On Coase and COVID-19

Abstract: From the epidemiological perspective, the COVID-19 pandemic is a public health crisis. From the economic perspective, it is an externality and a social cost. Strikingly, almost all economic policy to address the infection externality has been formulated within a Pigovian analysis of implicit taxes and subsidies directed by a social planner drawing on social cost-benefit analysis. In this paper, we draw on Coase (1960) to examine an alternative economic methodology of the externality, seeking to understand how an exchange-focused analysis might give us a better understanding of how to minimise social cost. Our Coasean framework allows us to then further develop a comparative institutional analysis as well as a public choice theory analysis of the pandemic response.

Author(s): Darcy W. E. Allen, Chris Berg, Sinclair Davidson, Jason Potts

Journal: European Journal of Law and Economics

Vol: 54 Year: 2022 Pages: 107–125

DOI: 10.1007/s10657-022-09741-w

Cite: Allen, Darcy W. E., Chris Berg, Sinclair Davidson, and Jason Potts. “On Coase and COVID-19.” European Journal of Law and Economics, vol. 54, 2022, pp. 107–125.

1 Introduction

Government responses to the COVID-19 public health pandemic have rested on the notion that governments can intervene to mitigate the externalities of the virus. The dominant policy response has been to impose ‘social distancing’ on much of the economy to mitigate transmission externalities. Recent literature argues that those externalities might be less prevalent and less costly than otherwise assumed (see Leeson & Rouanet, 2021) and that we must consider the realistic information and incentive assumptions that underpin government responses to those externalities (see Coyne et al., 2021; Powell, 2021). Our contribution in this paper is, like that of Ronald Coase’s work, a methodological one. We explore and contrast the standard Pigovian analysis of the pandemic with a Coasean and comparative institutional approach (focused on bargaining and exchange over externalities).

Many economists responded to the COVID-19 pandemic by seeking a unified epidemiological-economic analytic framework that might yield insight into optimal lockdown policies. Economists combined the canonical susceptible-infected-recovered (SIR) epidemic model of the dynamics of a virus through a population with canonical macroeconomic models, including Dynamic Stochastic General Equilibrium (DSGE) models (Alvarez et al., 2020; Eichenbaum et al., 2020; Gonzalez-Eiras & Niepelt, 2020) with extensions to learning-by-doing models (Jones et al., 2020) and search-and-match models (Garibaldi et al., 2020). This family of unified SIRDSGE models show that the decentralized equilibrium is inefficient because of the contagion externality and why a social welfare maximizing social planner will frontload mitigation and favour an earlier and harder lockdown than would decentralized agents.

A major limitation of this social planner perspective, however, is that the health shock and policy response are both assumed to be exogenous. This is particularly the case in epidemiological models that tend to use historical data to calibrate agent behaviour, rather than assuming agents will respond to incentives or themselves form rational expectations-type models to guide their decentralised actions. In a Lucas-critique style analysis, Chang and Velasco (2020) develop an economic theory of pandemics with forward-looking agents that shows how individual decisions about whether to go to work affect transmission dynamics, yet these decisions are endogenous to economic expectations of policy actions that affect the consequences of going to work (e.g. trust in government, expected stimulus, expected behaviour of other agents given the expected stimulus, etc.). The extent of endogeneity in externalities and expectations and the complex feedback between public health diagnostics and economic policy treatments has been a major revelation as both public health experts and economic policy-makers have scrambled to deal with the COVID-19 pandemic (see also Born et al., 2021).

Another limitation of the social planner models is their reliance on representa-tive-agent or uniform models. They treat populations and the policies imparted on them as homogenous. This simplified population analysis is largely for modelling convenience and due to severe real time data limitations. Elaborations of the unified SIR-DSGE social choice models have introduced targeted-versus-uniform lockdown policy in a multi-risk model, reporting “the qualitative finding that semi-targeted policies significantly outperform uniform policies” (Acemoglu et al., 2020, p. 4). In that model, social welfare was maximized with targeted policies that focused on protecting high-risk subpopulations rather than the uniform policies favoured by epidemiologists. This analysis is interesting because it shows how in a pandemic context a social planner can trade-off the costs and benefits to different groups in order to maximize a social welfare function. Social planners internalise externalities through taxation of work and consumption to affect containment (the stick) and redistribution to subsidise containment (the carrot).

This conception of social distancing is particularly Pigovian, where a mandatory social distancing policy is the equivalent of a 100 per cent tax rate on that activity. This approach forms the dominant modelling assumption so far used in analysis of optimal policy response to COVID-19. But once we start thinking about pandemics from an economic policy perspective, and then extend that to multiple agents, a new analytic framework comes into view: a Coasean analysis built around Ronald Coase’s famous theorem (Coase, 1959, 1960). A Coasean approach to the pandemic variously focuses on the reciprocal nature of externalities and the institutional conditions under which those externalities may or may not be bargained away through exchange (e.g. see Williamson, 2020; Coyne et al., 2021; Leeson & Rouanet, 2021; Boettke & Powell, 2021; Paniagua & Rayamajhee, 2021). This paper builds these insights together with comparative institutional analysis to explore and understand public policy responses to the pandemic.

In the Pigovian model of externalities, a social planner intervenes to reallocate economic resources in order to internalise the externality (in this case the contagion and congestion externality, Jones et al., 2020). In the Coasean approach, parties bargain their way to a solution that is resolved with an exchange that internalizes the externality. In the uniform SIR-DSGE model there is no possibility of Coasean bargaining because there is effectively just one agent (the susceptible population) who then experience probabilities of transitions to states of infection and recovery. It is the social planner who chooses in this formulation, and the policy choices then update the parameters of the model society.

In a model with individual decentralized agents, each agent’s choices impose externalities on others. These impositions are propagated unevenly and fall unevenly across the economy. When someone decides to go to leave their home when infected they may be incentivized to do so for leisure or other economic benefits, but there is no way for those who are harmed by that action (by increasing the risk of infection for others) to offer an incentive to stay home. There are missing property rights and missing markets to enable all the third parties to pay them to stay at home. It is important to note here that, as argued in Leeson and Rouanet (2021, p. 1113), the externalities imposed on private property are of a different nature to that on public property: “residual infection risk that visitors face from the on-site behaviours of other visitors is infection risk that they face contractually and thus risk that does not impose on-site external costs” (see also Boetkke & Powell, 2021). That is, externalities on private property, such as on-site transmissions that occur at a cafe, are internalized through contracts with higher or lower prices. Nevertheless, in economic theory the transaction costs of each agent contracting with others to stay at home, or not go shopping, would swamp the expected benefits of the trade. It would simply be too costly for those mutually beneficial trades to be discovered, negotiated and enforced. So a decentralised model will not be able to internalise the externality through trade. This is why the unified SIR-DSGE models recognize the existence of the COVID-19 externality and that social welfare suboptimality of a decentralized solution.

Now consider the Coasean analysis between coalitions sorted by risk, as in the multi-risk Acemoglu et al. (2020) model.1 Suppose for simplicity there are just two self-identified and self-sorting groups: (1) high risk of death from the disease; and (2) low risk of death. (We consider below the implications of strategic deception about identity in these groups, and the effects of uncertainty.) Around the world, governments have everywhere adopted a uniform lockdown policy, regardless of cohort risk. This has in effect imposed different statistical costs and benefits on the different risk groups. The low-risk groups are paying a large price in terms of lost utility from work and consumption to benefit a different group in terms of changed risk of mortality. But these are statistical not absolute risk groups. A uniform policy means that governments do not need to identify, target or differentially reinforce policies: they apply to all citizens. Nevertheless, as the Acemoglu et al. (2020) analysis indicates, if the information and enforcement cost assumptions of the model are true, a targeted approach would be superior in terms of minimizing deaths and economic losses.

A Coasean analysis asks a different question: could the groups themselves bargain their way to the same Pareto superior equilibrium? Or is a social planner necessary to get to good equilibria? To address this, we need to think about which group is imposing externalities on whom. If the low-risk group is freely moving about then they are imposing a contagion externality on the high-risk group. This is due to a lower expected cost of infection, i.e. the low-risk group expects to recover and not to die. But if the high-risk group prohibits the low-risk group from moving freely about and making a living, then the externality is being imposed by the high-risk group on the low-risk group. (There is also a congestion externality that is imposed inter-group, as each person who goes to work or to market imposes an increased risk on everyone else who also decides to go, but we ignore that here.) Just as in Coase (1960), both groups are imposing costs on the other groups-that is, the externalities are reciprocal. The Coasean analysis asks not who is causing the harm (a question perhaps of morality or justice), but rather who can avoid the harm at lowest cost (a question of economic efficiency). Under institutional conditions of clear property rights and low transaction costs we expect that a bargaining solution to arrive at the most economically efficient solution (see McChesney, 2006; Fox, 2007). Indeed, as Boettke and Powell (2021, p. 1095) describe in the standard law and economics approach this would involve “assigning rights such that the least cost mitigator bears the burden of adjusting to the externality.”

Whether such conditions hold depends upon a range of cultural, social and political factors. For instance, the high-risk groups (typically those over 65) may bargain with low-risk groups (working age populations) through political-democratic brokering. For instance, they might send messages to politicians that use voting blocs as rewards or threats. High risk groups could use political power to force a uniform policy. In turn low-risk groups may agree to that bargain in return for expected wealth transfers through raids on fixed income pension commitments through inflation, etc. As such, we can think of the policy decision not through the additive utility lens of a social welfare function (a Pigovian lens) but rather as political brokering of coalitional exchanges across different risk groups in society (a Coasean lens). In this way we can shift from what James Buchanan (1964) referred to as an ‘allocation’ lens of economic inquiry towards an ‘exchange’ paradigm. The former emphasizes the allocation of resources by a social planner with relevant information, while the latter “focuses on the process of interaction between people within a context-specific, and varying, institutional environments”, with more realistic assumptions about information and incentives (Coyne et al., 2021, p. 1122).

If transaction costs were zero, then “…each person would strike a deal with every other person whose infection risk their behavior might affect or whose behavior might affect their infection risk. All costs of such behavior would be internalised” (Leeson & Rouanet, 2021, p. 1109). Of course, even that simple two-group polit-ically-mediated Coasean bargaining prospect is conditional upon secure property rights (in this case well-formed and credible voting coalitions) as well as good and easily identifiable information about which risk group each individual belongs to. As further groups are identified the epistemic challenges compound. As Coyne et al., (2021, p. 1119) explore, the political economy of state responses to COVID-19 must consider both policymakers’ “epistemic constraints they face in trying to solve that problem” as well as those policymakers’ incentives. As Williamson (2020) argues in developing a Coasean social contract model of the pandemic, the “… large variations in individual trade-offs and private information about such trade-offs” suggests solutions based on individual choices and incentives rather than mandates. Early in the pandemic, however, there was a great deal of ambiguity about information such as risk profiles, and while growing evidence does seem to confirm that specific factors do characterise distinct risk groups (e.g. age, comorbidity) significant epidemiological uncertainty remains. Nevertheless, even a simple or ‘naive Coasean’ analysis of the exchange approach to COVID-19 policy is likely to yield valuable insight to address important economic issues and considerations that are largely or entirely ignored by the Pigovian or social welfare economic analysis.

A public health crisis involving an infectious disease is clearly a negative externality. Those infected individuals encountering non-infected healthy individuals can pass on the disease to those individuals resulting in their subsequent illness, or even death. In the very first instance, this can be described as being a ‘health externality’, which are typically negative.2 Further distinctions between the type of externalities in a pandemic have been outlined, such as ‘on-site externalities’ (where people impose externalities on others at a given site) and ‘off-site externalities’ (where the externalities are the effect of increasing infection risk of others at different sites) (see Leeson & Rouanet, 2021). Further complicating the nature of pandemic externalities, Rayamajhee et al. (2021) argue that pandemic externalities, rather than being global as is often assumed, are in reality “nested externalities at multiple scales”, where different actions at different scales have costs or benefits. For our purposes, we distinguish simply between a ‘health externality’ and a ‘behavioural externality’.

One of the challenges facing decision makers in relation to the COVID-19 pandemic is the lack of information associated with the virus itself, including the ‘health externality’ associated with it. Initially there was no knowledge of the characteristics of the virus-how much time there was between infection and symptoms, how contagious it might be and under what circumstances, what the fatality rate was, and so on. The social cost associated with spreading COVID-19 was unknown or highly uncertain through February and March 2020 when policy choices were being made. For the most part, policymakers in most countries assumed the social cost would be very high, and the unprecedented global policy responses (relative to viruses such as the seasonal flu) reflect that assumption.

The second externality (the ‘behavioural externality’) caused by COVID-19 may be either negative or positive. The behavioural response to the pandemic resulted in individuals voluntarily self-isolating in order to prevent themselves from contracting COVID-19. This ‘behavioural externality’ has similarities to a pecuniary externality in a market. To the extent that individuals withdraw from economic activity and reduce their consumption, this imposes costs on others and is a negative externality. It could also be the case, however, that these individuals, by following their own self-interest, inhibit the spread of the virus. If this were the case, then their behavioural response is a positive externality. On balance, the net externality could be positive or negative. For reasons that we explain below, policy makers acted in a way that suggests the net effect of this behavioural externality to be negative.

While previous studies have examined the nature of externalities in the pandemic (e.g. Leeson & Rouanet, 2021; Rayamajhee et al., 2021), the political economy of state responses (e.g. Boettke & Powell, 2021; Coyne et al., 2021), the complexity of pandemic policy (e.g. Pennington, 2021) and the economic consequences of the pandemic (Allen et al., 2020), this paper draws theoretical insights from Coasean economic theory, integrating these findings into a broader comparative institutional and public choice perspective. In Sect. 2 we discuss the origin and various meanings of the Coase theorem. In Sect. 3 we apply these to the COVID-19 pandemic using the framework of comparative institutional analysis. Section 4 considers pandemic management as a transaction cost problem. Section 5 examines some public choice theory considerations. Conclusions are offered in Sect. 6.

2 Beyond vulgar Coaseanism

One challenge for economists when approaching the Coase theorem is that there are many interpretations of what that theorem might be. Some economists, like Paul Samuelson, suggested that the Coase theorem was not a theorem at all. Other economists, like George Stigler, conflated it with other insights (on Stigler and Coase see Marciano, 2018). Unfortunately, Ronald Coase himself gave some credence to the Stigler interpretation, while insisting that he had made more of a methodological contribution as opposed to a hard and fast insight.

Coase (1988, p. 157) reports that he first expressed his theorem in a 1959 paper that had appeared in the Journal of Law and Economics. There he had made use of the example of a newly discovered cave. The argument was that the initial ownership of the cave and the ultimate use of the cave were independent of each other. The cave would be put to its most valuable use. The more famous 1960 article was an elaboration of that principle. As Coase (1988) notes, in the absence of transaction costs there can be no deviation between private and social costs.

Deirdre McCloskey (1988, p. 368) argues that this version of the Coase theorem is really ‘Adam Smith’s theorem’-that resources will gravitate into the hands of those who value them the most-if transaction costs are zero. According to McCloskey, the Coase theorem tells us that transaction costs do matter. While this is correct, it does seem to abstract from Coase’s other important contributions in his 1960 paper. Rather than express a theorem, Coase was attempting to make a methodological point-that how economists thought about social cost suffered from basic defects.

Coase recognised and emphasised that social costs problems (i.e. externalities) were reciprocal. In many of his examples the individuals were imposing harm upon each other. The question in Coase’s mind was: who should harm whom? The answer that he kept returning to was the arrangement which maximised the value of production. By contrast, the Pigovian solution to externalities would be to determine who had injured whom, and then require the advantaged party to compensate the injured party or levy a tax on the advantaged party.

Coase (1960, p. 131) also suggested, unkindly but not incorrectly, that economists did not carefully think through the problems at hand, leading them “to declaim about the disadvantages of private enterprise and the need for Government regulation.” He also argued that economists did not explore the full set of possible solutions to any problem of social cost. When confronted by a social cost, rather than immediately consider government regulation, there are other solutions that should be carefully evaluated. The immediate and obvious solution to any problem, he argued, is to do nothing-arguing that very often the costs of doing something would be greater than the benefits of that action. Then he suggests that markets could be deployed to resolve social costs. In a world of zero transaction costs the Adam Smith principle applies. Coase (1960), however, recognised that transaction costs may not be zero, or even low, and that markets would not always be able to resolve negative externalities.

It is important to dwell on that point. Very often Coasean solutions to externalities suggest that all that needs to be done is for property rights to be allocated to a party and then leave the market to allocate use rights. This may be a Coasean solution to the problem of social cost, but it is not the Coasean solution. This ‘let winners compensate losers’ or ‘losers bribe winners’ approach to resolving problems of social costs can be described as ‘vulgar Coaseanism’.

In the presence of market failure, given transaction costs, Coase (1960, p. 115) points to his 1937 paper on the nature of firm. There he had argued that hierarchical costs within the firm could be lower than transaction costs within the market and that firms existed when administrative decision-making costs were lower than market transaction costs. It is possible that some social costs can be privatised through vertical integration.

Only after the relative costs and benefits of doing nothing, relying on market forces, and vertical integration were considered, should government intervention be considered. Importantly Coase suggests that government intervention-Pigovian solutions-have costs and benefits and may fail to resolve problems of social cost just as markets do. Coase suggests that government intervention is likely to be more effective when coordination costs are high. Government does not need to incur the same coordination costs as do private actors-it can simply deploy its police power to impose solutions, including in situations where “… a large number of people are involved and in which therefore the costs of handling the problem through the market or the firm may be high” (Coase 1960, p. 118).

Coase’s (1960) contribution was not to demonstrate that transaction costs do or do not matter, or that market solutions require property rights, or that government intervention can fail too. His contribution was that economists should think carefully about potential solutions to the problem of social cost and evaluate real world alternatives. Indeed, “satisfactory views on policy can only come from a patient study of how, in practice, the market, firms and governments handle the problem of harmful effects.” (Coase 1960: 118). Harold Demsetz (1969) described decision making based on blackboard economics as being ‘nirvana economics’, which advocates a comparison between an idealized alternative and a real-world alternative. Coase advocates what Demsetz (1969) labels as being ‘comparative institutional’ analysis between real world alternatives. We apply such an approach to the COVID19 policy responses in the following sections.

3 An institutional choice framework for the COVID-19 pandemic

To understand the various responses to the externalities generated by the COVID-19 pandemic, we draw on this Coasean lens and combine it with the institutional possibilities frontier framework first proposed by Djankov et al. (2003). Djankov et al. (2003) were interested in explaining the growth of regulation over the course of the twentieth century and to explain why regulation seemed more prevalent in highincome economies. The frontier itself traces the trade-off between (private) disorder costs and (public) dictatorship costs. Following the Coasean insight, the costs of using market-based regulatory mechanisms are traded-off against the costs of using government-based regulatory mechanisms. In this context, disorder is defined as being ” $\ldots$. the risk to individuals and their property of private expropriation in such forms as banditry, murder, theft, violation of agreements, torts, or monopoly pricing” (Djankov et al., 2003, p. 598). Dictatorship is defined as being “… the risk to individuals and their property of expropriation by the state and its agents in such forms as murder, taxation, or violation of property” (Djankov et al., 2003, p. 598).

Djankov et al. (2003) then use this framework to examine four broad governance strategies that can be used to achieve some regulatory objective: ‘market discipline’, ‘private litigation’, ‘public regulatory enforcement’, and ‘state ownership’. In the analysis that follows we define disorder costs as the negative externality imposed on other individuals due to infection and a voluntary behavioural response to the pandemic. Dictatorship costs are the costs imposed by the government in response to the pandemic such as enforcement of quarantine, loss of civil liberties, and the like. Dictatorship costs include loss of economic opportunity that results from quarantine policies. It does not, however, include the costs of ‘hibernating’ the economy and costs incurred in restarting the economy after the quarantine period ends.

With that background, it is possible to set out a series of responses and policy approaches to the COVID-19 pandemic. For the sake of completeness, we include a ‘Do-nothing’ response. In this response, nobody does anything in response to the pandemic. Individuals do not modify their behaviour in any way, nor do governments respond in any way. Under this response, individuals go about their lives and infect other individuals. Currently the medical understanding of COVID-19 is that some infected individuals will not develop any symptoms of the disease and will not feel unwell at all. Asymptomatic individuals may still be infectious. Other infected individuals will become ill but will recover. Yet others will become very ill, and some will die. In this response the disorder costs are very high. The virus simply transmits through the population and the costs associated with the health externality are maximised. An epidemiological model of this process can be calibrated with the standard SIR model.

This ‘Do-nothing’ scenario is extremely unlikely and did not occur. Individuals respond to medical crises. For example, individuals who become ill may take sickleave from work. Those individuals who are vulnerable to infection may self-isolate. Others may withdraw their children from school or stop visiting crowded places such as cinemas, clubs, gyms, and the like. This scenario we label as ‘voluntary individual self-isolation’. In this response we see some reduction in the costs due to a health externality, but the introduction of a behavioural net negative externality. Some service providers may experience financial loss due to consumers reducing their purchases and changes to consumer behaviour. Related to this, Leeson and Rouanet (2021) argue that the externality context of COVID-19 suggests that the externalities are somewhat self-limiting.

The next response level we describe as being ‘voluntary corporate self-isolation’. Employers may voluntarily reduce the scale of their operations or even cease operations to protect their staff. This could entail reduced working hours, or fewer staff working during each shift. Schools could adopt distance learning models and some employees could work from home. Note that this is distinct from government mandating employers to restrict their staff, which occurred in many jurisdictions.

The responses we have described so far are voluntary. The social costs that are being imposed are disorder costs. Government may have provided public information and/or made recommendations in the scenarios and responses that we have described, but as yet there are no dictatorship costs in the composition of social costs being incurred. What is important to note is that as each scenario has emerged that the social costs due to the health externality are likely to be falling, while the social costs due to the behavioural externality are likely to be rising. The behavioural externality will result in disorder costs such as reduced amounts of economic activity resulting in job losses. It could (and did) result in panic buying and hoarding. Many countries experienced toilet paper shortages for example-prior to the imposition of formal and mandatory quotas. Very few governments appear to have relied on a voluntary response to the pandemic-Sweden and some Swiss cantons appear to have adopted this approach, while the United Kingdom initially indicated that it would adopt a voluntary approach to the pandemic it quickly changed tack.

Government responses to the COVID-19 pandemic have focussed on the health externality. Individual responses that were based on voluntary self-isolation were transformed by government fiat into involuntary quarantine policies. For the purposes of illustration three versions of involuntary quarantine policy can be described.

Mild quarantine consists of the government requiring that most people stay at home with only essential workers going to work. Essential workers here can be broadly defined. Under mild quarantine individuals might be allowed out of their homes for shopping and exercise at their own discretion. The police, however, do enforce the quarantine and do issue fines for quarantine violation. Strict quarantine consists of more restrictive definitions of essential workers and fewer exemptions to home quarantine. Individuals may be restricted on what they may buy (e.g. some countries have closed non-essential retail stores) or when they may leave their homes (e.g. only one adult may leave the home every three days, or an overnight curfew). Absolute quarantine-also included for completeness-is a situation where no-one is permitted to leave their homes for any reason. This form of quarantine is viable for very short periods of time only.

In these scenarios the behavioural externality that previously existed is now replaced with a dictatorship cost. Those individuals who would have self-isolated anyway under the same conditions as the government imposes are no better or worse off than they were before. Those individuals who would have self-isolated to a lesser extent or not at all are worse off than they were.

The important question, however, is which response or scenario results in a minimisation of social costs (from both disorder and dictatorship).

The first point to make is that the existence of a negative externality is not itself a necessary and sufficient condition for a response. As Coase pointed out, doing nothing is an option. As we know, however, people do not do nothing in the face of a medical emergency. There is a response-people both self-isolate and change their consumption and productive behaviour. For there to be a justification for policy intervention an externality must persist in equilibrium (Buchanan & Stubblebine, 1962). In disequilibrium social costs and private costs may diverge from each other. As externalities are internalised due to behavioural responses the divergence between social and private costs will fall. If that differential falls to zero before equilibrium, then there is no market failure. In the Buchanan and Stubblebine terminology the externality is not Pareto relevant. It may be the case, however, that the externality persists in equilibrium-that is, it is Pareto relevant. At that point market failure has occurred.

In the case of COVID-19 market failure occurs when individuals, despite their voluntary behavioural responses, are still imposing costs upon each other. Given that there are two externalities at work, this is very likely to be the case. The health externality and the behavioural externality work in opposite directions to each other. As more people choose to voluntarily self-isolate to avoid contracting the virus, they impose greater behavioural costs on others.

4 Pandemic management as a transaction cost problem

Setting out the institutional choices in such a way requires us to ask several uncomfortable and unavoidable questions. What is the optimal rate of infection from a public policy perspective? How does that compare to a private perspective? Arrow’s impossibility theorem indicates that the policy choice made by the government is not going to be some aggregate of private preferences.

Most developed world governments have sought to slow the rate of infections to target medical capacity to deal with the pandemic. This is the ‘flatten the curve’ model, most influential in March 2020 when many governments were making their institutional choices, in which the total number of individuals who are eventually infected is fixed (see Allen et al., 2020). The goal of flattening the curve is spacing infections through time to prevent a sudden influx of COVID-19 cases from overburdening health care systems.

The choice of this objective function introduces another consideration into the debate: individuals are not just imposing costs upon each other; they are imposing a cost on the health system. This healthcare system may or may not be public, or have complex public/private entanglements (on entanglement see Smith et al., 2011; Wagner, 2016). It may well be the case that no externality exists in equilibrium from a health perspective but for the health system. This insight is a law and economics, or public choice, problem and we defer discussion to a later section.

Irrespective of why governments chose a particular objective function the net effect of intervention was to assume that a health externality persisted in equilibrium, and to substitute private disorder costs due to the behavioural response to the pandemic with dictatorship costs. This cannot be an equilibrium solution. Government intervention in response to externality is to restore an equilibrium situation that would exist but for the shock to the equilibrium.

Market failure is usually due to one of four factors: monopoly problems, missing markets, asymmetric information, or transaction costs. The COVID-19 pandemic is not obviously a monopoly problem. It would be too easy and glib to suggest that the COVID-19 market failure was due to missing markets. To suggest that individuals vulnerable to the virus be given property rights to their continued health and be paid to self-isolate would be a ‘vulgar Coasean’ solution. So too the notion that vulnerable individuals pay everyone else to remain in quarantine.

It is useful, however, to think about ‘rights’ that individuals may have in the face of a pandemic. Vulnerable people can suggest that they have a right to life that in this instance includes the right to not become infected. Others may argue that they have a right to a livelihood or a right to choose. Reconciling competing rights, especially in the absence of cash payments, is difficult at the best of times. It does, however, go the question of who should be quarantined-just the vulnerable, or everyone? Almost uniformly governments have chosen to quarantine everyone (although in many jurisdictions vulnerable people have been subject to stricter rules, such as restrictions on access to aged care). Garzaerlli et al. (2022, p. 1) explores this uniformity through the lens of Rawlsianism, arguing that “lockdown by fiat is a policy that is closer to a maximin equity criterion rather than to a utilitarian one”.

What many governments have also chosen to do is make payments to those individuals who have either lost their jobs (beyond the usual unemployment benefit that might normally be paid under such situations) or have been temporarily stood down or furloughed. Details vary across jurisdictions, but the principle is broadly similar-employers who have been impacted by the quarantine policy can apply for a wage subsidy to be paid to their employees. This may strike some readers as being a Coasean payment for lost wages. But this money is not being transferred from winners to losers. Instead, it is being transferred through time, from future generations to current generations. The money is being borrowed (or printed-the macroeconomic consequences of the quarantine policy will be debated for decades and is beyond the scope of this article) and will be repaid from future tax revenues or budget cuts or inflation.

It is likely that a market failure exists due to transaction cost problems and information cost problems. A lack of information problem is distinct from an asymmetric information problem. Asymmetric information is possible but not likely to be significant for this analysis. For example, it may be possible for an individual to be knowingly infected, or to believe they are likely to be infected, but externally asymptomatic and infect others.

Before we proceed to discuss transaction cost and information cost problems, it is useful to point out that the market failure is not due to individuals simply being selfish. It is easy to argue that markets could simply fail to clear because individuals are selfish-the welfare of others simply does not enter into their utility function, and they are simply indifferent to other individuals’ premature or preventable death. This argument has been made by the authorities when justifying authoritarian regulation or enforcement of quarantine. The health externality is reciprocal-individuals may either infect others or become infected themselves. Indeed, Williamson (2020, p. 157) proposes a Coasean social contract model that “recognizes the reciprocal nature of the problem.” While the virus does tend to be more fatal to older and immuno-compromised individuals it is infectious and has a non-zero fatality rate for all humans. To the extent that individuals have no voluntary behavioural response to the COVID-19 pandemic this is very likely due to information asymmetry or direct economic incentive. Responding to direct economic incentives may be anti-social but it is not a market failure.

The direct cause of the market failure-assuming the market has failed-is the existence of radical uncertainty. Mainstream economics tends to make strong information assumptions to drive its results. When those assumptions are relaxed, they are so that information is costly (i.e. the information exists but must be acquired at a price) or is asymmetrically distributed. One of the features of the COVID-19 pandemic is that information either did not exist, or was highly uncertain, or contested. Behaviour must be conditioned by expectations which in turn is conditioned upon information. Bounded rationality – first proposed by Herbert Simon and popularised by Oliver Williamson (1985) – results in individuals making and using heuristics, rules of thumb, and various mental short-cuts when decision-making.

In the months that the COVID-19 disease emerged and spread globally, there was a high degree of this sort of radical uncertainty, around almost all epidemiologically relevant aspects of the disease. It is possible that individuals under-estimated the COVID-19 infection rate or severity and subsequently self-isolated too little, resulting in a health social cost in equilibrium. It is also possible that the government over-estimated the COVID-19 infection rate and imposed high dictatorship costs on the economy when there was no social cost in equilibrium. Given the breadth of these uncertainties and the sensitivity of comparative institutional analysis to those uncertain factors, it is implausible to suggest that the policy choices made between February and March 2020 were anywhere approaching optimal.

But epistemic issues facing the epidemiology of the virus itself are only the “first layer of complexity that policymakers must contend with” (Pennington, 2021, p. 204). Drawing on Hayek’s distinction between simple and complex phenomena, Pennington notes that even while government action might be warranted in response to the externalities, the complex nature of the problem means that determining an effective policy response is difficult. Indeed, the health effects of the virus spread are interacting with further complex phenomena of “political, economic, cultural and institutional arrangements” (Pennington, 2021, p. 208).

Radical uncertainty, however, does not directly explain why different governments imposed various degrees of strictness on quarantine conditions. While information about COVID-19 was uncertain, and the medical science preliminary, given the extraordinary effort made by public authorities and researchers around the world to investigate the characteristics of the disease, the information was highly accessible. International coordinating organisations, such as the World Health Organisation, also sought to provide governments with consistent responses.

One explanation of differing policies is different levels of ‘trust’ or ‘civic capital’ in different jurisdictions, as identified in the Djankov et al. (2003) framework. For instance, jurisdictions with higher levels of ‘civic capital’ might (1) be more confident that populations will voluntarily comply; and (2) have less tolerance of high dictatorship costs because of their democratic ideals, leading them to have fewer restrictions. As Rayamajhee et al. (2021, p. 12) argues, because ‘social distancing’ is co-produced between citizens and governments, “a provincial or national authority with a history of betraying public trust is unlikely to effectively implement social distancing guidelines/ policies”. Related to this, Paniague and Rayamajhee (2021) draw on Elinor Ostrom’s work to frame the challenge of the pandemic as one of “nested externalities that are organized in multiple, overlapping scales”. This suggests the need for a polycentric approach to pandemic governance challenges, acknowledging the need for institutional diversity and flexibility in response (see also Allen et al., 2020).

The stark differences in cross-jurisdictional approaches can also be explained from an epistemic perspective. The various costs of dictatorship and disorder relating to pandemic policies are subjective. As Allen and Berg (2017) argue, societies that view the trade-offs between different regulatory regimes in different ways. Similarly focusing on the epistemic challenges of pandemic policies-with an emphasis on the complexity of the problem-Coyne et al. (2021) point to the need to match externalities with their lowest level of decision making. From this perspective, the different policy approaches across jurisdictions have some benefit, in revealing or discovering information about effective policy responses. This policy learning process, however, is limited by a “‘signal extraction problem’ in deciphering what the results of various policy experiments may mean and whether any lessons can be applied elsewhere” (Pennington, 2021, p. 213).

5 The law and economics of the COVID-19 pandemic

Pigovian approaches to policy are made more fraught by the fact that the government is not a disinterested actor. Public choice theory-and law and economics more broadly-is the study of how government (and the politicians and bureaucrats that comprise it) is a distinct actor within an economic system with its own economic incentives (Mueller, 1976). One theoretical foundation is Arrow’s (1950, 1951) critique of social choice functions, which showed how it was impossible to aggregate private utility into a social utility function without violating some desirable conditions, one being the no dictatorship rule (i.e. that one agent’s preferences dominate all other agent’s preferences). Yet in the context of public policy to address COVID-19, exactly this situation has arisen in which the ‘dictator’s’ preferences for resource allocation may depart from the preferences of individual citizens, however aggregated.3 Note this does not depend on citizens having different preferences, and this wedge between the incentives of the state and the sum of incentives of citizens will hold even with identical preferences across all citizens.

As we introduced in Sect. 3 above, when individuals move from susceptible to infectious they are not just imposing costs upon each other as a contagion externality on private individuals, they are also imposing a cost on the health system, as an externality on the state. For instance, individual citizens will have private preferences not to become infected and to die from COVID-19, and these preferences will extend to social preferences4 for this fate to not befall others too. Governments, on the other hand, have preferences focused on the public health system, which they seek to protect, not on individual citizens. This is not a cynical point: the UK government, for instance, has directly explained this point in public communication, namely that the strategy was to protect their National Health System (NHS). The ‘flatten the curve’ diagrams were expressly designed, and communicated, as a strategy to protect the capacity of the public hospital systems. To put this succinctly, from the government’s perspective, they obviously do not want their citizens to die; but should they die, it is better that they should do so without harming treatment capacity in public hospitals. This is not a heartless statement, but an expression of the margin of concern for the government supplying public healthcare during a pandemic.

Another way of seeing this same point is to look at it from a dynamic planning perspective, recognising that it is extremely costly to ramp up or quickly substitute one type of health service for another due to asset specificity in medical equipment, hospitals, and skilled labour. Medical equipment cannot be quickly repurposed. At time \(t=0\), governments allocate funding X to public health on the assumption that it will need to provide services Y at \(\mathrm{t}=1\). Any demand above Y at \(\mathrm{t}=1\) (or a different configuration of demand) creates rationing, which is a cost borne by citizens. This is politically costly as those rationed citizens will punish the incumbent government because the excess demand signals that \(\mathrm{t}=0\) government failed to properly plan for \(\mathrm{t}=1\) scenarios.

But this sort of bureaucratic forward planning and budget allocations is destined to fail because of poor information and incentives by the bureaucratic agents (Mises, 1944), or worse, will be fully captured to pursue the agents own ends (Niskanen, 1971). Nevertheless, the legitimacy of the modern welfare system relies very heavily on the state delivering public goods to the population. Having the public health system collapse under the weight of a pandemic would be a major embarrassment to the perceptions of competence and legitimacy of a government.

Once a health budget has been allocated at \(\mathrm{t}=0\) (including a spending level and an allocation across services) a government experiences what Williamson (1985) calls a ‘fundamental transformation’ where they no longer have a wide set of options going forward, but a narrow set of capabilities that can only deal with a predetermined range of events. Any events falling outside that planning window will overwhelm the health system, which means to blow out the budget. Governments will therefore be incentivised to order events so that they fall within the health sector capability, even when that means imposing an externality back on citizens by for instance shutting down all elective surgery or banning any activity that could place demand on the health system such as driving, sports. Similar incentives extend to preferences over subsidising employment (in Australia, called the JobKeeper program) to avoid overwhelming the unemployment provisions and budgets allocated to welfare.

The COVID-19 pandemic and the government response also raise further questions that can be analysed through law and economics (and public choice theory) that we flag here as topics for subsequent inquiry. Most broadly, as Boettke and Powell (2021, p. 1090) argue, we must examine the “incentives and information that confront policymakers and voters and the institutional environments that shape their incentives and information”. As Coyne et al (2021) point out, the nature of political competition can lead to rent seeking in response to a public health crisis, where individuals exert influence on the public policy process to allocate resources that benefit themselves.

First, following Downs’ (1957) theory of log-rolling and the economics of political parties, we predict that the urgency to enact legislation to address the pandemic will significantly lower bargaining costs associated with vote trading (Buchanan & Tullock, 1962), leading to an increased number of back-room deals being made in order for the party in power to be able to present a single coronavirus emergency response omnibus bill before parliament or congress for expedited approval during some manner or restricted debate or sitting period.

A further prediction is that the lowered bargaining costs, due to the higher opportunity cost of a failure to reach consensus and to deliver effective emergency measures legislation, is that the efficiency of a multi-party system is reduced, as there only effectively needs to be one party, with all special interests able to deal behind the scenes. In times of crisis there is a common tendency to rally-around-the-flag (Mueller, 1985) and to support incumbent leaders and their party. Knowing this, rational opposition parties will put effort into political bargaining (vote-trading or log-rolling) toward a consensus bill rather than seeking to present an alternative legislative agenda.

This collapse in multi-party competition driven by falling political bargaining costs (because of the emergency response) and resultant omnibus legislative bundle rushed through the political process (to economise on political costs), which will therefore be complex and far less scrutinized than in normal times, is then predicted to have a further behavioural effect that the legislative act will be difficult to understand by individual voters, who indeed will have no incentive to understand the details (they will be rationally ignorant, Caplan, 2007), but will also give rise to expressive voting (Buchanan & Brennan, 1984), or conspicuous signalling of support for the consensus bill, and using social mechanisms to enforce compliance (shaming in public or on media, rallies of support, expressions of anger and even violence). In the COVID-19 pandemic, this process of aggressive public consent soon targeted any counter-narrative of the value of opening the economy back up.

We could also consider the long run effect examined by Olson (1982) on the economies of Germany and Japan after the Second World War, in which one of the benefits of losing the war was the institutional destruction of rent seeking regulations and legislation and clearing away of thickets of special deals between Pre-War elites that had accumulated over long periods of peaceful prosperity, but were a significant drag on efficient competition and resource allocation. The urgent deregulation of unnecessary regulations and licencing regimes, particularly in relation to urgently needed production and innovation in health and other essential industries, provides the opportunity for a constitutional or institutional reset, following defeat. From this perspective, a pandemic may have similar effects on long run economic growth as losing a war due to the opportunities for institutional creative destruction.

6 Conclusion

Negative externalities arising from an economic activity impose a social cost. This can be dealt with through government intervention targeting that activity-directly through regulation, or indirectly through market interventions (e.g. through taxation or subsidy to internalise the externality and minimise the social cost of an economic activity). This is called the Pigovian approach, after A.C. Pigou, who developed the foundations of modern welfare economics. But Ronald Coase recognised that this was not the only solution to the problem of social cost because it failed to recognise the symmetry in any situation of externalities, and therefore fails to focus on the problem of maximizing economic efficiency. Provided transaction costs are low and property rights are clear, Coase explained, parties can bargain their way to an efficient solution to externality problems.

We expect the coming months and years to feature heated retrospective debate about what policies were most effective in limiting the spread of COVID-19, and the relative trade-offs of those policies vis-a-vis their effect on economic activity. Much of that work will be empirical. But this paper has argued that there is a higher-level debate to be had about the policy framework that was adopted.

COVID-19 is a viral pandemic, causing a global public health crisis, but from an economic perspective it can be understood as a negative externality, thus presenting two policy pathways forward. To date, and globally, almost all public economic policy response has gone down the Pigovian path. However, from an economic theory perspective, there are arguments as to why a Coasean perspective could on some margins be a superior basis for public policy. We have sought to set those arguments out here. As governments prepare for economies to unfreeze (Allen et al., 2020), or prepare for future pandemics, this analysis urges policymakers to better understand the scope and limitations of policy responses available to them.

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Footnotes

  1. Also see Boettke and Powell (2021, p. 1095), whose analysis includes sorting society “into two discreet groups of young/healthy and old/infirm”. ↩︎
  2. For instance, Leeson and Rouanet (2021, p. 1109) argue that it is also possible that behaviours that increase others’ risks of infection can confer positive externalities on those who are already voluntarily locking others away, for instance by reaching ‘herd immunity’ faster. ↩︎
  3. We use the term ‘dictator’ in the technical sense to refer to a government’s largely suspending normal democratic or parliamentary processes in order to impose choices made by a select insider expert group on a civilian population, which is then strictly enforced. ↩︎
  4. Social preferences are defined as other people’s utility functions appearing as arguments in an individual’s utility function (Fehr & Fischbacher, 2002). ↩︎

The digital consequences of the pandemic

With Darcy WE Allen, Sinclair Davidson, Aaron M Lane, and Jason Potts. Originally a Medium post.

The global policy response to the COVID-19 pandemic has been extraordinary. We’ve seen a massive increase in government spending and social welfare programs, heavy handed policing, and some less remarked on crisis deregulation.

But the long run effect of the pandemic will be even more substantial. COVID-19 is driving far deeper, and profound, changes in the economy.

Some of these changes we can start to see already, but their full implications are still murky and distant. Nonetheless, as we argue in our book Unfreeze: How to Create a High Growth Economy After the Pandemic, the economy will not simply snap back into place. The post-COVID-19 economy will not look like the pre-COVID-19 economy.

Here we offer seven changes that have big consequences for policymakers, entrepreneurs, and employees.

1 — Digital acceleration

COVID-19 has massively accelerated the adoption of digital technology to facilitate work from home. But also shop from home, school from home, telehealth, and so on.

This digital shift is often remarked on but not well understood. Technology adoption normally follows a particular diffusion trajectory. Digital technologies that have significant scale effects must overcome behavioural and institutional resistance, and they can get stuck at take-off. This means that the productivity benefits from widespread technology adoption, especially infrastructural and production technology, can be very slow to realise.

COVID-19 arrived at a critical time in the history of technology — when a supercluster of digital technologies were forming, poised to disrupt the underlying infrastructure of the economy. This suite of digital platforms and technologies had been developing for the past several decades. But they had run into innovation constraints caused by coordination adoption problems and regulatory barriers.

In March 2020, many of these constraints suddenly vanished. The spread of online education and telemedicine, which had been until then a multi-decade process, occurred in a matter of weeks.

This was a massive, global, multisector, virtually-instantaneous coordinated adoption of digital technology. That’s utterly incredible — and perhaps unique in the history of technology adoption.

A major problem with platform technologies is to drive coordinated adoption. The pandemic did in a few weeks what decades of government effort had failed to do. Long-run that is very good. But short-run it is highly disruptive.

2 — A need for massive entrepreneurial adjustment

In Unfreeze we argue that there is an urgent need for entrepreneurs to adapt to the post-COVID-19 world. Economies are made of connections, information, contracts, webs of value, relationships. When we try to restart the economy, much of this connective tissue will be gone.

The rapid technological acceleration driven by the crisis creates its own unique needs for adaptation. We’re already seeing the formation of new consumer preferences, new types of jobs, new types of business models with new cost and demand structures, new patterns of supply, and new regulatory and legal uncertainties.

But this implies that a significant amount of human capital and physical capital (built for industrial era technologies and business models) has rapidly devalued.

The first priority for entrepreneurs in the post-COVID-19 economy will be understanding how particular markets and jobs and administrative functions have changed. For example, many restaurants have moved to take-away only. Will consumers expect those new services to continue? Much of the white-collar economy has moved to work from home. Will employees demand that continues?

Entrepreneurial skills are essential during periods of rapid change. Entrepreneurship is not something that can be supplied by governments. But it can be inhibited. Policymakers have to make sure they are facilitating — not impeding — entrepreneurial adaptation to the accelerated digital adoption triggered by COVID-19.

3 — Decentralised production and innovation

One consequence of this sudden digital uptake is increased decentralisation. With the rapid adoption of work from home — not just the technologies but the social practices — we’ve seen a shift in the locus of much economic activity from offices into homes.

This shift has several implications. One, it facilitates greater co-production of value. More household resources, including especially local information, are being mixed into production.

Two, this also shifts the sites of innovation, facilitating greater household innovation and user innovation. More innovation occurs in the commons rather than in markets and organisations. This in turn increases the need for trusted decentralised networks and, in turn, increases the demand for and use of distributed innovation technology and institutions.

Three, distributed production will require more distributed dispute resolution mechanisms. Traditional courts have been slow to adapt to the digital environment and parties will be looking to more agile forms of alternative dispute resolution.

Four, because more production and innovation is occurring in households and in the commons, this means that it is harder to measure value creation and improvements in these non-market contexts. The non-market part of the economy will increase in apparent scale. So our industrial era measurements of economic activity (like GDP) will need to catch up with these new digital era realities of value creation.

This new institutional economic order will require a new economics to make sense of these new patterns of consumption and production, and new digital forms of capital and value creation.

4 — Powered-up economic evolution

The pandemic is a selection filter. As the precursor and mechanism of many of these changes, the economic consequence of the economic policy response to the viral pandemic is a powerful evolutionary selection mechanism passing over the global economy and through each sector.

This brutal selection mechanism is causing job losses, contract terminations or renegotiations, demand reductions, business closures and bankruptcy, fire sales, credit shrinkage, asset repricing, factor substitution, and other distinct forms of economic destruction that will play out over the coming months and years.

This hard evolutionary selection mechanism is also a filter. It will kill off some things disproportionately and let other things pass through. Most obviously, digitally enabled businesses and sectors will do better, because they are more well-adapted to the new environment. Bigger firms with better capitalisation (or better political connections) will do better, and smaller firms will be selected against.

In labour markets some positions are more vulnerable than others, particularly part-time workers or contractors. While many workers and firms are on temporary support through public sector subsidy of wages or quasi-partial nationalisations, a proportion of those positions or organisations being kept alive will die as soon as support is removed. There are many zombies already.

Similarly, there will be a lot of bad debt on company books (and thereby in banks) that will be realised in market revaluations over coming periods. These collapses will release resources for subsequent entrepreneurial reconstitution and reinvention.

But we should also expect consolidation of existing markets and resources among surviving players. This may actually result in higher growth and profits among large adaptive companies — particularly technology driven companies. So a period of global economic destruction is not inconsistent with a booming share market.

5 — The twilight of conventional macroeconomic policy

At the same time, COVID-19 looks to fundamentally break the standard monetary and fiscal policy levers that have been used to manage business cycles over the twentieth century.

From a public finance perspective, the magnitude of the committed policy actions is already unprecedented. The levels of public debt that are planned in order to deal with this crisis — the policies to subsidise wages, provide rent and income relief, bail out companies, etc in order to avoid market catastrophe — are the largest that has ever been experienced. Moreover, these actions are being taken during a massive collapse in tax receipts. The implications for public finance are catastrophic, with a huge increase in public debt, a vastly worse central bank balance sheet, and looming inflation.

The result is a policy challenge that far exceeds capabilities of traditional monetary and fiscal levers. We will require institutional policy reforms to deal with the crisis. But institutional policy designed to free-up the supply side of the economy, to lower the costs and constraints on businesses, is politically much harder to achieve.

Indeed, the limits of these policy levers reveals the extent to which government administration (e.g. of money, of asset and property registries, of identity, of regulation and governance) is still the foundation of a modern economy. The pandemic has brought into sharp relief the limits and constraints of this centralised public infrastructure and the technocratic foundations of the macroeconomic policy mechanisms built upon them.

The real alternative to conventional policy levers isn’t different policies (like quantitative easing, negative interest rates, or universal basic income) but better institutional technologies. We’ve been looking in the past few years at distributed digital technology (that is, blockchain) that offers a new administrative and governance base layer of the economy (see herehereherehere and here to start).

A digital infrastructure base layer of industry utilities and digital platforms would provide a far more agile foundation for targeted economic policy and entrepreneurial adaptation.

6 — A new global trading order

One of the most powerful institutional forces over the past several centuries, and which has underpinned global economic prosperity in the industrial era, was the development of global trading infrastructure for commodities and capital. It was built around the Westphalian system of nation-state record-keeping and intra-nation state treaty-based institutional governance (i.e. trade zones). But it has come to a virtual halt in the crisis.

In the short and medium term the global trading order will rebuild around a different order, namely provable health identity and data to facilitate the safe movement and interaction of people. Where that can safely happen, so can economic activity. Health zones can become the basis for trade zones. Australia and New Zealand are already talking about a “health bubble”. It would be easy to include other highly successful health economies — Taiwan, Japan, Germany, potentially Hong Kong and Singapore, some Pacific Island nations.

Green zones (or cordon sanitaire) have long been used in pandemics and have once again been proposed as a way to exit lockdown. As the health zone grows, so can the trade zone. Economic zones can then free ride on the decentralised identity and data infrastructure created to build a health zone. The result will be the redrawing of physical and network boundaries, even eliminating artificial economic borders, to create integrated trade zones.

7 — A new political order

The costs of COVID-19 do not fall evenly across the population. The health risks fall heavily on some groups (the elderly and those with co-morbidities), and the costs of economic lockdown fall on different groups and will be felt differently. The differential impact by sector, jobs, education, human capital investments or physical or financial capital write-downs shape how the costs are distributed across society.

The virus imposes huge private costs that will be in part socialised through political bargaining. The outcome of these politically mediated bargains and transfers that will shape politics for years to come.

But the pandemic also shifts some of the anchor points of political economy. The sudden growth of the welfare state, of unemployment insurance and wage-support, of healthcare provision and childcare, even of social housing are unlikely to be easily rolled back. So there will be a higher demand for social welfare safety nets.

But to pay for this, along with the urgent need to address the huge deterioration of public balance sheets, economic policy will need an aggressive pro-market agenda to unleash economic growth. Politically, this is a pivot to the centre with very ‘dry’ economic policy and ‘wet’ social policy — what was called ‘third way’ in the 1990s.

The counterpoint to that centre-pivot is that many of the high-cost political projects of both the right and the left will be abandoned. Reduced economic growth means we can afford fewer of the luxuries of advanced capitalism.

This is a vision of a new kind of social-digital capitalism to be built after the reset — from the government-led physical infrastructure of the industrial era, to a digital era built on private, open and communally developed technology platforms.

Finally

The economic consequences of the COVID-19 pandemic are mostly currently being discussed as a macro policy response to dealing with the economic destruction that the public health strategy necessitates. This is talk of the V-shaped, U-shaped, L-shaped or W-shaped recoveries. In Unfreeze we wrote of the need for a square root shaped recovery — after the reopening, we’ll need a long period of high economic growth to return to the prosperity of 2019.

But here we’ve gone further. COVID-19 is driving structural evolutionary change in the economy. The accelerated adoption of digital economic infrastructure during the crisis will leave a lasting mark on the political and economic system of the future.

Look at our history: protectionism doesn’t work

With Vijay Mohan

We rarely think about supply chains – those immensely complex networks of production and logistics that structure the economy. 

That has changed. Early in the COVID-19 crisis, we learned that Australia imports much of its basic medical equipment like facemasks and other protective gear. As borders were being closed importing this high-demand equipment got suddenly very hard.  

Now there is an unsurprising clamour for the government to take more of an interest in how our supply chains actually work, and to use the traditional tools of protectionism to encourage domestic production of medical equipment and pharmaceuticals.  

Prime Minister Scott Morrison said in April that “we need to look very carefully at our domestic economic sovereignty”. 

But neo-protectionism to secure Australia’s supply chains would be a grave mistake – and it fundamentally gets the supply chain challenge wrong. 

First, the obvious but necessary point. We actually had a protectionist economy for most of the twentieth century. And we didn’t build facemasks. We built cars. We built cars because cars had a certain romance in the twentieth century and Labor and the union movement wanted to lock in prestigious manufacturing jobs for their supporters. 

This has always been one of the central planks of the case against protectionism. The choice of what industries to protect is not made by all-knowing and benevolent leaders, but by self-interested politicians. They get to the top of their profession not because they are skilled production managers or supply chain coordinators, but because they’re great at navigating political factions and going on television. 

Of course, our national leaders will come out of this crisis more focused on the risk of future pandemics, and more motivated to prepare our economy for this now-known risk. But as they say in the military, generals too often prepare for the last war, not the next one. We don’t need an economic system that is prepared for a crisis that looks exactly like COVID-19. We need an economic system that is prepared for an unexpected crisis – which, definitionally, could be anything. 

Indeed, it is the fact that the pandemic was unexpected to most in government that makes the strongest case for free trade. The crisis has caused a lot of market disruption. But global supply chains have adjusted remarkably well to new demands and routed around new constraints. For example, airlines have been doing temporary conversions of passenger planes to cargo planes – particularly important because medical equipment, which in normal times would be leisurely transported by ship, needs to get to new COVID-19 hot spots urgently. 

Protectionism invariably makes the industries it protects brittle and highly politicised, not agile and adaptable to sudden economic shocks. And it is a fantasy to suggest that a small, wealthy, highly-educated nation like Australia could or should ever be self-reliant in the production of all low-value goods that might be needed in unexpected crises. 

There are things the government can do to be prepared for the next crisis. Rather than making essential products, we can buy them and store them. This requires no more foresight than full-blown protectionism and is a lot cheaper. The idea of keeping extensive national stockpiles of equipment for emergencies is uncontroversial. By all accounts, the National Medical Stockpile has been an immensely valuable asset during COVID-19. 

With our RMIT colleague Marta Poblet, we have been looking at the problems consumers had getting reliable information on supply chain security in the first weeks of the crisis.  

Before the pandemic, Australian industry was interested in using new technologies (such as blockchain, 5G communication, and smart devices) to better combat food fraud in export markets or to how to prove to their customers that their products were organic or fair trade certified.  

But the pandemic revealed a more basic problem with about supply chain information. Consumers were not worried about quality or fraud. They were worried there were not enough goods available to meet demand at all – hence the panic buying of toilet paper, hand sanitizer, and dried pasta.  

This panic buying looked a lot like the sort of panic withdrawals you see in a bank run. If depositors aren’t convinced their bank is solvent, they rush to be the first to get their money out. And as we saw, Scott Morrison was no better able to convince shoppers that there were adequate domestic supplies of toilet paper in March 2020 than South Australian premier Don Dunstan was able to convince the customers of the Hindmarsh Building Society that there were adequate funds to cover deposits October 1974 — despite standing in the street outside its headquarters with a megaphone.  

In moments of high-stress consumers just don’t trust the political assurances they are given. Do we really blame them? 

Ultimately within a few weeks supply chains adjusted. Coles and Woolworths lifted their toilet paper sale limits. 

But the toilet paper panic symbolises the choice we now face when it comes to supply chain resilience. To go protectionist would be to trust our supply chains to the same political class that we simultaneously accuse of being underprepared for COVID-19. Or we could lean into free trade and open markets. We should encourage entrepreneurs to adapt rapidly to new circumstances, to experiment with new technology, and let them figure out how to operate in a disrupted global economy. 

Australia has a long history of protectionism. Let’s try to remember what we learned. 

Unfreeze: How to create a high growth economy after the pandemic

With Darcy WE Allen, Sinclair Davidson, Aaron M Lane and Jason Potts. American Institute for Economic Research, 2020

During March and early April 2020, much of the world economy was deliberately shut-down and frozen to combat the COVID-19 pandemic. Modern economies are complex systems that are not easily frozen and unfrozen. Governments now face the challenge of unfreezing their economies. The social and economic cost of the pandemic will be enormous and long-lasting. This book develops an analytic and policy framework—cryoeconomics—for understanding what needs to happen next and how to restore our standard of living. We spell out the policy settings necessary for the rapid adaptation and market re-coordination that is required to resuscitate the economy. We explain why a return to business as usual is simply not enough to get everyone working again. A period of high growth prosperity will be imperative to deal with the costs of the freeze. This book tackles the tough questions and fills some of the current void of ideas and thinking about economic recovery. We develop a framework and principles for an institutional re-build, presenting a path to recovery based on the ideas of private governance, permissionless innovation, and entrepreneurial dynamism.

Available at Amazon in print and Kindle and Amazon Australia in Kindle edition.

The COVIDSafe app was just one contact tracing option. These alternatives guarantee more privacy

With Kelsie Nabben

Since its release on Sunday, experts and members of the public alike have raised privacy concerns with the federal government’s COVIDSafe mobile app.

The contact tracing app aims to stop COVID-19’s spread by “tracing” interactions between users via Bluetooth, and alerting those who may have been in proximity with a confirmed case.

According to a recent poll commissioned by The Guardian, 57% of respondents said they were “concerned about the security of personal information collected” through COVIDSafe.

In its coronavirus rewhy sponse, the government has a golden opportunity to build public trust. There are other ways to build a digital contact tracing system, some of which would arguably raise fewer doubts about data security than the app.

All eyes on encryption

Incorporating advanced cryptography into COVIDSafe could have given Australian citizens a mathematical guarantee of their privacy, rather than a legal one.

A team at Canada’s McGill University is working on a solution that uses “mix networks” to send cryptographically “hashed” contact tracing location data through multiple, decentralised servers. This process hides the location and time stamps of users, sharing only necessary data.

This would let the government alert those who have been near a diagnosed person, without revealing other identifiers that could be used to trace back to them.

It’s currently unclear what encryption standards COVIDSafe is using, as the app’s source code has not been publicly released, and the government has been widely criticised for this. Once the code is available, researchers will be able to review and assess how safe users’ data is.

COVIDSafe is based on Singapore’s TraceTogether mobile app. Cybersecurity experts Chris Culnane, Eleanor McMurtry, Robert Merkel and Vanessa Teague have raised concerns over the app’s encryption standards.

If COVIDSafe has similar encryption standards – which we can’t know without the source code – it would be wrong to say the app’s data are encrypted. According to the experts, COVIDSafe shares a phone’s exact model number in plaintext with other users, whose phones store this detail alongside the original user’s corresponding unique ID.

Tough tech techniques for privacy

US-based advocacy group The Open Technology Institute has argued in favour of a “differential privacy” method for encrypting contact tracing data. This involves injecting statistical “noise” into datasets, giving individuals plausible deniability if their data are leaked for purposes other than contact tracing.

Zero-knowledge proof is another option. In this computation technique, one party (the prover) proves to another party (the verifier) they know the value of a specific piece of information, without conveying any other information. Thus, it would “prove” necessary information such as who a user has been in proximity with, without revealing details such as their name, phone number, postcode, age, or other apps running on their phone.

Not on the cloud, but still an effective device

Some approaches to contact tracing involve specialised hardware. Simmel is a wearable pen-like contact tracing device. It’s being designed by a Singapore-based team, supported by the European Commission’s Next Generation Internet program. All data are stored in the device itself, so the user has full control of their trace history until they share it.

This provides citizens a tracing beacon they can give to health officials if diagnosed, but is otherwise not linked to them through phone data or personal identifiers.

Missed opportunity

The response to COVIDSafe has been varied. While the number of downloads has been promising since its release, iPhone users have faced a range of functionality issues. Federal police are also investigating a series of text message scams allegedly aiming to dupe users.

The federal government has not chosen a decentralised, open-source, privacy-first approach. A better response to contact tracing would have been to establish clearer user information requirements and interoperability specifications (standards allowing different technologies and data to interact).

Also, inviting the private sector to help develop solutions (backed by peer review) could have encouraged innovation and provided economic opportunities.

How do we define privacy?

Personal information collected via COVIDSafe is governed under the Privacy Act 1988 and the Biosecurity Determination 2020.

These legal regimes reveal a gap between the public’s and the government’s conceptions of “privacy”.

You may think privacy means the government won’t share your private information. But judging by its general approach, the government thinks privacy means it will only share your information if it has authorised itself to do so.

Fundamentally, once you’ve told the government something, it has broad latitude to share that information using legislative exemptions and permissions built up over decades. This is why, when it comes to data security, mathematical guarantees trump legal “guarantees”.

For example, data collected by COVIDSafe may be accessible to various government departments through the recent anti-encryption legislation, the Assistance and Access Act. And you could be prosecuted for not properly self-isolating, based on your COVIDSafe data.

A right to feel secure

Moving forward, we may see more iterations of contact tracing technology in Australia and around the world.

The World Health Organisation is advocating for interoperability between contact tracing apps as part of the global virus response. And reports from Apple and Google indicate contact tracing will soon be built into your phone’s operating system.

As our government considers what to do next, it must balance privacy considerations with public health. We shouldn’t be forced to choose one over another.

This silent deregulation must become a pillar of recovery

The COVID-19 pandemic has seen a massive expansion of the power of the state – heavy-handed police action and huge increases in government spending are just the most obvious.

But at the same time, the crisis has also seen a major retreat of state power in other areas – a wave of deregulation across the economy that has almost no historical parallel. And these regulatory reforms offer us a path back to prosperity.

The most obvious regulatory reductions have been on the medical frontline. Some controls over the production and use of medical face masks, ventilators, virus testing and pathology have been relaxed. Supervision requirements have been reduced for nurses re-entering the workforce. Regulations have been eased to allow distilleries to produce alcohol-based hand sanitiser.

But the most consequential deregulations have been intended to keep the economy afloat. Night-time curfews on delivery trucks have been lifted to ensure supermarkets can be more easily restocked, and trading and operating hours restrictions for essential retail have been eliminated. Liquor licensing has been relaxed to allow restaurants and bars to do home-delivered alcohol. Construction work can now be done on weekends and public holidays to make up for productivity losses that might come from trying to build while social distancing.

Other reforms have involved the government relaxing its most burdensome regulations. The Australian Prudential Regulatory Authority has eased capital requirements on banks. The Australian Competition and Consumer Commission is reducing its enforcement and surveillance program, announcing that it would now “carefully consider the impact on businesses already under pressure” (this is great, but at the same time reveals a lot about their attitude before the pandemic).

The Australian Securities and Investment Commission has even put a hold on the program that embeds bureaucrats in private companies. This is the program introduced after the financial services royal commission that has government-appointed psychologists observing the ethical standards of senior management. It was widely derided as “shrinks in the boardroom” – and it is no longer active because of COVID-19.

The rules we didn’t need

Even more astonishingly, the communications regulator has suspended Australian content requirements on commercial television and pay TV. It would be hard to nominate a more heavily defended and politically sensitive bunch of regulations. And they have now been shelved with almost no comment.

For the past two decades Australian governments have repeatedly announced red tape reduction programs. Regulatory reform has been a major plank of the Coalition government’s agenda. It was a major plank of the Labor government before it. But none of those heavily promoted programs have had as much scope and scale as the COVID-19 deregulations.

Those earlier red tape reduction programs focused on the sorts of regulations that nobody was interested in defending. They tended to eliminate lots of minor rules rather than significant ones. The guiding principle has been quantity not quality. Ultimately they were less major economic reform and more tidying up the statute books.

But this time is different. The regulations that have been suspended are precisely those that are most burdensome. They are the rules that are most costly to comply with but also least essential to support a functioning economy.

In other words, they are the rules that governments worried about the effect of over-regulation on productivity and economic growth should be very reluctant to reinstate.

This is the conversation to have now. The pandemic is moving from urgent crisis stage to risk-management stage. The Reserve Bank governor warns that we are looking at the greatest hit to the economy since the Great Depression. We need to start thinking about what policy settings will be able to revive the relative prosperity we enjoyed at the end of 2019 – and pay for all the spending that the government has committed to.

Deregulations must stay

Making these temporary deregulations permanent should be one of the pillars of recovery. We cannot assume that the economy will happily bounce back once social distancing controls are lifted. The damage inflicted by the shutdown on business models and supply chains has made this naïve hope impossible. The economy needs to adapt to the post-pandemic world – quickly. Regulations that prevent this rapid adaptation or prevent firms from establishing new sustainable business models need to be culled.

In a 2016 paper published in the European Journal of Political Economy, the economist Christian Bjørnskov looked at how economic freedom (that is, low taxes and minimal regulation) affected how different countries performed during an economic crisis. He found that how heavily a country was regulated predicted how quickly it recovered from crisis – the less regulation, the quicker the recovery.

A lot of the growth in government is likely to survive after the COVID-19 pandemic. It will be politically hard to abolish free childcare or to return Newstart payments to where they were. But we’re going to need a much more productive and prosperous economy to pay for it all. So the deregulations done during the crisis should be locked in too. And the principles that have been established during this crisis – that many politically popular regulations make it hard for businesses to adapt to unexpected circumstances and keep people employed – will be needed to guide our policymakers when they return.

As Scott Morrison has said, all workers are essential. But not all regulations are.

Panic, Information and Quantity Assurance in a Pandemic

With Vijay Mohan and Marta Poblet

Abstract: During a pandemic or other disaster, public visibility of the supply chain can be useful for controlling the symptoms of coordination failure, such as panic and hoarding, that arise from the desire for quantity assurance by various sectors of the economy. It is also important for efficient coordination of the logistics required to tackle the disaster itself, with vital information flows to centralized agencies leading the response as well as to decentralized agents upstream and downstream in a supply chain. Publicly visible information about the supply chain at the time of a crisis needs to be secure, timely, possibly selective in terms of access and the nature of information, and often anonymous. Recent advances in distributed ledger technology allow for these characteristics to be met. Building digital infrastructure that permits visibility of the supply chain when needed (even if dormant during normal times) is essential for economies to be more resilient to black swan events.

Available at SSRN or in PDF here

The problem of ‘freezing’ an economy in a pandemic

This is a draft extract from Unfreeze: How to create a high growth economy (originally titled Cryoeconomics: How to Unfreeze an Economy), with Darcy WE Allen, Sinclair Davidson, Aaron M Lane and Jason Potts

The 2020 global pandemic abruptly brought into question many of our social, economic and political institutions. COVID-19 is more than a public health crisis—as economies and states falter there are deep questions about the resilience and robustness of our political and economic systems. Are we too reliant on global supply chains? If regulations don’t make sense in a crisis, do they make sense afterwards? Today we are presented the opportunity to rebuild the institutions and organisations of our modern economy. If we do this right, through a process of entrepreneurial discovery and bottom-up solutions, then we will emerge with a political-economic system that acts as an engine for prosperity, and one that is more resilient and robust to future shocks. In this book we tackle those questions and fill some of the current void of ideas and thinking about economic and political recovery. We develop a framework and principles for an institutional re-build, presenting a path to recovery based on the ideas of private governance, permissionless innovation and entrepreneurial dynamism.

Available at SSRN or in PDF here.

Cryoeconomics: how to unfreeze the economy

With Darcy Allen, Sinclair Davidson, Aaron Lane and Jason Potts. Originally a Medium post.

The Australian government, like many governments around the world, wants to freeze the economy while it tackles the coronavirus pandemic. This is what the Commonwealth’s JobKeeper payments and bailout packages are supposed to do: hold workers in place and keep employment relationships together until mandatory social distancing ends.

Easier said than done. We are in completely uncharted territory. We’ve never tried to freeze an economy before, let alone tried to thaw it out a few weeks or months later. That’s why our new project, cryoeconomics, looks at the economics of unfreezing an economy.

To understand why this will be so hard, think of an economy as a remarkably complex pattern of relationships. Those relationships are not only between employees and employers, but also between borrowers and lenders, between shareholders and companies, between landlords and tenants, between producers tied together on supply chains, and between brands and tastemakers and their fans.

The patterns that make up our economy weren’t designed from above. They evolved from the distributed decisions of consumers and producers, and are shaped by the complex interaction between the supply of goods and services and their demand.

The problem is that the patterns the government plans to freeze are not the patterns we will need when they finally let us thaw.

When the government decides to pull the economy out of hibernation, the world will look very different. As a simple example, it’s quite possible that many Australians, forced to stay home rather than eat out, discover they love to cook. This will influence the demand for restaurants at the end of the crisis. On the other hand, our pent-up desire for active social lives might get us out into the hospitality sector with some enthusiasm. There will be drastic changes because of global supply chain disruptions and government policies. These changes will be exacerbated by the fact that not all countries will be unfrozen at the same time.

The upshot is that the economy which the government is trying to hibernate is an economy designed for the needs and preferences of a society that has not suffered through a destructive pandemic.

Unfreezing the economy is going to be extremely disruptive. New patterns will have to be discovered. As soon as the JobKeeper payments end, many of the jobs that they have frozen in place will disappear. And despite the government’s efforts, many economic relationships will have been destroyed.

Yet there will also be new economic opportunities — new demands from consumers, and new expectations. Digital services and home delivery will no doubt be more popular than they were before.

These disruptions will be unpredictable — particularly if, as we expect, the return to work is gradual and staggered (perhaps according to health and age considerations or access to testing).

As we unfreeze, the problem facing the economy won’t primarily be how to stimulate an amorphous ‘demand’ (as many economists argue government should respond to a normal economic recession) but how to rapidly discover new economic patterns.

It is here that over-regulation is a major problem. So much of the laws and regulations imposed by the government assume the existence of particular economic patterns — particular ways of doing things. Those regulations can inhibit our ability to adjust to new circumstances.

In the global response to the crisis there has already been a lot of covert deregulations. The most obvious are around medical devices and testing. A number of regulatory agencies have stood down some rules temporarily to allow companies to respond to the crisis more flexibly. The Australian Prudential Regulatory Authority is now willing to let banks hold less capital. The Australian Securities and Investment Commission has dropped some of its most intrusive corporate surveillance programs.

The deregulatory responses we’ve seen so far relate to how we can freeze the economy. A flexible regulatory environment is even more critical as we unfreeze. Anything that prevents businesses from adapting and rehiring staff according to the needs of the new economic pattern will keep us poorer, longer.

Today the government is focused on fighting the public health crisis. But having now turned a health crisis into an economic crisis, it must quickly put in place an adaptive regulatory environment to enable people and businesses to discover what a post-freeze economy looks like.