The president tells us that we should be “bending the cost curve” on healthcare, and politicans everywhere are scrambling to present their favored pork projects as plans that would do just that. Lobbyists of every stripe and color are storming legislative offices with great wads of dead presidents and the commentariat debates angels dancing upon pinheads: that is, what could be done if we had a legislative system without legislators, pork, lobbyists, or dead presidents printed on pieces of paper.

What I have yet to see (and apologies to those who have said it but I have not seen their doing so) is the simple and obvious explanation for why medical treatment costs keep going up. No, it is not because of insurance companies gouging us all, no, it is not the American Medical Association restricting the number of doctors. Nor even is it an aging population, a lack of government involvement, or too much of such—and it is not even the fact that good 5-cent cigars now cost $5.

It is because healthcare is a service, dunderheads. Services go up in cost relative to manufactures. That is just what they do. This does not contradict Robert Fogel's point in THE AMERICAN that we desire to spend more money on healthcare as our incomes rise, it is rather an explanation of why medical costs, rather than the amount of income we spend on them, rise over time.

The go-to economist here is William Baumol, who explained back in the 1960s that it is much more difficult to increase productivity in services—the productivity of labor, that is—than it is in manufacturing. His example was that we cannot make a symphony orchestra more productive by asking them to play faster: add to this the well-known idea (even New York Times columnist Paul Krugman has been known to make this point) that average wages in an economy are determined by average productivity, and it is possible to construct an argument that services will become more expensive relative to manufactures over time.

While increasing productivity in services is difficult, it is not impossible.

Improving the productivity in manufacturing (or indeed farming) means that average productivity has gone up: thus we expect average wages to rise. But we have reduced the use of labor in manufacturing a great deal more than we have in services. Thus, the costs of the labor component of services will rise relative to those embedded in manufactured goods. Another way of putting this is that services will have a higher inflation rate than the average, because that average is, of course, of all sectors of the economy. This is why it should surprise no one that both medicine and higher education, both of which largely rely upon stonkingly large amounts of trained labor, have higher inflation rates than other parts of the economy. Yet it still does seem to surprise many, including an alarmingly large number of policy makers.

Now there is a way out of this: the conundrum posed by Baumol's cost disease (also called the Baumol effect). Our problem is that even if medical technology stayed static, if we did not have an aging population, and if we found no more expensive treatments for this or that, medical costs would still rise faster than inflation as the country grew richer. For our mismatch in improvements in the productivity of labor would still exist. The way out is that while increasing productivity in services is difficult, it is not impossible. With the symphony orchestra we do not ask them to play faster. We simply record them and then use our gramophones/Walkmen/iPods to replay that recording. Similarly, imagine the costs of retail banking services if we all had to use a human teller every time we wanted to make a transaction: the ATM and the Internet have reduced that massively.

That is the way out of the cost-disease problem, some mixture of invention and innovation which allows us to replace the human labor part of the provision of a service. As it happens, the go-to economist here is also one William Baumol, for he has been spearheading the attempt to study technological advance as something other than simply exogenous to the economy (“exogenous” is the economist's fancy word for “it just happens”). His simple observation is that there is something unique about this blend of capitalism and free markets as an economic system. No, strangely, it is not in what he defines as invention, the thinking up and creation of new stuff. As he observes, the Soviet Union came up with some pretty spiffy stuff even in the non-military world. In the medical field for example, the Soviet Union perfected, even if they did not entirely originate it, the idea of corrective surgery to obviate the need for wearing glasses.

Bending the cost curve through legislative fiat is silly, but to do so by limiting either capitalism and markets or innovation in new technologies is, quite frankly, insane.

No, the part that this capitalism/markets mix does so well is what Baumol calls innovation: the spreading of this spiffy stuff throughout the economy so that the new methods, techniques, and things raise the productivity of us all. The Russian Academy of Sciences may well have done the initial research that made Lasik possible, but it was the profit motive (i.e. greed) and competition that led to it being available on half the street corners of the nation at $500 an eye. This dynamic leads, over time, to this:

Nordhaus brackets the growth of real wages over the past century as somewhere between a 20-fold and a 100-fold increase. Alan Greenspan ... has suggested adjustments of the statistics that lead to an estimate of a 30-fold increase of material wealth over the past century. (DeLong 2001)

Imagine how much more expensive medicine is going to get with a similar rise in real wages over the next century: if we do not find some way to increase productivity, of course. And as we have already noted, it is not the National Institutes of Health or government that contributes to innovation. They can and do indeed invent, but not much in the way of innovation.

In fact, looked at this way, the complaint that the pharmaceutical companies spend more on advertising than basic research is the wrong way around. For if it is innovation that matters, the fanning out of the new methods across the economy, not the creation or invention of them in the first place, then advertising is more important than research.

Technology reduces the costs of providing services by reducing the amount of labor that must go into that provision.

Which leads us on again to the idea that the way to reduce the inflation in medical costs is to curb the use of “high-tech” medicine. Dr. Ezekiel Emanuel, the president's healthcare adviser, is said to be a fan of this idea, which is worrying. For of course it is entirely and absolutely wrong. It is precisely and exactly technology that reduces medical costs by increasing the productivity of labor.

As a silly example: there was a time when the only treatment for a headache was a comely maiden bathing one's temples with a wet and cool towel. Now we just pop 3 cents’ worth of aspirin. No, it is not a lack of comely women (nor the shortage of maidens in the technical sense in modern America) nor damp towels which has led to the change: it is that labor is now expensive and pills cheap. Technology reduces the costs of providing services by reducing the amount of labor that must go into that provision, a welcome change at a time of rising labor costs.

What we really want to do is to routinize and mechanize as much of the medical process as we can, and the one spur, the workable incentive, that we know encourages this is that combination of greed, profits, the division of labor and specialization, and the urge to find cheaper ways of doing things which comes from that odd but unique interaction of capitalism and markets.

It is a basic truism that if you do not identify the source or cause of a problem then you cannot discover a workable solution to said problem. The current laboring of the elephant will indeed produce a mouse to address the perceived problems of healthcare unless we grasp the basic points—that we want more, not less, high-tech medicine and that to get from here to there we have to harness both markets and capitalism to our desires, not attempt to abolish them from the system.

In short, attempting to bend the cost curve through legislative fiat is simply silly, but to try and do so by limiting either capitalism and markets or innovation in new technologies is, quite frankly, insane.

Tim Worstall is a writer regularly published in UK and U.S. national news outlets.

FURTHER READING: In “A Healthcare Free Lunch?” Worstall questions whether a government healthcare takeover would reduce healthcare's total cost.

Image by Darren Wamboldt/Bergman Group.