COVID-19: Prepare for second-order effects
As India enforces a 21-day lockdown, I have a sense that we are living in the pleasant hope that we will dramatically slow the spread of the virus over the lockdown period, and things will limp back to normal after the lockdown is lifted. This rosy scenario, combined with the tsunami of stimulus efforts unleashed by many countries including the US and India, will substantially mitigate the enormous global disruption. That is what the markets are looking forward to, which is why stocks have taken off from the lows they hit earlier this week. A global market rally underpins that hope and belief.
What if this belief turns out to be false? Just as we underestimated the pandemic, what if we are underestimating the recovery time? Human beings are fundamentally optimistic, a trait that helps us in our normal lives. That is how we pull ourselves up when we fall. However, there are times when scepticism is a virtue and optimism is plain silly. Like in a pandemic. The idea then is to take defensive, not offensive, actions that are based on hope. But this is not our first instinct. For instance, just because stock prices have fallen a lot, we assume that they will go back up once the reason for the crash is mitigated or removed. It is an opportunity to buy because in “normal” times stockmarket declines are usually the time to buy and not sit on the sidelines and worry. But as someone said: In the stock market you should follow the rules, and then know when not to follow them.
I have been through every market crash since the Harshad Mehta scam of 1992. While the reason for each crash was different, there is something common to all of them: The first big decline does not capture the full impact of the problem. Investors are shocked and distressed but remain optimistic. The high stock prices they were used to before the crash still play on their mind. They expect the stocks to go up again when things are normal. This phenomenon is called the “recency bias”.
Like optimism, we humans have another natural default selection. We see only the first-order effects — or the immediate result — of our action. First-order effects are simple and visible links between a cause and its effect. A 21-day lockdown (cause), which will slow the virus spread, is the first-order effect. But in complex situations (like a pandemic or financial upheaval), second- and third-order effects are much more important and unfold later. But we are not trained to visualise them. This is precisely why investors remain optimistic after the first big decline in an ongoing market crash. This happened in 1992, when stocks rallied between August and September to crash again. In 2000, stocks rallied between May and July to crash again. In 2008, stocks rallied between March and May, only to drop much lower. In each case, investors ignored secondand third-order effects.
I am not for a moment predicting where the markets will go. All I am saying is we may not be considering second- and third-order (negative) effects this time either. If we don’t, we will be blindsided and disappointed. We have already seen such effects after demonetisation, which did not even produce the firstorder effect of unearthing black money. But it badly hurt the informal economy, and destroyed income and demand as a second-order effect. We came to pay a heavy price for this, and other policy mistakes, with a paltry 2.5 per cent growth rate (it may be reported as 4.5 per cent but two percentage points lower by the old calculations).
What could be these effects in the coronavirus pandemic? It will not be about the virus, it is the economic impact of our war on the virus. Already, we can see the mass migration of labour back to their villages as result of the lockdown, a second-order effect, which the Modi government hadn’t thought of and planned for. I suspect we will see a prolonged and unprecedented demand and supply shock. We cannot predict how this will play out. Except health care and staples, it is possible that every single sector will be badly hit by the sudden global contraction. We have not seen this in our lifetime and we don’t know the chain of impact it can have. That is the single biggest reason to doubt a V-shaped recovery.
The worst part is that we are still looking to the government to change things with a package of measures. The stark reality is that even before COVID-19 hit us, we were staring at a clueless government unable to find solutions to the relentless decline in economic growth. As I have mentioned several times, this government has used the same playbook of previous governments and added a new vile element to it: Creating a continuous stream of social anxieties for the two most productive segments of the economy: Businesses (who create jobs and pay taxes) and households (who keep the demand going and pay taxes). When it has remained apathetic, arrogant, and clueless in a known situation of economic decline, where it had enough time to fix things, what would it be its response to second- and third-order effects of a pandemic? Well, we have seen its response so far and it has been pathetic. Brace yourself for huge, nasty surprises and hope for lucky breaks. It may be a long, bumpy ride.