Category Archives: virus crisis

The case for forbearance

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I believe that the best macroeconomic response to the virus crisis would be what I call forbearance. Bank regulators would tell banks that they will be allowed to fall below minimum capital requirements. They will be allowed to write down the value of loans without having to raise capital as a result. They will be encouraged to in turn offer forbearance to borrowers, provided that there is a reasonable prospect that borrowers will be able to get repayments back on track once the crisis has passed.

Under this policy, it will be up to banks to decide which borrowers are in short-term difficulty and which borrowers are never going to recover. If I were at a bank, I would bet on airlines coming back. I would not bet on cruise ships coming back.

You can think of forbearance as a selective soft bailout. When it comes to bailing out industries, you can think of a type I and type II error. Type I error is where you let a business collapse when it could survive with some help to tide it over. A type II error is where you save a business that is really not viable.

Ordinarily, you just let the market operate, and accept the errors that it makes. But the virus crisis threatens to become a financial crisis, and in a financial crisis there will be a lot of Type I errors. These in turn will cause economic activity to fall. But if you provide indiscriminate bailouts, you will make too many Type II errors.

If you provide funds to a troubled firm, then you may commit a Type II error without realizing it. If you only provide forbearance, then you discover your Type II error when even after the crisis passes the firm cannot get back on track. So that limits the duration of the error that you make.

If you just use generic macroeconomic instruments, such as fiscal and monetary stimulus, you end up with a lot of both types of errors. That is how I judge the response to the crisis of 2008. On top of that, there was all sorts of economically useless graft, such as the “green energy” programs included in the fiscal stimulus.

I am skeptical that either quantitative easing or the stimulus actually helped. That is because I think that the “aggregate demand” paradigm is flawed. Economic activity declined because particular patterns of specialization and trade were disrupted. This will also be the case with the virus crisis. More government spending or more expansion of the Fed’s balance sheet will just socialize more of the economy. That will be of little benefit in the short run, and it will cause harm in the long run.

My working assumption continues to be that the elites are two weeks behind in dealing with this crisis. That is, what President Trump did yesterday was probably what he should have done two weeks ago. What I would like to see the top leadership do is ask the Centers for Disease Control to come up with a plan for what to do if three weeks from now the number of cases continues to double every few days with no sign of stopping. Take that plan and execute it now.

The two-weeks-behind hypothesis

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My working assumption is that American business and political elites are two weeks behind in their attempts to address the virus crisis. The steps they are taking now were necessary two weeks ago. And the steps that are needed now will not be taken for another two weeks.

So you can look at the news about events being canceled, telework being encouraged, and so on, and say that this is all for the good. But it would have been better to have taken these steps before, say, the Biogen conference.

So ask yourself, what are the steps that we will wish we had taken two weeks from now? Perhaps more self-quarantining by people who do not think they have been exposed.

Macroeconomics of the virus crisis, 4

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Some very welcome humility from the economists on the IGM forum. They are asked whether we should think of this as mostly a demand shock or mostly a supply shock, and a lot of them refuse to take the bait.

Alesina says, “This is a new situation. We don’t have a clue.”

Duffie says, “For me, this is just too hard to entangle.”

Eichengreen says, “As someone who’s estimated lots of models designed to distinguish supply and demand shocks, good luck identifying them.”

Hall says, “I’m certain that the answer is totally uncertain.”

Schmalensee says, “Too early to call, I think. Workforce disruptions will affect demand as well as supply.”

There are others who are willing to try to pick one or the other. But some pick supply and some pick demand.

Of course, I think that the AS-AD paradigm is the wrong place to start. See my book.

Also, Tyler Cowen raises the possibility that the economy will suffer from a fragile financial system, which was fostered and joined by governments.

Macroeconomics of the virus crisis, 3

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First, I think that this article from MIT Technology Review is essential reading, if you have not already seen it.

According to Duane Newton, the director of clinical microbiology at the University of Michigan, the biggest limitation in diagnostics is not the technology, but rather the regulatory approval process for new tests and platforms. While this process is critical for ensuring safety and efficacy, the necessary delays often “hamper the willingness and ability of manufacturers and laboratories to invest resources into developing and implementing new tests,” he says.

Case in point: FDA rules initially prevented state and commercial labs from developing their own coronavirus diagnostic tests, even if they could develop coronavirus PCR primers on their own. So when the only available test suddenly turned out to be bunk, no one could actually say what primer sets worked.

Read the whole article.

Next, today’s WSJ has many editorials and op-eds that discuss measures to help households get through the crisis. But the most interesting piece is by Hal Scott on the financial sector. He says that after the 2008 financial crisis abated

there was growing public concern about “moral hazard”—that government backstops and guarantees created incentives for risky behavior. In response, the Dodd-Frank Act of 2010 limited the Fed’s lender-of-last-resort powers for nonbanks, an increasingly important part of the financial system. Fed loans to nonbanks can now be made only with the approval of the Treasury secretary. They must be done through a broad program, unlike the one-off rescue of AIG, and must meet heightened collateral requirements. Loans to nonbanks must be disclosed to congressional leaders within seven days and to the public within one year.

I agree that we should be concerned about the financial sector, because of the way that it can magnify an economic crisis. But just as in 2008, I would try to avoid loans to financial institutions and other forms of bailouts. Back, then, I proposed “forbearance,” meaning allowing banks to fall below regulatory capital standards for a while. I still prefer this approach. It might reduce the contraction of the financial sector without providing a direct transfer of resources from taxpayers to banks.

Commenter Jeff thought along similar lines.

I wonder if you couldn’t mitigate some of the worst effects of defaults with some kind of mass forbearance policy. After all, if Southwest no longer has the cash flow to cover the financing costs of it’s fleet, what are its creditors going to do in the middle of a public health crisis? Come and repo the jets? In order to do what with them?

Finally, the headline yesterday that stock had fallen 20 percent from their peak caused me to wonder whether that is too much. Here are the arguments for and against a sizable stock market drop.

The case for a sizable drop:

–When we have a recession, not only does GDP drop but the ratio of corporate profits to GDP also drops. This “double whammy” on profits is a reason that stocks should fall farther than the economy. Another way to think of this is to treat an index fund as a levered position in GDP. If GDP falls by X percent, then the index fund should fall by a multiple of X percent.

–A significant share of corporate profits of U.S. firms now depends on overseas activity. Some important trading partners appear likely to be hit particularly badly by both the virus and by their financial fragility.

The case against a sizable drop:

–Although trade and tourism are big industries, they are a relatively small share of the U.S. economy overall.

–This, too, shall pass. At some point, even trade and tourism will recover.

The self-quarantine decision: my thought process

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Even though we have no symptoms and no reason to believe we have been infected, my wife and I are going to try to do everything reasonable to reduce outside contact for a while. Call it “social distancing” or self-quarantining.

This means giving up discretionary trips to the grocery store or other shopping. It means giving up going to dance sessions (that is a big sacrifice, as far as I am concerned). It means not having social meals with others. It means not going to visit our children and grandchildren (an even bigger sacrifice).

My thought process is this:

1. I would rather be in front of an exponential curve than behind it.

When I started my Internet business in April of 1994, most people had not heard of the World Wide Web, and many of those who had heard of it took a “wait and see” attitude about whether it would work out as a business environment. It only became clear that the Web was a business platform more than a year later. But by that time, it was harder to ride the curve.

A lot of people, including government leaders in most countries, are going with a “wait and see” approach before reacting to the virus. They are certainly not getting ahead of the curve. In a few weeks, the self-quarantine decision we are taking may be imposed on everyone. Meanwhile, we hope to reduce our chance of contracting the virus and becoming spreaders.

2. In an uncertain situation, I like to compare the upside and the downside. When the upside of doing something is high and the downside is low, go for it. When it’s the opposite, avoid it.

So think about the upside and the downside of going about our normal business instead of self-quarantining. The upside would be that for the next few weeks I get to dance more and spend more time with friends and family. The downside is that I contract the virus and spread it. I think that the downside, even though it is unlikely, is worse, especially becoming a spreader.

3. How long will we self-quarantine? Either we’ll get something like an “all-clear” signal in a few weeks, or, if my worst fears are correct, there will be government-imposed measures that are as strong or stronger than what we are taking.

4. If I were in government, I would, in addition to making an all-out effort to test people with pneumonia symptoms, be making a large effort to test a sample of asymptomatic people. And re-test people in that sample every few days. From a statistical perspective, random testing strikes me as necessary in order to get a reliable picture of the epidemic. I would not trust an “all-clear” signal that was not backed by evidence from random testing.

Note that this post is not about the current Administration, so please self-quarantine your political comments and take them elsewhere.

UPDATE: John Cochrane recommends an essay by Tomas Pueyo. The message is to respect the exponential curve.

Macroeconomics and the virus crisis, II

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Before I get to that, Matt Ridley writes,

There are already several different strains of the virus, one of which, the L strain, looks to be more lethal than others.

What? Whoa!! Somebody needs to shout this from the rooftops. It suggests that there is no such thing as the death rate, even controlling for other factors. To me, it may suggests that we should be testing for this specific “L strain.”

Also, if there is more than one strain, does immunity to one strain not necessarily confer immunity to another? So you could get “it’ (i.e., one of them) again?

Now on to some other economists, who mostly make sense.

1. Alan Blinder writes,

If most Americans who wanted a test could get one, and if people who tested positive stayed home and sought medical attention, fear of going out wouldn’t disappear, but it would dissipate. Think of it as a super-effective form of fiscal stimulus. Test kits are ridiculously cheap compared with the GDP and job losses they might forestall.

2. Tyler Cowen writes,

Do you want to give people cash if they will just go out and spend it on entertainment or in large, crowded stores? Is that what you are hoping they will do? To what extent do we want the “transmitting sectors” to be contracting right now? Does it do much good to send consumers money they will spend on Amazon or pizza deliveries, two sectors that may do fine or even prosper during the tough times?

I do not think we should bail out shale oil producers or cruise lines. Presumably we wish to support businesses with an income gap for coronavirus reasons, but what exactly should we do? I am puzzled by the degree of certainty people seem to exhibit about this issue.

3. Timothy Taylor tells us about a quickly-published booklet edited by Richard Baldwin and Beatrice Weder di Mauro. Taylor quotes Baldwin and Eiichi Tomiura writing

the supply-chain disruptions that are likely to be caused by COVID-19 could lead to a push to repatriate supply chains. Since they [sic] supply chains were internationalised to improve productivity, their undoing would do the opposite.

I intend to download the booklet and read it. Meanwhile, I recommend Taylor’s entire post.

The booklet evidently includes some quantitative estimates of the GDP cost of the virus crisis. I am quite sure that the models used to produce those estimates are worthless. There is no way for them to estimate the cost of shifting to less-efficient supply chains. More important, nobody has a model of how leveraged financial institutions interact with the economy. Consider a cruise line that owes debt service payments on its ships or an airline that owes debt service payments on its planes. If they cannot service their debts and they have to declare bankruptcy, it is hard to calculate the effect of that on GDP. It is even harder to calculate the effect hits when the banks with the outstanding loans have to deal with the effect on their balance sheets.

Macroeconomics and the virus crisis

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Tyler Cowen writes,

First, consider the relatively optimistic view: Covid-19 will have effects akin to what economists call a seasonal business cycle — which is to say, it will be over quickly and without much lasting damage.

. . .This less sanguine option might look like this: The Chinese economic slowdown leads to a permanent loss of momentum and a global recession. At the same time, with Lombardy closed down, the Italian government defaults, but the European Union is unable to resolve the matter (and the associated bank failures) in a timely and resolute manner. Governments vacillate between policies that make it easier for people to stay at home to limit the spread of the disease and policies designed to get them back in the workplace.

The U.S. would be caught up in the general loss of confidence, as well as the contagion from European banks. . .

Let’s distinguish primary effects from secondary effects, short term and long term.

Primary effects are reductions in activity in certain industries that are a pretty direct result of the virus crisis. Secondary effects would be reduction in activity that take place because people who lose their livelihoods in a directly-affected industry at some point will have to cut back on purchases, and that will affect industries that otherwise you might think would escape problems.

The airlines take a short-term hit from a primary effect. Conferences and other events are being canceled, governments are making it harder to fly into or out of certain countries, and many of us are questioning the wisdom of taking discretionary trips. But at some point air travel will get back to normal.

Cruise ships would seem likely to take a long-term hit from a primary effect. My guess is that some of the fifty-somethings who have watched this crisis unfold have sworn off ever going on a big cruise ship when they reach retirement age, so I would lower my long-term estimates for demand in that industry (and presumably the short-term demand falls of a cliff).

Will the hit to convention traffic be short-term or long-term? What if video conferencing proves its effectiveness? Corporations might decide to save on travel expenses long after the virus scare is over.

Also, there are primary effects that come from disruptions to the international production system, commonly referred to as the supply chain. Some of these are merely short term. But long term, firms will be thinking about building in some redundancy or reducing the use of overseas suppliers. If China no longer needs to build manufacturing facilities, then they do not need to import any materials from the U.S. to build them.

Conventional “aggregate demand” policies would seem to me to be useless for dealing with primary effects. And it’s possible that the secondary effects will not be so severe. So the economists who are eager to flap their gums about what the Fed should be doing might instead want to just hold off for a while.

If there are large secondary effects, they probably will operate through the banking and financial sectors. Banks and shadow banks are often highly levered, meaning that a small adverse development can make a firm go bankrupt. And financial institutions are often intertwined, so that one bankruptcy can lead to another. As the saying goes, when the tide goes out, you find out who is swimming naked.

Perhaps governments have to be included as being among the highly levered financial institutions. Tyler mentions the government of Italy, which seems to be having considerable difficulty with the virus and is in a precarious financial situation.

When financial institutions are worried about their own survival, they are less likely to help the firms that are suffering from short-term primary effects to ride out the storm. So an airline that could still be viable if it could get some loans to tide it over might instead have to declare bankruptcy.

The specific nature of the primary effects argues against thinking that conventional fiscal or monetary stimulus will work. Instead, such policies strike me as equivalent to pouring gasoline all over a car in the hope that some of it seeps into the fuel tank.

In theory, what you want is precisely targeted support, aimed at keeping alive the firms that deserve to survive short-term effects. But what you are likely to get instead are policies that mostly favor firms that do not need help or other firms that deserve to fail.

Giving globalization a bad name

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Reacting to a post by Peirre Lemieux on the coronavirus, Alberto Mingardi writes,

Will people learn the lesson, and realize that a closed economy is poorer, as Pierre hopes? I fear not. Though the emergency measures somehow provide us with a preview of the kind of country the economic nationalists would like us to live in, they will quickly turn the tables, blaming the virus on globalization, and making trade with China the villain of the story. Italy’s reaction to coronavirus is convincing other countries to treat Italians as we treat ourselves – limiting direct flights, imposing quarantines, etc. This will also increase the perception that reliance on international trade is a weakness, thereby fueling a renewed rhetoric of the marvels of autarky. Sure enough, when people travel they carry their diseases with them: this is not news. Prepare for a new nationalist narrative built around this idea.

I agree. I don’t think that this will make people appreciate globalization–quite the opposite.

Incidentally, I think that this makes it unlikely that President Trump will suffer a political setback because of the coronavirus. Closing the border is his signature issue, and the Democrats have staked out a position as the “resistance” to that. I know that they think they can benefit from this crisis, but I would be surprised if they do.

As for the economics of the crisis, I see it in terms of a PSST story. Many patterns of specialization and trade depend on globalization. The conventional wisdom seems to be that the central banks will be prominent actors, but I could not disagree more. I would suggest that instead of monitoring the Fed, one should watch the transportation hubs–especially ports–and manufacturing centers. To the extent that the attempts to contain the virus cause those places to be shut down, patterns of specialization and trade will be broken, and there won’t be anything that the Fed can do about it.

In my view, Scott Sumner and Jason Furman and other macroeconomists who apply a monetarist or Keynesian “model” are simply not capable of interpreting the world as it really exists. That is a harsh judgment, but I cannot be more gentle.

As Peter Zeihan puts it,

Modern manufacturing is a logistical marvel that taps hundreds of facilities in dozens of countries, but that system is based on frictionless international trade. Break just a few links and the entire network collapses. A modern car has about 2000 parts. If you are missing ten, you’ve got a large paperweight.

I suspect that for the economy, the best-case scenario is that authorities gradually decide that it’s not such a crisis, they let everyone go about their business, and whoever gets the virus, gets it. The worst-case scenario is that clusters of cases continue appearing, and each appearance leads authorities to strangle more transportation and production centers. If the latter happens, then I am pretty sure you will find the PSST paradigm more useful in explaining and predicting outcomes.

Paula Bolyard draws an interesting analogy with the Y2K computer scare. If that analogy proves correct, then we should be closer to the best-case scenario. But one thing about the Y2K scare is that it had a definite endpoint–by mid-January of 2000, doomsday was a dud. I only see the coronavirus panic ending when the media can no longer attract eyeballs to the story.

As to the outlook for the virus itself, consider three scenarios:

1) the proportion of people exposed to the virus approaches 100 percent

2) the proportion of people exposed to the virus approaches 0.

3) the proportion of people exposed to the virus approaches some middle number.

I am not a virologist, but this virus seems optimized for spreading. So wouldn’t you bet on 1)?

Suppose that the virologists in the media successfully convince us to become OCD handwashers and germophobes. Will that actually be able to stop the virus? What other consequences, good and bad, might accompany such a change in culture?

Note that I wrote this at the end of February, adding the Bolyard paragraph on March 2 and the references to Peter Zeihan and Jason Furman on March 6. By the time this post appears, I may have to correct some of my claims in light of developments.

UPDATE: John Cochrane has thoughts. Also, Scott Alexander. And Tyler Cowen.