DRI-135 for week of 1-4-15: Flexible Wages and Prices: Economic Shock Absorbers

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Flexible Wages and Prices: Economic Shock Absorbers

At the same times that free markets are becoming an endangered species in our daily lives, they enjoy a lively literary existence. The latest stimulating exercise in free-market thought is The Forgotten Depression: 1921 – The Crash That Cured Itself. The author is James Grant, well-known in financial circles as editor/publisher of “Grant’s Interest Rate Observer.” For over thirty years, Grant has cast a skeptical eye on the monetary manipulations of governments and central banks. Now he casts his gimlet gaze backward on economic history. The result is electrifying.

The Recession/Depression of 1920-1921

The U.S. recession of 1920-1921 is familiar to students of business cycles and few others. It was a legacy of World War I. Back then, governments tended to finance wars through money creation. Invariably this led to inflation. In the U.S., the last days of the war and its immediate aftermath were boom times. As usual – when the boom was the artifact of money creation – the boom went bust.

Grant recounts the bust in harrowing detail.  In 1921, industrial production fell by 31.6%, a staggering datum when we recall that the U.S. was becoming the world’s leading manufacturer. (The President’s Conference on Unemployment reported in 1929 that 1921 was the only year after 1899 in which industrial production had declined.) Gross national product (today we would cite gross domestic product; neither statistic was actually calculated at that time) fell about 24% in between 1920 and 1921 in nominal dollars, or 9% when account is taken of price changes. (Grant compares this to the figures for the “Great Recession” of 2007-2009, which were 2.4% and 4.3%, respectively.) Corporate profits nosedived commensurately. Stocks plummeted; the Dow Jones Industrial average fell by 46.6% between the cyclical peak of November, 1919 and trough of August, 1921. According to Grant, “the U.S. suffered the steepest plunge in wholesale prices in its history (not even eclipsed by the Great Depression),” over 36% within 12 months. Unemployment rose dramatically to a level of some 4,270,000 in 1921 – and included even the President of General Motors, Billy Durant. (As the price of GM’s shares fell, he augmented his already-sizable shareholdings by buying on margin – ending up flat broke and out of a job.) Although the Department of Labor did not calculate an “unemployment rate” at that time, Grant estimates the nonfarm labor force at 27,989,000, which would have made the simplest measure of the unemployment rate 15.3%. (That is, it would have undoubtedly included labor-force dropouts and part-time workers who preferred full-time employment.)

A telling indicator of the dark mood enveloping the nation was passage of the Quota Act, the first step on the road to systematic federal limitation of foreign immigration into the U.S. The quota was fixed at 3% of foreign nationals present in each of the 48 states as of 1910. That year evidently reflected nostalgia for pre-war conditions since the then-popular agricultural agitation for farm-price “parity” sought to peg prices to levels at that same time.

In the Great Recession and accompanying financial panic of 2008 and subsequently, we had global warming and tsunamis in Japan and Indonesia to distract us. In 1920-1921, Prohibition had already shut down the legal liquor business, shuttering bars and nightclubs. A worldwide flu pandemic had killed hundreds of thousands. The Black Sox had thrown the 1919 World Series at the behest of gamblers.

The foregoing seems to make a strong prima facie case that the recession of 1920 turned into the depression of 1921. That was the judgment of the general public and contemporary commentators. Herbert Hoover, Secretary of Commerce under Republican President Warren G. Harding, who followed wartime President Woodrow Wilson in 1920, compiled many of the statistics Grant cites while chairman of the President’s Conference on Unemployment. He concurred with that judgment. So did the founder of the study of business cycles, the famous institutional economist Wesley C. Mitchell, who influenced colleagues as various and eminent as Thorstein Veblen, Milton Friedman, F. A. Hayek and John Kenneth Galbraith. Mitchell referred to “…the boom of 1919, the crisis of 1920 and the depression of 1921 [that] followed the patterns of earlier cycles.”

By today’s lights, the stage was set for a gigantic wave of federal-government intervention, a gargantuan stimulus program. Failing that, economists would have us believe, the economy would sink like a stone into a pit of economic depression from which it would likely never emerge.

What actually happened in 1921, however, was entirely different.

The Depression That Didn’t Materialize

We may well wonder what might have happened if the Democrats had retained control of the White House and Congress. Woodrow Wilson and his advisors (notably his personal secretary, Joseph Tumulty) had greatly advanced the project of big government begun by Progressive Republicans Theodore Roosevelt and William Howard Taft. During World War I, the Wilson administration seized control of the railroads, the telephone companies and the telegraph companies. It levied wage and price controls. The spirit of the Wilson administration’s efforts is best characterized by the statement of the Chief Price Controller of the War Industries Board, Robert Brookings. “I would rather pay a dollar a pound for [gun]powder for the United States in a state of war if there was no profit in it than pay the DuPont Company 50 cents a pound if they had 10 cents profit in it.” Of course, Mr. Brookings was not actually himself buying the gunpowder; the government was only representing the taxpayers (of whom Mr. Brookings was presumably one). And their attitude toward taxpayers was displayed by the administration’s transformation of an income tax initiated at insignificant levels in 1913 and to a marginal rate of 77% (!!) on incomes exceeding $1 million.

But Wilson’s obsession with the League of Nations and his 14 points for international governance had not only ruined his health, it had ruined his party’s standing with the electorate. In 1920, Republican Warren G. Harding was elected President. (The Republicans had already gained substantial Congressional majorities in the off-year elections of 1918.) Except for Hoover, the Harding circle of advisors was comprised largely of policy skeptics – people who felt there was nothing to be done in the face of an economic downturn but wait it out. After all, the U.S. had endured exactly this same phenomenon of economic boom, financial panic and economic bust before in 1812, 1818, 1825, 1837, 1847, 1857, 1873, 1884, 1890, 1893, 1903, 1907, 1910 and 1913. The U.S. economy had not remained mired in depression; it had emerged from all these recessions – or, in the case of 1873, a depression. If the 19th-century system of free markets were to be faulted, it would not be for failure to lift itself out of recession or depression, but for repeatedly re-entering the cycle of boom and bust.

There was no Federal Reserve to flood the economy with liquidity or peg interest rates at artificially low levels or institute a “zero interest-rate policy.” Indeed, the rules of the gold-standard “game” called for the Federal Reserve to raise interest rates to stem the inflation that still raged in the aftermath of World War I. Had it not done so, a gold outflow might theoretically have drained the U.S. dry.  The Fed did just that, and interest rates hovered around 8% for the duration. Deliberate deficit spending as an economic corrective would have been viewed as madness. As Grant put it, “laissez faire had its last hurrah in 1921.”

What was the result?

In the various individual industries, prices and wages and output fell like a stone. Auto production fell by 23%. General Motors, as previously noted, was particularly hard hit. It went from selling 52,000 vehicles per month to selling 13,000 to 6,150 in the space of seven months. Some $85 million in inventory was eventually written off in losses.

Hourly manufacturing wages fell by 22%. Average disposable income in agriculture, which comprised just under 20% of the economy, fell by over 55%. Bankruptcies overall tripled to nearly 20,000 over the two years ending in 1921. In Kansas City, MO, a haberdashery shop run by Harry Truman and Eddie Jacobson held out through 1920 before finally folding in 1921. The resulting personal bankruptcy and debt plagued the partners for years. Truman evaded it by taking a job as judge of the Jackson County Court, where his salary was secure against liens. But his bank accounts were periodically raided by bill collectors for years until 1935, when he was able to buy up the remaining debt at a devalued price.

In late 1920, Ford Motor Co. cut the price of its Model T by 25%. GM at first resisted price cuts but eventually followed suit. Farmers, who as individuals had no control over the price of their products, had little choice but to cut costs and increase productivity – increasing output was an individual’s only way to increase income. When all or most farmers succeeded, this produced lower prices. How much lower? Grant: “In the second half of [1920], the average price of 10 leading crops fell by 57 percent.” But how much more food can humans eat; how many more clothes can they wear? Since the price- and income-elasticities of demand for agricultural goods were less than one, this meant that agricultural revenue and incomes fell.

As noted by Wesley Mitchell, the U.S. slump was not unique but rather part of a global depression that began as a series of commodity-price crashes in Japan, the U.K., France, Italy, Germany, India, Canada, Sweden, the Netherlands and Australia. It encompassed commodities including pig iron, beef, hemlock, Portland cement, bricks, coal, crude oil and cotton.

Banks that had speculative commodity positions were caught short. Among these was the largest bank in the U.S., National City Bank, which had loaned extensively to finance the sugar industry in Cuba. Sugar prices were brought down in the commodity crash and brought the bank down with them. That is, the bank would have failed had it not received sweetheart loans from the Federal Reserve.

Today, the crash of prices would be called “deflation.” So it was called then and with much more precision. Today, deflation can mean anything from the kind of nosediving general price level seen in 1920-1921 to relatively stable prices to mild inflation – in short, any general level of prices that does not rise fast enough to suit a commentator.

But there was apparently general acknowledgment that deflation was occurring in the depression of 1921. Yet few people apart from economists found that ominous. And for good reason. Because after some 18 months of panic, recession and depression – the U.S. economy recovered. Just as it had done 14 times previously.

 

It didn’t merely recover. It roared back to life. President Harding died suddenly in 1923, but under President Coolidge the U.S. economy experienced the “Roaring 20s.” This was an economic boom fueled by low tax rates and high productivity, the likes of which would not be seen again until the 1980s. It was characterized by innovation and investment. Unfortunately, in the latter stages, the Federal Reserve forgot the lessons of 1921 and increases the money supply to “keep the price level stable” and prevent deflation in the face of the wave of innovation and productivity increases. This helped to usher in the Great Depression, along with numerous policy errors by the Hoover and Roosevelt administrations.

Economists like Keynes, Irving Fisher and Gustav Cassel were dumbfounded. They had expected deflation to flatten the U.S. economy like a pancake, increasing the real value of debts owed by debtor classes and discouraging consumers from spending in the expectation that prices would fall in the future. Not.

There was no economic stimulus. No TARP, no ZIRP, no QE. No wartime controls. No meddlesome regulation a la Theodore Roosevelt, Taft and Wilson. The Harding administration and the Fed left the economy alone to readjust and – mirabile dictu – it readjusted. In spite of the massive deflation or, much more likely, because of it.

The (Forgotten) Classical Theory of Flexible Wages and Prices

James Grant wants us to believe that this outcome was no accident. The book jacket for the Forgotten Depression bills it as “a free-market rejoinder to Bush’s and Obama’s Keynesian stimulus applied to the 2007-9 recession,” which “proposes ‘less is more’ with respect to federal intervention.”

His argument is almost entirely empirical and very heavily oriented to the 1920-1921 depression. That is deliberate; he cites the 14 previous cyclical contractions but focuses on this one for obvious reasons. It was the last time that free markets were given the opportunity to cure a depression; both Herbert Hoover and Franklin Roosevelt supervised heavy, continual interference with markets from 1929 through 1941. We have much better data on the 1920-21 episode than, say, the 1873 depression.

Readers may wonder, though, whether there is underlying logical support for the result achieved by the deflation of 1921. Can the chorus of economists advocating stimulative policy today really be wrong?

Prior to 1936, the policy chorus was even louder. Amazing as it now seems, it advocated the stance taken by Harding et al. Classical economists propounded the theory of flexible wages and prices as an antidote to recession and depression. And, without stating it in rigorous fashion, that is the theory that Grant is following in his book.

Using the language of modern macroeconomics, the problems posed by cyclical downturns are unemployment due to a sudden decline in aggregate (effective) demand for goods and services. The decline in aggregate demand causes declines in demand for all or most goods; the decline in demand for goods causes declines in demand for all or most types of labor. As a first approximation, this produces surpluses of goods and labor. The surplus of labor is defined as unemployment.

The classical economists pointed out that, while the shock of a decline in aggregate demand could cause temporary dislocations such as unsold goods and unemployment, this was not a permanent condition. Flexible wages and prices could, like the shock absorbers on an automobile, absorb the shock of the decline in aggregate demand and return the economy to stability.

Any surplus creates an incentive for sellers to lower price and buyers to increase purchases. As long as the surplus persists, the downward pressure on price will remain. And as the price (or wage) falls toward the new market-clearing point, the amount produced and sold (or the amount of labor offered and purchases) will increase once more.

Flexibility of wages and prices is really a two-part process. Part one works to clear the surpluses created by the initial decline in aggregate demand. In labor markets, this serves to preserve the incomes of workers who remain willing to work at the now-lower market wage. If they were unemployed, they would have no wage, but working at a lower wage gives them a lower nominal income than before. That is only part of this initial process, though. Prices in product markets are decreasing alongside the declining wages. In principle, fully flexible prices and wages would mean that even though the nominal incomes of workers would decline, their real incomes would be restored by the decline of all prices in equal proportion. If your wage falls by (say) 20%, declines in all prices by 20% should leave you able to purchase the same quantities of goods and services as before.

The emphasis on real magnitudes rather than nominal magnitudes gives rise to the name given to the second part of this process. It is called the real-balance effect. It was named by the classical economist A. C. Pigou and refined by later macroeconomist Don Patinkin.

When John Maynard Keynes wrote his General Theory of Employment Interest and Income in 1936, he attacked classical economists by attacking the concepts of flexible wages and prices. First, he attacked their feasibility. Then, he attacked their desirability.

Flexible wages were not observed in reality because workers would not consent to downward revisions in wages, Keynes maintained. Did Keynes really believe that workers preferred to be unemployed and earn zero wages at a relatively high market wage rather than work and earn a lower market wage? Well, he said that workers oriented their thinking toward the nominal wage rather than the real wage and thus did not perceive that they had regained their former position with lower prices and a lower wage. (This became known as the fallacy of money illusion.) His followers spent decades trying to explain what he really meant or revising his words or simply ignoring his actual words. (It should be noted, however, that Keynes was English and trade unions exerted vastly greater influence on prevailing wage levels in England that they did in the U.S. for at least the first three-quarters of the 20th century. This may well have biased Keynes’ thinking.)

Keynes also decried the assumption of flexible prices for various reasons, some of which continue to sway economists today. The upshot is that macroeconomics has lost touch with the principles of price flexibility. Even though Keynes’ criticisms of the classical economists and the price system were discredited in strict theory, they were accepted de facto by macroeconomists because it was felt that flexible wages and prices would take too long to work, while macroeconomic policy could be formulated and deployed relatively quickly. Why make people undergo the misery of unemployment and insolvency when we can relieve their anxiety quickly and compassionately by passing laws drafted by macroeconomists on the President’s Council of Economic Advisors?

Let’s Compare

Thanks to James Grant, we now have an empirical basis for comparison between policy regimes. In 1920-1921, the old-fashioned classical medicine of deflation, flexible wages and prices and the real-balance effect took 18 months to turn a panic, recession and depression into a rip-roaring recovery that lasted 8 years.

Fast forward to December, 2007. The recession has begun. Unfortunately, it is not detected until September, 2008, when the financial panic begins. The stimulus package is not passed until January, 2009 – barely in time for the official end of the recession in June, 2009. Whoops – unemployment is still around 10% and remains stubbornly high until 2013. Moreover, it only declines because Americans have left the labor force in numbers not seen for over thirty years. The recovery, such as it is, is so anemic as to hardly merit the name – and it is now over 7 years since the onset of recession in December, 2007.

 

It is no good complaining that the stimulus package was not large enough because we are comparing it with a case in which the authorities did nothing – or rather, did nothing stimulative, since their interest-rate increase should properly be termed contractionary. That is exactly what macroeconomists call it when referring to Federal Reserve policy in the 1930s, during the Great Depression, when they blame Fed policy and high interest rates for prolonging the Depression. Shouldn’t they instead be blaming the continual series of government interventions by the Fed and the federal government under Herbert Hoover and Franklin Roosevelt? And we didn’t even count the stimulus package introduced by the Bush administration, which came and went without making a ripple in term of economic effect.

Economists Are Lousy Accident Investigators 

For nearly a century, the economics profession has accused free markets of possessing faulty shock absorbers; namely, inflexible wages and prices. When it comes to economic history, economists are obviously lousy accident investigators. They have never developed a theory of business cycles but have instead assumed a decline in aggregate demand without asking why it occurred. In figurative terms, they have assumed the cause of the “accident” (the recession or the depression). Then they have made a further assumption that the failure of the “vehicle’s” (the economy’s) automatic guidance system to prevent (or mitigate) the accident was due to “faulty shock absorbers” (inflexible wages and prices).

Would an accident investigator fail to visit the scene of the accident? The economics profession has largely failed to investigate the flexibility of wages and prices even in the Great Depression, let alone the thirty-odd other economic contractions chronicled by the National Bureau of Economic Research. The work of researchers like Murray Rothbard, Vedder and Galloway, Benjamin Anderson and Harris Warren overturns the mainstream presumption of free-market failure.

The biggest empirical failure of all is one ignored by Grant; namely, the failure to demonstrate policy success. If macroeconomic policy worked as advertised, then we would not have recessions in the first place and could reliably end them once they began. In fact, we still have cyclical downturns and cannot use policy to end them and macroeconomists can point to no policy successes to bolster their case.

Now we have this case study by James Grant that provides meticulous proof that deflation – full-blooded, deep-throated, hell-for-leather deflation in no uncertain terms – put a prompt, efficacious end to what must be called an economic depression.

Combine this with the 40-year-long research project conducted on Keynesian theory, culminating in its final discrediting by the early 1980s. Throw in the existence of the Austrian Business Cycle Theory, which combines the monetary theory of Ludwig von Mises and interest-rate theory of Knut Wicksell with the dynamic synthesis developed by F. A. Hayek. This theory cannot be called complete because it lacks a fully worked out capital theory to complete the integration of monetary and value theory. (We might think of this as the economic version of the Unified Field Theory in the natural sciences.) But an incomplete valid theory beats a discredited theory every time.

In other words, free-market economics has an explanation for why the accident repeatedly happens and why its effects can be mitigated by the economy’s automatic guidance mechanism without the need for policy action by government. It also explains why the policy actions are ineffective at both remedial and preventive action in the field of accidents.

James Grant’s book will take its place in the pantheon of economic history as the outstanding case study to date of a self-curing depression.

DRI-291 for week of 6-8-14: The (Latest) V.A. Scandal: So What Else is New?

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The (Latest) V.A. Scandal: So What Else is New?

The news media has covered the recent medical-care scandal involving the Veterans’ Administration with its usual breathless urgency. Veterans of political economy find this ironic, since no feature of the political landscape is more ritualistic than the administrative scandal. Its elements are by now as stylized as those of the Japanese kabuki dance.

It begins with the uncovering of shocking facts – perhaps by journalistic investigation, perhaps by revelation from an internal source such as a whistleblower, perhaps by random circumstance. The facts are greeted first by denials, starting at the administrative level and proceeding upward – typically to the cabinet level, sometimes ending in assurance by the President of the United States that reports are greatly exaggerated.

Observers generally realize that it is the administrators and politicians who are exaggerating, not the journalists and whistleblowers, since few scandals emerge full-blown without any previous hint of their existence. Eventually, the fundamental truth of the allegations cannot be denied any longer, and the administrators and cabinet secretary in charge of the erring agency must fess up. This is the confessional stage of the scandal. It is characterized by admission of grievous fault, abject apology and plea for forgiveness, or at least understanding. The confession flagrantly contradicts previous insistence that the whole thing was an overblown attempt by political opponents to smear the present administration.

The last phase is the Presidential phase. The President is shocked, shocked to discover that error and scandal have invaded the administration of government on his watch. His attitude toward his administrative subordinates in the executive department is that of the admonishing schoolmaster: fair but firm, reluctant to punish but determined to root out all evil, to banish forever this unaccountable blot on the escutcheon of his tenure. The administrators must go, of course, even though they are able, noble, kind, determined, brave, clean and reverent. There will be an investigation, and when all the details are known, we will proceed to wipe this disgraceful episode from our memories and move on, to greater and more glorious triumphs…

The ellipsis reflects the fact that the entire purpose of the ritual is to pass through the period of scandal with the least possible political damage inflicted on the administration. The collective attitude of that of a child caught in a misdeed. The child is fully conscious of guilt; every word and action is oriented toward escaping punishment and returning to the status quo ante. Neither truth nor justice has any bearing on the child’s behavior. Likewise, they have no effect on the administration’s actions, either.

The recent V.A. scandal contains the classic elements. Not only is it predictable, it was predicted in this space in our previous discussions of the economics of medical care and Obamacare. Now the other shoe has dropped. The utter familiarity of the ritual means that the political aspects can be subordinated to our real object. It is the economic features that claim our interest.

The Details of the Scandal

The V.A. scandal concerns the provision of medical care for discharged members of the armed forces by the Veterans’ Health Administration in Department of Veterans Affairs. This is only one of the functions performed by the Veterans’ Administration, the others being administration of veterans’ benefits and supervision of burials and memorials for veterans. The cost of medical care to veterans depends on the ability to pay – it is either free or accompanied by a co-pay. When a vet is discharged from the service, he must enroll in the V.A. system in one of three ways: by calling a toll-free number, going online or visiting one of the hundreds of V.A. clinics across the country. In order to complete the enrollment process, the vet must possess his DD214 discharge form. At enrollment, the vet is given a means test to determine qualification for a co-pay.

Once enrollment is complete and the vet is accepted within the system, new patients must be seen by a physician within 14 days. Existing patients (who have already been treated and, thus, have already seen a physician for evaluation) must see a doctor within 14-30 days. The failure to meet the stipulated deadlines for these initial appointments is the gravamen of the current scandal.

The head of the V.A.’s health affairs office, Robert Petzer, testified that he knew as early as 2010 that V.A. health clinics were “using inappropriate scheduling procedures” to defer these initial appointments. The deferrals were done because of need; the clinics were simply unable to meet the demand for initial appointments. The excess demand for appointments grew over time and the situation worsened until it reached the epidemic proportions now forming the basis for periodic new revelations. Scandals within the armed forces (and the government at large) are investigated by inspectors general (known as “IGs”). An interim report on the V.A. scandal by the V.A.’s IG called the practice of inappropriate scheduling “systemic.” It involved the use of false or phony waiting lists that were tailored to give the impression that the V.A. was meeting its initial-appointment goals rather than falling further and further short of them.

The scandal erupted after a doctor at the Phoenix, AZ V.A. clinic complained to the IG about treatment delays. It should be noted that this doctor waited until after his retirement to lodge these complaints. The complaints were made in letters written in December, 2013 but did not rise to the level of a public scandal until May, 2014. It transpired that some 1,700 vets were kept on waiting lists and the average vet waited for 115 days for his initial appointment. Meanwhile, official records were falsified to hide these delays.

On June 9, 2014, the Department of Veterans’ Affairs released preliminary results of an audit of 731 V.A. clinics that showed about 57,000 vets who have currently waited for their initial appointment for an average time span exceeding 90 days. Some 13% of V.A. schedulers say they have been ordered to falsify appointment-request logs to make them compliant with the rules. The IG calls the current 14-day goal for initial appointment “unattainable” due to the logistical obstacles posed by insufficient money and personnel.

The news from Phoenix triggered a chain reaction of similar revelations from V.A. hospitals and clinics across America. In Fort Collins, CO, clerks were specifically taught how to falsify records to paint a misleadingly favorable picture of initial appointments kept. A police detective found that in Miami, cover-ups were “ingrained into the hospitals’ culture” and drugs were routinely dealt out of hospital premises. In Pittsburgh, PA, an outbreak of Legionnaire’s Disease in 2011-12 was revealed to be the product of “human error” rather than the “faulty equipment” that had been blamed in Congressional testimony last year.

The delays in initial appointments are important because they represent a delay in the potential diagnosis and/or treatment of one or more medical conditions. Much has been made of the statement by IG Richard Griffin that “we didn’t conclude…that the delay[s] caused… death. It’s one thing to be on a waiting list; it’s another for that to be the cause of death.” But in the case of 52 patients seen by the Columbia, SC gastroenterology unit of the V.A., it certainly was determined that those patients had “disease associated with” treatment delays. We are urged every day to visit our doctor, not to put off visits or hide conditions in hopes that symptoms will disappear, reminded that cancer and other diseases are curable with early detection. Now, suddenly, delays in seeing the doctor are downplayed as a factor in actual incidence or severity of disease.

The medical facilities were not the only loci of dereliction. The War on Terror launched by the Bush Administration has produced an avalanche of disability claims filed by veterans of the Iraq and Afghanistan campaigns. In order to claim a compensable disability, a veteran must show not only the existence of a disability but also a likelihood exceeding 50% that it is due to military service. He is not allowed to hire a lawyer (unless the lawyer works pro bono) before the disability determination is made, so as to preclude the lust for private profit from luring private-sector contingency lawyers into the Klondike of military disability determination. But this process of disability determination has been stalled by (you guessed it) a massive backlog of claims waiting to be heard. This backlog reached a high of 611,000 in 2013 before the resulting publicity triggered a mini-scandal that forced action by Eric Shinseki, Secretary of the Department of Veterans’ Affairs. It now stands at about 300,000 cases that so far have taken over 125 days to process.

One of the most highly publicized features of the scandal has been the bonuses received by upper-level V.A. administrators, tied to complying with V.A. rules for initial-appointment timeliness. These bonuses provided a clear-cut incentive for the falsification of records by lower-level employees operating under orders by their superiors.

The Economics of the V.A. System of Medical Care

Previous discussion of health care in this space touched on the V.A. system. Why should a separate system of medical care exist for military veterans?  Why should that separate system be administered by the federal government? If this separate system exists because it is superior to the one available to the rest of us, why not make it available to all? If it is not superior, why does it exist at all?

Some people have actually followed this logic to its ultimate conclusion. In 2011, the left-wing economist and political columnist Paul Krugman made the case that the V.A. does indeed constitute a superior system of medical care which should be broadened to the entire country. Part of his case rested on the V.A.’s success in meeting its initial-appointment guidelines. By doing so, he contended, it avoided the need for any rationing of care.

“Rationing” is the operative word applying to government provision of medical services. The whole purpose of designating government as the “single payer” for medical care is to sell the concept as “free medical care for all regardless of ability to pay.” Private producers cannot distribute goods for free but this is a specialty of government. As always, the big problem government faces is bridging the gap between its expansive claims and its inability to deliver what it claims. A free good is one for which there is no opportunity cost of provision, hence no scarcity. Saying that a good is free doesn’t make it free; it merely causes people to try to maximize their efforts to acquire it. Maximizing the demand for something is the worst possible way to deliver it free to everybody because it places the biggest possible burden on the supply apparatus.

The V.A. headlines its medical services to veterans as free, but upon reading the fine print veterans discover that they will be subjected to a means test and requested to pony up a co-pay. Of course, this is not the same thing as a unit price to an economist, but it does involve a sacrifice of alternative consumption. But this is small potatoes compared to the real shock in store for any veteran who thinks that his military status entitles him to health care in perpetuity.

Reading current newspaper accounts of the scandal would leave the impression that discharged vets enroll for medical benefits on a first-come, first-served basis. This is not so. Upon applying for benefits, vets are assigned to one (or more) of 8 “eligible priority groups.” The word “priority” hints at the purpose of these groups; they decide whose applications get processed first and in what order. In other words, medical care for veterans is rationed by the Veterans Health Administration from the instant of application for enrollment.

To erase any doubts about the veracity of this statement, we have the word of the V.A. itself. “Unfortunately, the Veterans Health Administration does not have enough resources to provide care to all veterans who need it. To address this issue, the VA has created eight priority groups for enrollment.” There we have it – the dirty little secret of VA medical benefits. Veterans are lured into the system with the promise of free benefits. Before they are even accepted, they find out that the benefits aren’t free and they may not even get them – or, if they do, the effective price may include a hefty upcharge for waiting time. At worst, that upcharge may be the loss of their life.

Each of the 8 eligible priority groups contains multiple subcategories of prioritization. Any connection to medical need or severity is tenuous at best. Group 1, the highest priority for enrollment, includes vets who are 50% or more disabled due to service-connected disability, then picks up those who are unemployed due to service-connected disability. Of course, it could be true that a 50% disability carries with it an immediate need to see a physician. It could also be utterly untrue; it depends on the specific medical circumstances.

Right away, we see that the criteria governing rationing are political and bureaucratic. Political because a disabled vet is a highly visible and ongoing political liability, much more so than a vet who dies awaiting treatment. In a free-market system, decisions about medical treatment are made by you and your doctor in consultation. You know your economic capabilities and your doctor knows you and your medical needs; together you can compare the value you would receive from each incremental bit of medical treatment with its cost. But in the VA, your medical decisions will ultimately be made by bureaucrats who know little or nothing about medicine. That is why criteria like “50% disabled” are necessary; they provide a pseudo-objective basis upon which medically untutored bureaucrats can affirm or deny treatment.

Group 2 includes 30-40% disabled vets. Group 3 is headlined by former prisoners of war, Purple-Heart holders, holders of the Medal of Honor, vets with lower disability status and those who disability was actually caused by treatment or rehabilitation. Again, politics is evident in this ranking with the inclusion of POWs and medal-winners. Why should medical care be turned into a popularity contest? Then again, once we have excluded the free market from consideration, any other system of allocating benefits would be arbitrary.

The lower-ranking Groups introduce other arbitrary criteria like service in Vietnam and exposure to atomic radiation at Hiroshima, Nagasaki or test sites. Low-income vets receive precedence over high-income vets; willingness to fork over a co-pay buys the vet a higher place in line.

When we combine the economics of the V.A. system with the known facts of the current V.A. scandal, the latter becomes easier to understand but harder to stomach.

The Economics of the Scandal

Note the fundamental difference between scarcity as it exists in a free-market context and in the command-and-control context of a politically motivated bureaucracy. Economists define scarcity as the condition in which we cannot have all that we wish to consume and must choose the things we value most. Nobody is automatically or inherently excluded from consumption; price tells us the value that people place on a good and its cost in alternative (or foregone) output. People choose how much to buy based on their incomes and tastes; they can buy small, medium or large quantities and vary their consumption as their incomes change and prices vary. At the V.A., the government chooses what to give you and how much to give you based on (mostly) arbitrary criteria that ignore price and cost. It frankly admits that some people will be excluded – once more based on arbitrary criteria.

Economic logic tells us that the government system is wildly inefficient. Moreover, its inefficiencies will get worse and worse over time because it encourages customers to demand more medical care than can be supplied.

There is nothing remotely surprising or shocking about the current scandal. And as the Washington Post points out, “President Obama has been talking for years about fixing the system.” According to Press Secretary Jay Carney, “This is not a new issue to the President.” Here is one sure sign that Krugman, et al, have missed the boat analytically; you don’t fix a system that is working brilliantly.

Everybody is acting as if the scandal is the result of something going terribly wrong with the system. But this is merely the system working as we expect a system of rationing to work – by excluding some people from service altogether. The V.A. itself says it is designed to do this and explains how it does it – just how surprised should we be when that is exactly what happens? The scandal is not that something has gone wrong with the system; the scandal is the system.

Economic logic tells us that the system is designed to ration care by excluding vets from medical benefits, thereby reducing the amount of medical care provided. This exclusion by rationing takes several forms. First, the vet may be excluded by not qualifying at all. Second, he may fall in the last (8th) eligible priority group, get tired of waiting to be processed and accepted and simply seek out paid care in the private sector. This relieves the V.A. of the burden of serving him. Third, he may die while waiting to be seen, as vets have done and continue to do. The larger the number of vets who face delays in acceptance and processing, the greater the likelihood that this will happen. And the longer the delays, the greater the likelihood that this will happen. Once more, this relieves the V.A. of the necessity of serving him. Fourth, the longer the delay faced by the vet, the worse (on net balance) will be his condition when he is finally accepted, seen and treated. This will shorten his life span and reduce the total amount of medical care the V.A. will be required to give him. (In this shorter time span, however, it will increase the need for greater spending on him, which will give the V.A. leverage to demand larger budget allocations in Congress. This is politically valuable to bureaucrats and their political sponsors.)

Of course, the V.A. can haul out testimonials from some vets who crow about the outstanding medical treatment they have received. In any bureaucracy – police, fire, public education, even the federal government itself – some individuals will stand out by ignoring the lack of incentives for performance and adhering to their own personal standards. And the fact that the V.A. picks and chooses who it treats, when it treats them – “we will treat no veteran before his time” – and how it treats them will allow the agency to provide good service to some vets. But claims of competitive superiority for the V.A. are a mockery considering that it is able to rig the game through rationing and, we now belatedly realize, rig its own statistics internally.

Claims by Krugman and others that the V.A. is a model for health care in general are false on their face. What little success the V.A. has enjoyed depends on the failures highlighted here. The V.A. cannot exist in its present form without the concurrent existence of a private-sector (or public-sector) alternative where its rejects can be dumped and where consumers can seek out consistently higher-quality treatment at a price. An attempt to impose the V.A. model on the country at large simply produces the kind of socialist, “national health service” health care found in countries such as Great Britain and Canada. These are characterized by long waits for care, lower-quality care, poorer medical technology and almost no new drug development. According to Krugman, we should be clamoring for access to the superior medical care provided by the V.A. Americans should be “health tourists,” traveling to Great Britain, France and Canada for their health care. Instead, though, the flow of health tourists runs the other way – into the U.S.

Democrats insist that the Bush Administration caused the V.A. scandal by overloading the system with applicants through its foreign wars. They cannot have it both ways. How can their system be superior if it falls apart when the demand for its product increases, which is the average business’s idea of paradise? Free-markets use flexibility of prices and quantities to handle variations in demand; they use higher prices to attract more resources into the system to handle the larger demand. It is command-and-control rationing systems, deprived of vital pricing tools, which crumble under the pressure of demand increases.

Public shock over the incentive bonuses paid to V.A. administrators for initial-appointment compliance not actually attained is likewise naïve. After all, critics of free markets and corporations scream bloody murder when CEOs are not paid for performance. The V.A. was simply trying to curry favor with the public by mimicking the private sector’s performance incentives. The problem is, of course, that the V.A. is not the private sector. In a free market, a firm couldn’t get away with faking its performance because you can’t fake the bottom line; failure to perform will reduce profits. But there is no bottom line at the V.A. and no way (short of audit) to detect the kind of fakery that went on at the V.A. for years and years. Sure, veterans complained, but nothing happened because vets did not control the bureaucracy and had no political clout. The only reason the scandal was uncovered was that the doctor who blew the whistle had recently retired and no longer had to fear bureaucratic retaliation for his actions.

Speaking of political clout…

Cui Bono?

Why has a federal agency so inimical to the interests of a beloved constituency persisted – nay, thrived – since its inception in 1930? The great myth of big government is that it serves the interests of its constituents. But as we have seen, this is hardly true.

The real beneficiaries of big government are government employees, bureaucrats and politicians. The V.A. has metastasized into a cabinet-level bureaucracy with over 330,000 employees, including thousands of mid-level bureaucrats. Most of its employees belong to a powerful public-sector union. Employees and bureaucrats vote for the politicians who vote the appropriations that pay their salaries and lucrative benefits.

These people are invisible in the current scandal, except for the passive role they play as order-takers and functionaries. But they are the reason why the system is not “reformed.” There is no reforming this kind of system, only tinkering around the margins. Genuine reform would disband the V.A. altogether since its rationale is utterly misguided.

That will not happen. The falsity of the V.A.’s guiding premise is irrelevant. It is not really intended to serve veterans, so its failure to do so does not really matter to politicians. Its real purpose is to win votes by conferring benefits on employees and bureaucrats and it is fulfilling that purpose just as well, if not better, by failing veterans as it would by serving them.

That is why the stern promises to “fix the problem” are so much hypocritical cant. There will be no fix and no reform – only the next scandal.

Cant Rules in Public Discussions of the V.A.

Why do we watch numbly as the V.A. scandal unfolds – the latest in a never-ending series? By now, we know the ritual by heart. What is that has us hypnotized?

Human beings mix reason with emotion, and we apparently remain enthralled by the cant that surrounds the V.A. “We love and revere our veterans – so much that we cannot entrust their physical well-being to the mundane ministrations of marketplace medicine. Veterans deserve only the very best. So, naturally, we put their welfare in the hands of the federal government, because it handles all our most important jobs and never fails to satisfy us. We will never rest until veterans are well-cared for, because their happiness and security is our first priority.”

In one part of our mind, this rationale reigns supreme. In the other part, we store all that we know about how the V.A. – and the federal government – actually operates. If those two parts ever commingled, they would probably short-circuit our mental processes indefinitely. We have not yet outgrown our fantasy of government as benevolent, omniscient, omnipotent parent.

In reality, the failures of government are all too painfully obvious. It is not that government has anything special against veterans, other than the fact that they keep showing up at the door expecting to be medically treated. No, government double-crosses and fails veterans just as it does the rest of us. When its failures become manifest, it lies about them. And the people who have placed their ideological and occupational bets on government lie, too.