Getting quickly out of crises – what do we know?

Christian Bjørnskov // 11 November 2020

Coronavirus has resulted in a major economic crisis, and caused immense damage to both the economy and people’s lives. This damage is both a result of voluntary social distancing and the draconian measures most Western governments have put in place in an effort to limit the spread of the virus. In the UK, GDP fell almost 20 percent in the first half of the year. It is therefore important to discuss what – if anything – can be done to achieve a fast recovery out of the crisis.

In principle, one might say that politicians and governments ought to react to economic crises in a way that both protects people’s jobs and livelihoods and limits the economic damage, as well as reducing the risk of future crises. That is also the way almost all crisis policy is sold to the public: as necessary interventions to either protect jobs, the entire economy, or government finances. The idea is based on a tradition dating back to Keynes, which claims that crises are a market failure of sorts.

Yet, even if one accepts the premise that government ought to do something, one has to ask the question whether politicians and civil servants in reality are willing and able to do the right thing. This type of question is central to what is known as ‘robust political economy’, a particular combination of insights from Austrian Economics and the Public Choice School pioneered by, among others, Professor Mark Pennington of King’s College London. These problems are substantial at the best of times, but become particularly severe in the build-up to economic crises where market information must logically be less precise than in more normal times.

Governments’ well-known problems of gaining precise and complete information to inform regulatory policy is made worse by the influence of special interests that provide biased information to governments and regulators. The regulations that result from such processes reduce investments and distort the allocation of resources. During crises, extensive market regulation is therefore likely to lead to deeper crises and slower recoveries, because they prevent firms and individuals from reallocation their financial capital, physical equipment and investments, and their labour to new and potentially profitable purposes.

As originally described by Gordon Tullock, the influence of special interest groups on politics can also deepen crises in another way. Entrepreneurs, who create new products and firms and introduce innovation, are specifically important during the recovery period of a crisis. Existing firms and jobs have been destroyed and both new and existing firms need to soak up unemployed resources. But special interest groups instead have incentives to lobby government to protect the firms that are most likely to die during a crisis.

As such, two different theoretical traditions within economics reach very different conclusions regarding what proper crisis policy ought to be. In a new policy brief for the Swedish think tank Timbro, I therefore explore why some countries are more likely to experience economic crises, and why some countries typically experience shorter and less damaging crises. The policy brief updates an analysis I published four years ago in the European Journal of Political Economy. Both the original analysis and the new policy brief reach the same conclusion: Economically freer countries do much better during crises.

The analysis in the policy brief rests on data from 389 crisis events between 1993 and 2017 in countries from all the world. I explore the risk of entering a crisis in the first place, the duration of the crisis, the time it takes to reach pre-crisis income again, and the full income loss during the crisis. Each of these four measures are associated with the index of economic freedom from the Heritage Foundation. The analysis provides substantial support for the policy view from robust political economy, as more economic freedom is both associated with a lower risk of entering an economic crisis and a substantially smaller loss of income during the crisis. This is particularly the case for easier regulatory burdens and substantial market openness.

The figure below illustrates the main finding through three examples: the trajectory of GDP in New Zealand, Portugal and Japan during the 2008 financial crisis. Although one might think that New Zealand, as a small, open, peripheral economy would prove to be more fragile during a crisis, being one of the economically freest societies in the world makes it much more resilient. Conversely, Portugal and Japan are closer to the global average and experienced much deeper economic crises around 2008.

In general, the estimates in the analysis show that had New Zealand been a typical Western country such as Austria, an economic crisis would on average result in and additional crisis loss per inhabitant of about £1,500. Noting that the Heritage Foundation assessment of market openness in rich countries varies between 62 in Greece and 86 in Australia (on a scale from 0 to 100), the effects in the analysis have both economic and political significance.

The bottom line and policy implication from crisis research in recent years is quite simple: politicians and bureaucracies need to get out of the way of existing firms and new entrepreneurs. Countries that have more flexible labour markets and less regulated financial and product markets have fewer and easier crises, and this time is no different.

EPICENTER publications and contributions from our member think tanks are designed to promote the discussion of economic issues and the role of markets in solving economic and social problems. As with all EPICENTER publications, the views expressed here are those of the author and not EPICENTER or its member think tanks (which have no corporate view).


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