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When rules don’t apply

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Summary:
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.

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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. Jump

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.

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