Two simple observations are key to explaining both the high level of spending on medical care and the dissatisfaction with that spending. The first is that most payments to physicians or hospitals or other caregivers for medical care are made not by the patient but by a third party—an insurance company or employer or governmental body. The second is that nobody spends somebody else’s money as wisely or as frugally as he spends his own. These statements apply equally to other OECD countries. They do not by themselves explain why the United States spends so much more than other countries.

The tax exemption of employer-provided medical care has two different effects, both of which raise health costs. First, it leads employees to rely on their employer, rather than themselves, to make arrangements for medical care. Yet employees are likely to do a better job of monitoring medical care providers—because it is in their own interest—than is the employer or the insurance company or companies designated by the employer. Second, it leads employees to take a larger fraction of their total remuneration in the form of medical care than they would if spending on medical care had the same tax status as other expenditures.

A look at the data is instructive. The effect of tax exemption and the enactment of Medicare and Medicaid on rising medical costs from 1946 to now is clear. According to my estimates, the two together accounted for nearly 60 percent of the total increase in cost. Tax exemption alone accounted for one-third of the increase in cost; Medicare and Medicaid, one-quarter.

If the tax exemption for employer-provided medical care and Medicare and Medicaid had never been enacted, the insurance market for medical care would probably have developed as other insurance markets have. The typical form of medical insurance would have been catastrophic insurance (i.e., insurance with a very high deductible).

Our mixed system has many advantages in accessibility and quality of medical care, but it has produced a higher level of cost than would result from either wholly individual choice or wholly collective choice.

The ideal way to do that would be to reverse past actions: repeal the tax exemption of employer-provided medical care; terminate Medicare and Medicaid; deregulate most insurance; and restrict the role of the government, preferably state and local rather than federal, to financing care for the hard cases. However, the vested interests that have grown up around the existing system, and the tyranny of the status quo, clearly make that solution not feasible politically. Yet it is worth stating the ideal as a guide to judging whether proposed incremental changes are in the right direction.

The key to returning true competition to health care is to make it possible for individuals to fire their insurance company, which requires eliminating the tax break on employer-provided health insurance by extending it to privately purchased policies.

The kind of plan the Obama administration envisions gives us the worst of both worlds. Its artificially low premiums will drive most private insurance out of business. Once there are no private insurers left, there will be no place left to shift costs. In a very short time, then, we'll have no reduction in cost due to cost shifting, and we'll have substantially less competition. The absence of competition will result in higher actual costs.

The better solution is to eliminate the preferential tax treatment of employer-provided insurance. That also, indirectly, would reduce the scale of the other major problem in American health care: covering the uninsured. Now it is very difficult to purchase insurance if you are not employed or if you work for a very small employer. Once insurance migrates out of large employer pools, sufficiently large pools will become possible with individualized insurance. Customers then would be able to vote with their feet if they are unsatisfied, and those who don't work for large employers no longer would have to pay higher premiums than everyone else.

There still would be some uninsured people. But that could be handled directly through insurance vouchers. A comprehensive voucher program would eliminate even further distortions and that would produce significant reductions in costs, not just shift costs.

Indeed, we already have such a program for something that is even more important than health care. With all its faults, food stamps have essentially eliminated the problem of hunger in America. Food stamps are vouchers that solve the problem in question directly while preserving competition. Small wonder they work so well.

Reading Brad DeLong's "non-Socratic dialogue on social welfare functions" has inspired me to return to one of my favorite literacy forms. In DeLong's original dialogue, Prof. Agathon helps Prof. Glaukon reach a shocking conclusion:

While the Obama administration has not, and does not seem likely to, put forward a specific reform plan, it is possible to discern the key components of any plan likely to emerge from Congress:

Human beings are as good at devising ex post facto explanations for big disasters as they are bad at anticipating those disasters. It is indeed impressive how rapidly the economists who failed to predict this crisis — or predicted the wrong crisis (a dollar crash) — have been able to produce such a satisfying story about its origins. Yes, it was all the fault of deregulation.