Wednesday, December 30, 2020

2020 was an economic lesson about insurance

My report on superannuation came out at the beginning of 2020. One of the main arguments in that report is that Australia’s superannuation system is not a retirement income system because it cannot perform an insurance function.

I didn’t know then that how we handle insurance at a society-wide level would be the most important economic policy lesson of 2020.

To explain what I mean, I must first differentiate between insurance in the financial sense and insurance in the economic sense.

Financial insurance smooths balance sheet variation when specific low-probability events occur. It works because any one person or group faces idiosyncratic risks so that pooling many people in an insurance system allows it to pay out for those few events from the funds collected from others.

But economic insurance is much different. Economic insurance deals with real resources, not financial ones.

A financial insurance system is an economic insurance system for any individual. As long as an individual’s loss of real economic resources—buildings, vehicles, equipment, stock—from an insured event is small relative to the system as a whole, these real economic losses can be easily replaced from the production of others without widespread economic disruption.

But when losses from an event are large relative to the productive economic system as a whole, simply repairing the balance sheets of individuals with cash payments will not overcome the resource loss that will affect many individuals across the system as a whole.

Consider a small island community who eat 100% of the food they grow to survive—there is not one bit of waste. If a cyclone destroys 50% of their food crops for a season, it won’t matter what sort of financial insurance systems they have in place. Their ability to feed themselves this season has declined by 50% and the loss will be felt across society, not just by the farmers whose crops were destroyed. Financial insurance cannot provide economic insurance for this type of event. The island community must suffer the loss of food and nutrition regardless of whether they can repair their financial balance sheets.

The reality of economic insurance is why I have argued in the past that a food production system that wastes a large portion of the food grown and cultivated is a type of economic insurance that provides a real resource buffer against large unforeseen shocks to the food supply system.

The military also has the features of economic insurance. Why employ tens of thousands of troops when your country is not at war? Why build and maintain ships, tanks, submarines, and jet fighters during periods they are not needed?

The answer is that financial insurance cannot stop the real resource losses from war. You must have some form of economic insurance in place with a real resource buffer being produced just in case of war. Often that requires spending years or decades devoting substantial materials and manpower to maintain a military with nothing to do.

So why is economic insurance the big lesson of 2020?

Because the health system in most countries is not run like an economic insurance system against large health shocks, even though it is clear that financial insurance will not help deal with the next pandemic. Hospitals are incentivised to run at, or near, full capacity at all times, even though health needs fluctuate, sometimes substantially, just as we have seen this year.

If we ran the health system like we do our military, or our food production systems, we would maintain a large buffer of real health resources. That would mean hospitals with surge capacity and staff maintaining them. It might involve, for example, international joint health operations to practice developing and distributing drugs and medical equipment in case of emergency.

If we ran our health system as an economic insurance system, like we do our military, that would mean an enormous expansion of health services generally. As well as being maintained as a buffer in case of emergency, these additional healthcare resources could be used for training and treating less serious health problems.

What has surprised me in 2020 is that few people are looking at the way we manage health resources and why the healthcare system is not designed as an economic insurance system like our military.

Tuesday, December 8, 2020

Australia's out-sized COVID stimulus

After the global financial crisis of 2008 the Australian government responded with a large fiscal stimulus.

Initially worth about $10 billion, it soon grew by $42 billion by February 2009. Out of this total about $21 billion came in the form of direct cash payments to households. 

At the same time the RBA reduced the cash rate, which flowed through a decline in variable rate mortgages from nearly 9% to around 6%. That 3% interest saving on the balance of mortgages at the time was worth around $30 billion per year. 

In total, we are looking at about $70 billion in total economic stimulus.

This scale of this stimulus effort was widely regarded to be appropriate for the circumstances of a large global macrocycle shock. 

So how big has the 2020 stimulus spending for the global COVID shock to the economy been compared to this reference point?

Early estimates of the combined fiscal and monetary stimulus were around $180 billion, or about 2.5x larger than the 2008-09 Rudd stimulus. 

On the fiscal side we have around $150 billion. 

  • Initial welfare boost = $18 billion
  • JobSeeker and JobKeeper and second welfare boost = $66 billion
  • Business cashflow boost = $32 billion
  • Early super release = $35 billion
We also have state governments increase spending and subsidies across the board, easily totalling $12 billion.

On the monetary side, we have again around $30 billion in annual interest savings to mortgage holders.  We also have the RBA intervening to lower all sorts of interest rates across the board. 

Just these items get us to nearly $200 billion, most of which came in the form of cash payments. In cash terms, rather than total value of government spending terms, the COVID stimulus measures are enormous. 

Instead of $21 billion in cash payments we are looking at nearly $130 billion in cash payments. 

Since there have been few spending options for all that extra income, the household savings rate has boomed. Households have spent $121 billion less than they earned so far this year. We can see just how much the income to households from stimulus spending has exceeded declines in incomes in the chart below. The orange bars are how much non-labour income, which includes government payments, contributed to growth in total household income. In short, disposable incomes are up massively and the main reason is the stimulus cash given to households. 

This out-sized stimulus package will have lasting effects throughout the next cycle. We have loaded up households with spending money. We have decreased the interest costs on their mortgages and encouraged them to borrow more money. We have turned off the immigration tap, meaning labour market demands can be more effectively channelled towards wage and salary growth.

To me, it seems obvious that the only thing that can happen is a massive economic surge coupled with rising asset prices. There is even a chance of a "surprise" rise in inflation. 

All of this could be seen in advance. Back in May I argued that house prices are more likely to rise than fall, and that most people had under-estimated the scale of the stimulus. 

Here's an interview were I explained my reasoning.