect force its suppliers to offer merchandise at rock-bottom prices.

I know that Wal Mart’s price advantages are often explained by its low salary structure and poor benefits, but that is under dispute. However, there is NO DISPUTE that Wal Mart gets its suppliers to sell at very low prices.

How does Wal Mart get these very low prices? By BARGAINING with its suppliers – the very thing Medicare is prohibited from doing.

So what’s the difference that leads supposedly free-market advocates to celebrate what Wal Mart does while prohibiting Medicare from doing the same? Is it because Wal Mart is not the government making it okay to force suppliers to constantly search for lower and lower cost items? -- often utilizing incredibly low-paid labor from, for example, China where, despite the rhetoric of Communism, workers are not allowed to form independent unions and bargain for decent wages?[5]

Meanwhile, Medicare, a government agency, would be bargaining not for a rock-bottom price from a vendor, but for a discount from a pharmaceutical giant on a price already inflated by a patent monopoly.

Unfortunately, due to the lack of wisdom of Congress, Medicare remains under this ridiculous prohibition, and that is the key failure of the Prescription Drug Bill.


[1] There are other things wrong with the plan as well. It is overly complicated with a wide variety of plans, each covering different drugs with different levels of payments. It involves a “donut hole” where participants get coverage up to a certain amount and then must pay a large sum out of pocket before the “catastrophic” part of the coverage kicks in. However, the most important shortcoming is the fact that the plan will do nothing to curtail medical cost inflation. The supporters of these “competition models” argue that the private sector firms competing for customers will produce great efficiencies and cost savings and give participants variety rather than what would exist if, for example, Medicare were a single payer for all pharmaceutical purchases. The problem with this argument is that it’s totally theoretical. Yes, competition sometimes can lead to reduced costs but in fact every time private insurance companies have competed with traditional Medicare, they have proven to cost MORE not less. That is why, in this law, Congress said that the only way to participate in Medicare, Part D, is through some private company. To control hospital reimbursement costs, Medicare operates an inpatient prospective payment system under which payments are made at a predetermined rate which represents the national average for treatment of such patients. A hospital that delivers the cost at a lower rate gets to keep the difference. A hospital that delivers the cost at a higher rate, loses money. [See 2004 GREEN BOOK, Background Material And Data on the Programs Within the Jurisdiction of the Committee on Ways and Means [GPO, 2004]: Vol. I, Part 2, P. 26.]

[2] I know there is a long tradition within journalism, politics and economics that says without patent protection there would be no more research to find new drugs and improve old ones. That is errant nonsense and the best source I can give you is an exhaustive study by Merrill Goozner, The $800 Million Dollar Pill, The Turth Behind the Cost of New Drugs (U. of California Press, 2004). The fact remains that because of patent protection, lots of drug company research is worthless “copycat” research to find a drug that does the same thing as the one with the patent but is chemically different (Think the difference between Viagra, Cialis and Levitra). Much drug company research is financed by the government already. It has been estimated that drug prices are inflated over 100% by patent protection. I might also remind people that in the case of life-saving retro-virals to fight AIDS, patent protection and the high prices charged internationally for licensing these drugs literally kills people in low income Third World countries.

[3] I’m not being coy here. I don’t remember who said it, but I do remember hearing it on a broadcast on WAMC around the time the bill was passed.

[4] The model applies to what are called “Natural Monopolies.” A public utility with high fixed costs like an Electric Company or local Cable company is given a monopoly – competitors are not permitted to enter the market. In exchange, there is a (usually state) regulatory commission which sets the rates. IN economic theory terms, they set the rate at the average cost of producing the electricity (or gas, etc.) so as to guarantee the investors in the company a “fair” rate of return. The argument then usually revolves around whether costs are being measured accurately and whether the rate of return predicted is indeed “fair.”

[5] I bring this up not to hype the issue. Wal Mart imports a tremendous amount of its merchandise from China. This phenomenon has created the concept in the retail industry of the “China price” for an item. The reason the “China price” is a standard is because Chinese workers are paid very low wages (they make Mexican workers appear to be living like Kings by comparison) and their businesses turn out items very quickly. The high productivity combined with low wages in Chinese factories creates low per unit labor costs which more than make up for the cost of shipping the merchandise halfway round the world to US outlets. [Business Week actually had an article about the "China Price."]

WE SHOULD DEMOCRATIZE THE FED

The following is a COMMENTARY delivered by Michael Meeropol on WAMC radio in November of 2005.

WHY DOES ALAN GREENSPAN HAVE SO MUCH POWER? WHY WILL BEN BERNANKE HAVE SO MUCH POWER? A DISCUSSION OF THE INDEPENDENCE OF THE FEDERAL RESERVE.

Alan Greenspan is arguably the second most powerful man in the world. As Chairman of the Federal Reserve – our Central Bank – (known simply as THE FED) he sits as first among equals in crafting Monetary Policy – controlling the level of interest rates.[1]

Interest rates affect the economy greatly. Raising interest rates means it costs more to buy a home, to finance a mortgage. Raising rates means less investment – factories won’t be built, equipment won’t be purchased, businesses won’t be created.[2] When interest rates rise too much -- recessions occur.

President Bush has recently appointed Greenspan’s successor Dr. Ben Bernanke.

I want to pose a question to those responsible for confirming Dr. Bernanke. Why is the FED chairman so powerful? Why isn’t our Central bank controlled democratically, as are other governmental institutions?

You heard me right. The reason Ben Bernanke will step into the second most powerful position in the world is because, by law, the FED is an INDEPENDENT CENTRAL BANK. It is not a branch of the Treasury.

The President can order the military to send troops anywhere in the world and to take military action under many circumstances without Congressional authorization.

But, the President cannot order the head of the FED and his colleagues to lower interest rates in order to stimulate the economy.[3]

Over the past 25 years whenever inflation has been in danger of getting too high, the FED has raised interest rates even if that caused an increase in unemployment.[4] Both of the last recessions (1990 and 2001) occurred as a result of the FED raising interest rates.

If the President had the authority to order the FED to lower interest rates, monetary policy would show more consideration for the people who get thrown out of work when interest rates go up.

So, why is the US Central Bank virtually immune from the democratic process? Our representatives determine how much should be spent on military activities and how high taxes should be. Yet somehow when it comes to setting monetary policy we are willing to surrender the democratic process to a bunch of appointed technocrats who are more beholden to the Banking industry than they are to the country as a whole.[5]

I don’t get it. I have been discussing this issue with my students for 34 years, and I’ve heard all the arguments.

The Central Bank needs to be independent of the politicians.

The people don’t understand finance and economics.

If the Central Bank listened to the people it would do the wrong thing.[6]

Couldn’t we make these arguments against democracy in general??

We could make the military independent.

We could have experts set tax rates.

Maybe we should not have democratic control over ANY important decisions?

Do we believe that? Emphatically NO!![7]

We recognize that there is a role for expertise.

For example, the President needs to consult military leaders with experience and skills in order to set the tactics to pursue military strategies.

However, THE CONSTITUTION explicitly puts the decision of whether to go to war in the hands of the people’s representatives. The Civilian Commander-In-Chief, the President is responsible for the conduct of any military operation.

Why should an unelected group of experts be independent of us?

Bernanke wrote a textbook in which he quotes one study which allegedly demonstrates that an INDEPENDENT Central Bank is more likely to take the difficult steps necessary to reduce inflation. The study concluded that this can be accomplished without increasing unemployment.[8] Bernanke neglected to quote a second study that comes to a contrary conclusion.[9] We can be pretty sure Bernanke believes in the “independence” of the FED – as do the majority of members of Congress.

I, however, think the Independence of the FED is one of those ideas that should be fully discussed and debated. I wish that the Senate Finance Committee while considering Dr. Bernanke’s appointment would widen the scope of its hearings by raising the question of whether the FED should remain independent or not..

I personally think we should actually give democracy a chance.

[1] The Federal Reserve System is composed of a BOARD OF GOVERNORS (seven members) appointed for 14 year terms which oversees the entire system. The system involves 12 Regional Federal Reserve Banks which are technically owned by the Banks in that region who are members of the Federal Reserve System. All 12 of those banks must follow national policy set by the BOARD OF GOVERNORS and an extremely important organization called the FEDERAL OPEN MARKET COMMITTEE (FOMC). The Federal Open Market Committee consists of the seven members of the BOARD OF GOVERNORS plus five Regional Bank Presidents four of whom serve on a rotating basis while the President of the NY Federal Reserve Bank is always on that committee. The BOARD OF GOVERNORS sets the Discount Rate (the rate at which the FED lends money to member banks) and Reserve Ratios (the percentage of bank deposits that must be kept as reserves and not lent out) while the FOMC determines how much government bonds to buy or sell on the “open market” (hence its name) in order to move an important short term interest rate called the Federal Funds Rate (the rate banks charge each other for overnight loans). All of the actions by the FED are designed to either increase or decrease the credit availability in the banking system by increasing or decreasing the money banks have with which to make loans. (Obviously if the reserve ratio rises, banks have less available to lend – if the FED sells government bonds on the open market, banks will have less available to lend). This then causes interest rates to change as a result of the increase or decrease in the supply of funds available to make loans.

[2] This doesn’t always happen. Sometimes interest rates will increase but businesses are so optimistic they will increase investment anyway. However, it is definitely often the case that increases in interest rates will restrain investment, especially in housing because of the impact of an increase in mortgage rates.

[3] It is true that an Act of Congress could order the FED to do anything. However, Congress has never taken any such action, even at the depths of the Depression in the 1930s. Presidents and members of Congress have made speeches attaching FED policy decisions (though not recently) but there has never been a bill introduced into Congress to reduce the independence of the FED. On the contrary, most political leaders go out of their way to emphasize that they respect and support the independence of the FED.

[4] The most dramatic example of this was in 1979 when the FED began a policy of restraining the growth of money in the hopes that this would reduce inflation without increasing unemployment. Interest rates rose and a recession occurred in 1980. Interest rates fell in response to that recession but in the Fall of 1981, interest rates rose again and this time the FED did not let up until December of 1982. The result was the worst recession since the 1930s which lasted from August 1981 till Decemeber of 1982. Unemployment peaked at 10.8% in December of 1982. After that the FED raised interest rates sometimes even before inflation went up and almost always this was accompanied by at least a temporary increase in unemployment. Such raises occurred in 1984, 1989 (which caused the recession of 1990), 1994, 2000 (which caused the recession of 2001). For Monthly Unemployment Data see www.bls.gov/PDQ/servlet. For the Federal Funds rate (the rate controlled by the FED) see www.federalreserve.gov/releases/h15/data/m/fedfund.txt.

[5] It is said that the Federal Reserve must recognize the wishes of the Financial Community in general but more particularly “the bond market.” The argument is, if “the bond market” loses confidence in the ability of the FED to control inflation they will sell all their bonds (because they carry a fixed interest rate, the value of which will be eroded by inflation) and that will cause a very big increase in interest rates that might trigger a recession (something like this actually happened in late 1981, despite the FED’s anti-inflation stance). Thus, it is not surprising that at least since 1979, the FED has been more interested in controlling inflation than in reducing unemployment. This is despite the fact that under the Full Employment and Balanced Growth Act of 1978 (which amended the Employment Act of 1946) the US government (including the FED) are bound by LAW to take actions to get the unemployment rate to 4% and the inflation rate to 3%. Every President with the exception of Bill Clinton from December 1999 through December 2000 (13 months in 27 years!) and every FED with the same 13-month exception has broken that law with regard to the unemployment rate. They’ve hit the inflation target more frequently (11 out of the 27 years). [For both the unemployment and inflation historical statistics go to www.bls.gov]

[6] These are virtually direct quotes from many different students in my classes over the years. The majority sentiment seems to always support the “independence” of the FED despite my best efforts to argue the contrary.

[7] This is rhetorical and based on hope rather than any deep research into public opinion polling. I’m sure people support the “idea” of democracy but might when pushed be very willing to surrender lots of decision-making to experts in lots of areas, not just the setting of Monetary Policy.

[8] See Andrew B. Abel and Ben S. Bernanke MACROECONOMICS, 5th ed. (Boston: Pearson, Addison Wesley, 2005): 557-558. The study was Alberto Alesina and Lawrence Summers, “Central Bank Independence and Macroeconomic Performance,” JOURNAL OF MONEY AND CREDIT, (May 1993): 151-162.

[9] That study was Hiroshi Fujiki, “Central Bank Independence Indexes in Economic Analysis: A Reappraisal,” MONETARY AND ECONOMIC STUDIES, (December 1996): 79-101.