As a proponent of market-based health care reform, I’m often accused of believing that free markets will cure what ails our broken health care system and that we just need to get government out of the way to make it all better. I believe no such thing. And I almost never use the term “free markets.” It too often connotes that markets can operate in the absence of government regulation. That’s not how it works.

I understand why so many people believe in “free” markets, because markets themselves are a natural phenomenon arising from fundamental human behavior. Certainly no government ever invented them. Markets just happened, because people want things they lack, and they have found they can get them in return for their own labor and produce. No one really understands why markets work, because they are such indescribably complex, nonlinear, adaptive systems. But somehow they do. They’re messy as hell, but they perform well enough to allow a paraphrase of Churchill’s famous comment on democracy: Market capitalism is the worst form of economic organization—except for all the others that have been tried.

I’m not saying that free markets don’t exist. They do. But lacking a basis in law, they tend to occur only in the primitive forms of black markets and criminal enterprises in which property rights, contracts, protection from theft, and other essential elements are enforced—if at all—by informal agreement, violence, corruption, and, by definition, lawlessness. Legitimate markets of the complexity necessary to sustain major economies cannot exist without law and regulation to ensure property rights, enforceability of contracts, rights of commercial speech and assembly, a sound currency, public infrastructure, a stable banking system, orderly bankruptcy procedures, national defense, social and economic safety nets, effective trade policies, efficient capital formation, prevention of corruption and criminality, protection from unacceptable negative externalities (e.g., environmental damage), and resolution of significant market failures (e.g., health care). These government functions are the desiderata of real markets. Some economists even suggest that such regulation originally arose as a means to reduce the costs of doing business, not to impede it. The trick, though, is for regulation to allow markets the freedom to function without unnecessary interference in the voluntary exchange of information and value that makes them so effective.

Health care constitutes a massive opportunity for an enlightened government regulatory role that will allow markets to cure all its problems of cost, quality, and access. Currently, health care is the only one of our five fundamental human needs not being met by well-functioning markets (the other needs are food, clothing, housing, and transportation). Yet health care, like the others, is what economists call an economic good, having both the scarcity and the discernible prices that normally allow markets to self-develop to become the optimal medium of production and distribution.

Why is health care the exception? Free-market advocates claim it’s because of decades of government interference with programs like Medicare, Medicaid, and SCHIP that prevent markets from functioning properly. But that’s not the reason. Those programs are simply a response—a poor response to be sure—to a fundamental market failure arising from the fact that no natural, self-organizing market will ever provide the necessary health insurance that everyone needs for protection against the risks of unaffordable, necessary medical care.

Health insurance works according to the Pareto Principle, more commonly known as the 80/20 rule. At any given time, about 20% of the people consume 80% of the medical care. Thus, an insurer’s customers must include 80% who are healthy in order to assure payment for the 20% who aren’t. Imagine an intellectually-challenged entrepreneur who opens a comprehensive, 24/7 health insurance supermarket that works like a food market or a clothing store. Any customer can walk in, take an insurance policy off the shelf, and pay for it at checkout. But who will actually shop in this supermarket? Right, sick people. Healthy people will stay away until they get sick, thus depriving the entrepreneur of the healthy 80% necessary to pay the bills. An economist might say that, because this adverse selection causes one person’s decision to purchase (or not) health insurance to increase another person’s price for it, there is a negative externality that results in a Pareto sub-optimal allocation of resources, or more simply, a market failure. Or, as the unfortunate entrepreneur might put it, “My God, I’ve gone broke!”

Although such insurance supermarkets can’t work, wiser entrepreneurs figured out a long time ago that there are two—and only two—natural markets for health insurance: large employer groups and healthy individuals. Large employer groups are inherently insurable because they fit the 80/20 rule (and not because of a WWII tax ruling that excluded employer-provided health benefits from federal taxes). That’s also true for healthy individuals, as long as the insurer is allowed to confirm their healthy status before agreeing to insure them. Unfortunately, however, there are no natural health insurance markets for the elderly, the disabled, the poor, or for sick individuals. This is the result of the above-described health-insurance market failure that no “free” market will ever correct.

It turns out, though, that this failure is one that could have been identified and corrected by relatively straightforward government regulatory and safety net reform at any time during the past eighty years. Such reforms would have yielded universal medical care with twice today’s quality at half the cost. Instead, the government bypassed regulated market-based solutions in favor of direct government interventions that have utterly failed to assure high quality, affordable cost, universal access, or long-term sustainability. The government has stepped outside of its appropriate role, and, as evidenced by the just-passed House health reform bill, plans to stay there.

In Part 2, I’ll discuss how to set this aright, so that all Americans can voluntarily and sustainably consume the full range of necessary medical care.