Question

Question Three

a. Based on the functions of the banking system, give reasons why governments bail out banks during an economic crisis?

b. Is the World heading for a recession? Explain the conditions under which the world can be classified as being in a recession as COVID-19 persists. Explain linking the pandemic to the various stages of a recession.

Answer 1

A.

We assume bankers are risk averse and take the benchmark, constrained efficient equilibrium in the model to be one where governments can commit
not to bail banks out. Because governments can commit, banks never go bust so as to ensure bankers never experience negative consumption. So, bankers optimally respect, in effect, a self-imposed solvency constraint. Since banks never go bust, distortive labour taxes are never levied on private agents. As noted, this is the constrained efficient equilibrium of the model.Being unable to dispense with banks, the government can replicate the constrained efficient allocation–the competitive equilibrium with no default by imposing a consumption penalty on bankers if a bailout has ever occurred. The reason why the penalty function is time-consistent is because it accepts that the bailout will happen if a default occurs and it is optimal to impose it. The penalty in the model is a function of aggregate state variables; in present model these are government debt, which reflects any past bailouts that may have occurred. The government cannot credibly commit not to bail out the banks but it can credibly commit to execute the penalty. The consumption penalty levied today is the present value of the bailout plus a surcharge that accounts for social cost of the bailout. That cost is driven by the distortion in labor supply caused by labor taxes

B.

Entire industries worth trillions are being decimated. Travel, dining, sports, entertainment, cruise ships, retail, etc. etc. The recovery won’t be as quick as was the cessation in mid-March when the pandemic was declared and the wheels of commerce begin to grind to a halt.

We have never seen anything like this before - even wartime during World War II didn’t eliminate normal life to the degree COVID-19 has. Life will probably never be the same again - regaining overall confidence levels could take a generation or more.

Government can’t create wealth or simulate a vibrant economy as they pour money into people’s pockets to create the perception that people don’t need to suffer from being forced into relatively non-productive inactivity.

The creation of money, i.e. the expansion of the money supply, when unaccompanied by increases in productivity / GNP is called “inflation,” and that’s what we are certain to see. The only question will be how severe it is and what form it takes viz a viz our lives. Inflation (defined as expansion of the money supply and not just increasing prices on a basket of goods and services defined by the government) coupled with severe disruption to normal patterns of supply and demand is something we’ve never really experienced like this before, so it’s hard to predict precisely what will happen to the economy overall other than “It will change for the worse pretty dramatically.”

Expect real estate values to plunge nationwide. Expect massive dislocations, shortages, and surpluses with attendant dramatic price fluctuations in both directions (we’ve already seen sanitizer and toilet paper up, gasoline and air travel down). The increased production and productivity (boom) in healthcare, public health, online entertainment, cooking supplies, puzzles and games, and medical sciences can’t make up for the losses in so many other sectors.

Expect the unexpected. We’re charting new territory economically, and both socialist and free market economics will be stressed and tested to the max. But one thing will become clear: government can’t tax and spend their way out of a recession. Massive transfers of wealth are happening and will continue to happen, for sure, but ultimately without the creation of wealth to accompany the transfers, the well of wealth runs dry - and wealth (value) is not being created at nearly the rate it was only a few months ago. And that is the key to understanding where the global economy is heading.

It’s just there’s no way to avoid a massive global recession over the coming months and perhaps years. So best to be prepared for things to get worse before they get better, and keep looking for the opportunities and bright side that severe disruptions are likely to offer those who are proactively looking for them.