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On the prospects for Obama's healthcare reform

I do not pretend to be an expert at handicapping the likelihood of a particular piece of legislation passing in Congress. But it seems to me that the chance of healthcare reform passing Congress via the reconciliation process is quite low. This legislation is unpopular, highly controversial, and extremely divisive. The process by which it is supposed to pass has been denounced repeatedly by Obama himself and by key members of Congress over the past several years. There is no precedent for using the reconciliation process to pass major legislation affecting almost 20% of the economy and every single person in the country.

Even if it were to pass, it will undoubtedly be attacked from several quarters on numerous grounds, some Constitutional, and there will be a furious campaign to recall the legislation.

This goes beyond audacity. It risks what remains of Obama's presidency and it risks the future of the Democratic Party. This is not good for anyone, and for that reason alone it should go down in defeat.

The jobs market turns the corner

Jobs are now growing, according to the household survey of employment. Abstracting from the addition of some 180K government-sector jobs in the past two months, the household survey shows an impressive net gain of 500,000 jobs since the end of last year (the red line in the above chart).

Jobs are still falling, according to the widely-watched establishment survey. But for all intents and purposes, the establishment survey is now telling us that the decline in jobs has ended, and job gains are right around the corner.

So both of these surveys now point to an end to the decline of jobs, just 8 months after the end of the recession, and a return to net new jobs. That's not too surprising, given the swiftness and depth of the preceding decline in jobs. But despite having achieved this milestone, the unemployment rate is likely to linger at fairly lofty levels for quite some time since the labor force (those working or looking for work) is likely to grow for awhile by at least as much as the growth in jobs as an improving economy draws more workers back into the search for jobs. Last month, for example, the 120,000 job gains in the household survey were outpaced by a 340,000 gain in the workforce.

It's an encouraging picture overall, but nothing to get really excited about. Still, since the market has been fearful of a double-dip recession since mid-January, it's a positive development that exceeds market expectations, and thus warrants continued optimism. The economy is still on the road to recovery. As the next chart shows, the yield on 3-mo. T-bills continues to rise as the market gradually loses its extreme desire for safety. 10-year Treasury yields are up about 10 bps today, as they also react to the better-than-expected jobs news. Expect higher yields across the Treasury curve in the weeks and months ahead. The market has been thinking that the Fed would be on hold for most of this year, but with news like this it seems clear that the Fed is going to have to raise rates sooner than expected, and that would be very welcome news for those of us who worry that the Fed could make a big inflation mistake if it waits too long to tighten.

Unit labor costs collapse, a portent of increased hiring

This is worth highlighting: unit labor costs fell last year at the fastest rate since records began to be kept in 1947. The flip side of this is that the productivity of labor increased 5.8% last year, which is also an impressive number. What this all means is that companies got lean and mean and much more efficient last year. Profit margins are up, and sales are increasing. This is very likely to translate into increased demand for labor over the course of the year. Labor got a lot cheaper last year, so the demand for labor is likely to rise. This is good news all around.

TIPS point to very slow growth

This chart is not meant to be scientific, it is meant to be suggestive of what the TIPS market may be implying about the outlook for real growth in the U.S.

The blue line represents the rolling, 2-yr annualized rate of real GDP growth. I've used a rolling 2-yr figure to smooth out the ups and downs in yearly data, and I think it's reasonable to assume that the market's outlook for the future tends to be influenced by the experience of the recent past. The red line is simply the yield on 5-yr TIPS.

The rationale for comparing these two is that real yields that can be purchased via the TIPS market should not be greatly different from expectations for real growth in the economy. If you invest in the broad stock market, your expectation for real returns should not be greatly different from the real growth of the economy. In other words, it would be difficult to expect positive returns if the economy were to be in a protracted recession, just as it would be reasonable to expect positive returns if the economy were to enjoy healthy growth. If markets are at all efficient, the real yield on TIPS should be somewhat less than the expected real returns on the average company (since TIPS real yields are guaranteed by the U.S. government, but equity real yields are not), and average real returns in the stock market should not be greatly different from the economy's average real growth rate.

From this I conclude that since yields on 5-yr TIPS today are only about 0.2%, the market is implying that expectations for real growth in the economy are only about 1-2% or so. And that is one reason I think the stock market is priced to very conservative, and even fearful assumptions about future growth. If real growth were expected to be 4% or more, real yields would almost certainly be higher than they are today, because the market would expect the Fed to tighten policy significantly if that were the case. The next chart is my rationale for saying that.

This chart compares the yield on 5-yr TIPS with my calculation of the market's expectation of the real Fed funds rate one year from now. The latter is a good proxy for how tight the market expects the Fed to be in the future. The impressive correlation of real yields to Fed tightening expectations is clear from the chart, and it also makes a lot of sense, since the Fed traditionally regards tightening or easing to be a function of how the funds rate changes relative to inflation. In other words, when the Fed wants to tighten, it must raise the funds rate relative to inflation. Thus, if the market expects a tightening in the future, then the market should demand a higher real yield from TIPS today. (The foregoing is just another way of saying that the Fed controls the level of real short-term rates, and it is the expectation of the real rate on Fed funds that drives the shape of the rest of the real yield curve.)

Currently the market is expecting the Fed to tighten monetary policy only slightly over the next year (with the definition of tightening being the level of the funds rate relative to inflation). That expectation, in turn, is driven heavily by the outlook for real growth. Neither the Fed nor the market expects real growth to be very impressive over the next year. If the economy were to strengthen unexpectedly, the Fed would tighten sooner and by more than the market currently expects, would it not? That the market expects the real funds rate to be -0.5% a year from now can only mean that the market's outlook for real growth is rather dismal.

UPDATE/CLARIFICATION: The point of this post is not to say that my expectation of growth is dismal, it's to point out how pessimistic the market's assumptions are. This in turn implies that it is unlikely that the equity market is overpriced. Thus my expectations for 3-4% real growth justify a bullish outlook for equities.

We need a smaller government

I've long been a supporter of the Cato Institute. Nearly everyone that works there is outstanding in his or her field. They are one of the most successful think tanks in the country because they stand for the principles of limited government, individual liberty, and free markets, and they know how to articulate their positions clearly and effectively. Here's an excellent recent example from Cato's Chris Edwards, entitled "Six Reasons to Downsize the Federal Government:"

1. Additional federal spending transfers resources from the more productive private sector to the less productive public sector of the economy. The bulk of federal spending goes toward subsidies and benefit payments, which generally do not enhance economic productivity. With lower productivity, average American incomes will fall.

2. As federal spending rises, it creates pressure to raise taxes now and in the future. Higher taxes reduce incentives for productive activities such as working, saving, investing, and starting businesses. Higher taxes also increase incentives to engage in unproductive activities such as tax avoidance.

3. Much federal spending is wasteful and many federal programs are mismanaged. Cost overruns, fraud and abuse, and other bureaucratic failures are endemic in many agencies. It’s true that failures also occur in the private sector, but they are weeded out by competition, bankruptcy, and other market forces. We need to similarly weed out government failures.

4. Federal programs often benefit special interest groups while harming the broader interests of the general public. How is that possible in a democracy? The answer is that logrolling or horse-trading in Congress allows programs to be enacted even though they are only favored by minorities of legislators and voters. One solution is to impose a legal or constitutional cap on the overall federal budget to force politicians to make spending trade-offs.

5. Many federal programs cause active damage to society, in addition to the damage caused by the higher taxes needed to fund them. Programs usually distort markets and they sometimes cause social and environmental damage. Some examples are housing subsidies that helped to cause the financial crises, welfare programs that have created dependency, and farm subsidies that have harmed the environment.

6. The expansion of the federal government in recent decades runs counter to the American tradition of federalism. Federal functions should be “few and defined” in James Madison’s words, with most government activities left to the states. The explosion in federal aid to the states since the 1960s has strangled diversity and innovation in state governments because aid has been accompanied by a mass of one-size-fits-all regulations.

Car sales look strong

Car sales dipped in February, but over the past year they are up 13.7%. Nothing moves in a straight line, but it seems to me that the upward trend here is clear (especially if you abstract from the temporary gyrations caused by cash-for-clunkers program last August). The bounce we've seen in the past year is about as strong as any we've seen coming out of prior recessions.

Labor market conditions gradually improve

The ADP calculation of job losses in February was 20,000, right in line with expectations. If the payroll numbers released this Friday don't show something close to zero or a small positive, then it will most likely be due to all the snowstorms in the East, not because of any deterioration in the economy. The labor market continues to gradually improve. Net job gains are at hand or just around the corner. Of course, we're still a long way from returning to conditions that might be considered healthy or robust. The economy is going to be "weak" for most people for at least the balance of this year even if we do see job gains starting this month.

From the market's perspective, however, this is good news. The market has been worried about a lot of things of late, particularly the prospect of a "double-dip" recession. There is no sign in the numbers released today that this is likely. On the contrary, the numbers keep pointing to a recovery that is spreading throughout the economy. Not a great recovery, but a broad and gradual recovery.

ISM Service Sector Index continues to improve

I'd put these charts in the category of showing "modest improvement." Nothing very spectacular here, but it does reflect ongoing improvement in the largest sector of the economy. Encouragingly, the employment sub-component of the service sector index reached its highest level since May '08. The green shoots and V-shaped recoveries that have been showing up in the nooks and crannies of the economy are now spreading throughout the economy. The recovery is gathering strength, despite all the headwinds from out-of-control fiscal policy and despite all the fears of a double-dip.

Corporate layoffs have all but vanished (8)

I first showed this chart exactly one year ago, when I said "this should probably go in the positive column." Since then it has been a leading indicator of improvement in the economy. Announced corporate layoffs, as tabulated by the folks at Challenger, Gray & Christmas have only been lower once (mid-2006) in the past 10 years. The process of shedding workers has effectively ended, and now it's just a waiting game to see when employers begin new hiring. We're almost there. If net new jobs don't show up in the February payroll numbers, to be announced this Friday, it will most likely be due to snowstorms, not the underlying status of the economy.

Fear subsides, prices rise (16)

A reminder of how closely correlated the value of equities has been, and continues to be, to the level of the market's fear and uncertainty.

NPR reveals the roots of our healthcare crisis

The travails of the Obama administration's efforts to pass healthcare reform are not likely to bear their intended fruit, but they are doing all of us a great public service by putting this extremely important issue under the microscope of public attention. The more we discuss the issue, the more we learn about what is wrong and how it might be fixed. And that is our best hope for putting in place the right fix. I'm pleased to report that I see great progress being made.

My own education on the problems with healthcare began about a decade ago when I heard Grace-Marie Turner of the Galen Institute explain the fiscal origins of the problem. It all started in the early 1950s when the government decided to allow companies to deduct the cost of the healthcare insurance they bought on behalf of their employees. That decision, in turn, was made in order to circumvent wage and price controls that had been put in place after the start of WW II, in an effort to keep inflation at bay. Since only employers could deduct healthcare costs, it quickly became apparent that the optimal, tax-efficient solution for everyone was to work for an employer that offered to pay for the most complete health insurance policy possible. We're now seeing the unintended consequence of this change to the tax code, since consumers now pay less than 12% of their healthcare costs out of pocket. Between employer-paid health insurance and government programs (e.g., Medicare, Medicaid), almost 90% of healthcare spending is paid for by a third party. The result: the healthcare industry in the U.S. has become totally separated from the discipline of free markets. No wonder things aren't working well.

My education was greatly advanced today, thanks to reading a transcript of a recent NPR "All Things Considered" program. (HT: Don Boudreaux and Glenn Reynolds) I learned that when the Medicare program was being designed 45 years ago, the government originally decided to pay doctors whatever they wanted to charge, because they needed the doctors' support. When this blew up because costs escalated beyond control, the government hired an economist to figure out what the value of thousands of procedures was. Now we know that the economist's calculations were wrong. To this day, the government is still searching for a method for determining how much to pay physicians. Nobody in the government has ever thought about letting the market figure out the right price. That's the fundamental problem of healthcare today: the government is not giving free markets a chance. No wonder everything is screwed up.

I'm going to reprint the entire transcript of the NPR show, because it needs to be spread far and wide, and it's not very long:

How Should Medicare Pay Doctors?

February 26, 2010 - MELISSA BLOCK, host:

After yesterday's summit there appears to be no more bipartisan consensus on health care today than there was before the summit. Part of the problem is, of course, political, but not all of the problem. With health care, even questions that seem simple just aren't. Take, for instance, the question of how to pay doctors.

David Kestenbaum and Chana Joffe-Walt from our Planet Money team report that doctor pay has confounded policy wonks, economists and presidents for decades.

CHANA JOFFE-WALT: In 1965, Joe Califano had to answer a question. He didn't know it was such a big question, or a question that would change the course of health care in American for the next five decades. It just seemed simple: How should the government pay doctors?

DAVID KESTENBAUM: Califano was President Lyndon Johnson's adviser for domestic affairs. And the government was about to get into the health insurance business in a huge way - about to launch the largest health insurance plan we've ever had: Medicare. But the idea made doctors nervous, so LBJ, Califano and lawmakers made what seemed like a small concession. The government told doctors: We will pay you for every procedure you do. How much will we pay you? Whatever you think is right.

JOFFE-WALT: Califano shakes his head describing that call now. But he says, look, the government needed doctors to participate. If doctors didn't accept Medicare, wouldn't see patients covered by Medicare, the whole thing would fail.

Mr. JOSEPH CALIFANO (Former Adviser, Domestic Affairs): We were on edge. We were on edge.


Mr. CALIFANO: About whether doctors would agree to take Medicare patients.

KESTENBAUM: Why were you worried they wouldn't participate? You were going to pay them whatever they wanted.

Mr. CALIFANO: They were so opposed to it. I mean, they reluctantly - believe me, within two years, they love it. But they really didn't understand what a bonanza this was going to be for them.

KESTENBAUM: Turns out, doctors had been giving out a lot of free care to old people and now they were going to get paid for that, and within limits, whatever they asked for.

Dr. Lucian Leape was a practicing surgeon at the time.

Dr. LUCIAN LEAPE (Surgeon): We found out what the general fee for our service was and charged that or maybe added 10 percent, 'cause of course I'm better than average. And so it was an incentive for doctors to charge what they thought was reasonable for them, and then of course to increase it every year by, say, 5 or 10 percent.

KESTENBAUM: Medicare solution for how to pay doctors put into cement this idea of fee for service, paying doctors per procedure for every test, every scan. That sounds reasonable, but it served as a nudge to err on the safe side - to do more tests, to do that exploratory surgery.

JOFFE-WALT: LBJ and Califano, all their people, all realized they created something of a monster right away. I mean, two years after Medicare passed, LBJ is pleading with Congress to let him change the way Medicare pays physicians.

Califano remembers it well.

Mr. CALIFANO: By late '67, the budget data was just stunning. I mean 1968, we knew that system should be changed. We asked Congress for authority to change it.

JOFFE-WALT: But you just created it.

Mr. CALIFANO: I know it. But we saw what was happening with costs so fast. So fast.

KESTENBAUM: But they couldn't change it. Doctors now like the system. They were getting paid for work they'd previously done for free. And that was that. This system, with all its problems, stayed in place for almost 30 years. Meanwhile, medicine got more expensive.

JOFFE-WALT: Figuring out prices for health services is really hard. We have an idea of what we should pay for toothpaste. Back surgery, no idea.

KESTENBAUM: And yet, in 1986, one man was convinced he could calculate the prices. An economist at Harvard by the name of William Hsiao; an economist with a small voice and a big, kind of weird idea.

Professor WILLIAM HSIAO (Harvard University): So the question is: Can we find a rational method that could be used to set physicians' fees?

JOFFE-WALT: Professor Hsiao decided, okay, the market does not work for health care services. So I will calculate the right prices for each and everything a doctor does.

KESTENBAUM: Hsiao brought in groups of doctors and asked them some pretty crazy sounding, almost philosophical questions like: How much mental work does a regular checkup require? He had them compare everything they did to one reference point. For surgeons, it might be a hernia repair: How technically hard is it, how stressful, how many supplies? Hsiao had doctors do this for thousands of procedures.

JOFFE-WALT: Congress loved this idea: An economist, a rational way of answering this annoying question. And Congress said if you can really do this, we will adopt your method. We will make it law.

KESTENBAUM: Now, if someone was talking about changing how you got paid, you'd pay attention - and doctors did.

JOFFE-WALT: While Hsiao was creating his Relative Value Scale, he'd invite groups of doctors in to advise him. And the doctors would bring their own advisors, consultants - lobbyists, really. Hsiao wouldn't let them in the room, so they'd sit outside. And then those consultants started coming out with their own relative value studies that were more favorable to whatever group of doctors they represented.

Prof. HSIAO: So then they were trying to trump us. And so it took tremendous amount of work, took years out of my life and my hair turned gray.

(Soundbite of laughter)

JOFFE-WALT: During that time?

Prof. HSIAO: Mm-hmm.

JOFFE-WALT: In 1992, Congress adopted Hsiao's Relative Value Scale, that enormous spreadsheet. And it worked for a while until just a few years later, it didn't anymore.

KESTENBAUM: There are different explanations for what happened. Hsiao blames lobbyists. Lobbyists and doctors say, sorry, health care just is expensive, and most of the time, Medicare actually underpays us.

JOFFE-WALT: Congress did try one more thing. It tried to slow growth of doctor pay by saying payments could not grow faster than the overall economy grows. But when the economy slowed, that would mean cutting doctor pay.

KESTENBAUM: When that happened, Congress balked and put off making the cut one year, then the next year and the next. Those delayed cuts added up and now this coming Monday morning, doctors are facing a 21 percent pay cut. Unless, of course, Congress puts it off again.

JOFFE-WALT: So that question about paying doctors, we're still working on it.

I'm Chana Joffe-Walt.

KESTENBAUM: And I'm David Kestenbaum, NPR News.

It's clear from all this that the solution to our healthcare crisis must start with any and all measures that restore free market forces to the healthcare industry. For starters, that means changing the tax code to eliminate the third-party payer problem—allow everyone or no one to deduct healthcare costs. That would ultimately put consumers in charge of spending their own money on healthcare, instead of their employers'. That would also solve the portability problem, since healthcare wouldn't be tied to one's job. It would also go a long way to solving the pre-existing condition problem, since people could buy a policy when they were young and keep it for life. Next, breaking down interstate barriers to selling healthcare insurance would greatly increase competition, by allowing consumers to discover that buying a policy that provides first-dollar coverage for just about everything doesn't make sense for everyone, and that high-deductible policies can be very attractive for most consumers.

Mitch Daniels, Governor of Indiana, has a great op-ed in today's WSJ that describes in detail how introducing market forces to the healthcare equation can improve results for everyone. The secret is to use Health Savings Accounts. Key takeaway: "Americans can make sound, thrifty decisions about their own health. If national policy trusted and encouraged them to do so, our skyrocketing health-care costs would decelerate." What a novel concept: trust the people!

Kazakhstan a better credit risk than California

This may be more amusing than instructive, but here goes. This chart shows 5-year credit default swaps on bonds issued by the State of California and the government of Kazakhstan. As Bloomberg's Chart of the Day notes, California would be ranked as the world's eighth-largest economy, while Kazakhstan's economy is only one-sixteenth as large. Yet the market is saying that California's bonds are 50% more risky than those of Kazakhstan.

In case you're wondering, similar credit default swaps on Greek government bonds are trading at 364 bps (only slightly higher than California's 303). Iceland 524, Portugal 163, Spain 130, and Italy 128.

The governments of California and Greece are in the same pickle: government spending is out of control and must be reined in, starting with public sector salaries and benefits. The market is saying that's going to be very difficult to accomplish. I'd like to think it's fairly easy: just say "no."

ISM employment index -- another V sign

This is a follow up to my post earlier today. This chart shows the Institute for Supply Management's manufacturing employment index. This index has traced what could be the biggest V-shaped recovery of them all, surging from a low of 25.9 to 56.1 in just one year. In the past 20 years it has been this high or higher in only 10 months (2004-2005). This is undeniably good news, as it is a clear sign of new hiring activity.

Risk aversion is receding (2)

I first wrote on this subject 10 days ago. The chart above shows the yield on 3-mo. T-bills, and as should be obvious, that yield has been rising for most of the year. We're still just talking about basis points, of course (with the current yield just shy of 0.13%), but the upward movement on the margin is what's most important. 3-mo. T-bills are the gold standard, if you will, of risk-free investing. When yields were close to zero at the end of last year it was a sign that investors worldwide were almost totally risk-averse. Now things are changing, and risk aversion is slowly fading. This has to do with rising confidence, and with increasing signs that the economy continues to expand.

When cash, which is ultimately the alternative to anything risky, yields zero then the only sensible explanation is that investors are basically terrified of risk and will forgo all rewards in exchange for safety. If you are holding cash these days that you would otherwise be investing, then it can only mean that you are extremely worried that risk assets will decline in value. By inference, you are also extremely worried that the economy will turn south, for whatever reason (e.g., the dreaded "double-dip" recession).

I'm sure many will argue with me that cash yields are almost zero because the Fed wants the Fed funds rate to be almost zero. While the Fed certainly has a lot of sway over short-term interest rates, the Fed often looks to the market for signals as to its next move. Meanwhile, the Fed is just as terrified of a double-dip as the market is, which is again the only reason they would want interest rates to be zero.

The longer the economy shows signs of recovery, the more pressure there will be on bill yields to rise. Similarly, the more we see bill yields rise, the more confident we can be that recovery is here to stay. I fully expect to see bill yields continue to rise, and for the Fed eventually to follow the lead of the market and raise the target for the funds rate to 0.5% as a first step. Rising interest rates won't be a threat to the recovery, they will be in response to the recovery, and that will be very good news indeed.

ISM index still strong

The ISM manufacturing index for February came in a bit weaker than expected, but as this chart shows, it is still very strong, and points to real economic growth in the current quarter of 4-5%. Since this is a diffusion index, the current reading says that 56.5% of respondents see things picking up. The prices paid index, in the next chart, shows that fully two-thirds of respondents report paying higher prices. Once again, we see strong evidence that deflation is dead at the producer level. Both of these indices strongly support an ongoing recovery, with no sign of the dreaded double-dip. The fact that so many are fearful of the double-dip means to me that pricing remains very conservative.