In the early days of hospital insurance, however, this fundamental defect was hardly noticeable. Twenty-one days was a very long hospital stay, even in 1929, and with the relatively primitive medical technology then available, the daily cost of hospital care per patient was roughly the same whether the patient had a baby, a bad back, or a brain tumor.

Today, this “front-end” type of hospital insurance simply does not cover what most of us really need insurance against: the serious, long-term illness that can be diagnosed and treated only with very sophisticated and expensive technology. In the 1950s, major medical insurance, which does protect against catastrophe rather than misfortune, began to provide that sort of coverage. Unfortunately it did not replace the old plans in most cases, but instead supplemented them.

The original hospital plans also contained the seeds of three other economic dislocations, unnoticed in the beginning, that have come to loom large. The first dislocation is that while people purchased hospital plans to be protected against unpredictable medical expenses, the plans paid off only if the medical expenses were incurred in a hospital. Cases that could be treated on either an inpatient or outpatient basis therefore became much more likely to be treated in the hospital, in order to take advantage of the insurance. This, of course, tended to maximize the use of hospitals, the most expensive form of medical care.

The second dislocation was that hospital plans did not provide indemnity coverage. Again, let’s look at auto insurance, which indemnifies the holder against loss. If a policyholder’s car is wrecked, the insurance company sends him a check for the value of the car, and the insured then shops for the best way to be made whole. He might have the car repaired, having looked around for the cheapest competent mechanic. He might use the money as the down payment for a new car, selling the wreck for what he can get. He might even put the money in the bank and walk to work thereafter.

But medical insurance provides service benefits, not indemnification. In other words, the insurance company pays the bill for services covered by the policy, whatever that bill may be. There is little incentive for the consumer of medical services to shop around. With someone else paying, patients quickly became relatively indifferent to the cost of medical care. This suited the hospitals perfectly because they naturally wanted to maximize the amount of services they provided and thus maximize their cash flow, smoothing out their financial problems. Doctors liked this arrangement for precisely the same reason that jewelry-store owners like vain women with rich and adoring husbands. If patients are

None of this is to libel doctors or hospital administrators, but only to note their humanity. They pursue economic self-interest just like everyone else, and arrangements that maximize income are always going to be looked upon favorably by those whose incomes are maximized. One result was that the medical profession began to lobby in favor of this system. In the mid-1930s, for instance, as Blue Cross plans spread rapidly around the country, state insurance departments moved to regulate them and force them to adhere to the same standards as regular insurance plans. Specifically they wanted hospital plans to set aside reserve funds in order to handle unexpectedly large claims, a necessary but expensive part of the insurance business.

Had hospital plans come to be regulated like other insurance companies, it is likely that they would have begun acting more like insurance companies and the economic history of modern American medicine might have taken a very different turn. But they were not. Doctors and hospitals, by and for whom the plans had been devised in the first place, moved to prevent this from happening. The American Hospital Association and the American Medical Association worked hard to exempt Blue Cross plans from most insurance regulation, offering in exchange to enroll anyone who applied and to operate on a nonprofit basis. The Internal Revenue Service, meanwhile, ruled that these plans were charitable organizations and thus exempt from federal taxes.

Because they were freed from taxes and the need to maintain large reserve funds, Blue Cross and Blue Shield (a plan that paid physicians’ fees on the same basis as Blue Cross paid hospital costs) soon came to dominate the market in health-care insurance, with about half the policies outstanding by 1940. In order to compete at all, private insurance companies were forced to model their policies along Blue Cross and Blue Shield lines.

Thus hospitals came to be paid almost always on a cost-plus basis, receiving the cost of the services provided plus a percentage to cover the costs of invested capital. Any incentive for hospitals to be efficient and thereby reduce costs vanished. In recent years hospital use has been falling steadily as the population has gotten ever more healthy and surgical procedures have become far less traumatic. The result is a steady increase in empty beds.

Did the hospitals shrink in size as a result? Not nearly enough. Because of the cost-plus way hospitals are paid, they don’t compete for patients by means of price, which would have forced them to retrench and specialize. Instead they compete for doctor referrals, and doctors want lots of empty beds to ensure immediate admission and lots of fancy

Doctors, meanwhile, came to be reimbursed for their services according to what were regarded as “reasonable and customary” charges. In other words, doctors could bill whatever they felt like as long as others were charging roughly the same. The incentive to tack a few dollars onto the fee became strong. The incentive to take a few dollars off, in order to increase what in crasser circumstances is called market share, ceased to exist. As more and more Americans came to be covered by health insurance, doctors no longer even could compete with one another for patients on the basis of price, let alone have an incentive to.

The third dislocation that lay hidden in the early hospital plans was that they paid off for illness but not to maintain health. Imagine an automobile insurance company writing a policy on a very expensive car, guaranteeing to pay for any needed repairs by any mechanic of the owner’s choice, regardless of cost, but not requiring the owner to have the car regularly maintained, inspected, or used in a prudent manner. If the owner never changed the oil or checked the radiator hoses, if he added dubious substances to the fuel—or to himself—to improve his immediate driving pleasure, the company would have to pay for the eventual results. Needless to say, such a company would be out of business in short order. But that is precisely the way many health insurance policies are written even today. The result in today’s high-tech, high-capacity, high-expense medical world is economic lunacy.

The cost of bringing a single seriously premature baby out of danger, for instance, would pay for the prenatal care of thousands, sometimes tens of thousands of babies and would prevent many such premature births. But many poor parents cannot get prenatal care, so society often has to spend as much as a quarter of a million dollars to rescue a child from a tragedy that could have been prevented in many cases for one-tenth of one percent of that sum.

Most company health plans in this country charge no more to insure smokers and heavy drinkers than they do their more sensible co-workers. Couch potatoes are insured for the same amount as their regularly exercising friends. And, because the system is weighted heavily in favor of acute care, acute care has become where the money is and thus where doctors tend to concentrate. Surgeons and surgical subspecialists earn six or seven times as much as primary-care physicians (the family doctor, in other words) in this country, even allowing for the difference in skills and training. It is not hard to see why the United States has more surgeons, per capita, than any other country in the world and, no surprise, more surgery.

During World War II, there

The IRS ruled that the cost of employee health-care insurance was a tax-deductible business expense, and in 1948 the National Labor Relations Board ruled that health benefits were subject to collective bargaining. Companies had no choice but to negotiate with unions about them, and unions fought hard to get them.

Businesses could now pass on a considerable portion of the cost of health insurance to the government via the tax deduction. (The deduction currently costs the federal government about $48 billion a year.) But a private individual buying his or her own policy could not. Thus, a powerful incentive for employer-purchased health care was built into the system. By 1950, as many as 54.5 million Americans were covered by employer-provided health plans out of a population of 150 million.

But the company plan increased the distance between the consumer of medical care and the purchaser of medical care by one more layer. When individuals have to pay for their own health insurance, they at least has an incentive to buy the most cost-effective available, given their particular circumstances. But, beginning in the 1940s, a rapidly increasing number of Americans had no rational choice but to take whatever health-care plan their employers chose to provide.

There is another effect of employer-purchased health insurance, unimagined when the system first began, that has had pernicious economic consequences in recent years. Insurers base the rates they charge, naturally enough, on the total claims they expect to incur. Auto insurers determine this by looking at what percentage of a community’s population had auto accidents in recent years and how much repairs cost in that community. That is why they charge someone living and driving in Manhattan far more every year than they would someone living in Frozen Sneakers, Iowa.

This system is known as community rating. Needless to say, the company also looks at the driver’s individual record, the so-called experience rating. If someone has had four crackups in the last year, he will have at the least a lot of explaining to do and is likely to be charged a far higher rate—if he can get insurance at all. Most insurance policies are based on a combination of the two rating systems.

But, in most forms of insurance, the size of the community that is rated is quite large, and this eliminates the statistical anomalies that skew

In order to compete with Blue Cross and Blue Shield, other insurers began to look for companies whose employees had particularly good health records and offer them policies based on that record at prices far below what Blue Cross and Blue Shield—which by law had to take all comers—could offer. This tactic, known in the trade as cherry picking, concentrated the poor risks in the Blue Cross and Blue Shield pool and began to drive up their premiums alarmingly. It also meant that small companies had a much harder time buying affordable health insurance, because a single employee with a poor health record could send their experience rating way up. The effects of this practice are clear: 65 percent of workers without health insurance work for companies with twenty-five or fewer employees. (Another consequence of cherry picking is that many people with poor health are frozen in their jobs, for they know they would never get health insurance if they left.)

By 1960, as the medical revolution quickly gathered speed, the economically flawed private healthcare financing system was fully in place. Then two other events added to the gathering debacle.

In the 1960s, the federal and state governments entered the medical market with Medicare for the elderly and Medicaid for the poor. Both doctors and hospitals had fought tooth and nail to prevent “socialized medicine” from gaining a foothold in the United States before finally losing the battle in 1965. As a result of their over-my-dead-body opposition, when the two programs were finally enacted, they were structured much like Blue Cross and Blue Shield, only with government picking up much of the tab, and not like socialized medicine at all. Medicare and Medicaid proved a bonanza for health-care providers, and their vehement opposition quickly and quietly faded away. The two new systems greatly increased the number of people who could now afford advanced medical care, and the incomes of medical professionals soared, roughly doubling in the 1960s.

But perhaps the most important consequence of these new programs was the power over hospitals that they gave to state governments. Medicaid quickly made these governments by far the largest source of funds for virtually every major hospital in the country. That gave them the power to influence or even dictate policy decisions by these hospitals. Thus these decisions were more and more made for political reasons, rather than medical or economic ones. Closing surplus hospitals or converting them to specialized treatment centers became much more difficult. Those adversely affected—the local neighborhood and hospital workers’ unions—would naturally mobilize to prevent it. Those who stood to gain—society as a whole— would not.

The second event was the litigation

Because of all this, it followed as the night does the day that medical costs began to rise over and above inflation, population growth, and rapidly increasing capability. The results for the country as a whole are plain to see. In 1930 ,we spent 3.5 percent of the country’s gross national product on health care. In 1950, it was 4.5 percent; in 1970, 7.3 percent; in 1990, 12.2 percent. American medical care in the last six decades not only has saved the lives of millions who could not have been saved before and relieved the pain and suffering of tens of millions more but also has become a monster that is devouring the American economy.

Is there a way out?

One possible answer, certainly, is a national health-care service, such as that pioneered in Great Britain after World War II. In such a system hospitals are owned by the government, and doctors and other healthcare professionals all work for the government on salary. The great advantage is that no one has to worry about paying for a major illness; all are automatically protected.

But there are a number of disadvantages. Because medical care is free, the demand for it always exceeds the supply. The only recourse in such a system is to use the government’s monopoly power to ration health care and to hold down major costs such as professional salaries.

Thus in Great Britain people above a certain age who come down with grave but expensively curable illnesses often are not cured, unless they pay for their treatments privately. A twenty-year-old with lymphoma is treated aggressively; a seventy-year-old is made comfortable. Someone who comes down with an unpleasant but not fatal condition must wait to reach the top of the list to be treated. Those who need their gallbladders removed may have to endure a completely fat-free diet—gastronomic purgatory—for as long as two and a half years while they await their turn.

A second disadvantage is that because it is in the government’s interest to hold down salaries as much as possible, many would-be doctors are dissuaded from entering the profession in the first place, and many more emigrate to where remuneration is greater. Great Britain has one of the lowest rates of doctors per hundred thousand of population of any industrialized country. And that rate would be lower still if the United Kingdom did not actively encourage the immigration of doctors from Third World countries. One consequence is that medical research

In any event, it is very unlikely that a proposal for a national health-care system could survive the political interests arrayed against it in this country. Many other proposals to reform health care, however, have been advocated in this presidential-election year, including one by President Bush, a sure sign that a serious search is under way at last.

Like chicken soup, most of these proposals won’t make matters worse, and by eliminating cherry-picking and other obvious abuses, they can certainly help. But none of them get to the real root of the problem: the fact that most consumers of medical services in this country don’t pay directly for what they consume, and thus don’t care what the medical services cost.

Here is one very simple proposal that would go a long way to fix that. It costs an American company about $4,500 a year to provide an employee’s family of four with medical insurance having a deductible of $200. A major-medical policy that had a $3,000 deductible, however, could be bought by the company for about $1,500. This policy would protect the family against medical disaster. If the company then put the remaining $3,000 into a “medical IRA” account for the employee’s benefit, and the employee, before retirement, could only spend the money for medical care, you would have an immediate, powerful incentive to care about what medicine costs. You would start asking questions. Doctors and hospitals would have to start answering them.

A more elaborate idea, advocated by the Heritage Foundation (no relation to this magazine), would work as follows. First, individuals rather than companies should be the primary purchasers of health insurance. That could be largely accomplished if the federal government eliminated the corporate tax deduction for medical insurance and provided an equal deduction—or better yet a tax credit for a portion of it—to individuals. If companies were required to pass on in the form of salary the money they had previously spent on health insurance, both the companies and the employees alike would be left just as well off. The companies, in fact, would be far better off, for they would be out of the health-insurance-purchasing business, with its mountainous paperwork.

But, in exchange for the tax credit, the government should require individuals to carry, for both themselves and their dependents, health insurance of the major-medical variety that protects against catastrophe and to note the companies and policy numbers on their 1040 forms. For those with low incomes, the tax credit should be refundable, so if the credit is larger than the income-tax liability, the

With individuals, instead of companies, buying insurance policies, insurance companies would have to cater to individual needs and persuade individuals to “self-insure” against the relatively minor medical expenses that are now paid for with “front-end” policies. This could have two important and immediate effects. First, it would make individuals much more conscious of preventive medicine. It is now more true than ever that an ounce of prevention is worth a pound of cure. Giving people a reason to act on that truism would save a lot of money and improve both the quality and the length of human life. The second effect would be to make people far more conscious of the relative costs of alternative remedies. Doctors and hospitals, at long last, would have a powerful incentive to find ways to cut costs; they would have to in order to maintain their patient loads. The enormous waste and duplication now built into the system would begin to be wrung out.

A third reform would be to require insurance companies to indemnify policyholders rather than pay service providers. The point, again, is to encourage “shopping around.” To be sure, the laws of the marketplace cannot work perfectly as a cost-control mechanism for the provision of medical services. And certainly someone with a heart attack or a severed major artery is in no position to drive a hard bargain or indulge in comparison shopping. But emergency medicine amounts to only about 15 percent of the medical services rendered in this country. The other 85 percent of the time the marketplace could powerfully influence the cost of medical care.

There would also be a great benefit to doctors if insurance companies paid patients rather than them. Thousands of tons of paperwork would disappear, as would the increasing tendency of insurance companies to second-guess doctors in the hope of holding down costs. Doctors could go back to healing the sick instead of clerking for insurance companies.

Adopting such reforms would certainly not produce a medical utopia. No matter how well things went, there would still be those who could have been cured and were not. The poor and weak would still be more likely than the rich and powerful to fall into the cracks of the system. But to insist on a perfect system in an imperfect world is futile. And there would be many short-term winners and losers as the reforms were phased in and began to have their effect. Good hospitals and doctors would prosper as never before while mediocre ones would suffer. There would undoubtedly be a rich harvest of horror stories on the local news.

But, when the dust settles, American medicine would be much more economically efficient. Thus there would be that