Chiang Ying-ying/AP Photo
Visitors to Taipei’s famous Hsing Tian Kong Temple wear protective masks, February 25, 2020.
On Monday, Wall Street discovered the novel coronavirus. Whether it was the spread to developed nations like South Korea and Italy, or the Centers for Disease Control’s assessment (“It’s likely that person-to-person spread will continue to occur, including in the United States”), the resulting fever sent stocks tumbling to their worst day in two years.
But the economic fallout did not start yesterday. U.S. business activity hit a six-year low in February, as demand in China slowed to a trickle. There’s no way to stimulate a quarantined economy, and when it’s the world’s largest, that shock ripples out. Worse, global supply chains have been rocked by the Chinese slowdown. Finished goods have stopped flowing, and factories around the world have sat waiting for component parts. Even when firms shifted production to Vietnam, plant managers who went back to China for Lunar New Year festivities can’t find their way out of a country under lockdown, halting production.
This problem will compound if South Korea, where 90 percent of the exports are intermediate goods like semiconductors and electronic displays, starts closing plants. Given just-in-time logistics, assembly lines are sure to remain still even if everyone magically returned to work in China tomorrow. The supply shock is already baked in.
How did this happen? How did the world become so reliant on one region, such that any disruption could have such a magnified impact? In at least one sector, the answer appears to be monopoly middlemen.
China is a major pharmaceutical hub for finished drugs, and 80 percent of active pharmaceutical ingredients come from China and India. About 150 medications are at risk of shortages if the supply-chain snarl continues, including many generics, sterile injectables used routinely at hospitals, and basics like antibiotics and penicillin, neither of which are made any longer in the U.S. Policymakers in both parties recognize this as a health security threat.
But shortages did not begin when the first COVID-19 case was discovered; that will prove a convenient cover story. The Food and Drug Administration keeps a drug shortage database that currently has 145 medications in it. This has been going on for years; a 2019 report from the University of Chicago found that 80 percent of hospitals had problems obtaining common drugs, and even sterile water for IVs.
Why? Market economies aren’t supposed to run shortages. But these markets are broken.
Phil Zweig is not a doctor, but he runs the nonprofit Physicians Against Drug Shortages, paying for much of it out of his own pocket. He connects drug shortages to the way U.S. hospitals buy routine drugs and medical supplies, through large buying groups known as group purchasing organizations (GPOs).
Started in 1910 as co-op buying groups to save money on supplies, GPOs changed in 1987 when Congress enacted a “safe harbor” provision, allowing the companies to be paid by the medical-supply vendors rather than the hospitals. The idea was to save hospitals money, but legalizing these kickbacks totally changed the incentives. GPOs were the only entryway into the hospital, and they played a gatekeeper role.
“The GPOs make money by selling sole-source contracts to the highest bidder,” Zweig says. “Instead of being in the business of saving money for hospitals, they were in the business of selling market share to the dominant suppliers.” GPOs structure their contracts to lock in purchases, placing penalties on hospitals that stray from buying from the sole-source supplier. That makes the market share more lucrative.
Shortages did not begin when the first COVID-19 case was discovered; a 2019 report from the University of Chicago found that 80 percent of hospitals had problems obtaining common drugs, and even sterile water for IVs.
In the mid-1990s, regulators gave the GPO industry an effective antitrust exemption, except in “extraordinary circumstances.” The idea was again to help out hospitals: Larger buying groups would enable bigger discounts on bulk purchases. It led to consolidation to four major GPOs—Vizient, Premier, HealthTrust, and Intalere—controlling $300 billion in medical-supply contracts.
For suppliers, getting a contract is prohibitively expensive. Documents in a federal whistleblower case show that Ben Venue Laboratories, at the time a major manufacturer of old-line generic drugs, paid an amount equivalent to 56.25 percent of its overall sales on one drug to access the contract of a major GPO.
Ben Venue is out of business today. “They couldn’t make any money,” Zweig says. With the high fixed cost to access hospitals through tribute to the GPOs, margins have become so low that generic drugmakers can’t stay alive. With production costs the major variable, companies sought cheaper labor and lower environmental compliance abroad. “By destroying the profitability of the domestic-based generic drug industry in the U.S., they pushed this business to China,” Zweig maintains.
That has concentrated the supply chain and made it susceptible to shocks and shortages. It’s also pushed out a lot of generic drug manufacturers entirely; if you can’t access GPO contracts, you lose your reason to exist. The sole-source nature of the contracts builds fragility into the system; even if other companies could survive and produce drugs, the hospitals must buy from the dominant supplier. Even small disruptions cause shortages; if Chinese factories shut down for an extended period, that’s obviously magnified.
“With the coronavirus, it’s a shot across the bow on why we’re making these drugs in China,” Zweig says. “All these drugs in short supply go through GPO contracts.”
Nobody involved in this wants to say much about it. Despite paying higher prices for supplies as suppliers pass on some of their GPO burden, hospitals receive “share-backs” from GPOs, a kind of payoff to keep them quiet. The drug companies don’t want to speak up because it would ruin their chances of getting GPO contracts. The main researcher of drug shortages, Erin Fox of the University of Utah, discloses that she gets all her data and some funding from leading GPO Vizient. Even the FDA spins a host of possible reasons for drug shortages, only glancing at GPOs.
There was a recent breakthrough, however. In largely overlooked congressional testimony last September, Senator Richard Blumenthal (D-CT) cited GPOs as contributing to “rising hospital costs, medication shortages, and stifling introduction of innovative products from smaller companies.” Makan Delrahim, the head of the Justice Department’s antitrust division, highlighted the anti-kickback safe harbor as creating the perversions in the marketplace, “where some of these GPOs are buying exclusivity at the risk of innovation, at the risk of cost and at the risk of lives of patients.”
By destroying the profitability of the domestic-based generic drug industry in the U.S., they pushed this business to China.
Delrahim’s Justice Department also filed an amicus brief in a case against GPOs filed by a small hospital system in Illinois that has been excessively squeezed on price, arguing that courts should punish what amounts to a price-fixing scheme. The case is critical, Zweig says. “I don’t remember any other antitrust case filed by the providers against the GPOs for overcharging. If they win, every firm in the country is going to be suing the GPOs. I’ve been told I’m a conspiracy theorist. I was delighted to see this amicus brief, saying it is a fucking conspiracy!”
In the meantime, some drug companies have figured out the dangers of a consolidated supply chain. French firm Sanofi announced Monday they would create a stand-alone company to manufacture active ingredients at several sites in Europe. There are initiatives in Congress to prevent the manufacture of certain ingredients and drugs in China. But without fixing the GPO problem, the generic drug industry will struggle to survive while paying for access.
Meanwhile, in 2018 hospitals established Civica Rx, a nonprofit generic drug company, to address supply shortages. But one of the leading hospitals in the project, Intermountain Healthcare, owns the fourth-largest GPO, Intalere. “It’s like a rogue fireman who starts the fire, leaves the scene, comes back to put out the fire and be treated like the hero,” Zweig says. “You have these four giant companies that control the largest market for hospital supplies and generic drugs, in the largest market in the world. It’s killing the generic drug industry.”
Self-preservation dictates that production of critical pharmaceuticals must diversify, and return to the U.S. But you can’t do that until you fix how the contracting works, which has generated this extreme concentration. “All I have ever said is just let the market work,” Zweig says. “We don’t need kickbacks, rebates. Let this be a normal market. There’s no reason why there can’t be a domestic generic industry.”
