The economy after the earth stood still (post covid-19)

I was wrong in my first prediction of how the economy would restart after the simultaneous quasi-paralysis of the world economy during the first quarter of 2020 because of the horrible covid-19. My first thought and impression was that the effects would resemble a sort of world-wide earthquake (like the big earthquakes in Chile, Ecuador, Haiti but for everyone at the same time). That is definitely not correct.

After dusting out and rereading my macroeconomics texts and print outs from a course taken with a dutch professor, Ward Romp (knowledgeable guy), it hit me: what if what is happening is actually the opposite from an earthquake situation? The world did not shake and shatter. Quite the opposite, it actually froze, it stood still. So if it stood still, then the reaction of the economy will be the opposite than the one after an earthquake.

Leaving aside my personal story, what was important from the course was that we were studying Tobin's Marginal Q (economics not finance). This "Q" is a value that, when larger than 1, means that a dollar invested in an additional unit of capital in the company will produce a positive total future returns. Diverting from the technical stuff, it is quite obvious: any person will invest in capital (ex. machines) if, and only if, the total positive future returns will exceed the 1 dollar invested, including opportunity costs and depreciation. So, while this future total positive returns exceed 1, investment will flow into the company. Investment generates production, which generates employment, which generates expenditure, which generates GDP and wealth.

So in class, Ward liked to test this concept in an extreme case scenario. He asked what would happen to Tobin's Marginal Q if an earthquake hits the economy? The answer was that part of the capital stock would be lost (machinery, infrastructure, etc) hence Tobin's Q, or the total future returns for a dollar invested in capital, would strongly increase. This increase in return, would call out to investors to take the high yield "low hanging fruit" opportunities fast. While investment flows in the total future returns will start to reduce until they reach back to their equilibrium (say 1+ opportunity costs + depreciation). This could happen in a couple of years time. Tobin's Q, or total future returns, will start decreasing fast at the beginning and slowly towards the end. For the capital stock, increasing rates would start fast and then slow down. All this technical paragraph is actually quite logical and common sense when seen in an example.

In a stationary or "saddle path" economy (an economy at equilibrium), Tobin's Q would be close to 1 plus opportunity costs and depreciation, this is because if it was higher, somebody would already have made that investment, and if it was lower, then nobody would invest. If an earthquake hits this economy and destroys all the food processing plants, then, knowing that people will eat and spend in food, it is highly profitable to invest in reopening that food processing plant. The returns will be very high. But, while the food processing plant is growing, the total future returns of new investment will decrease until an equilibrium is attained again. This will be when all people buy enough food to satisfy them. The problem is that this narrative, of the reaction of the economy in an earthquake scenario is if far from accurate in the post corona-virus scenario.

The quarantines and the world paralysis of production may be seen as (forgive my limited creativity, and yes, I am empathetic with the pain and suffering) a vacation of the whole world at once. Actually we could see it as if the world had a vacation from us humans. But the idea holds. All of humanity had a NON PAID vacation for a couple of months. What happened is that we all lived and consumed with our savings and credit in some cases. As we all know, when we have non paid vacation, we loose liquidity, we consume our savings. The world lost its savings. Only a few sectors remained working: food, health, energy and financial services. Most companies, from the rest of industries, lost their working capital paying for non productive salaries and rent. So demand has contracted itself. With a lower demand, future income of companies and people will be lower, thus consuming less in the future as well. This will continue for a while, for one year at least. Machines and infrastructure still remains, they have not been broken, they can still produce as fast as before if wanted so. Thus there is no production shock. This is different from an earthquake. Here demand has been hit, and hard. So supply will have to adjust itself to the new lower demand.

Regarding the total future returns of investment in capital, or Tobin's Q, at this point, what happened is it diminished immensely, and it is probably close to zero. So there will be no returns for any investment taken in capital. Hence, instead of investment there will be disinvestment, and the reduction of the associated costs and expenditure. Machines and buildings will be left there, covered, forgotten for a while because it is not profitable to pay someone to produce something which will be sold at less than it's production cost. At the beginning, managers and owners will dis invest fastly, and more carefully towards the end when reaching the equilibrium point again. And while disinvestment occurs, Tobin's Q will start growing again, until it reaches the point of 1 plus depreciation and opportunity costs. Managers will do so prioritizing the elimination of costs unrelated to production of sales, and will analyze the whole value chain. They will reduce costs, and dis invest if possible (selling machines, buildings, assets) until they have a minimally profitable business again. This is common sense again: if it is too big and there is not enough demandm then we have to sell and make it smaller and profitable.

Seen from a different angle: there is too much capital stock (machinery) for such little money. When demand contracts, supply will have to adjust, and the new equilibrium price will be lower, so at lower income, companies will have to reduce costs to be able to remain profitable. If companies do not lower their prices they will be competed out of the market and will extinguish. The only way is to lower price, reduce costs and remain sustainable in time.

I do want to state that the faster companies dis invest and reduce costs (sell, freeze or transform assets) the faster they reach a positive investment scenario and start growing organically again. There is no sustainable way to keep non profitable companies going on, since only sincerity and productivity is rewarded in time. It is not philosophy, its economy, evolutionary economics in fact. Only when Tobin's Q reaches a larger than 1 value will companies start investing again.

Now, some industries kept working, they actually are making more money than before (and in relative terms made even more money). They profited from society, and it would be in societies' interest those profits go right back to the economy via acquiring the assets other companies want to sell. They would inject money back in the economy and help it circulate. It is also important to take into consideration that some assets meant to be frozen may actually be better off transformed to serve in a new tendency industry like e-commerce, machine renting, etc.

The economy always adapts, if and only if, we let it. Economies in history were founded from simple to complex, from cheap to expensive, from a few hundreds to billions. Now, things are expensive and we have to go back to cheaper, so that in the future we can go back to expensive. Regulation, trade barriers, all barriers have to become simple again, so that they can become more complex again in the future. I do hope this will be done correctly next time.

At the moment, the best policies that governments have and must take, since liquidity was the problem in the first place, is to increase liquidity and leave possible high inflation rates aside. So the best specific policies are: the injection of liquidity into economies through soft credit, direct transfers (UBI best) and the temporary increase of government spending (maybe infrastructure, public companies to be sold later on, etc). This with the aim to "jump start" the economy. This is equivalent to braking the contraction of demand while pushing up the supply curve, which in turn will increase the demand curve again. Of course a "jump start" is temporary, not long term. Yes, a problem is government financing. Credit from multilateral organizations or private markets or even printing out coin will do most of the trick. A more challenging situation arises for the countries without inorganic emissions like Ecuador. Multilateral organizations will, and must, be of service and available for this high priority countries.

As well, and not less important, governments must make it easy for companies to sell, transform or freeze assets and make it easy to reduce their related costs and expenditure. Companies have to have the freedom and flexibility to reinvent themselves in times of stress and hardship. As well, it is of high importance to rethink many policies which have been blocking the ease of making business: such as value aggregate taxes, tariffs, and others. Economies must open themselves to other markets to generate net wealth again. Economic policies should mainly target consumer protection (ex. elimination of oligopolies), and only protect strategic production industries like milk and some agricultural products which give sustenance to most rural families in a country (especially in nations in development).

So now we know. If the earth sits still, then demand will contract.