The Role of the Capital Markets in Restructuring Health Care

Who would have predicted at the time of the Arrow article in 1963 the growth in assets invested in health care that we have seen ¹ fueled by an unprecedented use of tax-exempt debt, retained earnings, and new stock? Enfranchisement of the formerly uninsured through Medicaid and Medicare plus the continued growth of private health insurance have given marginal providers the cash flow that allowed this dynamic growth in capital investment while substantial subsidies lowered their financing cost.

Yet it is not clear whether access to new sources of funds precipitated the restructuring of health care or the demand for capital ² was simply the result of fundamental need. Irresponsible investments by managers certainly have occurred. ³ Yet once the industry embraced capitalism's largess, it found that the accompanying market discipline was a demanding counterforce to its excesses. The capital markets have been a major factor in both expansion and contraction, allowing excesses and demanding fiscal responsibility.

How much of this was anticipated in the classic Arrow article? More important for our day are (1) how and why the capital market provides the funds it does to the health sector and what it expects in return; (2) how the resulting market discipline extends to both for-profit firms and nonprofit organizations; (3) what this means for the structure of ownership and control of the industry; and (4) what the implications are for access, quality, and cost.

What Did Arrow Say about the Capital Markets, and What Has Changed?

Professor Arrow implicitly assumed that capital was an integral part of the production of health services, but he did not particularly distinguish it from other factors. He discussed the "ownership of assets and skills that command a price on the market" in passing but did not consider it explicitly as a critical element (Arrow 1963). The overall manner in which health care providers presented themselves to potential buyers was his concern in achieving a Pareto optimal distribution. This lack of explicit attention may reflect the relatively smaller reliance on capital investments in the production of health services at that time. Furthermore, Arrow's world was physician-centric with little attention to the hospital except as a "physician workshop," a concept popular during the subsequent period (Pauly and Redisch 1973). Hospitals and other institutional providers were not viewed as separate economic actors.

However, the massive private investment and financing of capital assets in the years since Medicare have changed all of this. Community fund-raising and the Hill-Burton program (grants and loan guarantees) of Arrow's time had provided most of the capital in the previous decade, and profits were largely nonexistent. Since then funding has come largely from retained profits, tax-exempt bonds, and stock issues. These later sources depend completely on payment systems, which did not exist in 1963. Medicare and Medicaid, in particular, converted formerly unprofitable segments (the poor and elderly) into paying customers. Furthermore, the original cost-based payment systems used by the government in 1965 included interest and depreciation as reimbursable expenses thus assuring the cash flow needed for debt interest and principal payments. As a result, the credit ratings of formerly weak organizations improved to the levels of those who promised to reimburse them--namely, the government and private insurers. With better ratings came full access often aided by tax-exempt bond authorities established in many states to further lower the cost of borrowing (Gershberg, Grossman, and Goldman 1999). By any stretch of the imagination, this form of payment and subsidy dramatically reduced the required return on investment to justify expansion or replacement. With such reduced cost, investment was sure to boom, and it did. As long as patients with insurance showed up, almost any expenditure could be justified and financed whether clinically or financially responsible. It is little surprise that...