John Steele Gordon shares with Barron’s readers some of the historical background for the current American health care predicament.

… [O]nce policies and programs start, they foster constituents who are benefited by them. These beneficiaries then resist even the most obviously logical reforms because they would change the pattern of benefits. There is no better example of this second phenomenon than U.S. “health insurance.”

HOSPITALS HAD BEEN rare before the germ theory of disease began to revolutionize medicine in the mid-19th century. There were only 149 hospitals in the entire U.S. in 1873. By 1923, there were 6,830. But hospitals are capital intensive and labor intensive. Such expenses run on regardless of the patient load.

In 1929, Baylor University Hospital in Dallas had a bright idea to smooth out its cash flow. For $6 a year in premiums, it offered a local teachers’ association with 1,500 members up to three weeks of paid hospital care per year, a very long hospital stay even then.

Designed by hospital administrators, not insurance men, this was the first step down the wrong road. It paid the first dollar of unexpected expenses, not the last, the opposite of real insurance. It also incentivized patients to demand to be treated as a hospital inpatient—the most expensive form of medical care—rather than as an outpatient or simply by the doctor at home.

Most foolishly, it didn’t indemnify the patient against loss; it paid for services regardless of cost. That was an open invitation for hospitals to raise prices, which they have been doing ever since, with a vengeance. It also made patients indifferent to costs, allowing medical-service providers to raise prices more easily.

But because it improved the big problem with hospital finances, the idea quickly spread to other hospitals and was elaborated into Blue Cross, which first operated in Sacramento, Calif., in 1932. The Blue Cross model (along with Blue Shield, which covered doctors’ fees) quickly spread across the country.

State insurance regulators moved to force these plans to act like insurance companies, maintaining sizable reserves to meet unexpected claims. Had they been regulated as insurance, Blue Cross and Blue Shield might have evolved into real insurance companies.

But the American Medical Association and the American Hospital Association lobbied to have Blue Cross-Blue Shield exempted. The Blues offered instead to accept anyone who applied for coverage, and they said they would operate as nonprofits. State insurance departments and the Internal Revenue Service accepted this bargain.

Hospitals thus came to be paid almost entirely on a cost-plus basis, eliminating any incentive to watch costs. Doctors were paid on the basis of “reasonable and customary charges,” which turned out to be a powerful incentive to add to the charges and a powerful disincentive against offering lower fees