With COVID-19, multiple failures in obtaining and applying the right information to key decisions led to economic and social calamity, says Professor Joshua Gans. For potential COVID-29s, we need to do better.
Vaccines aside, the solutions to combating COVID-19 — screening, personal risk management, contact tracing, to name a few — are based on a deeper principle. Specifically, the primary economic tool at our disposal for fighting the economic consequences of pandemics is the collection and use of information about infectious people. I believe, therefore, that our preparation for dealing with inevitable future pandemic threats must involve building our information infrastructure and the decision-making skills to make use of it.
In my first book about the brutal economics of COVID-19, The Pandemic Information Gap, I speculated that we would need to invest heavily in supranational institutions to deal with pandemics. From the vantage of 2020, that seemed like the only option. Pandemics always start somewhere, and therefore we need to ensure that the right people know about the onset as soon as it happens. And those right people must also have the authority to act on that information — even if it means that the rights (say, of movement and trade) of those most immediately affected are subverted for the global good.
This is always a tough call. Sovereignty is something we default to, and some proposed pandemic solutions are seen as moving us in the opposite direction. But faced with an unprecedented global negative externality, do we have a different option?
Now that we are further down the track, I have to admit that I find myself backing away from regarding a supranational authority over other interests as a necessity; instead, I see this option as being potentially desirable. That is not much of a shift in thinking, but the reason for it is instructive. I now believe there are ways to deal with the pandemic information problem at a national level. I say this knowing that we cannot necessarily rely on individuals to do the right thing at the right time, and knowing that we might not make the needed investments in information infrastructure quickly enough.
Nonetheless, there is a practicality to my suggestions. As evidence, I want to revisit an economic tool we use to solve other information problems: The worldwide network of central banks.
Financial vs. Viral Contagion
There is something about the ebb and flow of the financial system that causes scientific minds to see the system as a puzzle to be solved. The system has periods of relative stability followed by a rise in optimism or buoyancy followed by pessimism and the bursting of bubbles. Sometimes this involves stocks, bonds and the familiar turf of financial markets. At other times, similar patterns have impacted housing, toys and tulips.
To a physicist, the economic boom followed by the seemingly inevitable bust looks like the law of gravity at work: The fabric can be stretched, but it will bounce back into place. That did not stop Isaac Newton from investing in what was later known as the South Sea bubble of 1719. For Newton, the investment resulted in a financial loss of today’s equivalent of many millions of pounds. Bad investment decisions aside, Newton’s interest in physics and investing was fitting, for many physics models have connections with economics. Indeed, the first Nobel Laureate in Economics, Ragnar Frisch, famously used wave dynamics to model business fluctuations.
To Robert May, one of the founders of mathematical epidemiology, the wake of the 2008 financial crisis reminded him of the way infectious diseases develop into outbreaks:
An increasing amount of work draws analogies with the dynamics of ecological food webs and with networks within which infectious diseases spread. For the latter analogy, one can view the dodgy financial devices as newly emerging infectious agents. Indeed, the recent rise in financial assets and the subsequent crash have rather precisely the same shape as the typical rise and fall of cases in an outbreak of measles or other infection.
He went on: “One basic question, of course, is how to prevent a problem that arises in one bank from cascading through the entire banking system. Here, insights from medical epidemiology have been helpful, and indeed the word ‘super-spreader’ is now used often.” To May, the association between epidemiology and various aspects of financial crisis was clear.
It is a stretch to consider the ups and downs of financial prices and economic activity as having a similar pattern to fluctuations in the number of cases during a pandemic. There is a boom and a bust to those cases, but generally speaking, typical pandemic paths do not mimic market patterns. However, there is an interesting linkage between epidemics and financial instability. This can be described with the concept of contagion.
Optimism that leads to booms is like a contagion that can afflict even someone like Isaac Newton. Pessimism is similarly like a contagion, compelling people to suddenly change their minds about the market — sometimes like Wile E. Coyote when he has already passed the edge of a cliff.
It is therefore tempting to think in terms of critical mass: When there are many optimistic people, those people convince others to view things the same way; when some investors turn pessimistic, it takes a while for people to realize that something is wrong and then run for the exits. We saw this play out in late 2020, with a dramatic rise (again) in the price of Bitcoin — an asset that involves such an abstract foundation that its value is often merely based on the opinions of others. This is similar to other odd bubbles in history, such as those for tulips centuries ago when single bulbs rose to prices ten times the annual income of typical workers. When that bubble burst, investors at least had a tulip in hand.
The links between pandemics and market fluctuations lead many economic policymakers to adopt the language of infectious diseases to explain financial instability. Consider what Andrew Haldane of the Bank of England said in 2009:
These similarities are striking. An external event strikes. Fear grips the system which, in consequence, seizes. The resulting collateral damage is wide and deep. Yet the triggering event is, with hindsight, found to have been rather modest. The flap of a butterfly’s wing in New York or Guangdong generates a hurricane for the world economy. The dynamics appear chaotic, mathematically and metaphorically.
These similarities are no coincidence. Both events were manifestations of the behaviour under stress of a complex, adaptive network. Complex because these networks were a cat’s-cradle of interconnections, financial and non-financial. Adaptive because behaviour in these networks was driven by interactions between optimizing, but confused, agents. Seizures in the electricity grid, degradation of ecosystems, the spread of epidemics and the disintegration of the financial system — each is essentially a different branch of the same network family tree.
Haldane was interested in the tendency of investors and others to engage in flight when things start to crash. They leave the system and ‘hide’ in a manner quite similar to social distancing in a pandemic. Haldane’s analogy, however, is not perfect: In the case of market crashes, when more people hide, the economic conditions grow worse, which is the opposite of what happens to health conditions during a pandemic.
Despite that difference, Haldane’s point is valid. When assessing the probability of instability and risk of widespread contagion, both epidemiology and finance come to the same conclusion: Global interdependence is the source of risk. Therefore, we need ways to break transmission chains so as to calm the waters. Specifically, if the problem is with some institutions that engage in risky behaviours, maybe we need to put a ring around those institutions so that we can protect ‘ordinary’ activities. In other words, we need to reduce interdependencies.
If COVID-19 has taught us anything, it is that pandemics
are also economic problems.
Contagion and Information
Analogies lead people to notice not just similarities, but also differences. Mathematician and epidemiologist Adam Kucharski saw one rift:
To get infected during a disease outbreak, a person needs to be exposed to the pathogen. Financial contagion can also spread through tangible exposures, like a loan between banks or an investment in the same asset as someone else. The difference with finance is that firms don’t always need a direct exposure to fall ill.
We could propose trying to isolate potentially problematic financial behaviours, but how can that be done if there is no direct relationship between the people taking excessive risks and everyone else who ends up being caught in the wake?
Simple stories of financial contagion often miss a critical ingredient: information. Unreasonable booms and the magnitude and speed of busts are both accompanied by an information failure. The easiest way to see this is to consider a bank. A bank takes deposits from savers and then lends money to other people. Its job is to make sure that it assesses the creditworthiness of borrowers. That involves gathering information. Critically, this information is not shared with savers. After all, what would they do with that information? It is the bank’s job to find credit-worthy borrowers and to give savers a return on their savings. In ordinary times, no one wants to be the wiser.
All of this relies on whether depositors have a certain degree of confidence in the bank. They know the bank does not keep their money in a vault, and they know that the bank will give them ‘on-demand’ access to their money should they want it. The whole exercise is a bet that things will remain ordinary. However, should depositor confidence in the bank falter, things will quickly not add up. In theory, that loss of confidence could be caused by nothing other than fear itself. In that situation, the fact that depositors do not know who the credit-worthy borrowers are would become a reason for why their fears cannot easily be allayed.
Fortunately, depositors do not all wake up one day with a loss in confidence. Instead, information percolates, which causes them to reassess their beliefs regarding whether a bank can return their money. That situation has been fundamentally solved. Following the Great Depression, banks around the world engaged in a quid pro quo with the government. In return for accepting additional regulation and oversight, which involved sharing information about their activities with the government, the government agreed to guarantee deposits. That guarantee removed the rationale for a potential loss of confidence in the banks. Thus, people could happily continue in their ignorance while the banks could do their job.
In this area, ordinary people are pretty well protected. But the financial system is itself a sly beast. It invents new ways of moving money around, from those who want to save to those who want to spend. In so doing, banks end up accepting deposits for other banks and non-bank financial institutions. In other words, the banks are now taking our deposits and mixing them with others under the same conditions of ignorance that exposed the whole system in the first place. Those pooled bank deposits are not guaranteed. Such conditions undermine confidence and leave the system exposed.
This is precisely what happened in 2008 when banks suddenly realized that the mortgage-backed securities they were offering to investors were based on subprime lending (an issue of poor creditworthiness). Prior to the crash, investors had no easy way to find out the truth.
This is why the pandemic information problem draws on language from the financial information problem. A financial system crisis involves people who decide to not participate in the financial system (they hide). Depositors withdraw their funds and put them under proverbial mattresses or in some other ‘safe’ asset. They run for safety not because they believe that all bank and financial institution activities are bad, but because they believe that some borrowers to whom they are lending are not credit worthy. If investors lack adequate information, they might treat all borrowers as being equally bad.
Precisely the same type of withdrawal from social and economic activity occurs when people learn about a disease that is spreading through the population — if they lack information about who, specifically, is infectious. In a context of uncertainty, people will often ‘hide’ because they don’t want to risk losing everything.
Our system of central banks is a template
for building local pandemic institutions.
To restore confidence — during market crashes or pandemics — people must be able to quickly identify the specific problems and separate them from the whole system. We have seen the challenges associated with that in pandemics, and also how an infrastructure to produce that information is possible, but rarely available. In financial systems, that job falls mainly to central banks.
Central banks might be in the dark about some institutions, but they know a lot about others with whom they have been working and monitoring for years. In those cases, they have more information on which to base their confidence (or not). For those financial institutions that are found trustworthy, central bankers are happy to be a lender of last resort. More often than not, central banks end up making money on loans to trustworthy institutions. Thus, what looks to some like a bailout is, in fact, an investment opportunity based on long-term information gathering.
We want to see this same dynamic in local pandemic management. When a pandemic is on the horizon, we need a local institution that knows the risks and that is able to step in and quickly sort out who is infectious from who is not. That will require good surveillance data at a first instance, particularly about the interconnections of individuals in their networks. We will also need information about which activities can be cheaply moved to ‘contact free’ mode. We will need to quickly roll out screening efforts to ensure that only uninfected individuals are allowed to travel, cross borders, enter schools and workplaces, etc. Screening systems will also help to keep essential services open. In other words, there is a job to be done by local institutions. They should be designed and equipped to keep the economy open by assessing risk — not credit risk, but individual risk of infectiousness.
The job of central banks and prudential regulation is not to prevent financial crises per se, but rather to prevent crises from spilling into other activities. In other words, the job of central banks is containment, and this role is based on one principle: independence. In normal times and during crises, central banks have had independent authority over their decisions. This includes whether to order banks and others to redress problems.
Central banks have had independence in deciding how to engage in market interventions, how to control the money supply, and how to manage financial and economic stability. That independence was not baked-in from the start. It was established because the consequences of political and other interference were all too plain to see. Politicians are frequently subject to pressure by special interests. Those groups often want, in the financial sphere, release from regulations they perceive as unnecessary. Politicians are also subject to pressure to spend too much and tax too little. Strict constraints on spending exist at the U.S. state level, but the U.S. Congress benefits from softer constraints. The biggest temptation at the federal level is to print a little more money to cover deficits and hope that no one will notice. And then maybe the government can print a little bit more. And so on.
Independence is, therefore, granted to the institution that is perceived to be the long-term entity — the central bank. When a central bank conducts activities with independence, there is greater confidence that it is doing so in a transparent and nonconflicted way. There is an implied recognition that a writ of confidence can only be issued if it comes from an underlying reputation of trust. This principle is familiar in public health settings.
Indeed, to endow public health officials with independence and to empower them to manage key messaging during pandemics are regarded as best practices. These practices are based on the recognition that politicians and others may not be sufficiently resolute to deal with pandemics before they break out of control. Thus, if public health officials are not upsetting people by their actions to contain a potential pandemic, they are likely doing it wrong.
Unfortunately, these important roles for public health officials have been confined primarily to the realm of health policy. If COVID-19 has taught us anything, it is that pandemics are also economic problems. That being true, pandemics should be handled by addressing the information problem. Not taking that into account is the primary reason why we were unprepared for COVID-19. We have been playing catch-up throughout the entire crisis. We need an institution that can act independently, and that is prepared and equipped to intervene and right the ship. That preparation, in this pandemic, was not there.
There are different lines of defence against infectious diseases. The front line is early warning and being able to intervene locally to protect globally. Then, at the global level, there is a role for a supranational institution. We have those in various forms, such as the International Monetary Fund for finance, but the current institutions have proven to be too weak to prevent local problems from spilling into the global arena. Even so, we need other lines of defence. The financial arena shows us that local crises might spread. In those situations, the backstop defence lines are local institutions. They need to be free to intervene, and they need resources to be prepared.
In my view, our system of central banks is a template for building local pandemic institutions. Local pandemic authorities could become a repository of public health expertise, surveillance strategies and economics. They would serve long-term, apolitical interests. They would significantly augment local public health authorities to resolve the information problem. There would be no more funding cuts to key services (as was done in Canada) just to satisfy short-term budgetary pressures. Instead, local pandemic authorities would sit beside the military and economic institutions as a core feature of responsible modern government.
Unless dealt with quickly, viruses get out of control. The fundamental challenge is an informational one: Gather the right information and we have an arsenal for attacking pandemics. However, information is not gathered for information’s sake. It needs to be used to inform decisions, such as whether to isolate riskier individuals from others, or deciding which areas of the economy need to be locked down. The right information has to get to the right people or entities who make the tough calls, precisely because they are the ones with the complete informational picture that others do not have. When decisions are made blindly, costs are large and actions take too long. By contrast, preemptive information acquisition enables those with the authority to stop pandemics.
In regard to COVID-19, multiple failures in obtaining information and then applying the right information to key decisions led to economic and social calamity. For potential COVID-29s, we need to do better. Above all, we need to ensure that we have institutions in place with both the right information and the authority to act.