From phase transitions to Modern Monetary Theory: A framework for analyzing the pandemic of 2020

• Date: 01 January 2021
• DOI: http://doi.org/10.1002/rfe.1122
• Published date: 01 January 2021
• Author: Bluford H. Putnam

Rev Financ Econ. 2021;39:3–19. wileyonlinelibrary.com/journal/rfe

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© 2020 University of New Orleans

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INTRODUCTION

The COVID-19 virus swept across the globe in 2020 stressing healthcare systems to the limits and causing economies to par-

tially shutdown, closing bars, restaurants, hotels, and restricting air travel to a fraction of previous levels, resulting in a sharp

and abrupt economic contraction. Millions of workers were either temporarily or permanently laid off. Economists from aca-

demia, business, and government were faced with analyzing an economic collapse with little to no useful parallels in modern

times. This research attempts to build a framework for analyzing an economy in a “far from equilibrium” state, such as the

pandemic created. Our focus is on the US economy; however, the framework provided has broader application for many coun-

tries around the world.

Our discussion of the applicable economic literature focuses on a few seminal works that aid our “far from equilibrium”

analysis as well as a some selected footnotes and references to provide context to key challenges that emerged during the pan-

demic. The economic literature references will be integrated into the different sections of this research as appropriate rather

than as a background section of its own. The research is presented in the order that seems to create a seamless narrative for each

of the key questions being examined.

Received: 8 September 2020

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Revised: 13 September 2020

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Accepted: 14 September 2020

DOI: 10.1002/rfe.1122

ORIGINAL ARTICLE

From phase transitions to Modern Monetary Theory: A

framework for analyzing the pandemic of 2020

Bluford H.Putnam

Department of Economics, CME Group,

Chicago, IL, USA

Correspondence

Bluford H. Putnam, Department of

Economics, CME Group, Chicago, IL,

USA.

Email: bluford.putnam@cmegroup.com

Abstract

Analyzing the economic impact of the COVID-19 pandemic of 2020 requires an

appreciation that price signals were no longer primary determinants of supply and

demand. Economic agents were acting out of health fears, government-mandated

shutdown rules, and dealing with financial distress. The economy had entered a state

that was far from equilibrium. Orthodox tools, such as comparative equilibrium anal-

ysis, can tell one about state “A” and state “B,” but provide no guidance as to how

to analyze the phase transition. We turn to the physics of phase transitions to help

us understand what essentially was a network collapse. The analysis is extended to

examine whether the initial policy responses were more likely to cushion the blow or

to accelerate the eventual economic recovery, which is extended into an examination

of Modern Monetary Theory. Finally, we study the behavioral changes induced by

the pandemic that are likely to be long-lasting and impact the pace of the recovery.

And we note a variety of data anomalies that are sure to vex empirical researchers as

they study the pandemic of 2020.

KEYWORDS

behavioral finance, Modern Monetary Theory, monetary policy, pandemic, phase transitions

JEL CLASSIFICATION

G01; D50; D85; E40; E52

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PUTNAM

The first section discusses the analytical tools for analyzing the pandemic's economic impact from the perspective of “far

from equilibrium” economics. Specifically, the analysis turns first to the physics of state changes and phase transitions to help

build a framework for answering many key questions about the economic impact of the pandemic. What is important to note

is that during the critical phase transitions brought about by the pandemic, economic agents were responding to health fears,

government orders for partial shutdowns, and the abrupt onset of financial distress suffered by many consumers and businesses.

Price signals were not the primary input into decision making by economic agents, rendering most traditional economic models

useless. In the second part of this section, we explore one of the implications of using the phase transition analysis, which is

that traditional economic statistics may well be seriously flawed and that by using alternative data one can get a much broader,

clearer, and more up to date picture of how the pandemic influenced economic activity.

The second section builds on the phase transition analysis to provide insights into how to interpret fiscal and monetary

policy responses. First, we compare policy responses in 2020 to those in 2008–2009 and the 1930s. Next, we assess policies

in terms of whether their likely impact is on (a) cushioning the economic contraction or (b) accelerating the rebuilding of the

economy after the shutdown shocks. Third, there is an examination of potential data distortions related to the severity of the

financial distress that was experienced. We close this section with an analysis of the issues raised by the fusion of fiscal and

monetary policy—aka Modern Monetary Theory or MMT.

In the third section, we look at what types of behavioral changes may be long-lasting. Stressful periods require creativity

and adaptability. Unexpected lessons may be learned and behaviors of both consumers and business may be impacted for

long after the crisis has been contained. For example, lessons from white-collar businesses being forced into a “work from

home” situation are likely to lead to permanent changes in the flexibility companies allow workers and to reduce the need

for business travel. Both of these changes will mean that white-collar businesses will reduce their real estate footprint and

tightly constrain travel budgets, which difficult implications for the economic recovery of downtown business districts and

the travel industry.

The final section brings together a discussion of the implications of some of the key insights from our phase transition,

policy, and behavioral change analysis. First, we want to reflect on the debate on the shape of the economic recovery—V, U,

W—as compared to the V-shaped rebound in equity indexes. Then, we summarize a few warnings for future research due to the

economic assumptions to be avoided and the data anomalies of which empirical researchers needs to be aware.

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FAR FROM EQUILIBRIUM ECONOMICS

Due to the pandemic-induced shutdown of 2020, the US and other economies around the globe abruptly shifted from a steady-

state growth equilibrium to a state that might be best characterized as “far from equilibrium.” Getting back to a steady-state

growth equilibrium appeared to involve three distinct phase transitions, with each phase having strikingly different character-

istics that would need to be considered in the analysis.

The term “far from equilibrium” was made popular by Dr. John Rutledge's web blog (drjohnrutledge.com). Rutledge (2015)

argues that economies can be seen as energy systems. When economies are far from a typical equilibrium state, they are likely

to be involved in a major phase transition and that the analysis should follow the concepts proposed by physicists as they analyze

state changes. Take for example, going from a liquid to a gas. In phase transitions, all the turbulence is at the boundary line.

Think of a pot of water boiling and the bubbles forming in a chaotic manner on the surface of the liquid as they move into their

new gaseous state. One may understand very well the characteristics of a liquid or a gaseous state, yet know little to nothing

about the chaotic transition from one state to the next.

Bak (1996), in his classic book on How Nature Works, argues “that complex behavior in nature reflects the tendency of

large systems with many components to evolve into a poised, ‘critical’ state, way out of balance, where minor disturbances may

lead to many events, called avalanches, of all sizes. Most of the change takes place through catastrophic events rather than by

following a smooth gradual path. The evolution to this very delicate state occurs without design from any outside agent. The

state is established solely because of the dynamical interactions among individual elements of the system.” [p.1].

One of our key takeaways from Rutledge and Bak is that analyzing phase transitions relies on complexity theory and dynamic

systems, which has little or nothing to do with the comparative equilibrium economics taught in universities. Understanding the

equilibrium conditions in state “A” and in state “B” does not tell us anything about how an economy gets from state “A” to “B.”

We need to think in terms of phase transitions to analyze the pandemic episode of 2020.

To challenge our thinking about “far from equilibrium” economic states, we also went back to great academics of the 1930s

who were writing about The Great Depression as they experienced and observed it. Keynes (1936), in his classic General

Theory, rejected classical equilibrium economic ideas to examine the likely efficacy of monetary and fiscal policy in handling