The negative economic effects of the pandemic come from two sources: capital obsolescence and belief scarring. The pandemic and lockdowns forced consumers to work and consume differently, which can generate persistent changes in tastes and habits for years to come. Capital obsolescence reflects this long-lasting change in the economic value of installed capital. For example, in the post-pandemic world there might be more online shopping instead of in-store purchases. Hence, some installed capital, for example, commercial real estate such as shopping malls, could become obsolete.2 The blue area in the figure shows that capital obsolescence accounts for most of the initial economic impact of the pandemic, and its net present value is equivalent to about 38 percent of 2019 GDP. 

Beliefs scarring explains most of the long-term costs. For example, in the post-pandemic world, investors in leisure and hospitality, such as restaurant owners, will take into account the risk of future pandemics and lockdowns and the associated economic costs. The orange area in the figure shows that the net present value of belief scarring is about 52 percent of 2019 GDP. Hence, both capital obsolescence and belief scarring generate prolonged effects on the economy — a much larger value than the initial 9 percent drop of GDP in 2020.

Notes

1 We have seen the scarring effect in action before. Previous Economic Synopses (Kozlowski, 2019a-c) have shown the Great Recession of 2008 generated a persistent increase in "tail risk" that had large economic costs and affected the return on safe and liquid assets. See also Kozlowski, Veldkamp, Venkateswaran (2020b).

2 Think about the loss of specific investments or other forms of lasting damage from a prolonged shutdown. Such loss could come from the lost value of cruise ships that never sail again or businesses that never reopen, loss of customer capital, or just less-intensive use of commercial space due to a persistent preference for more distance between other diners, travelers, spectators, or shoppers. It could also represent permanent changes in health and safety regulations that make transactions safer but costlier.

References

Kozlowski, Julian. "Tail Risk: Part 1, The Persistent Effects of the Great Recession." Federal Reserve Bank of St. Louis Economic Synopses, No. 18, 2019a; https://research.stlouisfed.org/publications/economic-synopses/2019/08/05/tail-risk-part-1-the-persistent-effects-of-the-great-recession. 

Kozlowski, Julian. "Tail Risk: Part 2, The Missing Recovery After the Great Recession." Federal Reserve Bank of St. Louis Economic Synopses, No. 19, 2019b; https://research.stlouisfed.org/publications/economic-synopses/2019/08/06/tail-risk-part-2-the-missing-recovery-after-the-great-recession.

Kozlowski, Julian. "Tail Risk: Part 3, The Return on Safe and Liquid Assets." Federal Reserve Bank of St. Louis Economic Synopses, No. 20, 2019c; https://research.stlouisfed.org/publications/economic-synopses/2019/08/07/tail-risk-part-3-the-return-on-safe-and-liquid-assets. 

Kozlowski, Julian; Veldkamp, Laura and Venkateswaran, Venky. "Scarring Body and Mind: The Long-Term Belief-Scarring Effects of COVID-19." Jackson Hole Economic Policy Symposium Proceedings, 2020a; https://www.kansascityfed.org/~/media/files/publicat/sympos/2020/20200806veldkamp.pdf?la=en.

Kozlowski, Julian; Veldkamp, Laura and Venkateswaran, Venky. "The Tail that Wags the Economy: Belief-Driven Business Cycles and Persistent Stagnation." Journal of Political Economy, 2020b, 128(8).

© 2020, Federal Reserve Bank of St. Louis. The views expressed are those of the author(s) and do not necessarily reflect official positions of the Federal Reserve Bank of St. Louis or the Federal Reserve System.

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