Editor’s Note: The paper behind this column appears in the first issue of CEPR’s new initiative, Covid Economics: Vetted and Real-Time Papers.
Research on the economic fallout of the ongoing COVID-19 pandemic naturally focuses on the short-term impacts from mitigation and containment strategies (Correia et al. 2020). However, as governments engage in large-scale counter-pandemic fiscal programmes, it is important to understand what the economic landscape will look like in the years and decades to come. That landscape will shape monetary and fiscal policy in ways that are yet not fully understood. Our goal is to fill this gap by focusing on the medium- to long-term effects of pandemics.
Economists have used aggregated data to study the relationship between pandemic incidence and economic outcomes before (for example, studies of the 1918 flu such as Brainerd and Siegler 2003, and more recently Barro et al. 2020). However, most historical studies have typically focused on one event, in one country or region, and have traced local outcomes for up to a decade at most. But in large-scale pandemics, effects will be felt across whole economies, or across wider regions, for two reasons: either because the infection itself is widespread, or because trade and market integration – in capital and/or labour markets – eventually propagates the economic shock across the map.
In a new paper (Jordà et al. 2020) we take a global view of the macroeconomic consequences of pandemics by using data reaching back to the 14th century (Schmelzing 2020) across a number of European economies. Pandemics, like many other natural disasters, offer a unique opportunity to study how economies work. Their random occurrence can be largely regarded as completely delinked from economic conditions on the ground. It could be said that they are like large-scale randomised controlled trials. Lessons from such historical events can be a useful guide of how the future usually unfolds.
Using newly available data on yields of long-term sovereign debt stretching back to the 14th century (Schmelzing 2020), we estimate the response of a European natural rate of interest following fifteen major pandemics since the Black Death. Each of these fifteen episodes accounted for at least 100,000 casualties. The possibility that global real rates can be pulled down by adverse local shocks is well known (Eggertsson et al. 2016), and ours is a historical exploration of this theme.
The real natural rate of interest is an important policy variable. Central banks adjust monetary policy around this rate in response to conditions that may cause the economy to deviate from its potential in ways that distort prices, labour markets, and growth. In the long run, as the role of these momentary distortions wanes, the relative demand and supply of loanable funds by savers and borrowers determines the natural rate.
In addition to constituting a policy guide, the natural rate is an important economic barometer. For example, as populations become more frugal, the relative supply of savings increases; or, when the underlying pace of growth wanes, investment becomes less attractive; in both cases, the natural rate declines to restore equilibrium. This are just two examples of the many secular forces impinging on the natural rate.
In particular, we infer the natural rate of interest as a latent state variable using raw data on yields. The raw data and our estimate of the natural rate are displayed in Figure 1. As is well known, the natural rate has been declining for centuries. Importantly for our analysis, it is useful to keep in mind the recent decline in the real rate over the last 30–40 years as a point of reference for the results that we will report below.
Figure 1 The European real natural rate of interest, 1315–2018
Based on our estimate of the real natural rate of interest, Figure 2 displays the response of the natural rate to a pandemic, 1 to 40 years from the end of the pandemic (the shaded regions provide a 1 and 2 standard error confidence band). As the figure shows, pandemics have effects that last for decades. Following a pandemic, the natural rate of interest is tilted down by nearly 1.5 percentage points about 20 years later – that is, comparable with the decline in the natural rate experienced from the mid-1980s to today. The decline in the natural rate induced by the pandemic slowly unwinds so that about four decades later, the natural rate returns to the level it would be expected to have had the pandemic not taken place.
These results are staggering and speak of the large economic effects that pandemics have had throughout centuries. It is well known that after major recessions caused by financial crises, history shows that real safe rates can be depressed for 5 to 10 years (Jordà et al. 2013), but the responses here display even more pronounced persistence.
Inspecting the mechanism
The evidence presented in Figure 2 is consistent with the well-known neoclassical growth model. Loss of labour without a concomitant destruction of capital leads to a rebalancing of the relative returns to labour and capital. The results may also be amplified by increased saving by pandemic survivors – they may wish to simply rebuild their wealth or may just act more frugally than before, perhaps for precautionary reasons.
If this disarmingly simple mechanism explains what is happening in Figure 2, we should see a very different pattern following a very different type of historical event that also leads to massive loss of life: wars. Unlike pandemics, major armed conflicts also result in destruction of crops, land, structures, and machinery. Or in other words, capital.
Figure 2 Response of European real natural rate of interest following a pandemic
To explore further, we extended our initial estimates to included major wars that resulted in large loss of life (and large loss of land, structures, and other traditional forms of capital). Thus Figure 3 compares the response of the natural rate of interest from pandemics and wars. The results could not be clearer. In wars, the relative loss of capital to labour tilts the response upwards, not down.
Figure 3 The response of the real natural rate to pandemics and to wars
Wars tend to leave real interest rates elevated for 30–40 years and in an economically (and statistically) significantly way. Moreover, there is extant research documenting the positive effects of Black death on real wages (Clark 2010), which we can draw on to examine whether the response of wages to a pandemic is indeed in the opposite direction as that of the real natural rate we saw in Figure 2. This is reported in Figure 4, which corroborates, once more, the logic of the neoclassical growth model.
Figure 4 The response of real wages to pandemics
The great historical pandemics of the last millennium have typically been associated with subsequent low returns to assets. Measured by deviations in a benchmark economic statistic, the real natural rate of interest, these responses indicate that pandemics are followed by sustained periods – over multiple decades – with depressed investment opportunities, possibly due to excess capital per unit of surviving labour, and/or heightened desires to save, possibly due to an increase in precautionary saving or a rebuilding of depleted wealth.
A further implication of our analysis in the current low interest rate environment pertains to the secular stagnation hypothesis (Hansen 1939, Summers 2014). If the historical trends we have highlighted play out similarly in the wake of COVID-19 – adjusted to the scale of this pandemic – then secular stagnation would remain a concern for monetary and fiscal stabilisation policy for the next two decades or more.
Central banks in the advanced economies have lowered interest rates down to, or below, zero and conducted large scale asset purchases in anticipation of the financial fallout from economy-wide lockdowns. A sustained period of low real interest rates likely will provide welcome fiscal space for governments to mitigate the consequences of counter-pandemic stimulus interventions. In fact, issuances of safe government debt may help avert the further downward trend in real interest rates.
Even so, a major caveat of extrapolating from historical trends is that past pandemics occurred at time when virtually no members of society survived to old age. The Black Death and other plagues hit populations with the great mass of the age pyramid below 60, so this time may be different.
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