“The Cost Disease: Why Computers Get Cheaper and Health Care Doesn’t” by William J. Baumol and others

We’ve all read many articles recently about the increasing costs of important services, health care chief among them. The rising costs of education, social services, and the arts have rated hand-wringing as well. “The Cost Disease” provides a fascinating counter to this view. In the book, William J. Baumol, an economist at NYU, and his co-authors argue that the rising productivity of manufactured goods (because automation reduces the amount of labor required to produce them) offsets the rising costs of services (whose costs rise because the amount of labor required cannot be reduced). What’s more, he argues, we can afford them and should continue to pay for them.

The cost disease, Baumol argues, is the perception that because costs of services like health care are rising faster than the rate of inflation, they are being priced out of our reach. But this perception, he says, is wrong. The problem is two-fold. It’s not so much the costs themselves that bother us as it is the rate at which costs are increasing. When we look at an average increase in real costs, we forget that it’s an average – and that while some costs increase faster than the average, others decrease slower. The costs of providing education, health care, or arts like opera, dance and music require a lot of labor. And the people providing that labor need to be paid enough to live, and to keep them from moving to other jobs. Baumol notes that he first published the theory in the 1960s – and that the data of subsequent years have confirmed it. For example, he reports, the salaries of health care workers have barely kept up with inflation, and those of employees at colleges and universities did not.

So, Baumol argues, if we think about the economy overall and understand that the unevenness of productivity growth is the source of the perception we will be able to afford increasing costs, even as the services take over a larger section of the economy. (He views that as an effect, not a cause.) The cost of manufacturing will continue to decrease and we will continue to to innovate so the economy will continue to grow. He cautions that because the poor will continue to get poorer, we must make a choice to cut back on some manufacturing and invest in social goods. Baumol attaches some caveats to his prediction, among them the need for wise government policy-making, careful education of the public, and tackling some of the foremost problems we have already created: climate change, the easy availability of dangerous weapons, and, well, our own cupidity.

Baumol discusses cost disease in these contexts as well as in the context of global health care, and those chapters are very interesting. One point is important to note: in health care at least, the quality-adjusted productivity has increased; that is, we're getting more benefits from our care. But when, he says, we look at productivity not adjusted for quality the result more mixed. If we don't do look at productivity alone, we fail to think about how much money must be raised to purchase a product. If this sounds a lot like a cost-benefit analysis it is, but it's an analysis that includes the context of the services. And that exposes a paradox: as Baumol puts it, we want the improvements in health care but don't like the associated costs.

It's when Baumol discusses the hybrid sectors of the economy, such as Research and Development or social services that things get really interesting. In these sectors, the cost of equipment, such as computers to support the work quickly become negligible compared to the labor costs. But the work is heavily labor-dependent: you can't, for example, trust a computer algorithm to come up with the right combination of services, in the right order, to help a family enough to prevent a steep decline into violence or child neglect. This imbalance often leads to poor government-decision making in the name of cost-savings.

But there is cause for hope. In addition to recognizing the cost disease, there are some hybrid sectors of the economy that repay investment. Software and business process services are Baumol's prime examples, as each repays investment two and three times, once when the developing company puts them to work and again when their customers do. Another way of thinking about them is as inputs to other services. This reframing can - and should - be applied to social services as well. A prime example is Steve Rothschild, whose book "The Non Non-Profit" I reviewed here. Rothschild sets out "create economic value from social benefit" as a key value. Doing so is critical, because showing that services create taxpayers from people who otherwise might continue to receive government benefits indefinitely is a compelling argument about efficacy - and for future funding.

"The Cost Disease" is a well-written book, very clear even for non-economists. (If I have one quibble, it's that the small pages mean that the small charts can be very hard to read.) The book should be required reading for anyone interested in public policy.

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"The Non Nonprofit" by Steve Rothschild

A friend recommended "The Non Nonprofit" by Steve Rothschild and I'm glad he did, because the book takes a completely different approach to the problem of paying for social services from anything else I have read. The book is organized around seven principles, with an additional chapter about how important it is to put the principles into practice together.

Rothschild is a former executive at General Mills who went on to use his business experience, acumen, and connections to form a nonprofit, Twin Cities RISE!, whose purpose is to reduce concentrated poverty. Notice the use of the word purpose where you might expect to see mission. Organizations need both, Rothschild explains. Purpose guides programming, reinforces a long-term perspective, and encourages flexibility and innovation. Mission, on the other hand, is concrete. It sets out what the organization does (and does not) do; it puts the purpose into operation. Rothschild's first principle? "Have a clear and appropriate purpose."

The other principles are worth bearing in mind also - measure what counts, be market driven, create mutual accountability, support personal empowerment, and be learning driven. All good things, and Rothschild's take on them, particularly the mutual accountability and personal empowerment sections, are worth reading. Alert readers will have notice that so far I have mentioned only six principles.

The seventh is "Create Economic Value from Social Benefit." In this chapter, Rothschild argues that since every improvement in social good creates social value it is up to nonprofits to quantify who is receiving the value and what it is worth. As he puts it, our current approach to financing social service work "doesn't make sense." Why not? We have big problems, but pay small organizations to deal with them. The problems are systemic, but we spend money in one to two year cycles. Nonprofits focused on these issues don't have access to the long-term capital that for-profits do.

Rothschild outlines two alternative approaches to what he calls the "no financial return expected" approach - the one that government and philanthropic funders use now. These approaches go beyond performance based contracting as it is practiced now. Both depend on calculating a firm and credible return on investment.

I have discussed one of the alternatives, social impact bonds, here (as well as its cousin health impact bonds, here.) Rothschild's alternative, and he appears to have invented the concept (and founded an organization that worked for passage of a Minnesota law to try it out), is the Human Capital performance bond. One explanation of Human Capital Bonds is:

Human Capital Performance Bonds . . . are State AA "annual appropriation" bonds that fund high-performing human services.

The bonds pay market rates, and might be bought by private investors, financial institutions, or social investors. As Rothschild puts it:

The basic mechanism of the [human capital bond] is simple: if the social outcomes that a nonprofit generates create economic value that is greater than the state's cost of borrowing the funds, then the state will have both a social and economic incentive to sell the bonds.

Here's a diagram of how it works:

Human Capital bonds have yet to come into existence, even in Minnesota, and there are lots of questions remaining to be answered. For one interesting take, see this article.