The Competition Solution W - Milken Institute...terests the bad news. They all worked with...

65Fourth Quarter 2005

b o o k e x c e r p t

WThe Competition

Solution

b y pa u l l o n d o nWhy is the American economy, for all its

blemishes, the most productive on the

globe? Hard work – maybe too much hard

work – has something to do with it. So, too, do elite higher education, easy access to

technology, market-friendly institutions and a Federal

Reserve that is tough on infl ation. But in The Competition

Solution* Paul London argues convincingly that the

Goldilocks growth of the 1990s was in large measure the

payoff to years of efforts to reduce economic regulation

and to open cozy sectors of the economy – everything

from transportation to banking to autos – to fi erce com-

petition. ¶ London was an assistant secretary of commerce in the Clinton administra-

tion. But he acknowledges that the success of the effort turned on the mobilization of

both Democratic and Republican administrations going back to the Ford White House.

Ah, for the good old days .… — Peter Passell

*Published with permission from the AEI Press. All rights reserved.ap/w

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66 The Milken Institute Review

The resurgent economy was glorious in part because it came after a dismal beginning. The decade began with unemployment rising above 7 percent, the painful level that had prevailed for long stretches during the 1970s and 80s. Worse, most economists believed that joblessness could not drop much below 6 percent without reigniting infl ation.

From 1992 until 1994 the economy im-proved, but the mood of the country re-mained sour. It was seen as a “jobless recov-ery” – although unemployment was, in fact, falling fairly quickly. Then, almost miracu-lously, the American economy became sun-shine itself, even as once-feared economic challengers, Japan and Europe, were stum-bling. By the latter part of the decade, unem-ployment had dropped to 4 percent (its low-est level in over 30 years), yawning budget defi cits had turned into surpluses and infl a-tion seemed a thing of the past.

To be sure, the 2001 recession was painful. The boom years had been so good that even a relatively modest recession hurt badly. The speculation in tech-centered stocks started to collapse in early 2000. When the terrorist at-tacks on September 11, 2001 shocked the economy again, corporate profi ts dropped dramatically and investment fell off sharply. Unemployment rose from 4 percent in 2000 to a peak of 6.3 percent in June 2003, before edging back down to 5.1 percent by mid-2005.

The contraction of employment in manu-facturing was especially sharp because the growth of consumer demand slowed while

productivity kept rising. When productivity improves while growth is slow, fewer people are needed to produce the goods and services consumed. High-tech, telecommunications and fi nance – the hottest sectors during the 1990s – took especially big hits in the fi rst years of the new millennium.

Still, the U.S. economy grew faster than most other advanced economies in 2003 and 2004 despite a much more uncertain world. So the persistence of unemployment in 2005 well above the level in 1999 and 2000 should not be too discouraging. Indeed, rather than believing that the economic performance of the 1990s is out of reach, we should under-stand why the economy was so good then – and what we could do to recapture the magic.

Former Treasury Secretary Robert Rubin has suggested that the reasons for the record-breaking prosperity were many and varied, and that economic historians would still be identifying them decades from now. I believe, however, that the explanation is both under-standable today and quite different from what most economists and political pundits have been saying. These commentators, regardless of their politics, give too much weight to pol-icies that had relatively little to do with the success of the 1990s, while giving too little credit to the most important causes.

The “supply-side” argument has been pop-ular with conservatives, and is especially in-fl uential among Republicans in Congress and the Bush administration. For them, low taxes – especially taxes on interest, dividends, capi-

The American economy of the 1990s was the envy

of the world. More than 20 million jobs were created, investment and

productivity soared, and the fear of infl ation, which had haunted policy-

makers for 40 years, almost disappeared. The key question is why.


tal gains and inheritance – are crucial to growth because they create incentives for cap-ital formation. The supply-siders believe that tax cuts enacted by President Reagan in the 1980s (like the so-called Kennedy tax cut en-acted under Lyndon Johnson in 1964) led to surging investment and are the key to the prosperity. By the same token, they argue that the rebound from the 2001 recession was due to the tax cuts championed by President George W. Bush.

Others credit the Federal Reserve and its long-serving chairman, Alan Greenspan. They believe that the conquest of infl ation and the prosperity of the 1980s and 1990s were prin-cipally the result of wise monetary policies fi rst pursued by Paul Volcker from 1979 to 1986, and subsequently by Greenspan.

A third group, many of whom worked in the Clinton administration, has its own ex-planation. For decades, Democrats were seen as the party of government spending and budget defi cits, hostile to business. In part to combat these perceptions, Democrats have recently emphasized that private investment

surged and defi cits turned into surpluses under Clinton. They argue that Clinton’s will-ingness to raise taxes on upper-income tax-payers in 1993 and to restrain the growth of some government programs led to lower in-terest rates and encouraged the record-break-ing surge in investment. To stimulate the economy in 2004, they would have raised taxes on more-affl uent Americans, reducing the defi cit and encouraging investment while preserving some tax cuts for lower- and mid-dle-income taxpayers.

A fourth group believes that prosperity was largely the result of new technology. In this view, productivity surged during the 1990s because investments in technology made over previous years began to pay off. In other words, prosperity had little to do with particular policies or approaches, and was largely a non-political phenomenon.

Despite large apparent differences, all these explanations have an essential common core: They stress broad policies that affect the whole economy – what economists call mac-roeconomics. By contrast, I believe policies ap

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that increased competition are the most im-portant forces behind America’s prosperity. The secret of the 1990s and the substantial re-covery from the 2001 recession lies not in taxes and money supply, but in more than two decades of bipartisan policymaking that made competition far more intense in targeted sec-tors of the economy.

Of course, sensible tax and monetary poli-cies are important, as are efforts to keep gov-ernment spending within bounds and to use tax revenues wisely. New technology did, in-deed, make a signifi cant contribution. But it is impossible to explain why the American economy was so good in the 1990s – and why America did better than other countries – without understanding the role played by more intense competition. American indus-tries as varied as automobiles, steel, tele-phones, airlines, trucking, fi nance and retail-ing were far more dynamic than they had

been in the 1960s and 1970s because of more vigorous competition, not because of fi scal or monetary policies or technology.

There is a surprising political dimension to this story that Adam Smith would have un-derstood but that is never told: competition in industry after industry became more in-tense despite strenuous efforts by powerful business and labor interests to limit it. These established interests wanted the government to help them keep out new competitors, but American political leaders held their ground. “Special interests,” which according to con-ventional wisdom, get what they want in America, threatened and begged. But political leaders largely rebuffed them – and the coun-try prospered as a result.

Future economic performance, this expe-rience suggests, will depend more on expand-ing competition in uncompetitive areas like health care and education, than on tax ar- st

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rangements and changes in interest rates, which do little to stimulate change in poorly performing industries.

What kinds of policies and political fi ghts are important? Recent experiences offer clear guidance:

American manufacturing in general, and automaking in particular, would never have modernized had it not been for policies that encouraged both competition from imports and greater foreign investment in the United States. Such policies will be just as important in the future, and the fi ghts will be fi erce.

Key industries, including transportation, communications and energy were fundamen-tally changed by legal, regulatory and legisla-tive decisions that increased competition. These industries would never have changed if political battles had not been won by the ad-vocates of greater competition. Clearly, simi-lar policies encouraging price competition and new competitive entrants in other sectors of the economy will be vital to prosperity in the future.

Strong enforcement of antitrust laws, start-ing as early as the 1950s and 60s, also helped increase competition. Antitrust lawsuits, for example, led to the end of fi xed brokerage rates for securities and opened up fi nancial markets, helped new entrants break AT&T’s telecommunications monopoly and made it impossible for established retailers to keep new competitors out. Antitrust will have to play a similar role in the future to maintain these gains and to create parallel ones in sec-tors where competition is still weak.

Neither America’s overseas rivals nor Americans, who often overestimate the power of special interests, fully appreciate how suc-cessful the country’s fl exible political system was in making established interests do what they did not want to do – or how important this willingness to challenge entrenched in-

terests will be in the future.This book centers on the battles that began

in earnest in the 1970s to make competition more intense than it had been during the immediate postwar years. It recounts the courageous efforts by political leaders of both parties to help new competitors challenge entrenched business and labor interests – the Big Three auto companies and the United Auto Workers, Big Steel and the steelworkers union, AT&T and the Communications Workers of America, the trucking companies and the Teamsters union, the major eastern banks and fi nancial institutions, and even powerful re-tailing interests and their employees who wanted to keep new competitors out.

There were political heroes – congressional leaders who held hearings, civil servants and regulators who listened and were persuaded that more competition would be good, and political appointees who told the powerful in-terests the bad news.

They all worked with presidents in the 1970s, 80s and 90s who took the political heat to make competition more intense. John Rob-son and Alfred Kahn at the old Civil Aeronau-tics Board led the fi ght to open air travel to competition during the Ford and Carter ad-ministrations. Republican Paul MacAvoy (working in Ford’s White House) and Demo-crat Stu Eizenstat (in Carter’s) both confront-ed the Teamsters in high dudgeon. And presi-dents Reagan, George H.W. Bush and Clinton took political risks to face down powerful in-terests that wanted to limit competition.

a case study: retailingIn the 1980s, our friends who lived in New York City did all of the back-to-school shop-ping for their kids in western Massachusetts, where they spent summer vacations. Later, I saw many other New Yorkers shopping in the new malls outside the city.


It was not just the high city taxes sending them away to shop. Indeed, one reason New York City is beginning to loosen restrictive zoning rules and allow huge stores to open is that tens of thousands of New Yorkers shop in these stores anyway. In America, it is possible to evade local restrictions by going to a near-by community with different rules, or to an-other state.

New Yorkers are hardly the only Ameri-cans willing to struggle for lower prices. Cul-tural as well as political factors have always encouraged a highly competitive, technologi-cally adaptive style of retailing in America that has made limits on competition diffi cult to enforce.

One reason is that commerce has always been more

respectable in the United States than in other places. Colonial commercial interests were major supporters of the Revolutionary War. By the same token, American farmers were never isolated from commerce. Traveling salesmen were common in the earliest colo-nial days, and by the 1830s, American farmers could buy seed from catalogs. The mail-order catalogs of Montgomery Ward and Sears, Roebuck made manufactured products avail-able to rural Americans in the late 19th cen-tury, boosting the development of both man-ufacturing and agriculture, and linking the countryside to the cities.

wal-mart changes the rulesIn 1970, Wal-Mart was a dot on the retail horizon, with sales of only $44 million. Like the transplant auto-makers, new steel mills, upstart phone companies, and new fi nan-cial institutions, Wal-Mart was not part of the “new industrial state” of the 1960s. Three decades later, its revenues exceeded $200 billion – 7 percent of retail sales in the United States – making it the largest retailer and private em-ployer in the country. Wal-Mart

grew by lowering prices and providing service to people who had been served poorly. And Sam Walton, the founder, made established fi rms shape their strategies to his, or go out of business.

When Walton began in the business, big-city retailing was dominated by large depart-ment stores. Discounters were only beginning to come in, mostly at the local and regional levels. Small-town and rural residents on tight budgets did their shopping at variety stores – really small-town department stores. Some commentators are nostalgic for those times, but this Norman Rockwell world was to

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hardly great for shoppers. Variety stores often stocked lower quality merchandise. And they typically used “high-low” pricing, drawing in customers with low prices on a few items and making their money by sharply marking up their other goods.

Walton turned comparison shopping into an art form. He wanted customers to be able to compare the prices of brand-name prod-ucts at his stores against his competitors’ pric-es, so it would be clear what good deals Wal-Mart was offering.

To be able to sell brand names at lower prices, Walton had to be more effi cient than his competitors. To this end, he located his stores in rural areas where property was cheap. And he freely borrowed ideas from Fed-Mart, which was founded by a legendary California retailer named Sol Price in 1954. Walton, moreover, fought to get lower prices from manufacturers and wholesalers that he could pass on to customers.

Many of Walton’s innovations in retailing were similar to those that worked in other sectors. His stores improved service and in-creased options at the lower end of the mar-ket, just as Japanese carmakers, domestic steel mini-mills and new fi nancial institutions did. He managed his retailing empire with a small headquarters staff that was characteristic of other success stories, such as Nucor Steel. In time, he applied advanced information tech-nology to all aspects of retailing and distribu-tion. But above all, Wal-Mart won customers by offering them a better deal.

Change swept over the whole retail sector as new formats and competing chains burst on to the scene. Suddenly, manufacturers were cutting prices and costs to get contracts from the new retailers, suggested retail prices became meaningless, and customers learned that they had options.

The politics behind the changes in retail-

ing resembled the dynamic that operated in other areas of the economy where established interests were being challenged by new com-petitors. To be sure, retailing was not domi-nated by oligopolies and monopolies with na-tional reach in the 1970s, as were autos, steel, telecommunications and some types of fi -nance. Yet in cities and towns all over the country, retailers were locally dominant. The associations that represented these older re-tailers went to government to argue that com-petition from the emerging chains was unfair, a danger to neighborhoods and employment, and a threat to the environment.

the politics of retail competitionThe battles that new retailers fought all through the 1980s and 90s against efforts to limit them were actually the continuation of a longer war. Retailers have been trying to stop successive waves of larger new competitors since the early 20th century.

One strategy has been to get manufactur-ers to require that their products be sold at minimum prices that would guarantee even small retailers a good profi t. In 1911, the Su-preme Court had decided that the Sherman Antitrust Act prevented manufacturers from requiring retailers to sell at predetermined prices in interstate commerce. The Court also said, however, that states could allow retail price-fi xing within their own boundaries.

California, responding to the political de-mands of small retailers, passed legislation al-lowing manufacturers to set minimum prices. But the federal courts stepped in again, decid-ing this time around that even state-level leg-islation violated antitrust principles.

Proponents of minimum prices did not give up. They sought federal legislation to allow states to pass what were called fair-trade laws permitting manufacturers to sign con-tracts with retailers setting minimum resale


prices. In 1937, with the country in the grip of the Depression, they pushed through the Miller-Tydings Retail Price Maintenance Act, exempting the California law and similar state statutes from the antitrust rules. In time, some 40 states passed fair-trade laws.

During World War II, when infl ation rath-er than cutthroat competition became the issue, states were reluctant to enforce these laws. After the war, however, pressures to limit price competition resurfaced. A key Supreme Court case in 1951 involved a Louisiana li-quor merchant who wanted to compete by slashing prices. He insisted that, despite Mill-er-Tydings and Louisiana fair-trade laws, the antitrust laws made it illegal for his suppliers to require him to enter into price-fi xing ar-rangements. The Court agreed.

In response, Congress passed the Mc-Guire-Keogh Fair Trade Enabling Act in 1952, which closed the loophole allowing retailers to reject price-fi xing contracts. However, states varied in their willingness to enforce fair-trade laws in the 1960s and 70s – no doubt because many were reluctant to deny their residents the advantages of shopping at the new discount stores. Finally, in 1975, the Miller-Tydings and McGuire-Keogh acts were repealed.

The Miller-Tydings approach assumed that manufacturers preferred to sell at high fi xed prices. Some manufacturers, however, preferred to sell to large chains that would make volume purchases. Small retailers tried to bar this approach by backing laws that pre-vented manufacturers from giving large dis-counts for volume purchases. In the 1920s, small grocers, druggists and tire dealers used Miller-Tydings to slow the growth of chains. But, predictably, they did not get far while prosperity lasted.

The Great Depression increased the pres-sure for such measures and brought Washing-

ton into the picture. Advocates for the small retailers argued that larger retailers were using their bargaining power with manufacturers to put the “little guys” out of business. They claimed that, once the small retailers had dis-appeared, the chains would boost prices. This led to the 1936 Robinson-Patman Act, which required manufacturers to justify volume dis-counts on the basis of effi ciencies. But that legal tactic, like efforts to force retailers to maintain minimum prices, never got very far because regulators and courts were deeply ambivalent about using the law to prevent price cutting.

challenging the department and grocery storesSome even more ancient history is useful to put the Wal-Mart phenomenon in perspec-tive. Sears was the Wal-Mart of the 19th and early 20th centuries. More than a hundred years ago, its 500-page catalogs were reaching into thousands of communities, creating competition for the high-priced small-town stores. Moreover, Sears’ distribution centers before World War I were a technological mar-vel, as is the Wal-Mart information system today. Henry Ford is said to have visited a Sears distribution center and copied the as-sembly-line techniques it used for fi lling and shipping orders.

If Sears stood for modern retailing in rural America, the department stores played that role in the cities. For the fi rst three-quarters of the 20th century, the department store sell-ing fashions, cosmetics and household goods was the retailing icon of city-centered Ameri-can culture. It served as the anchor for a block or two of smaller specialty shops, as well as movie theaters, restaurants and other enter-tainment. Even small cities had a commercial Main Street with one or two department stores and co-dependent retailers.


But in the 1950s, depart-ment stores responded to the rush to the suburbs by opening branches. And in the 1970s, suburban shopping gradually be-came mall shopping. As in the downtown shopping districts, department stores usually anchored the mall, with the specialty shops that had once grouped around the urban stores now located around their branches. Soon entertainment was added, replicating the mix of options once offered in the down-town shopping districts.

But suburban department store branches typically “left their basements behind,” opting not to offer off-price merchandise. That high-end strategy created openings for the early discounters who sold products like TVs and refrigerators for less.

The story of chain grocery stores was sim-ilar to that of department stores. A&P (the Great Atlantic and Pacifi c Tea Company) had 100 stores in the 1870s and was the country’s fi rst major grocery chain. By the 1930s, it had stores in thousands of neighborhoods

and was the target of a backlash quite like the one affecting Wal-Mart today.

By the 1990s, of course, A&P was being overtaken by Kroger, Albertsons, Safeway and the Dutch company, Ahold. These chains started in the early 20th century as local op-erations that to a signifi cant extent followed the A&P model – but away from the North-east, where A&P was strongest.

the retail competition ripple effectKroger is now the leading American super-market chain, with almost 2,500 stores and $50 billion in sales volume in 2001. Albert-sons, Safeway and Ahold each have at least 1,500 stores and sales volumes well over $30 billion. The most startling recent develop-ment, however, has been Wal-Mart’s competi-tive charge into groceries. Its supercenters, Sam’s Clubs and smaller local markets in le

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2001 sold $80 billion worth of groceries, sur-passing all other chains.

To meet the challenge, grocery chains have had to consolidate, build larger stores and close smaller ones, improve their product offerings, strengthen their information-handling and logistics, add pharmacies and in-store banks, and experiment with conve-nience-store subsidiaries, prepared meals and other innovations.

Competition is driving innovation and technological change in the grocery business as it has in every industry and sector dis-cussed in this book. In the 1970s, for example, Ahold began to acquire smaller American chains, including Giant in the mid-Atlantic states and Stop & Shop in New England. It is buying computer systems to bring order to warehouses. Information from the checkout lines is being fed directly to warehouses and

suppliers, an approach pioneered by Wal-Mart. Truck deliveries and pickups are more carefully planned. Goods are stacked in pre-planned locations, and computers choreo-graph the movement of forklifts through the huge spaces.

Competition from Wal-Mart and other mass retailers was the driv-ing force in retailing in the 1990s. It is now a fact of life rippling through most retail specialties, forcing changes in pharmacies, home-remodeling suppliers, sell-ers of offi ce supplies, mar-keters of toys and household furnishings – and even purveyors of fashion.

Pharmacy chains such as CVS, which led modern-ization in their own sector in the 1980s and 1990s, now have to adjust to mass

retailers that are opening pharmacies in their own stores. Pharmacies have developed com-puter systems for prescription drugs so that almost all of them can communicate in real time with insurance companies to get ap-proval for prescriptions. More intense com-petition, however, is also forcing them to in-crease their effi ciency in non-drug areas, and to add departments and services to keep up with grocery chains and mass marketers.

Home Depot and Lowe’s, along with re-gional home-remodeling suppliers, are also battling for customers, driven in part by com-petition from mass marketers. In offi ce sup-plies, Offi ce Depot, Staples and Offi ce Max fi ght fi ercely for market share in Europe and Asia as well as in the United States, and face the same challenge from Wal-Mart, Costco and others. Toys “R” Us, Circuit City and Best Buy also fi nd themselves under pressure from to

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the mass marketers selling toys and consumer electronics.

Neiman Marcus, Nordstrom and other high-end department stores continue to pros-per by offering superior products and better service to affl uent customers. At the same time, fashion specialty stores like The Gap, Old Navy, The Limited and Banana Republic have become powerful forces in American retailing by developing youth and leisure markets.

Chain specialty stores have also come along to sell merchandise such as books (Barnes & Noble, Borders), sports equipment (The Sports Authority) and white goods (Lin-ens ’n Things, Bed, Bath & Beyond). These stores are called category killers because they create new groupings of merchandise in a big-box format and pull customers away from more traditional shops.

All these retailers use computer technolo-gy, modern communications and inventory control, knowledge of overseas manufactur-ing capabilities and highly automated distri-bution centers to adjust to customer prefer-ences more quickly than the older stores. Outlet malls have also become shopping des-tinations, allowing manufacturers to develop their own lower priced outlets for name brands, competing with both the higher priced department stores and the lower priced mass marketers and category killers.

Wal-Mart, Target, Costco and other mass retailers face competition themselves, but they represent a force that has sharply in-creased competition in American retailing, pushing innovation in what would not other-wise seem to have been a leading-edge indus-try and making faster growth without infl a-tion possible. It may be hyperbole to say that Wal-Mart did more to fi ght infl ation than the Federal Reserve, but it is certainly not an ex-aggeration to say that the broader Wal-Mart phenomenon in retailing has done so.

continuing efforts to limit competitionMost efforts to limit competition and pre-serve old retailing structures have failed, but opponents don’t give up easily.

Besieging Manhattan. Retailing in New York City is very different than in the sub-urbs, where big-box formats are everywhere. It is more like Japan, where small retailers com-pete fi ercely but work with wholesalers and other groups to keep out new competitors.

Some argue that the new retail formats, dependent on the automobile and convenient parking, cannot work in the vertical metrop-olis. But, as in Japan, it is zoning – political obstacles, not parking constraints – that keeps them out. Rigid zoning imposes high costs on New York City residents and drive many to shop outside the city. Mayor Rudolph Giu-liani tried to change the rules in 1996 to allow stores of up to 200,000 square feet in former industrial areas, but the city council turned him down.

Nevertheless, the tide is turning. The city council has approved a number of store sites – Costco, Home Depot, Target and Ikea among them – almost all in the boroughs outside Manhattan. One reason is that, in America, much more so than in other coun-tries, it is possible to evade local restrictions by going to a nearby community with differ-ent rules. New Yorkers have always found ways to shop in stores outside the city where products are cheaper.

The Vintners’ Internet Wars. The fi erce bat-tle to allow the direct marketing of wines via the Internet is another example of the politics of retailing in America. When Prohibition was repealed in 1933, states were given the right to regulate sales of alcohol. Most li-censed wholesalers and retailers. Some even established state-owned liquor stores, and several gave localities wide discretion to make


their own arrangements. As of 2003, 24 states prohibited direct shipments of wines that by-passed wholesalers. Several others allowed in-trastate shipments, but not shipments from out of state – discrimination that made them vulnerable in the courts.

State legislatures may oppose Internet sales because they fear the loss of tax revenues. But it is wholesalers who have the most at stake. Southern Wine and Spirits of America, the biggest of the wholesalers, has led this fi ght, often arguing that direct Internet sales of wine would give teenagers access to alcohol. The smaller vintners, organized as WineAm-erica, are pushing to ease the state laws, argu-ing that many of them cannot reach custom-ers through the wholesalers.

Based on what has happened in other areas of the economy, it is likely that, sooner or later, larger retailers and small wine pro-ducers are going to be able to bypass the mid-dlemen. Indeed, the Supreme Court’s 5-4 de-cision in May 2005, striking down restrictions on direct marketing as discriminatory, seems destined to accelerate the process. The Court said that the states could not bar interstate sales by mail and Internet if they permitted similar intrastate sales.

health care: the next battlegroundThe importance of the health care industry to economic growth is hard to exaggerate. In 2002, U.S. health care expenditures were in the neighborhood of $1.4 trillion – 14 per-cent of the country’s GDP – and rising sharp-ly. Other advanced countries including Cana-da, France and Sweden pay only 8 or 9 per-cent of GDP for care that is comparable to that in the United States, and even better in some areas.

U.S. health care costs are fi nanced from three sources. Employers who insure their

employees paid roughly 36 percent of the costs in 2002, or $474 billion. The costs of Medicare for the elderly and Medicaid for the poor, lumped together with insurance for government employees, are paid by the tax-payers and come to 44 percent of the total na-tional medical bill. Patients pay the last 20 percent out of pocket. While costs are falling in most parts of the economy, they are rising at 7 to 8 percent a year in this one.

Actually, health care’s problems extend be-yond rising costs. Researchers have known for years that many more angioplasties, back op-erations, cesareans and hysterectomies are done in some localities than in others, but these medically absurd variations in practice continue. The industry also suffers from what are euphemistically called quality problems – avoidable mistakes in hospitals and doctors’ offi ces that kill tens of thousands of patients each year. The Institute of Medicine of the National Academy of Sciences reported in 1999 that between 44,000 and 98,000 patients die in American hospitals each year from medical errors, such as mistaken prescrip-tions and drug interactions. And, no doubt, tens of thousands more are killed by mistakes in non-hospital settings.

A principal problem contributing to rising costs, uneven treatment and medical errors is health care’s archaic business model. Hun-dreds of thousands of small medical offi ces, in the words of the Institute of Medicine, “practice in isolation,” and 5,000 or so hospi-tals operate independently. Indeed, one way to think about the organization of health care is as a mass of unconnected retail stores not very different from the organization of the grocery business in the 1920s.

Back then, consumers had no good way to comparison-shop. If the storekeeper was rea-sonably personable he was likely to keep their business. Similarly, choosing a doctor today


remains largely a matter of convenience, word-of-mouth, insurance coverage, and, most of all, faith. Patients have no way to compare the quality of care or its cost.

A retailing analogy also works for hospi-tals. They, like doctors, are organized the way department stores were organized 50 years ago. Most small cities and towns have one. They are important institutions and major employers, but patients’ ability to compare them is limited and many effectively function as local monopolies. Wealthier people may go to hospitals in other cities – just as wealthy people used to go shopping in New York or Chicago – but others do not have such op-tions. In any event, informed comparisons of doctors and hospitals based on who gives the best care for the least money simply cannot be made by patients, or even by businesses that insure employees and retirees.

The department store analogy works with-in hospitals, too. Most departments in most hospitals operate independently, and coordi-nation of care is informal. The for-profi t con-glomerates try to coordinate purchasing and billing, but it is diffi cult to change the culture of care.

Experts have talked about weak competi-tion in health care for years. The focus, how-ever, has been on competition between insur-ers, and that focus has been further narrowed to what is covered and how much the plans cost – not who produces the best outcomes for the least money.

This is where the government should enter as a standard setter and facilitator of compe-

tition. Information is crucial to making com-parisons and therefore to making markets work. Coordination of care is also essential, and is now almost nonexistent because doc-tors communicate with one another and with patients in only the most haphazard ways. Re-quiring doctors and hospitals to adopt com-puterized patient records (with appropriate privacy protections) would allow patients and insurers to compare doctors, hospitals and approaches to treatment, and would greatly facilitate the coordination of care.

Imagine going to a doctor, giving him per-mission to open your medical record, and seeing on the fi rst computer screen all the in-formation you have given to him and other

choosing a doctor today remains largely a matter

of convenience, word-of-mouth, insurance coverage,

and, most of all, faith. Patients have no way to

compare the quality of care or its cost.

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doctors over the years. On that fi rst page is a list of the doctors you are seeing, the condi-tions for which you are being treated, the medicines you are taking and the follow-ups that are on order.

The lack of computerized information also drives the costs of research sky-high. In-stead of easily fi nding a sample of 50,000 fi fty-year-old diabetics who smoke and whose blood type is O-positive, it takes months to put together the records of just a few hundred.

It is not surprising, then, that the Institute of Medicine of the National Academy of Sci-ences said in 1991 that computerized records that could be shared by all the personnel treating a patient were an “essential technol-ogy for health care today and in the future.” More surprising, perhaps, a decade after the report, the IOM lamented that only a handful of hospitals and medical practices were using computerized records.

Doctors know that medical information systems are inadequate. But without the pres-sure of competition, they make excuses for the system and for themselves. The doctors remind me of the auto industry leaders at the hearings I attended back in January 1958. They thought that the people who wanted them to build small cars in America did not understand their industry. Even the auto in-dustries’ critics at those hearings, like critics of today’s American health care system, par-roted the comforting idea that the American industry was the best and most advanced in the world – until Toyota, Honda and Nissan proved them wrong.

A hopeful development is that private pay-ers are pushing the industry to modernize. More than 100 large companies, including the Big Three automakers, GE and Caterpillar, have formed an organization called the Leap-frog Group, whose aim is to reduce hospital medical errors. The group is trying to get the

employees they insure to take their business to hospitals that use computerized systems for ordering prescriptions. In the longer run, the group wants doctors and hospitals to adopt computerized systems that provide the information needed for real competition. Government support for these private-sector customers may fi nally break the logjam.

An important problem here is that em-ployees tend to trust doctors and distrust their employers. Businesses have thus been afraid to push the medical establishment hard because they know that the doctors will im-pugn their motives. What’s more, pro-com-petitive change in the structure of health care has gotten nowhere near the kind of support from the White House that competition got in trucking and airline deregulation. The health care establishment, it seems, intimi-dates the government more effectively than the Teamsters did 30 years ago.

Ideology also stands in the way of compe-tition, better care and lower costs. Liberals are refl exively committed to Medicare and Med-icaid as government programs rather than to reforming the business plan of a monopolis-tic industry. They are suspicious of efforts to cut costs by changing the structure of the in-dustry, and have not always recognized that runaway health care costs make covering more of the uninsured almost impossible.

Conservatives, for their part, are distracted by their own pet issues. They would like to see individual patients pay more of their own medical costs through health savings ac-counts, believing that this would lead to less waste. But this is based on the dubious as-sumption that a signifi cant fraction of the costs in health care are the result of overuse by pa-tients who aren’t paying for their own care, rather than the result of an archaic system of local monopolies in an industry where almost everything could be done more effi ciently.


Nonetheless, there are signs that a critical mass of support is forming in both parties that will make the job of supporting competi-tion easier. If Washington can fi nd an ap-proach that allows payers and large numbers of patients to take their business away from the health care laggards and shift it to those that are modernizing, the system will change.

Concessions may have to be made to the medical establishment. Hospitals and doc-tors, for instance, want assistance with the cost of information technology, and there are good reasons to concede them this. Over time, installing modern information systems in 5,000 hospitals and 500,000 doctors’ offi ces might cost $150 billion – a lot of money.

My bet, based on what happened in other industries between the 1970s and 1990s is

that competition in a health care industry with modern information technology could save the country 30 percent of current costs – or $300 billion to $400 billion a year – even as it improves the quality.

• • • • •The American economy in the 1990s was

glorious because, for some two decades, American political leaders had supported change by supporting new competition. Es-tablished industries were forced to face chal-lengers despite opposition from the compa-nies and unions affected. Maintaining com-petition in these areas and bringing it to new ones is the key to future prosperity, and re-mains, in large measure, a political task. It can only happen if the bipartisan commitment to competition is continually renewed.

M

IIf you fi gured out that the caricature on the spine of the past four issues of the Review was of Irving Fisher (1867-1947), go to the head of the class. For while Fisher was a very big deal – many scholars rank him as America’s greatest econo-mist ever – he has largely been forgotten by those outside the profession.

Fisher got the fi rst PhD in economics awarded by Yale (in 1891) and spent his entire career there. Though most celebrated for his research in index numbers, he made a mark in a half-dozen other areas by applying rigorous mathemati-cal methods to the new science of econometrics. By no coincidence, he was one of the founders of the Econometrics Society and its fi rst president.

Fisher was also far ahead of his time on macroeconomics. Starting as an orthodox monetarist, he struggled to explain the Great Depression in more modern terms

– terms that brought him close to a Keynes-like integration of

monetary theory and busi-ness cycle theory.

And, like Keynes, it’s worth noting, Fisher had an eye

for making a buck. He became a multimillion-aire (when that really

meant something) as a principal in the company

that eventually emerged as Remington Rand. Unlike

Keynes, however, he fell victim to the frenzy of the late 1920s

bubble economy, losing most of his money (and his reputation as an economic guru) in the

1929 stock market crash. davi

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