DEBATE BETWEEN OVERREACTING VS. UNDER-REACTING | Home

Punchline #1: I think it’s better to overreact than underreact, though the costs of incorrectly overreacting are potentially much larger than the costs of not responding appropriately to Covid-19. 

In terms of economic policy, I do think there is a valid debate on whether the negative effects on the economy induced by government lockdowns would actually end up causing more disruption in people’s livelihoods than the loss of lives caused by Covid-19 if we do not enact those extreme measures. In other words, with all the restaurant and hotel workers being laid off and small businesses being forced to shut down, chances are some of those people cannot make their next rent or healthcare copay because of unemployment, and they might lose their lives in the process. 

This kind of worry is different from ignorantly asking “more people get killed by car accidents each year anyways, so why are we being so dramatic about this virus?” As we’ve explained earlier, there are systemic vs. idiosyncratic, exponential vs. static event types that will warrant different magnitudes of responses, and arguably, having the government impose a set of policies that result in large-scale shutdowns will kick off a vicious downturn cycle that could be getting exponentially worse as it spirals off. Thus, here, we’re comparing two systemic events – government-induced economic recession vs. pandemic-induced fatalities. 

Between the two, I would rather err on the side of mistakenly causing a recession than letting millions die. I am not just arguing it from a normative perspective, but also from the perspective of pragmatism – it is much more predictable of how many people will lose their jobs because of the restaurants shutting down than how many could die from this novel virus that we know little about. The asymmetric uncertainty here should trump us to be cautious when dismissing the potential magnitude of economic disaster caused by Covid-19 if we don’t try to get ahead of it. 

I think the central banks’ extreme reactions are largely justified. Not that I know much about central banking, but I conjure that aside from the actual prospect for a recession itself, another reason that allows for the current set of measures is that our economy still has extremely low inflation. If the virus shock passes by quickly and the easy monetary policy turns out to be too much, what we’ll have is just slightly more inflation. That’s gonna be a much better outcome than being wrong and having the U.S. plunging into a severe recession, by which point people will blame the Fed for not further easing the monetary policy. What could the Fed say then? Because we believe the equities markets will automatically stop the free fall after a reasonable 20% correction? Because we were worried about some prospect of inflation that’s not really present? None of these are very convincing excuses. For Covid-19, we have to get ahead of it in order to stop it, and just from a policy perspective, the Fed would probably rather be blamed for overreacting than underreacting. 

And what if we actually go into a global recession starting in Q2? As drastic as those policy responses may be, it doesn’t seem to me that the stability of the financial system is really of key concern here. Global equity markets are down 15-20% over the last month, and though nobody really saw this coming, investors have long recognized that the market valuations are around 20-30% overvalued, and a “healthy” correction that doesn’t threaten the banking sector’s liquidity like the case in 2008 was largely anticipated at some point down the road. 

This pandemic originated outside of the financial system and is truly an exogenous shock, and I don’t think there’s any significant evidence indicating that the overall global financial system has been fundamentally undermined. Sure, credits are strained; investors’ short-term sentiment is at an all-time low; market volatility is at an all-time high; and very weirdly, bond prices and stock prices moved together last week, not in opposite directions as they usually do (on Wednesday and Thursday, as the S&P 500 was down 14%, the benchmark 10-year Treasury bond yield rose by about 0.10%). But these aren’t problems we cannot quickly address. The Fed’s facilities will be well equipped to deal with the constrained credits; market volatility is projected to have an overall downward trend; and the weird bond and stock price movements can be explained by the possibility that major financial players were experiencing a cash crunch, selling whatever they can as a result – again, something the Fed understands quite well and can easily address as the lender of last resort.  

I think the markets will be marked by a period of daily “zig-zag” movements in the next few weeks and even months, bouncing between investors becoming more skittish (deciding to sell off) and markets regaining slight confidence over some forward-guidance announcement by the government. We’ve already seen many of those trading days in the past two weeks, as stocks generally picked back up for a few percentage points after one of the worst performing days in financial history. This is just a phenomenon of increasing volatility, though, and will unlikely to be overshadowed by something fundamentally problematic that engulfs and upends the system like we saw in previous financial crises or global recessions.