F.OR THE Over the past 40 years or so, economists, central bankers and other personalities have gathered in front of the imposing backdrop of the Teton Mountains in Wyoming to overcome the day’s great monetary challenges. Not this year. How The economist Organized by the Federal Reserve Bank of Kansas City, the Jackson Hole Symposium work has been published online thanks to covid-19. Those who tune in are all too aware of the economic damage caused by the pandemic. But the headache is only just beginning. As explained in one of the papers presented at the conference, covid-19 is likely to transform people’s beliefs about the world in ways that complicate the already daunting task of restoring the health of distressed economies.
The idea that a major economic shock could cause long-term damage is not new. Since the Depression, macroeconomists have understood that deep downturns could drive an economy into a “liquidity trap,” where interest rates fall to zero and monetary policy cannot readily deliver a stimulating kick. Without a heavy dose of fiscal stimulus, the economy will be stuck in a slump. Or a brutal recession can lead to “hysteresis” in the labor market, which for example leads to a permanent rise in the unemployment rate. People who have been unemployed for long periods of time may become so disconnected from the labor market that their skills and motivation deteriorate that, even when demand recovers, they will struggle to find work. (In the 1980s, Olivier Blanchard of the Massachusetts Institute of Technology and Lawrence Summers of Harvard University argued that this explained why unemployment was much higher in Europe than in America.) Both types of scars could constrain the economy if they did Leaving the shadow of the pandemic.
However, research also suggests that traumatic economic episodes can affect growth by simply changing people’s beliefs about the future. For example, Ulrike Malmendier of the University of California at Berkeley and Leslie Sheng Shen of the Federal Reserve examined post-downturn consumption patterns and found that periods of economic hardship and unemployment depressed people’s consumption for some time even after controlling income and other variables . Not only do consumers spend less, they also opt for inferior or discounted items. Young people are particularly affected, who may prolong the dampening effect on the economy. Pandemics are undoubtedly seen as potentially scarring economic trauma. In a recent study of 19 of them from the 14th century, Jscar Jordà, Sanjay Singh, and Alan Taylor of the University of California at Davis conclude that such outbursts depress real returns for decades. They find that rates drop on average for about 20 years and don’t return to their previous levels for 40 years. They speculate that this effect may reflect the toll on people caused by past pandemics, which has shrunk the workforce and reduced the return on new capital investments. But they also believe that increasing savings through cautious households could be depressing.
New work by Julian Kozlowski of the Federal Reserve Bank in St. Louis, Laura Veldkamp of Columbia University, and Venky Venkateswaran of New York University to be featured at the conference suggests that covid-19 could leave similar economic scars . As the authors explain, people’s investment decisions are shaped by their belief in the future. Their risk outlook, in turn, is influenced by their experience, and adding an extremely negative shock – like Covid-19 – to that pool of experience can result in a mass revision of beliefs that will last throughout their lives. No doubt, even before the coronavirus spread this year, based on expert warnings and awareness of history, some people would have thought that extremely disruptive pandemics could occur. But the tangible, persistent, and grave harm associated with an actual pandemic informs beliefs about the likelihood of another similar shock in ways that abstract knowledge cannot.
The authors are building a model to assess how this effect on beliefs might affect recovery from Covid-19. After a very severe initial economic shock from the pandemic, production is recovering but is not returning to the previous growth path. Part of this long-term depressing effect can be explained by “capital obsolescence”: the fact that part of the existing capital stock can no longer be used as efficiently as before or no longer at all. For example, office space can be used less intensively as a precaution. But people are also revising their expectations of the return on future investments because they expect pandemics to become more likely. This translates into less investment, different things, and slower growth. Long-term GDP is even 4% below the pre-crisis level. The authors estimate that the current discounted value of losses related to obsolescence and changing beliefs can be up to ten times the cost of the initial shock. And most of the long-term loss comes from overhauling beliefs.
Give me a reason to believe
Psychological scars could make policy responses to covid-19 seriously difficult. An increase in retirement savings and a decrease in investment appetite will continue to depress interest rates when their extremely low levels already limit the size of the economic boom that monetary policy can provide. And pandemics aren’t the only shocks that could affect belief in risk. Those caused by climate change are also emerging.
Governments have tools in place to reduce the psychological harm caused by crises. Spending on public goods like infrastructure could help by increasing the return on complementary private investments. This could also result in a more robust safety net by limiting the cost to individuals of bad economic bets. However, a full recovery could also require work to reduce the likelihood and potential harm of future shocks, for example through better preparedness for pandemics and efforts to slow climate change. Anything else leaves the task of restoring the economy unfinished. ■
This article appeared in the Finance & Economics section of the print edition under the heading “Razing Hope”.