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Michael Milken outlines the capital shortage for pharma. That is, the "cure-recession" that threatens all of us.

Posted Feb 10 2011 12:00am

Michael Milken, chairman of FasterCures, a Washington-based center of the Milken Institute, published important  ideas for advancing Serious Medicine in The Wall Street Journal yesterday. 

Milken has been a visionary advocate of improved health and medicine for more than a decade, and his piece hits many key points--from reforming the NIH and FDA to encouraging wellness.  

But one Milken point in particular needs emphasis:  The reality that we are in the middle of what might be called "capital strike" in the healthcare sector.    That is, investors are looking elsewhere, away from the healthcare sector, for good returns on investment.  And that’s obviously "ominous," as Milken puts it, for our long-term health, as well as the longterm solvency of healthcare programs, including Medicare.   Perhaps Milken is being polite in his word choice.  Perhaps a better word than ominous is "disastrous," or even "catastrophic."  

Yet the real issue is the reality of the status quo, not this word or that word.   In his piece, Milken contrasts the stock-market valuations of various kinds of companies against the valuations of the pharma companies and concludes that the market has assigned a lesser value--more precisely, a lesser price-earnings ratio--to the pharma sector.  Here’s an excerpt of Milken’s piece: 

Consider companies that make consumer products—things like soft drinks, detergent, cosmetics and beer. While their price-earnings ratios will vary, in today's market their average will most likely be in the neighborhood of 20. But the average P/E of the largest American pharmaceutical research companies (Abbott Labs, Bristol-Myers Squibb, Johnson & Johnson, Eli Lilly, Merck and Pfizer) was recently near 10. Investors must have concluded that pretzels and eyeliner produce faster profit growth than prescription medicines.

Lower pharma P/E ratios are a recent phenomenon. A generation ago, drug firms regularly topped magazine lists of the most-admired companies in America, a reputation usually reflected in their stock prices. But facing the specter of regulated returns, enterprise values dropped sharply during debates about proposed health-reform legislation in 1993. When the proposals failed in Congress, valuations eventually recovered. In the last decade, pharma P/E ratios dropped again.

So we might ask: Is it really in America’s national interest to be assigning so little value to the pharma sector?  We can further ask: Which is more important--potato chips and soft drinks, or new cures and new treatments?  A few market-fundamentalists, to be sure, might insist that the free market has decided that snacks are more important than life-saving pills, and thus defend the wisdom of the market.  The answer to that assertion is that the healthcare market has been badly distorted by excessive regulation and litigation.    

And in any case, the overwhelming majority of Americans would disagree with libertarian purity.   Americans think that the market should work for them, not the other way around.      

Indeed, we can further conclude that the average American probably has no idea that so little is happening in the pharma sector--that the number of new drugs has fallen by two-thirds over the past 15 years.  The American people might not care much, or at all, whether or not the pharma sector is making money, but they do care about the drought in cures.  And so if they could be persuaded the capital drought is leading to the cure drought, there’d be a change.   If folks were to know, for example, that the number of new drugs coming through the pipeline has fallen by two thirds, they would demand action.  
Because the deep perversity of the current incompetent system is that there is enormous public demand for new medicine--for new cures.   For Serious Medicine.  Just turn on a TV and watch the news: The “health” category is full of stories about new treatments and cures-- in utero surgery for spina  bifida being the most recent heartening example --as opposed to health insurance. 

The question, then, is why the supply has been choked off?   Why can’t demand be matched by supply?  We can that mismatch a “cure recession.”  And so where did that cure-recession come from? 

This cure recession is very strange, because the permanent torrent demand for healthcare is there. And that should make for a permanent boom in the sector.   The late Nobel Prize-winning economist Paul Samuelson’s spoke of “insatiable” demand for just about everything.  That’s certainly true for Serious Medicine, the stuff that improves our lives and keeps us alive.  

But that demand has not been met by supply. 

To be sure, the supply numbers sound impressive at first glance--that is, the supply of money.  The Pharmaceutical Research and Manufacturers Association (PhRMA) reports that its members invested $45.8 billion in 2009 in discovering and developing new medicines, and that industry-wide research and investment reached a record $65.3 billion in 2009 .  

That sounds good, but at the same time, as we have seen, t he number of new medicinal drugs approved by the Food and Drug Administration has shrunk by two-thirds in the last 15 yearsWhat could be driving this?  One factor is the extraordinary cost of a new drug.  According to Pfizer, the cost has risen five-fold over the past two decades, to $2.4 billion for each “new medical entity.”  Thus we see a disastrous “scissoring” of trends--more money being spent, but fewer drugs coming out of the medical-industrial pipeline.    So the seeming abundance of pharma capital is actually, on closer inspection, a scarcity.  

A common and accurate term for this diminishment is “drought,” but that word, useful as it is, suggests there’s something natural about it.  But in fact, there is nothing natural about this slowdown--indeed, the slowdown runs counter to the innate enthusiasm of people for more and better cures--so we can call this slowdown by a name that connotes its man-made origins.   And that term is cure-recession.   Or even planned cure-recession--planned by people who think, for example, that we spend too much on healthcare.    Some specific causes of this cure-recession are over-regulation and over-litigation.   But we can also note a simple explanation: There’s not enough money--chased off, of course, by the regulators and price-controllers.    And that shortfall, of course, is the result of of some wrong-headed thinking about where to spend the healthcare dollars that we do spend.  In a nutshell, we spend too much after the sickness hits, and not enough before.   

A basic conundrum of our health system is that we spend so much on care and yet so little on cure.  Once again, it's as if our healthcare system were designed to benefit such labor-intensive industries as nursing homes.    America’s R&D budget for medicine--the money spent by the federal government, the pharmaceutical companies, medical institutions, philanthropy--is  approximately $113 billion a year.  That's a big number, but if, as we have seen, each “new medical entity” costs $2.4 billion, then that $113 billion doesn’t stretch that far.

Moreover, $113 billion is only about four percent of the $2.6 trillion that the US spends on healthcare every year.   In business terms, we can think of the $2.6 trillion as operating expenses, while the $113 billion is the capital budget--a puny amount.   And for  further perspective on that $113 billion, we can note that Americans spend about $40 billion a year on weight-loss programs and products , and about $400 billion a year on sports of all kind .   No doubt the P/E ratios, or other economic equivalent, for those industries, is much higher. 

So once again, if the pharma market were more functional and more robust, capital would come flooding in, and the cure-recession would be over   Such an influx of capital would probably help the existing pharma companies, but the real beneficiaries would be the American people.  Plus, of course, whatever medical geniuses might be lured into the field, or might find themselves empowered to actually make their cure-vision a reality.  


Yet we might ask: Where is this money going to come from?   As we consider the relative amounts of capital needed for Serious Medicine, we might step back and think about larger sources, in keeping with the larger challenge-sources from around the country, and around the world.   

We might say, for example, that the $113 billion R&D figure should be compared to America’s overall Gross Domestic Product (GDP), which is approximately $14.5 trillion.  In that case, R&D spending comes to less than one percent of GDP--eight-tenths of one percent, to be precise.  Is that all we’re worth to ourselves?  Is it right that just one dollar out of every 125 that we generate is spent on developing medicines for our health and our lives?  Is that really the right ratio? 

As we survey this capital shortage for Serious Medicine, we can think back to the lingering and cumulative impact of the Seventies Scarcitarians: They decided, long ago, that we were spending too much on our health and well-being, and they have been everything they can do to vindicate their judgement--basically an aesthetic judgment, driven by anti-technological impulses.  

Meanwhile, when we see that tiny number for medical R&D, next to the enormous potential supply of money for such R&D, it’s a sure sign of underinvestment--some might call it a “capital strike.”  But a more neutral term from economists is “market failure”; in the current environment, capital simply cannot find enough worthy projects to be invested in.  Hence the cure-recession. 

Indeed, we might go further, noting that the net worth of the country is about $55 trillion, and so annual medical R&D amounts to just .2 percent of our wealth.  Finally, we might note that the net wealth of the world is around $200 trillion, and people everywhere, rich and poor alike, are interested in cures--and they would eagerly contribute to the cure-effort, if they could.  By these multi-trillion-dollar denominators, the numerator--the $113 billion the US spends on medical R&D--seems puny indeed.   


Thus, to invoke economic terms, when demand-siders--that is, Keynesians such as Samuelson--say that robust demand is paramount, they are correct.   And when supply-siders--such as, say, the late Jack Kemp--maintain that robust supply is paramount, they, too, are correct.  

What we have described above is the definition of a demand-side recession, and current prospects for the cure-sector seem bleak, as Obamacare-ish price controls kick in, or even threaten to kick in.   Medical R&D, presently receiving sparse demand, is being sparsely encouraged to invest in research.  In order to convince the cure-sector to invest, we must see a greater demand for cures.  Yes, that can be seen as a Keynesian argument, but  century-and-a-half before Keynes, the same argument was made by Adam Smith, who wrote in The Wealth of Nations that it is “perfectly self-evident” that “Consumption is the sole end and purpose of all production; and the interest of the producer ought to be attended to, only so far as it may be necessary for promoting that of the consumer.” .  So perhaps we can conclude that both Keynes and Smith were wise in their words--and wisdom, of course, transcends left and right.  As the New America Foundation’s Michael Lind observes, “To consume, one must be alive and preferably healthy.  H  ow health is a cost upon production is bizarre, unless you think we live to make widgets for their own sake.”

And here we might add, that there has been an overemphasis on alleviation, as part of the general trend away from medical-scientific solutions in our society, and toward nursing and long-term care.  (The fact that nursing and longterm care is more labor intensive, and thus more voter-intensive, might have something to do with this trend.) 

Perhaps that argument--away from technology, toward care--sounds like a strange argument to make, given the obvious enthusiasm that we have for the latest "app," but of course, iPhones and Droids are a different field.  As we have learned from the late Stephen Jay Gould et al, evolution of all kinds is episodic, including scientific and technological development.  Evolution stops and starts and stops again.  The jargon phrase for this phenomenon is punctuated equilibrium .    So while computer science is rocketing along, other fields are stagnating.    And as Milken helps show us, Serious Medicine is stagnating. 

So what’s needed is a strategy--a Serious Medicine Strategy to not only get capital into the drug-making process, but also to get those new drugs into the hands of doctors and patients.    

Here's the text of Milken's valuable article: 

Health-Care Investment—The Hidden Crisis: When the stock market values companies that make cosmetics and beer far above pharmaceutical companies, you know that incentives are out of whack.

Since 1820, world per-capita income has risen more than eightfold, thanks in part to the spread of democracy, open trading markets, and the rule of law. But a less-noted source of growth—improvements to health that have given us longer, more productive lives—has produced as much as half of the increase in the global economy over the past two centuries, as research by the late British economist Angus Maddison suggests. It would be logical to assume that companies whose products make us healthier would be among the most valued enterprises on the planet, but this assumption is wrong.

Consider companies that make consumer products—things like soft drinks, detergent, cosmetics and beer. While their price-earnings ratios will vary, in today's market their average will most likely be in the neighborhood of 20. But the average P/E of the largest American pharmaceutical research companies (Abbott Labs, Bristol-Myers Squibb, Johnson & Johnson, Eli Lilly, Merck and Pfizer) was recently near 10. Investors must have concluded that pretzels and eyeliner produce faster profit growth than prescription medicines.

Lower pharma P/E ratios are a recent phenomenon. A generation ago, drug firms regularly topped magazine lists of the most-admired companies in America, a reputation usually reflected in their stock prices. But facing the specter of regulated returns, enterprise values dropped sharply during debates about proposed health-reform legislation in 1993. When the proposals failed in Congress, valuations eventually recovered. In the last decade, pharma P/E ratios dropped again.


Contributing to these lower valuations are patent expirations, regulatory complexity, uncertainty about litigation exposure, and high U.S. taxes on repatriated foreign income. These factors undoubtedly influenced the decision by Procter & Gamble to leave the pharmaceutical business entirely in 2009 and concentrate on consumer products.

Procter & Gamble responded rationally to clear market signals that discouraged development of life-saving drugs. But for people whose health, and perhaps survival, will depend on these medicines—that includes you and me—the implications of the disparity in market valuations are ominous.

We can remove some of the barriers to growth in medical research through several public-policy steps:

*Match the inducements of other countries. Many nations offer generous tax incentives, easier recruitment of clinical-trial subjects, strong government partnerships and far less litigation. We cannot and should not stop American biopharmaceutical and medical-device manufacturers from expanding overseas operations. But we can reduce needless bureaucracy at home, implement tort reform, and restructure taxation of foreign income.

*Recognize the return on investment in federal health research. We clearly need spending restraint in Washington. But smart budgeting will factor in the economic gains that come from longer, healthier life spans and the savings from improved therapies. One 2006 study by Kevin Murphy and Robert Topel of the University of Chicago showed that life-expectancy gains since 1970 added $3.2 trillion per year to America's national wealth. A mere 1% reduction in cancer deaths would be worth $500 billion, they noted, and the present value to future generations of a full cure is a nearly incomprehensible $50 trillion—more than three times today's GDP.

Congress doubled the budget of the National Institutes of Health (NIH) between 1998 and 2003. It was money well-spent, and we're now seeing exciting announcements from the nation's medical research centers, including 39 new cancer drugs that have been approved since 2004. In our view at the Milken Institute's FasterCures, the past year has produced the greatest progress against cancer since I first began working with the research community in the 1970s. Progress is accelerating on a range of other diseases as doctors gain traction by using rapidly evolving technology and by collaborating across disciplines.

But the prospects for continuing this discovery bonanza are threatened. NIH funding has trended down in real terms since 2003. Current budget realities portend severe future cuts that will cause some younger medical scientists to either change careers or take their work to places like Singapore that put out the welcome mat for promising researchers. Whether continuing breakthroughs emerge from U.S. laboratories or somewhere else will profoundly affect America's role among nations in the 21st century.

*Support prevention. There's great concern with rising health-care costs, yet too often we overlook that the single best way to contain them is to keep people from getting sick in the first place. That starts with recognizing that lifestyles, not genes, are the biggest contributors to disease. Public and corporate programs aimed at even slight reductions in obesity, tobacco use and other damaging behaviors pay large social and economic dividends.

*Give the FDA adequate resources. At a recent New York conference hosted by FasterCures, Food and Drug Administration Commissioner Margaret Hamburg told me that imports of products subject to FDA inspection have increased to 20 million from six million shipments in a decade. In fact, an estimated 25% of the U.S. economy is affected by FDA oversight. And the new food-safety legislation that Congress passed in December further expands the agency's responsibilities.

Given all this, the FDA soon won't be able to keep up with the pace of innovation in such areas as medical-device development and regenerative medicine—the use of stem cells to repair damage to tissues and organs. That will further slow the movement of effective drugs and devices from laboratory to patient.

As they seek to bring deficits under control, Republicans and Democrats will disagree on which investments in education and medical research make the most sense to secure our future. But they'd better start agreeing on something soon. A 2009 study by the Information Technology and Innovation Foundation, "The Atlantic Century," benchmarked the U.S. against Europe on several measures of innovation and competitiveness. Although the U.S. currently ranks sixth out of 40 nations (down from first in previous studies), it's slipping and making the slowest progress toward what the report characterizes as a knowledge-driven, high-innovation economy.

Improved public health translates directly into greater national productivity, which underpins all economic growth. So let's get our priorities straight. America's economy used to be the sun—the gravitational center—in the "solar system" of leading nations. In the future, we'll no longer be the sun. But by investing in our own health, we can help solidify our position as Jupiter, the largest planet.
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