Fixing a broken economy

Lockdown-related market closures have created ‘institutionalised ignorance’, triggering shortages and inflation

12 November 2021 Stephen King, Senior Economic Adviser

During the Global Financial Crisis, the financial economy snapped. Now the pandemic is stress-testing the resilience of the real economy with shortages of goods and labour.

While the 2008 crisis involved a loss of trust, the latest economic fracture reflects a massive loss of the market information that balances supply and demand. The financial crisis was a simple daisy chain of connections from, say, sub-prime borrowers through to Norwegian pension funds. Today’s complex daisy matrix links a wide network or resources, logistics and labour.

Most of the time, economies work. If we need something, we can normally find it – on the internet if not the high street. Shortages happened in the centrally-planned Soviet Union or hyperinflationary Venezuela, but not so much in developed countries. Until now.

The UK has seen empty supermarket shelves, queues at fuel stations and collapsing energy companies. Worldwide, semiconductor shortages have crimped car production, pushing up used-vehicle prices. Vacancies have surged, raising wages without increasing productivity.

All this has occurred even as the level of GDP remains depressed. Current shortfalls may reflect supply problems, not low demand. The pandemic has seemingly revealed a lack of resilience in our economic systems.

Market complexity is usually solved through the price mechanism. Yet, during lockdowns, individuals can have only a highly subjective perspective on what is driving prices.

If a car-parts manufacturer sees orders drop, is it because demand for vehicles has fallen, or because semi-conductor shortages have curbed car production? As the parts-maker lays off workers and local shops suffer, a negative supply shock will look like a demand shock.

In a complex daisy matrix, each link faces a similar information vacuum leading to ‘institutionalised ignorance’.

Markets generate constant feedback between buyers and sellers. When they’re locked down, the allocation of resources will be sub-optimal.

Attempting to return economies to pre-pandemic levels of demand is asking for trouble if supply cannot respond fully: the combination of demand ambitions and information limitations leads to inflation.

The financial crisis led to more resilient banks as capital buffers and regulation were strengthened. The real-economy equivalent is amassing stocks, but stockpiling all goods is impractical while stockpiling labour – truck drivers, waiters – is impossible.

Instead, markets have to spring back to life. Only then will information flows be restored. Markets are not the problem, but the solution.

 

First published 28th October 2021.

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