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The reason is that it's not labor cost that's the relevant measure.  It's productivity.  And productivity can depend on many factors.  As a somewhat contrived example, let's take two farmers.  One, an American farmer, has the benefit of all the modern tools and methods.  The other, a third-world peasant farmer, has an ox and a bag of seed saved from last year's harvest.  Let's suppose the modern farmer might make $50,000 per year.  The peasant farmer, $1000.  Which is overpaid?  If one compares only wages, the clear answer is the modern farmer, by a factor of 50.  But the modern farmer produces far more crops – both in terms of how much field he can cover, and in terms of how much crop can be grown per acre with modern hybrid seeds, pesticides, etc.

Relevant productivity, however, can depend on more than equipment.  The modern farmer has a modern highway system, and modern trucks to move his crops to the big city to sell.  The peasant farmer can hitch up a cart to his ox, and, if he's lucky, take it over rough paths to the nearest town.  More generally expressed, infrastructure has an impact on productivity.

But your typical American farmer won't generally drive his own crops into the city to sell, but will have access to numerous distributors who will buy his crops and be able to ship them to wherever they will command the highest price – and because here are many such distributors, the competition among them will guarantee the farmer gets the best price available to him.  The peasant farmer, if he's lucky, might have one middleman, who might aggregate crops from various peasant farms and take them to a single city, getting whatever price might be available in that city – already likely less than the modern farmer would receive, and because of lack of competition among middlemen, the peasant farmer will get less still.  Business infrastructure also has an impact on productivity.

Eventually, the peasant farmer will get tired of farming by ox and want to buy a tractor of his own.  Unfortunately, that avenue is likely closed to him – making barely subsistence wages, there is no way that he could ever save up enough money to buy a tractor.  The American farmer didn't have enough money either, but he was able to get a loan from the local bank.  Financial infrastructure also matters.

The point is that in the US, we have all of these things in place.  Many other countries do not – and are not likely to any time soon.  The reason is that all of these things have their foundation in three core values that each nation must affirm for itself – the rule of law, property rights, and economic freedoms.  Compare, for instance, East and West Germany immediately before the unification – the East Germans were no less hard working than those in the West, and moreover shared a language, culture, and geography.  But what did it profit them?  After years under socialism, East Germany was, for all intents and purposes, a third-world country; West Germany was one of the mightiest economies in the world.

While the farming example might have been somewhat contrived, it's not too far from the truth.  In a recent study conducted by the United Nations, American workers are the most productive in the world.  And the hypothetical farm workers?  At $50K, the US farmer turns out to be the bargain.  The average Chinese farmer, with only $910 in output, would be overpaid at 1/50th of the salary of the US worker – despite, one presumes,  working dramatically longer hours.

A true gloom-and-doomer reading this might think “sure, but it's only a matter of time before many third world countries have the physical, business, and financial infrastructure that we do, and then we'll be in real trouble”.

We won't be, but that's the subject of the next article.

Part of the problem is that increasing costs are a natural consequence of any system where price is not factored into decision making.  If someone else (the insurance company in this case) is footing the bill, there's no motivation to shop around for a lower cost.  As a result, providers are under no particular pressure to keep prices down, and, surprise of surprises, costs rise.

But there's another aspect here that appears to be generally overlooked which is relevant not just to the question of healthcare costs, but to many inflation measures.  Namely, that it's inherently wrong to just compare prices between two different time periods, even when those time periods are only separated by a year.

The reason for this is that it's generally two different things that are being compared.  As an illustration, let's step away from healthcare for a moment and look at computers.  A modern-day computer was not available at any price five years ago.  Conversely, if someone were to attempt to manufacture a computer based on state of the art from five years ago, it would be difficult to sell for any price today – who would want it?   Even a one year old model has to be heavily discounted to be able to sell in a market full of better hardware.

The point is that looking solely at costs ignores the fact that a dollar today is buying a much better product than it was in the past.  In that regard, medicine is actually quite similar to computer hardware – in both fields the rate of progress is very high.  While it's easy to get upset about how much more expensive medical care continues to become, think about this the next time you find yourself complaining – if you were seriously ill, would you rather have access to the modern-day state of the art, or, when your life depends on it, would you prefer substandard simply because it would be cheaper?

Another problem with Gross's claim is that he appears to be confusing price and value.  To quote an old adage, “price is what you pay, value is what you get”.  Even in a reasonably liquid market (which housing is most certainly not) it is possible for assets to be bid up beyond their realistic value.  Take the stock market bubble of the late 90's for instance.  Is the housing market similarly overvalued?  Three common metrics would suggest yes (see for instance Davis, Lembert, and Martin; MSNBC, or efinancedirectory.  First, a comparison of home price  to imputed rental income (a similar approach to a P/E analysis for stocks) suggests home prices are higher than “fair” (using historical norms as a proxy for “fair”).  An analysis of median home price versus median income similarly suggests prices are too high. Finally, an analysis of home price movements alone suggests the recent runup has been well outside of historical norms.  If it is indeed the case that house prices are too high compared to their values, prices will fall.  Markets might not always be efficient, but they get there eventually.  And his fall will happen regardless of whether the government bails out homeowners, bondholders, or no one at all.  But what if these analyses are wrong?  What if prices are not meaningfully higher than fair value?  In that case, it's hard to understand by what mechanism the market will fall.  And Gross doesn't posit one – perhaps he assumes that foreclosures alone will accomplish this.  But even in the face of high foreclosures, if prices are fair, any drop in prices should reflect an incredible buying opportunity for investors and home seekers alike, who would be able to obtain properties at a net discount to fair value.  And thanks to the miracle of leverage, would therefore stand to make a tidy profit by buying, and in so doing, providing considerable stabilization to prices.

The last issue with Gross's claim is that he appears to be making the fallacious assumption that housing is a liquid market. It's anything but – due to location specificity, transaction costs, unpleasantness of moving, and lack of similarity.  The vast majority of people have quite long time horizons for their homes.  Just as the runup in prices did not translate into realized gains for the vast majority, the same will be true for any short-term drop in prices.  While on paper there might be considerable asset deflation, it's a form of deflation that is simply not relevant tot he vast majority of homeonwers.  Contrast that with the stock or bond markets.  Such instruments tend to be frequently traded (being highly liquid).  Even if one doesn't sell a security, being a liquid instrument, one generally has to “mark to market” upon price change, having immediate impact on a bottom line.  There is not, nor can there be, due to their illiquid nature, any similar “mark to market” mechanism for housing.  Simply put, given the long-term nature of residence, any short-term price dip is not going to have any substantial macroeconomic consequence.  Yes, anyone who has to sell during a dip will realize a lower price.  But remember that for the vast majority, even if prices drop 10% (if you still believe this number, please reread the last two paragraphs), they will still have huge gains in their house thanks to the amount of gains during the recent boom years.  There will, granted, be some who end up taking a loss – generally those who bought at the very end of the boom cycle.  And that they will lose money is truly unfortunate.  But no more unfortunate than any other case in which people lose money, and certainly nothing that would rise to the level of a national emergency requiring the taxpayers to foot their bill.

Every sort of investment bears risk.  To the extent that one understands those risks, there is a potential for profit to be made.  But there is also the potential for loss if one judges risk poorly. For a free market system, both profit and loss are important – profit as a reward and motivator for success, loss as a punishment and disincentive for those who have made poor choices.  Those who bought the CDOs/MBSs stood to make a nice profit if things went well - to which they would have been justly entitled.  Any losses that may result, however must also be borne by them.  A situation in which a party can enjoy the upside of gain but is shielded from loss – effectively what Mr. Gross is suggesting - results in a detrimental future risk behavior, as per yesterday's discussion of moral hazard.  Sad though it may be, losses are every bit as important to a free market system as profits – as it is aversion to loss that motivates one to prudence in risk taking.  It's unfortunately the same for the homeowners that Mr. Gross claims to be speaking in the interest of.  Those who made questionable mortgage decisions expecting rising real estate prices to make them rich regardless stood to make a bundle if they were right – and many of them were.  But it is neither just nor economically sound to remove the potential for loss from those who were wrong at the expense of those who made more prudent choices.

The second and third “solutions” are both predicated on the notion of forcing taxpayers to cover the losses of those who took unwise risks.  This brings with it its own moral hazard issue.   If those who made money off risky mortgages are rewarded, and those who lost are bailed out, the government sends a loud and clear message – take any risk you want, however bad, and we'll be there for you.  There's also the inverse message to those who didn't take the risks – by taking from them (via taxes to cover the bailout) to reward those who acted foolishly, the government punishes them for their discretion.  Are these really the messages we want to be sending?  Perhaps the best summary is from the Fed itself:

“The last thing we should want, therefore, is to widen or spread this unintended but nevertheless corrosive dimension of the safety net to other financial and business entities and markets. It is clear that to do so would not only spread a subsidy to new forms of risk taking.....”

More on this topic in the next article.

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