Why recession insurance will work

The chief economist of the International Monetary Fund, Olivier Blanchard, and several IMF economists have proposed in a recent paper that governments should offer what they call 'recession insurance.' Companies and/ or individuals would buy insurance policies, pay a regular premium for them, and receive a benefit if some measure of the economy, such as GDP growth, dropped below a specified level. Such insurance, they argue, would help firms and people deal with the 'extreme uncertainty' of the current economic environment.

Recession insurance might, indeed, help alleviate the economic crisis by reducing uncertainty. After all, the real problem that we are currently facing is one of paralysis: uncertainty has placed many spending decisions -- by businesses (on higher output) and by consumers (on the items that businesses produce) -- on hold. Reducing uncertainty might augment, or even be superior to, fiscal stimulus programmes, for it would address the root cause of the unwillingness to spend.

Moreover, recession insurance might, in contrast to fiscal policy, impose no costs on the government, for if it stimulates confidence, then the risk being insured against is prevented. The government's ability to offer such insurance on a scale sufficient to make it costless is one reason to favour a public scheme over private insurers.

Blanchard and his colleagues point out that banks might condition loans to firms on their purchase of recession insurance, which might help credit markets function better, addressing a serious problem underlying the current crisis. Tantalisingly, they say that doing this would create 'a market-based view of future output and the likelihood of severe shocks,' although they do not explain how this market would be structured.

Indeed, there is no market for other kinds of recession-related insurance provided by the government, such as unemployment insurance, old age insurance or disability insurance. Instead, the government merely sets an insurance premium and forces everyone to pay it.

The IMF authors are not saying that governments should do this with recession insurance, so perhaps they mean that governments would auction off the policies, which would create a market price. But the market price would depend especially on how much insurance a government decided to auction off, because the supply would influence the price both directly and through the insurance's effect on the underlying recession risks.

Governments are in a good position to create new risk-management policies, and they can then set an example for private insurers to follow. But, as an alternative to the IMF proposal, there could be purely private recession insurance.

Such insurance already exists on a small scale in the form of credit insurance against unemployment. A New York-based firm, the Assura Group, has been working for four years on a plan to launch privately issued supplemental unemployment insurance to anyone. Their policies would piggyback on US state unemployment insurance programmes, allowing Assura to avoid getting into the monitoring business.

One problem with market-based policies is strategic adoption and cancellation. GDP risk is a long-term risk. The price of the insurance would have to be adjusted regularly to adjust for varying public knowledge of the likelihood of a recession, and people could not be allowed to cancel their policies, and stop making payments, whenever the economic outlook became rosier.

The Assura Group had to get permission from the New York State Department of Insurance to have a dynamic rate filing, meaning that they will set prices by a formula, rather than using a fixed rate, so that their prices vary in rapid response to changing economic conditions.

In a recent paper, Mark Kamstra and I proposed that governments issue shares in their GDP, with each share amounting to a trillionth of GDP. These 'trills' would help individual countries manage their GDP risks. We thought that the issuers of such securities would have, in effect, a form of recession insurance.

Another way to create a market price for recession risk is to offer the MacroShares that my firm MacroMarkets pioneered. Our first MacroShares have been for oil price risk, but plans for GDP risk are on the drawing board. These securities are offered in pairs – one long and one short -- and, unlike in a government-run scheme, in whatever quantity the market demands.

Once we have a market price for recession insurance or similar products, the question then arises: Will it be so high that few people want to buy? We know that we are probably in a recession right now, and may be for some time, so the expected losses currently are enormous. As a result, people may balk at the price and not want to buy the insurance. The only insurance that people might think they can afford could carry a large deductible, and if the deductible is very large, people might not feel so reassured by this insurance. 

There are uncertainties with any really new proposal. But the proposal from the IMF is an important step, because it deals with the essential problem that we are confronting right now: fears about the future of the economy become a self-fulfilling prophesy. We should not look askance at such a policy because of its potential shortfalls.

The current global economic crisis is an opportunity for some new experimentation that might not only lead to its resolution, but might also set in place institutions that help to prevent future crises. Recession insurance is one such idea.

The author is professor of economics at Yale University and chief economist at MacroMarkets LLC. His latest book is The Subprime Solution: How Today's Global Financial Crisis Happened, and What to Do about It.