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The Financial Crisis Arising From COVID

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The measures to combat the COVID-19 pandemic will substantially reduce economic activity for an uncertain period. The size, scope, and speed of this economic contraction, as well as the great uncertainty surrounding policy and economic outcomes, are unprecedented

As a result, financial markets have been under great stress, prompting a quick reaction by the Federal Reserve.

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Since the 2002 Sars outbreak, the NIH has spent $700m on coronavirus research and development. The large public funding going into health innovation means governments should govern the process to ensure prices are fair, patents are not abused, medicine supply is safeguarded and profits are reinvested back into innovation, rather than siphoned out to shareholders. And that if emergency supplies are needed – such as medicines, hospital beds, masks or ventilators – the same companies benefiting from public subsidies in good times must not speculate and overcharge in bad times. Universal and affordable access is essential not just at national level, but at international level. This is especially crucial for pandemics: there is no place for nationalistic thinking, like Donald Trump’s attempt to acquire an exclusive US licence for the coronavirus vaccine. Fourth, it is time to finally learn the hard lessons of the 2008 global financial crisis

As companies, from airlines to retail, come asking for bailouts and other types of assistance, it is important to resist simply handing out money. Conditions can be attached to make sure that bailouts are structured in ways that transform the sectors they’re saving so that they become part of a new economy – one that is focused on the green new deal strategy of lowering carbon emissions while also investing in workers, and making sure they can adapt to new technologies. It must be done now, while government has the upper hand.

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Unfortunately, the success of this measure was usually limited because it triggered an adverse selection effect (Stiglitz and Weiss 1981). The more the interest rate was hiked, the higher became the probability that the central bank’s discount window would be frequented by dubious customers gambling for survival. In addition, market participants interpreted the dramatic rate increases as signals that the reserve situation of the Bank was indeed becoming dire. Instead of abating demand, the hikes seemed instead to intensify the runs (Hughes 1956). Hence, in 1847, despite having hiked the discount rate to unprecedented levels, the Bank was rapidly approaching a breach of its minimum reserve requirement. When it saw no other way out, the Bank adopted quantity rationing alongside its price rationing strategy. As my co-authors and I show in an ongoing research project (Anson et al. 2020), the rapid decline in the reserve ratio led the Bank to systematically discriminate against certain financial market participants

Quantity rationing did not eliminate the supply constraint per se and it did not constitute a benign, let alone fair, policy. Most importantly, it did not guarantee that those who really needed liquidity effectively received it. Eventually, the only truly successful policy response came during the autumn of 1847. When the financial panic reached previously unseen levels of severity, the British government gave the Bank temporary permission to breach its minimum reserve requirement. The mere publication of the declaration of suspension led to a sudden end of the runs.

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In any event, recessions are predominantly cyclical, not structural, events. And yet the boundary can be blurred. To illustrate, the global financial crisis was a (very bad) cyclical event in the U.S., but it had a structural overhang. The economy rebounded, yet household deleveraging is an ongoing secular phenomenon — household willingness (and ability) to borrow is structurally impaired, and the collateral damage, structurally, is that policy makers find it much harder to push the cycle just by managing short-term interest rates today

Could Covid-19 create its own structural legacy? History suggests that the global economy after a major crisis like Covid-19 will likely be different in a number of significant ways.

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Anson, M, D Bholat, K Rieder and R Thomas (2020), “Mechanics and effects of central bank credit rationing: Quasi-experimental evidence from the Bank of England’s lending policies during the crisis of 1847”, unpublished working paper.

Bignon, V, M Flandreau and S Ugolini (2012), “Bagehot for beginners: The making of lender-of-last-resort operations in the mid-nineteenth century”, The Economic History Review 65(2): 580–608.

Diamond, D W, and P H Dybvig (1983), “Bank runs, deposit insurance, and liquidity”, Journal of Political Economy 91(3): 401–19.

Hughes, J (1956), “The commercial crisis of 1857”, Oxford Economic Papers 8(2): 194–222.

Stiglitz, J E, and A Weiss (1981), “Credit rationing in markets with imperfect information”, The American Economic Review 71(3): 393–410.

Wilson, B (2020), “Off our trolleys: What stockpiling in the coronavirus crisis reveals about us”, The Guardian (The long read), 3 April.

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