Monthly Archives: September 2012


An increasing number of readers have been demanding encouraging me to set up a Twitter account. I’m not sure if this means that they want to hear more from me (thinking I will tweet more than I post) or they want me to be more concise (limit my characters). In any event, you can now follow me on Twitter @RebelEconProf.

On Administrative Costs in Health Insurance

In a recent post, Garett Jones asks, “Will ACA’s cost-cutters outcut private insurers?” The post was inspired by a new paper in the New England Journal of Medicine presents an argument in favor of the ACA. I would like to offer some corresponding comments.

One thing that the paper emphasizes is the role of administrative costs. One argument often made in favor of a single payer system is that there are lower administrative costs with one insurer. This is thought to be true of both the insurers and the providers who would only have to negotiate payment rates with one insurer rather than many. Typically, single payer advocates use this to argue that more administrative costs imply that there is a waste of resources. Nonetheless, there are important reasons to question these claims.

First, the game is rigged. Estimates of administrative costs for government-provided insurance never include any estimate of the deadweight loss from taxation that would result from switching individuals on private insurance plans to a public plan.

Second, and substantially more important, is that this argument treats the problem as static rather than dynamic. Insurance companies have an incentive to reduce these costs. If these firms innovate in eliminating some of these costs, these innovations will also leak over into other areas of the economy. To the extent to which insurance companies are marginalized, such innovations will be less likely, which can potentially reduce the benefits of positive externalities that result from innovation.

Third, there seems to be either a misunderstanding or a lack of curiosity with respect to the issue of administrative costs on the insurer side. For example, if the government exhibits economies of scale and the private sector doesn’t then the government can provide the service more efficiently. However, the observation of lower administrative costs on the part of the government does NOT imply greater efficiency. Suppose that administrative costs are predominantly variable costs (the more claims, the higher the cost). It is possible that each individual firm’s variable cost curve lies below the government’s variable cost curve, but that the sum of the variable costs of all private firms is above that of the government. Since we are generally looking at aggregate costs of the private sector versus the public sector, this is consistent with the observation that administrative costs in the private sector are above the public sector, but does not imply any gain in efficiency by switching to the government.

Finally, on the provider sign, the claim is that providers are wasting resources by negotiating with multiple insurers. But, this argument begs the question. Why don’t providers simply negotiate rates multilaterally with insurers? Why do they choose to negotiate individually with insurers with different characteristics like size? To the extent that we believe that health care providers are profit-seeking, why wouldn’t they explore other arrangements? The observation that providers voluntarily choose to negotiate different rates with different insurers suggests not that these negotiations are a waste of resources, but rather that they are beneficial. Thus, in this instance, “waste of resources” seems to imply “not using resources the way we want them to.”

QE3 and the Optimality of Nominal GDP Targeting

The Fed’s announcement last week that they intend to conduct open-ended open market purchases has been seen as a victory for advocates of nominal GDP level targeting, especially market monetarists. Scott Sumner has received praise from a number of publications for leading the charge (see here and here). Scott has long advocated nominal GDP level targeting and was criticizing tight monetary policy from the beginning of the recession. The shift toward open-ended open market purchases is therefore certainly a change in the direction of policy and one that is much more in line with a level target. Nonetheless, I don’t think that this is as much of a victory for level targeters as is being claimed. Thus, I would like to take this post to describe my differing view and also the recent discussion of optimal monetary policy.

The intuition of a level target runs as follows. The purpose of the level target is to anchor long run expectations. Thus, suppose that the central bank announces that their objective is to target 5% trend growth in nominal GDP consistent with the trend from essentially 1983 – 2008. This policy announcement suggests that the central bank would like to create nominal GDP growth in the short term that is higher than 5% (since we have been below that trend since 2008), but once nominal GDP returns to trend, growth will return to 5%. So long as the central bank has a good degree of credibility in committing to these actions, this should help to anchor expectations.

Thus, if nominal GDP is significantly below the long run trend, the policy suggested by this intuition is for the central bank to announce its intention to conduct open market purchases sufficient to achieve its target. In other words, the central bank announces a plan to conduct open-ended open market purchases (i.e. whatever it takes to hit its target).

The recent Fed statement represents a stark change from previous policies specifically as it pertains to its efforts at quantitative easing. Specifically, rather than announcing particular dollar values of assets that they intends to purchase, the Fed has changed their statement to reflect their desire to “increase policy accommodation by purchasing additional agency mortgage-backed securities at a pace of $40 billion per month.” That’s clearly open-ended. However, advocates of a nominal GDP level target and similar objectives should NOT see this a clear victory.

As the description of the intuition behind level targeting makes clear, the use of open-ended open market purchases should be coupled with an explicit objective for policy. There is no such objective in the Fed’s statement. The duration of policy is not defined in terms of objectives, but rather time:

To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens. In particular, the Committee also decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that exceptionally low level ofs for the federal funds rate are likely to be warranted at least through mid-2015.

The federal funds rate is not the objective of monetary policy, it is the intermediate target. In addition, and perhaps more importantly, we need the Fed to define what they mean by “after the economic recovery strengthens.”

The closest the FOMC statement comes to an objective is the following statement:

The Committee will closely monitor incoming information on economic and financial developments in coming months. If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability. In determining the size, pace, and composition of its asset purchases, the Committee will, as always, take appropriate account of the likely efficacy and costs of such purchases. [Emphasis added.]

This is hardly an explicit objective for policy. In addition, not only does the statement leave out an explicit objective, its one mention of a criteria for adjusting policy is a reference to the labor market. Does the Fed now believe that they can target employment? So some less skeptical of the Fed, this question might seem facetious. However, the Fed explicitly put in the statement that they will judge policy in accordance with fluctuations in the labor market. What is an acceptable amount of unemployment to the Fed? To what extent do they think that they can reduce unemployment?

Note here the important difference between the nominal GDP targeting example given above and the actual policy that is being implemented. The adoption of a nominal GDP level target would lead to higher nominal GDP growth in the short run which, given non-neutralities, would lead to a corresponding short run increase in real GDP thereby reducing unemployment. Thus, the objective of the policy would be to increase nominal GDP growth. The result of the policy (assuming that it is successful) would be to reduce unemployment. The actual policy of the Fed, however, seems to be to use unemployment as their objective. This is not the same thing.

This brings me to my final point. Throughout the discussion above, I was comparing the difference between actual Fed policy and a hypothetical nominal GDP target. This latter type of policy has become substantially more popular in the public conversation thanks to Scott Sumner. Its popularity in the economic literature has been somewhat lagging, but once had the support of Ben McCallum, Greg Mankiw, and others. More recently, Michael Woodford quasi-embraced nominal GDP targeting in his recent talk in Jackson Hole. However, Woodford also stated that he doesn’t see nominal GDP targeting as optimal policy. Rather, flexible inflation targeting in which the central bank targets inflation, but gives some weight to the output gap is optimal within the New Keynesian framework.

On this last point, Woodford is clearly correct — he wrote the book on optimal monetary policy in New Keynesian models, literally. Nominal GDP targeting can be consistent with optimal monetary policy in these models, but it depends on the particular characteristics of the model and the value of the parameters. Nonetheless, it is in the New Keynesian framework that nominal GDP targeting should find much of its support. Optimal monetary policy within these frameworks is defined as the policy that minimizes fluctuations in utility around the steady state. By performing a second-order Taylor series expansion of the utility function around the steady state and some mathematical manipulation, it can be shown that the optimal monetary policy is one that minimizes the weighted average of deviations of inflation from its target and output from its “natural” level. (This, by the way, is contrary to the assertions by Scott Sumner and George Selgin that the welfare criteria in these models is ad hoc.) Woodford is obviously correct that in this context that flexible inflation targeting is the optimal monetary policy. However, how should one use this criteria to practically guide monetary policy? I would argue that New Keynesians should advocate nominal GDP targeting because flexible inflation targeting places a large knowledge burden on central bankers as it requires that they know what natural (or potential) output is an any given point in time. In fact, we have very poor estimates of the output gap in real time — a point highlighted in work by Athanasios Orphanides.

Regardless of what policy is optimal, however, recent Fed policy is only a minor step in the direction of the desired policy of advocates of more expansionary monetary policy.