Sunday, 15 March 2020

It is not irrational to be concerned


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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