Where Health Care Cuts Will Hit

 | Oct 17, 2011 | 4:30 PM EDT  | Comments
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Budget deficit reduction is not just a political concept. It can affect the economy in real ways and how those deficits are reduced may shape which sectors outperform others.

Government expenditures are dollars that flow into the real economy and deficits are funded in large part by U.S. borrowing, often from abroad, in dollars that don't all necessarily come out of our own economy (although they are financed in part by our trade deficit with our creditor nations).

I've argued that it is impossible to reduce the budget by any meaningful degree by only cutting appropriated (discretionary) spending, as our deficits swamp most spending in that category. Absent significant revenue increases, the cuts also need to come from entitlements, especially Medicaid and Medicare.

The St. Louis Fed recently published two papers on the budget deficit generally and why the cuts need to come from cutting health care spending.

As our population ages -- not just because of the Baby Boomers retiring, but also due to a lower birth rate more broadly -- more of our population will be collecting Medicare benefits, but there will be fewer people paying into the system. We can either raise taxes or we can cut, or at least curtail, the growth of health care spending to reduce those large projected deficits.

It is those large deficits down the road that are the biggest challenge. Right now, we don't have any trouble financing the current budget deficit. Treasury yields are very low, indicating creditors are confident in our ability to repay those debts. And there is no evidence of crowding out of government borrowing at the expense of borrowing by the private sector, as these low rates demonstrate. 

The problem is that projections of deficits into the future are troubling, and that is where we need to focus our efforts. This is in contrast to a focus on the garden-variety spending and revenue issues we have now, much of which is largely related to the current economic climate and which could dissipate on their own once conditions improve.

What won't just go away on its own is how much we spend on health care, as that is a function costs, rising faster than overall inflation and consumers' expectations of and demands for premium coverage. As an example of how health care spending has grown in the past, one can use the gross output by industry data from the Bureau of Economic Analysis and determine that, since 1987, gross output of the health care sector as a percentage of total output expanded by 56%. It has increased by an average annualized 6.8% in absolute terms, far above the 4.7% annual growth rate of aggregate gross output of all industries. That type of increase will likely only accelerate as the population ages and medical care becomes more complex, with newer (and more expensive) technologies, medical devices and pharmaceuticals.

This growth aspect of health care has helped the sector weather the recession relatively well, especially when one looks at employment within the sector.  While total nonfarm employment is still about 5% below its level just prior to the beginning of the recession, employment in the health care sector increased more than 8% during that period.

So, what happens to growth in that sector if we try to trim health care spending?  When we talk about cutting entitlement programs, like Medicare, we need to think less in an abstract sense and more in terms of impact on the economy and specific sectors. Medicare reimbursements are not mailed to Mars. They are sent to doctors, hospitals, pharmaceutical manufacturers and makers of medical devices. Cutting health care spending means curbing the growth of a sector that has been particularly resilient to current, adverse economic forces.

These changes aren't going to happen right away. But we do need to consider how reducing health care spending is going to affect that part of the economy and the companies that operate in that space and the people they employ. I will leave it up to securities analysts to divine the effects of how cutting the budget deficit by reducing health care spending will affect those companies' bottom lines.

But deficit reduction will affect employment, as well as the revenues and profits of companies that might be on the receiving side of those Medicare reimbursements.

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