What do health care, education, symphony orchestras and hairdressing all have in common? They all seem to get remorselessly more costly to produce. A new book – The Cost Disease by William Baumol and others – sets out to explain why.
The idea of the ‘cost disease’ was originated by Baumol and Bill Bowen back in the 1960s – what is startling is that the trend they identified then has been consistently borne out by the data over the past 50 years. Their insight was simple: labour-intensive services – notably health and education – increase in cost persistently at above average rates. This is for the simple reason they are always lagging substantially behind the growth in productivity of the rest of the economy, and probably always will.
This story begins with the Industrial Revolution – the clue is in the name. For tens of thousands of years human productive capacity had grown very, very slowly. As another new book – The Next Convergence by Michael Spence – points out most of the global human community was at more or less equivalent levels of productivity up until about 1750.
The Industrial Revolution changed all that, as some parts of the economies of a few countries in Europe suddenly became fantastically more productive, with eventually about 15% of the worlds population benefitting from these enhanced levels of wealth creation. (Spence argues that period has come to an end as the rest of the world starts to catch up, but that’s for another day).
But the productivity gains of the Industrial Revolution which started in the late 18th century were not evenly spread or immediate across all sectors of the economy. Some sectors lagged behind – agriculture, for example, didn’t benefit from large-scale mechanisation until the 20th century.
The central Baumol thesis is simply that “human services” that involve face-to-face delivery find it very difficult to improve productivity very much. But as general wage levels rise, these “stagnant” sectors become ever more costly – hence the “cost disease” (Baumol’s language is unnecessarily negative – the capital-technology intensive sectors are called the “progressive” part of the economy.)
These ideas are especially important for the public sector. In 2006 Health and Education spending amounted to 11.1% of GDP across the OECD countries – over a quarter of all public spending (43.5% of GDP). The very nature of these service makes them difficult to improve productivity in. (But please NB: the “cost disease” applies to human services whether publicly or privately owned – its the nature of the production process, not ownership, that causes the problem. Which means privatisation won’t necessarily help).
The data seem indisputable, and yet, as Baumol notes, “none of these ideas seem to have found their way into current political discussions.” In Britain all the political parties accepted the idea that the NHS could achieve efficiency savings of 5% a year. Between 2001 and 2008 annual average productivity growth across the whole economies of OECD countries was only just under 1.75%, in the UK just under 2%. I know productivity and efficiency are measured differently, but does anyone really, seriously, think that human-services like Health can increase their efficiency/productivity at 5% per annum?
Just for the record, I made precisely this argument about the last Labour governments “Gershon” efficiency drive back in the 2004-2007 period, pointing out in evidence to the Treasury Select Committee several times that efficiency gains in the public sector of 3% a year seemed “challenging” with national productivity only growing at about 2%.
The other central – and rather cheering – point of Baumol’s book is one made to him and Bowen 50 years ago by the economist Joan Robinson: as the economy as a whole increases its productivity we can generate the wealth to pay for (ever) more expensive human services – if we want to.