As economist Frederic Mishkin noted after the global financial crisis, the macroeconomy is highly non-linear and exhibits kurtosis – an increased probability of tail risks occurring – at certain points in time. COVID-19 has confirmed that the societal distribution of risk is also non-linear. Vulnerability to individual financial damage as a result of an economic crisis increases exponentially as one moves towards the bottom of the income distribution. This combination of macroeconomic kurtosis and certain individuals’ frailty to the crisis fallout means that at certain points in time, such as the present, the probability of certain groups suffering from disproportionately severe economic hardship is high.
Whilst COVID-19 has exposed this as a problem, my proposal for question 1 – Fiscal Resiliency and Inequality – displays that it has also created an opportunity to address this disproportionate risk faced by some socioeconomic groups through increased public support for government-implemented fiscal resiliency. It is an opportunity that must be seized. If economic crises increase inequality due to the aforementioned non-linearity of societal risk, then each crisis will serve to stifle long-term growth, as imperfect capital markets mean that poorer individuals become less likely to bear the sunk costs of education. If initially wealthier individuals accumulate more human capital, this will stifle social mobility and create severe allocative inefficiencies, limiting growth. Indeed, Federico Cingano found in 2014 that higher income inequality has suppressed growth in the OECD over the past three decades through exactly this human capital accumulation channel. Lower human capital accumulation may also undermine the fundamental driver of growth and innovation in the UK – ideas – since inequality-induced allocative inefficiencies are likely to lead to fewer low-income youths becoming researchers as adults. Clearly, these inequalities must be addressed if the UK economy is to continue to thrive.
Furthermore, macroeconomic volatility is positively associated with income inequality. Whilst volatility itself deters long-term investment and so inhibits growth, a Brookings paper by Aaronson et al. in 2019 found that certain vulnerable groups display substantially more unemployment volatility in response to output volatility than other less vulnerable groups. As such, those groups that are more vulnerable going into an economic crisis, such as the COVID crisis, become more vulnerable to future economic damage as a result of that crisis, causing a kind of kurtosis facing more vulnerable groups specifically. Beyond macroeconomic volatility and inequality being positively correlated, one might argue that they are self-reinforcing: inequality creates volatility, volatility increases inequality, and both damage future growth of the UK economy at large, as well as damaging societal relations and perhaps ultimately undermining political institutions.
UK economic policy should thus be targeted more heavily towards instituting protections for vulnerable groups should economic downturns occur, rather than seeking to respond to them when they do. I therefore propose the establishment of a Department for Crisis Resiliency located within the Treasury, whose aim would be to identify and model the most likely sources of risk to the UK economy, and to propose policies to pre-emptively protect those groups most vulnerable to a downturn should it occur. The Department would use specific econometric modelling to diagnose the groups that would be most vulnerable to downturns with different causes. Clearly, the global financial crisis and the COVID-19-induced economic downturn have affected different sectors of the economy in very different ways. However, at its most crude, the relative priority of instituting policies to protect a given socioeconomic group could be characterised by the probability of a given risk occurring, multiplied by the expected per capita monetary loss that would be caused to that group should the risk occur.
The world is chaotic, and despite in-depth statistical analysis it is impossible to diagnose exactly where the next economic crisis might come from. Things with an almost infinitesimally small chance of occurring do occur because an almost infinite number of events are taking place always and everywhere. The probability that COVID-19 would come into existence on any given day is essentially zero. The probability that at some point there would be another global pandemic was likely quite close to one. However, policy can act as an antidote to this chaos by minimising the economic damage that occurs with such events. If a Department for Crisis Resiliency had been able to identify and suggest policies to protect low-income BAME groups prior to COVID-19, it would not have stopped the pandemic or the ensuing recession, but it might have helped to avoid the massive casualties that the pandemic has caused amongst such groups. It is in this sense that the Department could be used to break the cycle of growth-suppressing economic volatility and inequality discussed above. An attempt to persistently identify the causes and likelihood of future crises, thereby identifying when the macroeconomy is exhibiting kurtosis and so prioritising measures to create resilience against this is important and worthwhile in preventing future economic downturns. Admittedly, however, it may occasionally fail for the above reasons. Nevertheless, identifying and recommending policies to protect those most vulnerable to downturns when they do occur can create further protection for these groups when risk identification fails. A Department for Crisis Resiliency that serves these two functions can thus alleviate the kurtosis facing vulnerable groups in the wake of economic crises.
In the period following the COVID-19 crisis, the biggest risk to the macroeconomy is that we discount the likelihood that an event like this may occur again. As Reinhart and Rogoff documented in the wake of the financial crisis, the build-up to such events is often characterised by a feeling that ‘this time is different’. A permanent Department for Crisis Resiliency, recommending policies to government on how to protect against and minimise damage to the most vulnerable groups from potential crises – and publishing risk identification reports for public consumption – would minimise the likelihood that society forgets the lessons of COVID-19. This would be to everyone’s benefit. A vicious cycle of inequality and volatility suppresses economic growth for all. This Department might serve to break that cycle.
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