Competitive Federalism and Health Insurance: A Comment on Ezra Klein

In a federal system, such as the United States, we observe two forms of regulatory competition. Vertical competition when both the national government and some state government seek to regulate the same behavior. Horizontal competition occurs when states seek to regulate the same behavior.

The combination of the Supremacy Clause, the Supreme Court's expansive definition of what constitutes interstate commerce for purposes of the Commerce Clause, and the Court's cramped interpretation of the 10th Amendment means that the federal government will always prevail (assuming it has the political will) in competition with the states.

But suppose the federal government leaves an area to state regulation. We now have an opportunity, as Brandeis put it, for states to operate as laboratories of democracy. "It is one of the happy incidents of the federal system that a single courageous state may, if its citizens choose, serve as a laboratory; and try novel social and economic experiments without risk to the rest of the country."

This sets up a dynamic in which states can compete: If State A tries an experiment that succeeds, people will move to it, giving it a higher tax base. In turn, other states will respond by copying the successful experiment so as to retain citizens. The possibility of exit (albeit at non-trivial transaction costs) thus tends to lead to Pareto optimal results.

On the other hand, however, if the rules of the game are such that one state can regulate transactions that occur anywhere in the country, competitive federalism can lead to a race to the bottom. In corporate law, for example, the internal affairs doctrine provides that disputes about corporate governance are governed by the law of the state of incorporation no matter where the shareholders live. If a Delaware corporation has its principal place of business in California and is sued by a California resident shareholder in a California court, Delaware law controls. Those who believe that state competition results in a race to the bottom believe that Delaware’s corporate statute is skewed to favor the interests of corporate managers rather than those of investors. As the story goes, because it is corporate managers who decide on the state of incorporation, Delaware caters to management, allowing them to exploit shareholders.

This background is necessary for evaluating a post by Ezra Klein on proposals to facilitate selling insurance across state lines.

Klein explains that:

Insurance is currently regulated by states. California, for instance, says all insurers have to cover treatments for lead poisoning, while other states let insurers decide whether to cover lead poisoning, and leaves lead poisoning coverage -- or its absence -- as a surprise for customers who find that they have lead poisoning. Here's a list (pdf) of which states mandate which treatments.
The result of this is that an Alabama plan can't be sold in, say, Oregon, because the Alabama plan doesn't conform to Oregon's regulations. A lot of liberals want that to change: It makes more sense, they say, for insurance to be regulated by the federal government. That way the product is standard across all the states.
Conservatives want the opposite: They want insurers to be able to cluster in one state, follow that state's regulations and sell the product to everyone in the country. In practice, that means we will have a single national insurance standard. But that standard will be decided by South Dakota. Or, if South Dakota doesn't give the insurers the freedom they want, it'll be decided by Wyoming. Or whoever.

In other words, liberals prefer vertical federalism with the federal government prevailing, while conservative prefer horizontal federalism. Klein claims this will inevitably lead to a race to the bottom:

The industry would put its money into buying the legislature of a small, conservative, economically depressed state. The deal would be simple: Let us write the regulations and we'll bring thousands of jobs and lots of tax dollars to you. Someone will take it. The result will be an uncommonly tiny legislature in an uncommonly small state that answers to an uncommonly conservative electorate that will decide what insurance will look like for the rest of the nation.

The trouble with this argument is that true races to the bottom are pretty rare. (See Ogus, Anthony. 1999. Competition between National Legal Systems: A Contribution of Economic Analysis to Comparative Law. International and Comparative Law Quarterly 48:405-18, at 414.) In corporate law, for example, state competition leads to a race to the top. According to this account, investors will not purchase, or at least not pay as much for, securities of firms incorporated in states that cater excessively to management. Likewise, lenders will not lend to such firms without compensation for the risks posed by management’s lack of accountability. As a result, those firms’ cost of capital will rise, while their earnings will fall. Among other things, such firms thereby become more vulnerable to a hostile takeover and subsequent management purges. Corporate managers therefore have strong incentives to incorporate the business in a state offering rules preferred by investors and, as a result, competition for corporate charters should lead to statutes that maximize shareholder wealth. Although some still contest the claim, I believe the evidence is quite convincing that state corporate law in fact races to the top. (See my article available here.)

Consider the sole example Klein cites; namely, the credit card industry. It is true that South Dakota has captured a lot of the credit card business. But so has Delaware. The migration of credit card operations to South Dakota and Delaware began with the Supreme Court's decision in Marquette National Bank v. First of Omaha Service Corp., which held that a national bank can charge all of its customers the maximum interest rate permitted by the law of the state in which the bank is chartered even if that rate would be treated as usurious under the law of the state in which some of its customers resided. Delaware and South Dakota responded by loosening usury restrictions and succeeded in attracting banks to charter therein.

So a race to the bottom? Well, only if you think usury laws are pareto optimal. Personally, I think usury laws prevent efficient transactions from happening and constitute a paternalistic restraint on trade:

The wonderful thing about voluntary loan transactions in the free market is that both the borrower and the lender benefit from such transactions. Loan transactions occur in the first place because borrows and lenders have different rates of time preference, and the fact that the agreed upon rate of interest is very high does not change that reality. (Link)

In sum, the automatic assumption that horizontal competitive federalism will automatically lead to a race to the bottom is simply unfounded. A national market will expose insurers to more competition, which will require them to compete successfully by offering terms and prices that are attractive to consumers. Insurers that congregate in the states envisioned by Klein will be at a competitive disadvantage.

In contrast, the liberal preference for vertical federalism is likely to be anti-consumer. Regulatory capture is a lot easier when you only have to capture one regulator instead of 50.

Comments

[Mikey]

Auto insurers write polices that conform to many different states' requirements. Why would health insurers not do likewise?

There's hardly been a "race to the bottom" in auto insurance--rather, there's a booming market with many insurers, and plenty of competition.

Letting health insurers operate in similar fashion would certainly reveal how different states' coverage mandates influence the prices of various policies.

[Kevin T. Keith]

So your counter to Klein's example is to argue that the consumer credit card market is in fact optimal (or nearly so) for consumers. And your support for this claim is some airy prediction grounded on corporatist ideology, in defiance of the actual facts Klein cited.

How about some empirical evidence? For instance, the fact that the consumer credit market is a vicious cesspool which ruins its own customers' lives daily, and is universally hated?

(Note also that, although, by your argument, credit card companies *could* set up in the 48 less-prostrate states, they *don't* - which requires us to believe, again by your argument, that there just is no pressure whatsoever for credit card companies to do so. Their shareholders actually *want* them to operate in the states that give those shareholders as little rights as possible, as we can plainly tell, because they do so, so therefore their shareholders must want it. It has absolutely nothing to do with deregulation - in keeping with . . . what was it? . . . "the wonderful thing about . . . the free market", companies' shareholders and customers just want the companies to ignore their interests, and are oh so grateful to find that there are a few states that allow them to do so, as opposed to all the states that do require companies to be responsive, which nobody at all actually wants.)

But leaving aside the risible notion that there is just nothing that could possibly be done to make things better for credit-card customers other than giving their lenders even greater power over them, notice that the credit-card market and the health insurance market don't operate in anything like the same way.

The credit-card market, for all its faults, is at least selling a product consumers could largely or entirely avoid using if they chose. Healthcare is a virtual necessity, and healthcare insurance is the only reasonable way to finance it for the large mass of consumers (though many of them still forego it because they simply can't afford it). If you take a market in which customers are desperate to purchase, with literally their lives hanging in the balance, and arrange it so the terms of the purchases are entirely up to the most grinding and manipulative corporation in the least protective environment possible, it's just barely imaginable that things won't work out entirely to the benefit of the customer.

In addition to which, whether you believe in the market or not, the importance of a healthcare market is not that it maximizes profits for insurance providers, it is that it provides easy access to effective healthcare for as many people as possible. The argument for the free market has always been utilitarian - that free markets are good because profit-seeking happens to optimize outcomes. In some cases, that's clearly not going to be true (although it's unlikely we could have a not-for-profit credit-card company, we could easily have a non-profit healthcare system - most other industrialized countries already do). In the case of healthcare in the US, it's unmistakably not true because the market has already failed at that task. There is no argument for a free market in healthcare; that market patently does not do what a market is supposed to do, and in this case we don't have the luxury of screwing around hoping somebody will come around and sell the sizzle or whatever stupid thing it is that markets do that doesn't involve providing healthcare to people who are dying. We know how to deliver healthcare at affordable prices; the market refuses to do it; we ought to just go ahead and do it. Offering them incentives to do less for more as fast as they can is hardly going to help.

[steve]

You could have saved yourself the typing time by just saying Klein has another light wait, poorly concluded, sophomoric article about the topic of the day. Ezra is the master of quantity over quality. You know the monkeys typing theory, hopefully he creates his Shakespeare at some point in his life. Any way I am glad I happened across your blog it is well worth the read.

[Chris-gerrib]

Okay, so despite a documented race to the bottom in the credit card industry, we wouldn't see a race to the bottom in health insurance?

[save_the_rustbelt]

Klein is considered a major health care expert by many on the left, but his only qualifications are:

1. being a blogger, and
2. ah, ah, nothing else

[Allan]

Another problem is regulation. I know, you think regulation is bad. But sometimes it can be useful.

If I have a problem with my insurance (auto, home, or health), I can go to my state insurance commissioner, who is relatively responsive and (I hope) not captive to the industry.

Whom do I go to for my credit card problems? Case in point is automobiles. The NTHSA is not very responsive to consumers because it is relatively insulated...

There is no simple solution. But it should be clear that allowing companies to sell in a state without giving the state the ability to regulate the product does create problems.

By the way, if usury laws were so bad, would not states adapt their laws to allow infinite interest rates? Seems to me that a lot of places thought that "blue laws" were bad and they were repealed (except for car sales).

[Chris Bolts Sr.]

You could've save even more time by just giving one example: DVD players, or in this case, Blu-Ray. When the first Blu-Ray hit the market in 2006 it cost anywhere around $1,000. Fast forward a scant 4 years and a Blu-Ray can be had for as low as $150. This "race to the bottom" argument that liberals always use to counter free market competition is always baseless. More insurers = more choices for consumers = insurers needed to compete on all cylinders (price, quality, accessibility, features) to win consumers.

And there has been no race to the bottom in credit cards. Credit card companies aggressively compete for consumers by offering attractive rates and generous program (prior to the implosion in the credit market). If there is a "race to the bottom" in credit cards I have yet to see it.

One more thing, healthcare is not a necessity, but a privilege. You first should take care of yourself as you yourself is the major determinant in determining your quality of health. When you get sick you are obliged to pay a doctor for his prognosis and he'll give you a recommendation. You're free to follow or ignore the doctor's advice. Finally, if you come down with a serious illness or need emergency medical services you can purchase insurance to cover these unforeseen events. Our problem is that we have turned insurance into an entitlement that treats for everything that is completely unrelated to an unforeseen event. People like Ezra Klein and Paul Krugman would seek to keep insurance operating that way and exacerbate our problems.

[Sean L.]

Kevin,
You are wrong on many points -

"...it's unlikely we could have a not-for-profit credit-card company..."

Actually, we have lots of them. They're called credit unions. Here's one: https://www.wescom.org/loans/creditcards.asp

"There is no argument for a free market in healthcare; that market patently does not do what a market is supposed to do"

If by 'that market' you mean a government-controlled hyper-regulated market. If you take a look at the ONLY part of the health care system that actually is a truly free market, you'll see market forces working perfectly:
http://reason.tv/video/show/how-to-fix-health-care

And my favorite, "the fact that the consumer credit market is a vicious cesspool which ruins its own customers' lives daily, and is universally hated?"

That's a fact, is it? This reminds me of another quote about Ruggeri's restaurant in St. Louis, "Nobody goes there anymore. It's too crowded."
http://en.wikipedia.org/wiki/Yogi_Berra#Quotes

[David Welker]

I think your argument is incorrect. Even if there is not a race to the bottom in the corporate law context (which I doubt) because investors tend to be somewhat more sophisticated, you cannot expect most ordinary consumers to understand the nuances of how insurance contracts are regulated differently in different states. In fact, the difficulty of consumer comprehension of insurance contracts is the primary justification for regulating insurance contracts at all.

Now, your point about whether there has been a race to the bottom in the usury context is merely so much quibbling. You don't think that usury laws are desirable, so you don't mind having those laws undermined. To you, this is not a race to the bottom, but a race to the top. But the problem is this. We should not label something a race to the bottom or a race to the top based on your individual policy preferences. Instead, if the policy preferred by a democratically accountable majority is undermined, it should be considered a race to the bottom, regardless of the underlying goodness of the result.

Consider this hypothetical:

If 90% of the people in California disagree with you about usury, shouldn't they get what they want, absent being overruled by Congress? They may be, from your perspective, wrong, but don't people have the right to be wrong?

I don't see how you can argue that what has happened in the credit card context is not a race to the bottom from the perspective of the majority of people who are against usury. And it should even be a race to the bottom from your perspective, because you should know that the proper way to bring change to usury laws should be to convince a majority of your fellow citizens in California that usury laws should be ended, not a majority of the citizens in South Dakota.

Another problem with this is the lack of accountability. The goal is apparently to end the regulation of insurance. This fits into the narrative that regulation is bad, which has been advanced by Republicans since the Reagan era. Well then, let Congress pass a law saying that the states no longer can regulate insurance. Then there would be accountability. But ending insurance regulation by saying that it will be regulated by the states is deeply problematic, in so far as most people do not realize that this would be the effective end of insurance regulation. An honest advocate of ending regulation of insurance should do so directly, rather than play games in order to avoid accountability for doing something that would be very politically unpopular. In other words, an honest advocate should not merely pass a law that has the indirect effect of ending insurance regulation, but should pass a law that has that direct effect.

[David Welker]

Oh, I should have put that last paragraph differently.

I meant that it is a dishonest way to advocate for insurance deregulation by saying it should be allowed to be sold across state lines, when the practical effect of this is to end insurance regulation and where this is the intended effect.