The Financial system after COVID-19
Richard Reinsch (00:18):
Welcome to Liberty Law Talk, I’m Richard Reinsch. Today we’re talking with Arnold Kling about the post-COVID economy. Arnold Kling is an economist. He’s a scholar and he’s a writer, frequent public commentator on policy issues, which he approaches from an economics perspective. He writes frequently for EconLog, a sister website to Law & Liberty. He also contributes to Law & Liberty from time to time, usually on issues related to macroeconomics. He’s the author of numerous books, including The Three Languages of Politics: Talking Across The Political Divides, Specialization and Trade: A Re-Introduction to Economics and also Unchecked and Unbalanced. Arnold, this essay that we’re going to discuss, and I’m glad to have you on Liberty Law Talk, this essay appeared in the summer edition of National Affairs and is a sort of an exploration of our economy during this COVID-19 pandemic and how the government is trying to interact with it. Maybe talk more about the themes you explore there.
Arnold Kling (01:22):
One theme is that I feel that the general macroeconomic paradigm has been breaking down for a while and it’s particularly not useful for this situation. There’s a ton of confusion out there about what’s going on. We can get into sort of what that paradigm is.
Richard Reinsch (01:40):
Before that though, so we got a number back yesterday, 33% GDP growth in the third quarter. Second quarter GDP had declined by, I’ve got 31.4%. What do you make of those numbers?
Arnold Kling (01:56):
Not much, actually. Either one, because GDP is most reliable when the nature of the economy is pretty stable and the economy is very different in this COVID environment. So if you’re trying to measure output, what you’re trying to do is add together sort of apples and oranges. And if the relative value of apples and oranges changes, then that addition process doesn’t really work so well. And that’s what’s happened, is that a lot of the so-called lost output, that means the decline in GDP, is stuff that all of a sudden people decide they don’t want. Like they don’t want to take their airplane vacations, stay in hotels. They don’t want to go to conferences. They don’t want to go to big sporting events.
Even if the fears of the virus went away tomorrow, people have learned to do a lot of things differently. I think most people who have the luxury of working from home would not want to go back to commuting five days a week. I bet there will never be as many business conferences as there were a year ago.
So to value that output at yesterday’s prices and say, well, it’s lost, I think it isn’t correct. And the output that’s regained, kind of a different story, that may be more or less valuable depending on the nature of that. So anyway, GDP is a tough measure. Like you’re trying to add together the value of healthcare services and manufacturing of nails and pins. It’s a difficult measure. So what I prefer to track, see how well the economy is doing overall is employment. And year over year from September to September employment is down by 10 million or about six or 7%. So that to me is an indicator of sort of how off the economy is and that’s pretty far off. That’s a major year over year decline. So rather than try to figure out what’s going on with the GDP numbers, I would use the employment numbers. I would say that the economy has really been thrown off. We have 6%, 7% fewer people working than you did a year ago.
Richard Reinsch (04:07):
And that kind of gets into your essay. One you talk about macroeconomic dominant paradigm. Right now you don’t think is very useful. And this can be a way to think about how the economy will evolve after the pandemic. So maybe talk more about that.
Arnold Kling (04:25):
Yeah. So the dominant view is to treat the whole economy as if it were a single factory, I call it the GDP factory where everyone’s producing the same thing and all of a sudden demand falls off for what our single factory produces. And then the factory hires fewer workers. That’s greatly intuitive. It’s a very intuitive picture, but it’s wrong. It’s just wrong. But the challenge with the economy isn’t getting enough demand for what the factory produces. The challenge is to allocate people properly. So you can think of a situation where you have a thousand people and you don’t know really what they’re good at and who’s best at things and which things are valued. How would you allocate them? How you decide who becomes a garbage collector, who becomes an entertainer, who becomes a farmer.
The economy challenge is to figure that out. And when the economy is unstable for a while, people mostly have that figured out. Millions of people actually change jobs every month because the economy is constantly reconfiguring in response to changes in technology, other factors. So my view of what happens in a downturn is that in concept, the economy gets confused, it gets mixed up. I think of it as a Rubik’s cube where the pieces have been really shuffled and it’s going take a long time to get them back into the place.
Richard Reinsch (06:00):
What kind of a crisis do you think COVID poses to the economy, comparative to say the 2008 financial crisis, so to speak?
Arnold Kling (06:07):
The 2008 financial crisis, first of all, it’s very concentrated in the financial sector. And the economy, I think, is still in the situation where everyone is trying to run with minimal cash reserves as possible. So people wanted to buy a house with no money down, firms were heavily indebted and so you have this very fragile financial situation and then a relatively minor crisis in the broad scheme of things and the real estate industry just cascaded through because people shouldn’t have, not so much people, but businesses and especially banks didn’t have the kind of cash reserves to get through a crisis. So that’s a very different situation. People were not caught so much short of financial reserves. Although businesses, especially small businesses, could have been in better shape. But there was just a change in what people wanted to do. People did not want to be eating in restaurants next to people who might be sick. They didn’t want to go and undertake business travel. They didn’t want to go into the office. And if they didn’t go into the office, they didn’t go out to lunch near the office. So all these activities had to change.
The current situation is so extreme in terms of the reconfigurations that are needed, that you need just an awful lot of entrepreneurial activity, and it’s going to take a long time for entrepreneurs to figure out how to use these extra 10 million or so people.
So it’s like the Rubik’s cube got really messed up and it’s going to take a long time and a lot of turns of the cube to get it back in shape. And another complication is that you don’t know how much of that is short-term and how much that is long-term. And then if the fears of the virus went away tomorrow, a lot of these activities would come back. But even if the fears of the virus went away tomorrow, people have learned to do a lot of things differently. I think most people who have the luxury of working from home would not want to go back to commuting five days a week. Maybe two days a week, maybe three, I bet there will never be as many business conferences as there were a year ago. It’ll just be, “Oh, we don’t really need to have this conference.”
Richard Reinsch (08:21):
What do you make of habitation patterns? I mean, you’ve read a number of sort of anecdotal pieces. I’ve had read in The Wall Street Journal of people leaving high cost locales like San Francisco and decamping to Utah and they’re still working there. Their company is still based in Silicon Valley, but they’re now working from Utah, much lower cost of living, et cetera. Do you see that as really a huge change to the urban landscape in America?
Arnold Kling (08:47):
Potentially yes. But we don’t know how much that will be. I mean, people are arguing back and forth. Some business executives say working remotely doesn’t work well. Other people say it does. I think the typical worker is probably pretty happy to not be commuting and so on. Not have to deal with that. So some of these changes could be changes that would have happened anyway, that have just celebrated by… I mean, everyone just, they’re building what I call remote work capital. People learning to use Zoom and those kinds of tools. There’s a combination of short-term changes and long-term changes. And so we talked about the GDP number which showed a sharp decline that included a lot of short-term changes. And then the bounce back with some of the reversals of those severe short-term changes. But there’s still a lot of long-term changes that are going to be worked through. I mean, do we think that higher education is going to revert back to what it was a year ago? I suspect not.
Richard Reinsch (09:53):
Yeah. I was just going to say, you in the National Affairs essay, you talk about the way unemployment just lingered at pretty high levels after the financial crisis in 2008 and didn’t really come down until maybe seven or eight years later. And that’s sort of maybe a way to think about the patterns of specialization that you discuss. But then do you see something like that happening with sort of the post-COVID economy that unemployment remains at seven, 8% as we figure out this stuff?
Arnold Kling (10:22):
The question is, how do we understand what’s going on? I think it was misunderstood in 2008. Now with this old paradigm of the GDP factory. If we just somehow put enough money in people’s pockets, they’ll go to the factory and everything will be fine. Whereas it’s really a problem of figuring out where people fit in, in reconfiguring the economy. In a way it’s odd that it took so long to reconfigure the economy in 2008, or is it that things got so bad. But I think again, it was because banks and businesses were operating on very thin margins. And so a lot of people went under that wouldn’t have had to if they’d had more reserves. And also the policies that were followed were again, based on the assumption of GDP factory, if anything, what you need, in my opinion, when the economies get shaken up in this way, there’s a lot of entrepreneurial activity because people need to start new businesses and figure out new projects that employ people.
What’s the best use for the people who are not working. Are there 10 million people who were working a year ago who are not working today? I mean, it’s actually, there are many different people, many people got in jobs who didn’t have them before many people lost jobs, but did have them, but on net 10 million people not working. That’s an entrepreneurial opportunity to find something useful for them to do. But that means you have to encourage entrepreneurship. And under the Obama administration, you had discouraging entrepreneurship because they kept piling on regulation. And one of the quiet things that the Trump administration has done is to loosen those regulations so that entrepreneurs could work more quickly. But the current situation is so extreme in terms of the reconfigurations that are needed, that you need just an awful lot of entrepreneurial activity, and it’s going to take a long time for entrepreneurs to figure out how to use these extra 10 million or so people.
Richard Reinsch (12:27):
You write about that, the government in 2008 responded with a lot of stimulus and also the Federal Reserve engaged in quantitative easing, trying to take on productive assets off of financial balance sheets and putting it on the Federal Reserve’s balance sheet. And then now in this crisis, a much larger stimulus package was passed over 3 trillion. And the Federal Reserve, to a lot of people’s thinking, has sort of crossed a new line and is now lending directly to businesses. Talk about that. How does that relate to sort of this macro economic thinking.
Arnold Kling (13:02):
It’s really odd. It’s based on this old paradigm. In the GDP factory paradigm has something called a supply shock where the factory has to shut down because it can’t get new parts or a machine breaks down or something. And even a conventional macro economist would look at what’s going on and saying that has elements of a supply shock in it. That the economy isn’t supplying the stuff that people want in the current environment. And the cost of supplying things has gone up. You could see that in terms of like schools having to reconfigure themselves and come up with new equipment to open. So there’s a supply shock, but the way the policymakers respond is entirely trying to boost demand, which is really strange. If you think about it, the government shoving money at people and then saying, but don’t go to restaurants, we’re going to close them down. Don’t go to small business, we’re going to close them down. It’s really kind of feudal. What needs to happen is there needs to be some reconfiguration. Again, if fears of the virus decline, which is probably the best thing the government could do is sort of take steps to reduce people’s fears of the virus. Then some of the other activities will come back, but then a lot of activities left to be reconfigured. Maybe people have been projecting for a long time, that education could be reconfigured, sort of some different combination of in-person and remote learning. The value of putting a thousand kids in a lecture hall just can’t be compared to giving that same information online. There may be other things that are much more valuable in person, but it’s time for higher education to figure that out. Things like business conferences, again, will be reconfigured. So the longterm changes, they’re not affected by stimulus measures, they’re affected by people in business and in these institutions figuring out how best to do things.
Richard Reinsch (15:14):
How would you advise, I mean, to me the stimulus was sort of this democratic process where something had to be done, something large had to be done. Because the government had shut down so many businesses, state governments, local governments. The government had to act in some way to compensate people for those losses. But how would you prescribe, if we could follow what you’re saying, what would be measures to take?
Arnold Kling (15:39):
Okay. The first thing that comes to mind is some kind of employment subsidy. So you’re giving employers reason to hire people. You could just have a one year or two year moratorium on the payroll tax, for example, would give employers more reason to hire people, that would be one.
Richard Reinsch (16:03):
Make business startups easier. Make it easier to form and start new businesses.
Arnold Kling (16:09):
Yeah. And any kind of deregulation on those lines and things like clearly reducing business liability for people getting COVID when they go to work or go to an event. And as long as the business isn’t sort of unreasonable and forcing people in close quarters or whatever.
Richard Reinsch (16:33):
We are likely though to just continue to bail out these different parts of our economy, hotels, airlines. One can see higher ed getting a bailout. We haven’t even touched a lot of the states that are way over their heads here. I see that as a possibility.
Arnold Kling (16:51):
And that’s something where you wish that there were some thought going into it, as opposed to just who’s got political power. But if you think about it, the political power will be, people have businesses in every congressional district. So if the real estate industry were in trouble, which is not, you would get a big bailout. But it did in 2008, things like auto dealers will probably get whatever they ask for and higher education will get whatever they ask for, you’ve got institutions everywhere. And it’s a very powerful lobby. A real challenge is what to do with small businesses. What I proposed months ago was to have a general line of credit available to small businesses that’s sort of equal, proportional to the revenues that they were getting prior to the crisis. But the longer this goes on and the longer the small businesses are down, the more unreliable they are, even if they were given very low interest loan. Again, the best subsidy there is somehow reduce the fears of virus.
Richard Reinsch (18:06):
If I were doing the exact opposite. At least the reporting that I see every time there’s a spike in cases that we’re told and this is of its own an alarming fact. Do you fear, I ask a question about the Federal Reserve, my understanding is that lending facility they were given by the first stimulus, they have not even remotely exhausted. Do you fear that there’s a new Federal Reserve coming into being, in relationship to businesses and the economy?
Arnold Kling (18:33):
Yeah. There’s the potential really for almost the end of capitalism, as we know it, and that the Fed basically has so much power over particular businesses, whether they live or die. Even if they didn’t use that politically, which they probably won’t do that as they’re not going to all of a sudden saying, well, every business owner who supports a particular political party gets credit and the other ones don’t, I don’t think they’ll go that far. But they don’t have the wisdom to make the decision that local banks do about which businesses are likely to survive and which are not. And they will be under pressure to give credit to the airlines or whatever. Even if airlines have a low probability of survival, which means there’s less credit for other businesses. But it’s very disturbing that to centralize the decision-making about credit to that extent. And what I think the Fed ends up doing is kind of re-decentralizing it in a way, but in a weird way, by hiring companies like BlackRock or whatever, to tell them what to do. So it’s the opposite of the bank with the local knowledge, making a decision, large firms at the behest of the Fed.
Richard Reinsch (19:56):
Elite driven financial system, truly.
Arnold Kling (19:59):
More like a Chinese system where you want to centralize financials.
Richard Reinsch (20:05):
I know there’s a monitor limit on what the Fed can do. But is there a time limit? I mean, does it just sort of keep on until they’ve exhausted that supply or?
Arnold Kling (20:13):
I don’t know legally, but I don’t think the history shows any instance of the Fed ever losing a power that it gained. The history is it just gets more and more power. And Congress is talking about giving it more and more mandates. A mandate to worry about climate change, for example, mandate to worry about economic inequality. And the more mandates it gets, the more power it will hold on to.
You don’t gradually notice a debt crisis. You can either be in one of two states. You can either be trying to borrow or in a crisis. There’s no kind of simple warning, gradual onset. It comes suddenly or not at all. And I guess that’s a weird thing for people to get their minds around. So what’s happening now is we’re creating a situation where a crisis will be harder and harder to resolve.
Richard Reinsch (20:41):
Systemic racism was one I’ve heard, also at least the Fed should be concerned about systemic racism. It springs the obvious thought here, or maybe not obvious. You’ve got those in control with power, making very top-down decisions, as opposed to a more market process of people interacting based on what they know about their discrete situation in the market. And that should inform lending. And that leads to this sort of waste of capital or not the most efficient deployment of capital. And so you get a very different kind of economy too.
Arnold Kling (21:14):
Capitalism is an evolutionary system. There’s a lot of trial and error. I mean, that’s how we’re going to get these 10 million people employed. And there are a lot of businesses are going to start. At least half of them will fail. And over time, people will settle into jobs that are productive. When you have this centralized allocation of resources, you don’t get that evolution, you mostly get attempts to prop up what’s existing businesses. There’s a little bit of value in propping up to think that their problems are temporary. So again, if it’s a business has a problem because the fear of the virus is very high now, but the problem will go away very quickly if the fear goes away, fine. But what you’re going to get is long-term propping up of institutions and businesses that really have lost their viability for a long time. And that takes you to a bad place.
Richard Reinsch (22:12):
You write, towards the end of the essay, about debt about household debt and also public debt. In the midst of this crisis, you’ve got this large stimulus, there’s a call for even more stimulus. We don’t seem really to be constrained that much by thinking about what we’re doing to our already very high debt. And then we’ve got, of course, these sort of structural debts and forms of entitlements that are going to be coming due over the next few decades, and it seems we can’t even begin really to pay off. Why did we stop worrying about debt? Both the debt households carry and also public debt?
Arnold Kling (22:52):
Well, I haven’t stopped worrying about it.
Richard Reinsch (22:54):
We seem to be the only ones.
Arnold Kling (22:56):
Yeah. I think the reason is that we’ve survived so far. It’s sort of like the guy who jumps out of a 10-story window and halfway down says well, it’s fine so far. Government debt is a weird thing. And that as long as people are confident that the government can repay it, that the interest rate will be low and it will just be able to keep rolling over debt. Once people lose confidence, then they won’t supply credit to the government anymore. The interest rate goes up and it becomes a self-fulfilling thing where it hits the debt crisis. So my point is you don’t gradually notice a debt crisis. You can either be in one of two states. You can either be trying to borrow or in a crisis. There’s no kind of simple warning, gradual onset. It comes suddenly or not at all. And I guess that’s a weird thing for people to get their minds around. So what’s happening now is we’re creating a situation where a crisis will be harder and harder to resolve. That’s what having all this high debt GDP at high amount of unfunded future liabilities means. Is that if and when a crisis occurs, it won’t be much more severe than it would have been had we been more prudent. So it’s not that we’re gradually bringing on more of a crisis it’s that we are sort of making a bigger bomb to go off when the crisis occurs. There will be much worse devastation when a crisis occurs
Richard Reinsch (24:46):
You think about the debt situation America was in after World War II, which is understandable. But a younger country, a country that was about to embark upon a tremendous productive surge in its capacity. And a country that was really the one of the few countries standing at the end of the war. That was a totally different picture than where we are. Now we just seem incapable of paying this debt off.
Arnold Kling (25:08):
There are two main differences. One is we actually did for a little while and payed our way out of some of the debts. The second is that we really ran government surpluses for most of the years following. At the time we had two budgets, we had the official budget and we had Social Security, which was running big surpluses at the time because the Social Security system was very new. They weren’t paying out very much to people and a lot more people were paying in than paying out. But the social security surplus was not counted as part of the budget until the late 1960s. So all through the 1940s and 50s, people were looking at the budget and saying, “It’s about balance.” It’s actually a big surplus. So we actually ran surpluses for about 15 years and that paid off the debt. Like if you pay down your credit card bill, you pay down your debt. The government was doing exactly that. We’re not close to that. Now we’re including Social Security, but Social Security actually, there’s more money being paid out than coming in. There’s nothing like that where we’ve been running bigger and bigger deficits in good times and bad. Trump ran a bigger deficit even in the pre COVID economy. So yeah. No, you’re right. It’s just not at all like World War II.
Richard Reinsch (26:37):
We are accustomed to deficits year over year, we’re accustomed to debts and it’s been a part of American government for four decades. The speech that Senator Daniel Patrick Moynihan gave in the early 1980s, calling attention to this fact that this had become an American way of life and how odd that was. And I think now we just sort of, we just accept this. There’s no real debate going on.
Arnold Kling (27:00):
And part of the problem is that those of us who’ve been warning about deficits and debt have been warning about it for a long time. And it’s easy to say, well, you made the same argument 20 years ago for 20 years, we’ve run bigger deficits and nothing’s happened. It’s like, again, you’ve jumped off the 10th story, you’ve made it all the way down to the second floor now, still nothing wrong, so you just extrapolate from that.
Richard Reinsch (27:28):
So the bomb going off could be inflation likely that doesn’t seem to be a fear at all either. You’ve written about inflation for Law & Liberty, but I think it relates to the situation.
Arnold Kling (27:40):
And even that doesn’t necessarily get you completely out of the crisis because things like Social Security and Medicare, these unfunded liabilities. They go up in inflation. So my view of it is it will cause tremendous political conflict that, basically the way we resolve political conflict in recent years is just spend money. Give people wealth, now you’re going to have to take it away. You’re going to have to tell somebody that they’re not going to get paid. You’re going to have to tell a bond investor, sorry, you’re not going to get your money. Or you’re going to have to tell a Social Security recipient, you’re not going to get your money or something.
Richard Reinsch (28:21):
And the government would do that through inflation, would be one way?
Arnold Kling (28:25):
Yeah. Again, that may or may not work. But the point is the politics will be very very rough and there’ll be a lot of strife. So you want to simplify the costs and say, Oh, your children will be poor or something. That’s not really what happened. What will happen is that the government that claimed that it can satisfy everybody will now be in a situation where it’s got obligations to lots of people, but it cannot satisfy. And there’s fight over who bears the pain. It’s a big cost.
Richard Reinsch (29:04):
Yeah, it seems to me, it’s just thinking about this, the financial crisis of 2018 to reveal that we couldn’t keep doing what we were doing in a lot of ways, both financially our financial system, our government debt payoff system, we didn’t really restructure to take account of that. COVID seems to be revealing also these kinds of same problem, but we don’t want to heed them in any sort of accountable, responsible way.
Arnold Kling (29:31):
I think that there’s kind of a trade-off between running a business or an economy at high efficiency and running it in a way that’s robust. So for example, if you have a really complex supply chain, it may be very efficient, but if one little part of it breaks, then trouble. And financially, if nobody’s got any reserves, if the typical consumer run into any financial difficulty at all can’t function, or if a small business that loses revenue for a month and has to default on its loan, it’s not a robust system. That’s a very fragile system. And I think that’s the way we’ve kind of run. And after 2008, the claim was, “Oh, we’re not going to do that again. We’re not going to have this kind of fragile financial system.” So when we came right back to it, come right back to a situation where a lot of financial institutions and a lot of corporations could only operate if there was no adversity at all. So running an economy that’s not fragile, it’s a real challenge, I guess, politically, but it would mean changing the ways the laws treat debt versus equity. For example, people to run less fragile businesses with sort of lower returns on equity, but more ability to withstand the shot.
Richard Reinsch (31:05):
Yeah. There’s no political will to do that. Arnold Kling, thank you so much for talking with us about economics post COVID. We appreciate your time.
Arnold Kling (31:14):