When rules don't apply

It’s a cliché that this is a crisis. But what exactly is a crisis? I like Richard Bookstaber’s idea – that it is a time when normal economic rules don’t apply.

For example, in normal times investors can reasonably think about valuations and corporate earnings. But in crises what matters instead is risk and liquidity. In normal times, negative feedback loops dominate: cheap assets will rise in price. But in crises, there’s a heightened danger of positive feedback whereby selling begets more selling.

In the 2008 crisis, for example, some opposed bank bailouts fearing a moral hazard problem. But they were applying normal times thinking. What mattered much more was keeping the financial system alive.

We’re seeing the same thing now. This crisis means that some normal ideas don’t apply. Here are five.

1. Robert Peston asks whether the furlough scheme is destroying work incentives. He’s not alone. Universal Credit was designed to incentivize work, by making the application process complicated; by ensuring a long wait between application and payment; and by keeping unemployment benefits low.

But this is not the issue now. Quite the opposite. We actually want to disincentivize work, to ensure that people don’t spread the virus.

2. Fiscal rules might be needed in normal times. But we don’t need them now. The same crisis that is raising government debt is also increasing demand for safe assets. This is why gilt yields have fallen this year despite the OBR’s forecast (pdf) that the crisis will add £429bn to public deby by 2021.

3. In normal times we should worry about allocative efficiency, and not bail out lame duck companies. In this crisis, however, this concern is a low priority. James Tobin’s famous remark is more true than ever: “it takes a heap of Harberger triangles to fill an Okun gap.”

4. Economic forecasts are sometimes useful – although as Prakash Loungani has been saying for years they always fail to foresee recessions in time. But they’re not so much now. We know that economic activity is plummeting and that unemployment is soaring. But we cannot know the magnitudes and do not need to. If I were to say that GDP will drop 10 per cent this year rather than 15, it would be daft to infer that we should support the economy less. 10 per cent is still a lot. And given the uncertainty around it, we should err on giving maximum support. If a man if falling from a plane, he doesn’t need to know at what speed he’ll hit the ground: he needs to know how to open a parachute.

5. Ordinarily, we should worry about the distributional impact of support packages, incentive effects and whether systems will be gamed. In a crisis, though, these are low priorities. What matters, as Eric says, is that the support be immediate and large. If your house is on fire, you should not worry about your carpets getting wet. You should put the fire out and clean up the mess later.

Our priority must be to protect valuable economic assets. This means protecting jobs, because unemployment is a source of much misery. It also means protecting companies, because organizational capital and firm-specific human capital are valuable assets. Contrary to the simple-minded Econ-101ers, capital and labour are not fungible.

Yes, supporting firms means keeping some lame ducks in business, such as the many mediocre retailers and restaurants that would have gone bust even if the virus had not struck. But If they are to go bust, let’s have them do so during the recovery, when their labour and assets can be hired by expanding firms.

And there’s tons more the government can do. It could give tax rebates to firms and the self-employed. It could give rent holidays: unlike workers and firms landlords don’t (for the most part) provide useful assets and so should be a low priority for support. And it could also provide loan repayment holidays too, if necessary by taking a bigger place in banks’ capital structures. In this sense, Sunak’s support does not go far enough: the fact that Universal Credit applications are soaring tells us as much.  

In ordinary times, these would not be great ideas, and they'd have to be reversed in the upturn. But these are not ordinary times. And we must all be intellectually flexible enough to spot the difference.

Comments

[Ralph Musgrave]

“It also means protecting companies, because organizational capital and firm-specific human capital are valuable assets. Contrary to the simple-minded Econ-101ers, capital and labour are not fungible.”

If companies are not protected, capital and labour do not need to be fungible in order for a quick recovery post Corvid. E.g. if British Airways goes bust, someone will pay something for BA assets. Failing all else, I’d pay 1p for the billion or so dollars worth of aircraft (out of the kindness of my heart). BA’s shareholders and bond-holders are wiped out, of course.

Then come the recovery, I’d set up a new airline “UK Airways”. I’d re-hire all the old BA pilots, flight attendants etc. Hey presto: I’m the proud owner of a billion dollar corporation which cost me 1p.

It’s amazing what free markets can do when the would be economic planners stop interfering.

[Robert Mitchell]

"unemployment is a source of much misery."

This is ergodic thinking, using a generalized representative agent to eliminate those of us who become suicidally depressed at work. We are completely eliminated from your model. We are silenced, ignored, marginalized. Will you delete this post, to keep your model plausible?

[Blissex]

«In the 2008 crisis, for example, some opposed bank bailouts fearing a moral hazard problem. But they were applying normal times thinking. What mattered much more was keeping the financial system alive.»

This is the purest "centrist" propaganda: keeping the financial system alive is a very different thing from keeping the existing financial system management, spivs and frauds all together, in their comfy positions of rent.

I would have been quite easy to keep the financial system alive by moving the back offices of exiting banks into new banks and simply lopping off the failed management layers of the existing banks.

In practice the USA and UK governments did not "keep the financial system alive", but bailed out property speculators, finance conglomerate management, and other "leaders" of the debt/sell-side lobby rolling in the money, and well away from any embarrassing criminal investigations.

The same should have happened now to the management spivs and frauds who very determinedly did not build reserves or pay for insurance to cope with even a few weeks or months of bad business, because they wanted to distributed more of company earnings to themselves as bonuses and stock option repurchases.

In practice those management spivs and frauds decided to run their companies by grossly under capitalizing them against risk, knowing that if they needed capital, their mates at the BoE and Treasury would give them grand handouts.

The usual: private gains and public losses, a 50-50 mixed economic partnership :-).

[bizimmekan]

I’d pay 1p distributed more of company for the billion or so dollars worth of aircraft

[georgesdelatour]

@Blissex

In “Skin In The Game” Taleb explains why many Roman aqueducts are still standing after 2,000 years. It’s because the Roman authorities made the architects live directly underneath them, so they’d be the first to die if the structure collapsed.

I think lack of “Skin In The Game” is a key problem with banking malfeasance. Maybe we should require all contracts in the banking sector to include penalties as well as bonuses. Or maybe we need an equivalent sanction to the GMC having a doctor “struck off”.