62 Finance & economics The EconomistAugust 29th 2020
F
or thepast 40 or so years, economists, central bankers and
other eminences have gathered against the imposing backdrop
of Wyoming’s Teton mountains every August, in order to chew
over the great monetary challenges of the day. Not this year. As The
Economistwent to press the proceedings of the Jackson Hole sym-
posium, organised by the Federal Reserve Bank of Kansas City,
were unfolding online, thanks to covid-19. Those tuning in are all
too aware of the economic damage wrought by the pandemic. But
the headaches are only beginning. As one of the papers due to be
presented at the conference explains, covid-19 is likely to reshape
people’s beliefs about the world in ways that will complicate the al-
ready daunting task of restoring beleaguered economies to health.
The notion that a severe economic shock might do long-run
damage is not new. Since the Depression macroeconomists have
understood that deep downturns might tip an economy into a “li-
quidity trap”, in which interest rates fall to zero and monetary poli-
cy cannot easily provide a stimulating kick. Without a powerful
dose of fiscal stimulus, the economy stays mired in a slump. Or a
brutal recession may lead to “hysteresis” in the labour market,
causing, say, a lasting increase in the unemployment rate. People
out of work for long spells may become so disconnected from the
labour market, as their skills and motivation erode, that even
when demand recovers they struggle to find jobs. (In the 1980s
Olivier Blanchard of the Massachusetts Institute of Technology
and Lawrence Summers of Harvard University argued that this ex-
plained why unemployment was much higher in Europe than in
America.) Both sorts of scarring could restrain economies as they
leave the shadow of the pandemic.
Yet research also suggests that traumatic economic episodes
can exert a drag on growth simply by altering people’s beliefs about
the future. For example, Ulrike Malmendier of the University of
California, Berkeley, and Leslie Sheng Shen of the Federal Reserve
studied consumption patterns in the aftermath of downturns and
find that periods of economic hardship and spells of unemploy-
ment tend to depress people’s consumption for some time, even
after controlling for income and other variables. Consumers not
only spend less but tend to opt for lower-quality or discounted
items. Young people are especially affected, potentially prolong-ingthedampeningeffect on the economy. Pandemics unquestion-
ably count as potentially scarring economic traumas. In one recent
study of 19 of them, going back to the 14th century, Òscar Jordà,
Sanjay Singh and Alan Taylor of the University of California, Davis,
conclude that such outbreaks depress real rates of return for de-
cades. They find that rates decline, on average, for about 20 years,
and do not return to their previous level for 40 years. This effect,
they speculate, could reflect the human toll exacted by past pan-
demics, which shrank the workforce and reduced the return on
new capital investment. But they also reckon that an increase in
saving by wary households could have a depressing effect.
New work by Julian Kozlowski of the Federal Reserve Bank of St
Louis, Laura Veldkamp of Columbia University and Venky Venka-
teswaran of New York University, due to be presented at the con-
ference, suggests that covid-19 could leave similar economic scars.
As the authors explain, people’s investment decisions are shaped
by their beliefs about the future. Their risk outlook is in turn influ-
enced by their experience, and the addition of an extreme negative
shock—like covid-19—to that stock of experience can lead to a
mass revision of beliefs that lasts throughout their lifetimes. No
doubt, even before the coronavirus spread this year, some people
might have thought that highly disruptive pandemics could occur,
based on experts’ warnings and an awareness of history. But the
tangible, persistent and severe harms associated with an actual
pandemic inform beliefs about the likelihood of another similar
shock in a way that abstract knowledge cannot.
The authors build a model in order to assess how this effect on
beliefs might influence the recovery from covid-19. After a very se-
vere initial economic shock from the pandemic, output recovers
but does not return to the previous growth trajectory. Part of that
long-run depressing effect can be accounted for by “capital obso-
lescence”: the fact that some of the existing capital stock can no
longer be used as efficiently as before, or at all. Office space, for in-
stance, may be used less intensively, as a precaution. But people
also revise down their expectations of the return on future invest-
ments because they expect pandemics to become more likely. This
leads to less investment, other things equal, and slower growth. In
the long term gdpis as much as 4% below its pre-crisis level. The
authors reckon that the present discounted value of losses associ-
ated with capital obsolescence and changing beliefs may be as
much as ten times larger than the cost of the initial shock. And
most of the long-term loss stems from revisions to beliefs.Give me a reason to believe
Psychological scarring could seriously complicate the policy re-
sponse to covid-19. A rise in precautionary saving and decline in
investment appetites will further depress interest rates, when
their extremely low level is already constraining the size of the
economic boost that monetary policy can provide. And pandemics
are not the only shocks that could affect beliefs about risk. Those
stemming from climate change also loom.
Governments do have tools to lessen the psychological damage
wrought by crises. Spending on public goods like infrastructure
could help, by raising the return to complementary private invest-
ments. So, too, might a more robust safety net, by limiting the cost
to individuals of economic bets gone bad. A full recovery, though,
might also require work to reduce the likelihood and potential
harm of future shocks in the first place, through better pandemic
preparedness, say, and efforts to slow climate change. Anything
less leaves the job of rehabilitating the economy unfinished. 7Free exchange Razing hopes
How the psychological scars left by economic hardship could depress growth for decades