Economic Myths - NHS spending and the Baumol Effect

This theory (also known as Baumol's cost-disease) is given a lot of credence by e.g. The Economist, the LSE and Tim Worstall/Forbes.

The Economist explains it thusly:

HEALTH-CARE expenditure in America is growing at a disturbing rate: in 1960 it was just over 5% of GDP, in 2011 almost 18%. By 2105 the number could reach 60%, according to William Baumol of New York University’s Stern School of Business. Incredible? It is simply the result of extrapolating the impact of a phenomenon Mr Baumol has become famous for identifying: “cost disease”...

In 1913 Ford introduced assembly lines to move cars between workstations. This allowed workers, and their tools, to stay in one place, which cut the time to build a Model T car from 12 hours to less than two. As output per worker grows in such “progressive” sectors, firms can afford to increase wages.

In some sectors of the economy, however, such productivity gains are much harder to come by—if not impossible. Performing a Mozart quartet takes just as long in 2012 as it did in the late 18th century. Mr Baumol calls industries in which productivity growth is low or even non-existent “stagnant”.

Employers in such sectors face a problem: they also need to increase their wages so workers don’t defect. The result is that, although output per worker rises only slowly or not at all, wages go up as fast as they do in the rest of the economy. As the costs of production in stagnant sectors rise, firms are forced to raise prices. 

These increases are faster than those in sectors where productivity is improving, and faster than inflation (which blends together all the prices in the economy). So prices of goods from stagnant sectors must rise in real terms. Hence “cost disease”.

The theory is that therefore health spending will inexorably rise as a percentage of GDP.

It seems like nonsense to me. For sure, in relative terms the cost of labour-intensive services increases, but only in relative and not in absolute terms. In truth, the cost of labour-intensive services stays constant and the price of automated, mass manufactured products decreases.

Think about the two extremes.

a) Wages rise exactly in line with GDP, in which case, the cost of labour-intensive services, wages generally and GDP go up in step. Health spending stays constant as a percentage of GDP.

b) All the benefits of automation go to the people who invent and own the machines that make stuff and wages stay constant. In this case, wages fall as a percentage of new enlarged GDP and the cost of labour-intensive services also falls as a percentage of GDP.

In neither scenario does the cost of labour-intensive services like healthcare increase! That only happens when there is a sharp contraction in GDP, wages in protected sectors like health being inflexible downwards - the sharpest increase in NHS spending as a percentage of GDP was between 2007 and 2009.
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I think that the tried and tested explanations for the increase in healthcare spending are the correct ones, these apply to both extreme types of funding (USA and UK), in no particular order and these all overlap and tie in with each other:

1. Most treatment is paid for by insurance, whether that is private premiums or compulsory mass-insurance via the tax system, meaning that treatment is free or cheap at point of use, it is "other people's money".

2. Healthcare is a victim of its own success. They invent new treatments for non-curable/non-fatal diseases/conditions, which means that such diseases are passed down to more children and people live much longer. So there are more people with those conditions, and healthcare gets more and more expensive the older people are, because there is more that can and will go wrong.

3. Healthcare feels like a necessity from the point of view of an individual (choice between living or dying), but is actually a luxury good i.e. the amount that people are willing/able to spend on it rises disproportionately as a share of income; so healthcare takes up a disproportionate share of GDP growth.

4. They keep inventing new and more expensive treatments. Heart transplants were a novelty fifty years ago, now they are almost routine. Thirty years ago, getting HIV was more or less a death sentence, so people just died. Luckily, the virus itself is nowhere near as virulent as it was, and they have developed medicines that enable people with HIV to live fairly normal lives for decades.

5. Politicians in Europe can always earn a few brownie points with the voters by promising to spend more on healthcare, even though the law of diminishing returns applies and a lot of the increase in health spending just goes into higher profit, salaries and white elephant spending and not actual additional treatments. This is particularly crass in the UK as there is a disconnect between 'spending on the NHS' and 'spending on healthcare'. Compare and contrast - all nurses and doctors get a 3% pay rise vs. the NHS employs 3% more nurses and doctors on the same salaries.

6. There is massive rent seeking in health care. Back in pre-NHS days, GPs would practice discriminatory pricing and charge wealthy people more than poor people for the same treatment. Faced with a choice of life or death, somebody with only a few hundred quid savings can't pay more than a few hundred quid. The GP can hold millionaires to ransom and charge them tens of thousands. Pharma companies love inventing medicines that will alleviate symptoms of long-term incurable diseases/conditions. The bigger the NHS gets, the higher the salaries that all the top dogs can pay themselves and get away with it. And I am sure that the US insurance companies really take the piss.

7. For the benefit of Ralph Musgrave, let's chuck in this phenomenon, this one and this one for good measure.

Here endeth.