We are in the midst of a crisis that no one knows how it will turn out. Or do we? As in any other crisis, widespread bankruptcies, liquidity shortages, large losses, increasing unemployment rates, and failing financial institutions will be happening rather sooner than later. But is it really the same type of crisis that we saw in 2008 with the housing bubble and the Lehman bankruptcy or in 2000 with the dot-com bubble?
Endogenous vs. Exogenous Crisis – What’s The Difference?
The crucial aspect is to look at the underlying reasons for a crash. By differentiating between endogenous and exogenous crises, we can look at the crisis from a different angle and compare the corona crisis to previous crises.
Endogenous crisis - triggered by the system
An endogenous crisis comes from within the system. For example:
- Black Monday 1987: program trading and illiquidity
- Dot-com bubble 2000: overvalued technology companies
- Financial crisis 2008: subprime loans and credit default swaps
In the end, we can say that each of these crises was a fault of the system. A faulty system led to a breakdown that was more or less foreseeable (if you had all the data). Just as the Ford Pinto was a horribly constructed car that just caught fire because of design flaws.
Effects of an endogenous crisis
It takes a lot of effort and time to repair the entire system. Fortunately enough, systemic crises are not too frequent. A typical OECD country is expected to experience a systemic crisis about one year out of 43. However, the damage is enormous and a systemic crisis will cost more than a tenth of GDP.
The 2008 crisis is a prime example of an endogenous crisis, just as 1914, 1866 and even 1766. Before the crisis, the market participants had infinite liquidity as an unrealistic central assumption. When the market questioned that assumption, liquidity evaporated and a crisis ensued. It gets worse when an endogenous gets hit by an exogenous crisis as it was the case in the early 2000s with the dot-com bubble bursting and 9/11 striking next.
Exogenous crisis - unpredictable crises
On the other hand, an exogenous crisis hits the economy from nowhere like an asteroid might hit planet earth. This might be a war (Early 1990s recession because Iraq invaded Kuwait in July 1990, causing oil prices to increase), a volcano eruption (e.g. 2010 eruptions of Eyjafjallajökull which caused enormous disruption to air travel across western and northern Europe), a terror attack (stock markets crashing after 9/11) or a virus. There is no formula in the world that could predict this scenario.
How can you save people and an economy in a pandemic crisis? So let’s look ahead. What is to come? Do non-pharmaceutical interventions (NPI) such as lockdowns work and what are the economic costs?
A very recent paper from MIT investigates the effects of measures based on the 1918 Spanish Flu pandemic in the U.S. Exposed areas had a sharp and persistent economic decline that reduced the manufacturing output by 18%. Cities that intervened earlier and more aggressively with NPIs grew faster after the pandemic was over and they led to lower mortality. This is shown in the following graph. It shows the correlation between the 1918 flu mortality rate and the growth in manufacturing employment from 1914 to 1919. Higher mortality is associated with lower economic growth. Looking at the two groups of cities that put NPIs in place for longer (blue dots) and shorter periods of time (red dots) it becomes obvious that NPIs play a crucial role in reducing mortality without reducing economic activity.
The results of the study may relate to the current COVID-19 scenario. It seems that countries that implemented NPIs more consequently, such as Taiwan or Singapore, have fewer infections and consequently fewer deaths along with less economic impact. Therefore, NPIs are not to be seen as causing major economic costs rather than avoiding it.
Lessons learned: What are the scenarios for 2020?
The coronavirus has hit the world and the economic costs are there. Therefore, falling stock markets are reflecting the impact of the virus on the economy. The crisis is exogenous. As long as it remains exogenous, there will be a quick recovery when the pandemic is over. However, there is a risk of endogenous risk amplification, even if the trigger is exogenous. The most recent endogenous crisis is only a bit more than a decade ago. Banks are in better shape than they were in 2008, people are still aware of the risks and regulation is strong. Nowadays, highest-risk lending is more and more done by non-bank institutions, sovereign wealth funds, hedge funds and bond markets so that private investors are less prone to risk. After all, there is still a lot of cash and, in consequence, liquidity in the market, so that bankruptcies can be handled by the system.
Therefore, there are some conclusions we can draw:
- A great depression scenario is the worst case and would mean several years of recession. The crisis is still only exogenous and we currently do not see strong endogenous factors that can amplify the crisis. Also, the last endogenous crisis is only a bit more than a decade ago.
- Recoveries from exogenous crises are usually faster than from endogenous crises. Therefore, the focus must be to end the spread of the virus and find a treatment. Economic recovery will follow.
- The COVID-19 virus will lead to a strong development of digital and biotech capabilities. Therefore, new markets and investment possibilities will evolve strongly.