10 Sep 2020 3 min read

Pandemics, belief scarring and the Fed

By Tim Drayson

The annual Jackson Hole economic symposium can lay the intellectual foundations for thinking at the US central bank. From the event, I review a potentially influential paper on economic scarring.


Some 15 years ago I told my wife I was going to Jackson Hole. As an economics graduate she was initially impressed. This soon turned to anger after I added I was ‘researching’ Corbet’s Couloir and leaving her at home with our newborn, rather than attending the symposium where central bankers, finance ministers and other luminaries debate the economic issues of the day.

This year I finally got to participate as the event moved online. There was one particularly impressive paper co-written and presented by Laura Veldkamp of Columbia Business School. The key insight is that even after a successful vaccine and virus elimination, there will be large output losses in the long-run. People raise their probabilities of extreme negative shocks in the future after experiencing the pandemic (belief scarring). So greater than previously perceived tail risk makes investing less attractive.

Critically, these long-run costs are not caused directly by bankruptcy or shifting tastes from the pandemic, which could render some capital obsolete. Absent of ‘belief scarring’, the shock would not change the long-run trajectory of the economy as capital would be rebuilt.

Policy implications

Interestingly the model suggests credit spreads and equity valuations change little in response to the increase in tail risks because firms respond to the increase in risk by cutting back on debt. The policy implications are clear. The long-run neutral interest rate is lower due to the increase in risk and reduction in investment. Policies should work hard to prevent capital depreciation and especially to limit bankruptcies. Finally, combined with the move to average inflation targeting, this suggests the US Federal Reserve (Fed) should be even more accommodative over the next cycle than previously.

Alan Blinder, the former Fed vice chair, said in the discussion that this was definitely something central bankers need to think about. In a world where there is uncertainty about whether this is the correct model, the costs of being too accommodative are probably seen as asymmetric. There might be time to change course if the economy fully recovers, but pre-emptive monetary tightening could exacerbate long-term scarring.

Risk perception

Still, as the authors concede this is only one small contribution as to how the future might evolve. It is not proof of economic scarring. Everything hinges on the increase in risk parameters, which occurs due to learning about the pandemic. But what about other risks? The resilience of the banks in this crisis might have reduced the probability of a banking crisis (which arguably has been too high in economic agents’ minds since the financial crisis).

Similarly, a successful vaccine could change beliefs once again. Not all tail events have to be negative. These and other factors could offset the perceived increase in pandemic risk.

The paper assumes the world was in a steady state pre-virus, but it is not clear investment was optimal. There appeared to still be plenty of caution, which means investment might not be held back any further in future. Lower investment in the model reduces the capital stock and productivity. But what if the pandemic has accelerated ‘creative destruction’? It is possible that total factor productivity (i.e. the part not due to increased human and physical capital) rises as a result. The crisis has forced firms to discover better ways of working. So even with belief scarring, productivity could be unaffected with a lower capital stock.

The behavioural aspect is also in question. After the shock of 9/11, there were widespread predictions that demand for air travel and high rise buildings would suffer, but both bounced back rapidly. An increased threat of job loss could raise precautionary saving, yet worries around future illness or restrictions on consumption could bring forward consumption in the good times. This would have an accelerator effect on investment.

But overall, we believe the message from this paper works in the same direction as the move to average inflation targeting. The Fed will be in no hurry to unwind its stimulus and is prepared to take much bigger risks with inflation than it has done in a generation. However, we probably need to see stronger growth first before the costs of this gamble become apparent.

Tim Drayson

Head of Economics

Tim keeps a close watch on global economic developments, with a particular focus on the US. He believes nothing good ever happens after midnight, which is why he is rarely spotted out late. Tim joined in 2008 from the number-one ranked economics team at ABN AMRO, with prior experience from HM Treasury, and graduated with a MSc from the University of Nottingham. When not crunching economic data, he can be found studying the weather forecast, analysing his cycling statistics or looking anxious on three-foot putts.

Tim Drayson