If we thought that Brexit was a major economic challenge it pales into insignificance compared to the threat posed by COVID-19. As the days unfold, the spread of the disease is following the normal pattern associated with infections, which in the early stages follows an exponential curve until it begins to level off. It is quite obvious that things are going to get worse before they get better which is going to result in a lot of human misery, never mind the economic consequences.
If we can take a step back, however, it provides a
fascinating test bed for many of the theories put forward by behavioural
economics, which applies psychological insights to the economic actions that we
take, and which is in stark contrast to the assumption of rationality which
underpins much of conventional thinking. I was reminded of this by the signs
which began to appear reminding us all to wash our hands in a bid to spread the
disease. This is a classic application of nudge theory which attempts to provide
positive reinforcements to encourage a particular course of action.
Supermarkets have known for years that prominently displaying a particular type
of item encourages sales and it has also been used by various health campaigns (recall the famous 1980s campaign designed to combat AIDS “Don’t die of ignorance”).
Nudge theory works up to a point, in as much as it does have an impact on
short-term behaviour although its usefulness as a determinant of long-term
behaviour is open to debate. However, as this study noted just a month ago, the case for hand washing as a first step to control
the spread of epidemics appears indisputable.
Perhaps one of the most contentious issues in the early
stages of the outbreak is the extent to which people are stocking up on
provisions in case they will be needed. This led to the bizarre situation last
weekend whereby shops were completely sold out of toilet rolls and other forms
of sanitary wipes, whilst hand sanitizers are virtually impossible to get hold
of. The government’s advice is that people should not panic buy. But can we
really describe the current situation as panic buying?
Panic can best be described as taking irrational actions in the
face of extreme stress. However, as an economist, the notion of taking
preventive action strikes me as a perfectly rational forward-looking response. Whilst
I am less sure about the need for such huge quantities of toilet rolls, there
is a case for having some emergency food provisions. Indeed, the Swiss
government has long recommended that each household should have a stock of
drinks and food for a period of seven days in the event of a disaster (not that
they all do). If you believe that a major problem is about to be visited upon
you, which in the worst case will prevent you from leaving your home, a
sensible forward-looking economic actor will make some sort of contingency
rather than trust to luck. You certainly do not have to be some hardline survivalist
(or prepper, if you prefer) believing in the imminent collapse of society to
anticipate that the information given by governments today will change in
future in response to changed circumstances. However, there is also an element
of herd instinct driving some of the recent actions by individuals. We
may not in the end need the huge quantities of toilet roll that have been
purchased, but in the event we do, you certainly do not want to be the
individual who has ignored the actions of the rest of the herd.
Human history is littered with examples of catastrophe, from
plagues to harvest failures which once upon a time were a regular occurrence. These required societies to set aside a store
of food to tide them through the hard times, but modern societies which rely
heavily on just-in-time inventory management are unable to cope with shocks of
this magnitude. Many western societies are unused to making such provisions and
it feels very alien to our way of living to have to think in such terms. It
ought to act as a wakeup call on so many levels. Our supply chains are long and
easily broken and should force us to think more carefully about the limits to
globalisation. As I noted in this post in 2016,
my views on weighing the costs and benefits of globalisation have changed over
the years. The current episode has also made people realise the benefits of
international cooperation. Admittedly the rapid spread of COVID-19 has been
made possible by the extent to which borders have opened up but equally the
solution to what is now a global problem will also have to be global.
As for recent market moves, investors’ actions of late have
not been entirely irrational. Financial investors always have to deal with decision
making under uncertainty, but today the uncertainty levels have risen to
unprecedented levels. I have long extolled the virtues of the distinction
between risk and uncertainty which was made by the economist Frank Knight in
his magnum opus Risk, Uncertainty and Profit a century ago. In his words, “risk means in some cases a quantity
susceptible of measurement, while at other times it is something distinctly not
of this character.” A known risk “is
easily converted into an effective certainty” while “true uncertainty … is not
susceptible to measurement.” Accordingly it makes perfect sense for markets
to sell off in what is the biggest shock to markets since 2008. The unknowable
economic consequences are such that we cannot predict what will happen to
corporate earnings other than to say there is no near-term upside, and it is
impossible to call the bottom of the current slide. However, most investors
believe things will get worse before they get better.
And they have certainly been bad of late. On the basis of UK
data going back to 1709, the performance of the FTSE All Shares so far this month
has been worse than at any time since the collapse of 1720 following the
bursting of the South Sea Bubble when prices declined by 38% in September and a
further 25% in October of that year. The 1720 episode was the response to a good
old-fashioned bubble. The collapse of 1987 (which was bad enough) was
attributable to global monetary tensions and exacerbated by automatic trading
systems which contained no circuit breakers. Today, it is attributable to
genuine concerns about life and death and in the grand scheme of things, market
moves can often seem somewhat trivial.
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