An important debate in economics is whether a problem should be tackled at its source or whether one should treat its consequences. We think this distinction is important in the context of COVID-19.
The steps of the recent COVID-19 crisis are: appearance of the virus, spread of the virus, followed by the economic consequences of the spread of the virus. As economists, we cannot do much about the outbreak of the disease. However, since we study decision-making of agents who have limited information-processing ability, we can do something about the spread of the virus. Most writing by economists in the recent days has focused on the economic consequences of the pandemic (e.g. Baldwin and di Mauro 2020). In this column, we focus instead on what new economics says about how one can tackle the problem at its source by stopping the spread of the virus.
In a 2018 paper, “Lack of Preparation for Rare Events”, we proposed a new view of crises: a rare event occurs, agents who did not prepare for the rare event because it was unlikely take bad actions, and catastrophic consequences follow (Maćkowiak and Wiederholt 2018). The catastrophic consequences follow because of the lack of preparation. It seems to us that the COVID-19 epidemic has these features and we therefore want to use this theory to think about the optimal policy responses to the outbreak.
The theory we developed in our paper can be summarised as follows. There are two periods. In the second period, the world will be in one of two states: a normal state or a rare state (think of the appearance of a new, potentially deadly virus). Citizens and policymakers have to take actions in each state. Agents are unsure about the best action in each state but can reduce uncertainty about the best action by thinking about it. In the first period, agents can prepare for the second period – they can think ahead. The key assumption is that agents can process only a finite amount of information in every period. This assumption implies that agents will not take the best actions in the second period, which in turn creates an incentive to prepare for the second period in the first period. However, since agents also face a constraint on information processing in the first period, agents will not prepare perfectly for each contingency.
This theory makes the following predictions. Since the incentives to prepare for a rare event are small, agents will be unprepared when the rare event occurs. Agents will think hard to compensate for the lack of preparation, but this will not be enough to overcome the lack of preparation. Agents will take inappropriate actions and severe consequences will follow. The theory predicts that the loss due to inappropriate actions will be inversely proportional to the probability of the event.
- In the high-probability event, agents are prepared, take good actions, and losses will be small.
- In the low-probability event, agents are unprepared, take bad actions, and losses will be large. Inappropriate actions will happen on all levels – policymakers and individuals – and losses due to inappropriate actions will be particularly large when the rare event is particularly unlikely, when best actions in normal times provide little guidance on how to act in the rare event, and when the inappropriate action of one agent inflicts damage on other agents.
In our paper, we used this theory to think about recent crises: the global financial crisis of 2007-08, the European sovereign debt crisis, and the Fukushima nuclear accident of 2011. The theory also seems to apply well to COVID-19. The appearance of the virus was a non-zero probability but rare event. If the virus had been contained in Wuhan, its consequences would have been less severe. Instead, sub-optimal actions made the disease spread, with significant consequences for health, everyday life, and the economy around the globe.
It is always difficult to judge with certainty whether someone has made a mistake. Ideally, this requires knowledge of the appropriate action. Signs that a decision-maker may have made a mistake are reversal in actions (an action is first ruled out with certainty and then implemented) or heterogeneity in actions (different individuals or institutions are taking different actions under the exact same circumstances). We are currently seeing both of these during the COVID-19 epidemic.
Our theory implies the following recommendations for individuals and policymakers to limit the spread of the virus.
- First, when the rare event does occur in the second period, individuals should acknowledge that they are unprepared to act in this situation and that they need to think hard before taking decisions.
- Second, policymakers should acknowledge that individuals will not behave optimally in the rare event.
For example, if individuals perceive a correlation between the best action in normal times and the best action in the rare event, they will tend to take actions that mimic best actions in normal times but which might not be the appropriate ones in the rare event.
- Third, policymakers should organise centralised information processing to take advantage of economies of scale in information processing and they should then provide assistance in choice.
This assistance in choice can come in the form of clear messages or by requesting certain actions by law. It seems necessary to have a debate about the implied trade-off between avoiding inappropriate actions and maintaining freedom of choice. In the theory, the market failure that such policies are addressing is limited information processing ability on the individual level.
- Fourth, passing legislation that subsidises or requests preparation for future rare events can improve wellbeing in the society.
In our paper, we identify the circumstances under which preparation for rare events is inefficiently low from the perspective of the first period. In this case, subsidising or requesting preparation for future rare events increases expected wellbeing in the society.
Finally, our theory does not directly say which policies should be conducted to address the economic consequences of the spread of the virus. Nevertheless, these measures might have consequences for the spread of the virus. In the following days, many economists will probably call for a demand stimulus. It is unclear to us that this is the right policy recommendation. First, people are told to limit social interactions and stay at home to reduce infections. Then, they are pulled back into the office through an increase in demand. To simultaneously limit the spread of the virus and reduce its economic consequences, the government could instead replace the market income of agents during the epidemic with transfers or guaranteed loans.
Authors’ note: The views expressed in this column are solely those of the authors and do not necessarily reflect the views of the ECB.
References
Baldwin, R, and B Weder di Mauro (2020), Economics in the Time of COVID-19, a VoxEU.org eBook, CEPR Press.
Maćkowiak, B, and M Wiederholt (2018), “Lack of preparation for rare events,” Journal of Monetary Economics 100: 35-47.
