Pandemic creates a new economic channel: scarring effect

Julian Kozlowski of St Louis Fed in this research article introduces a new channel which impacts economic activity – scarring effect.

What are the long-run economic costs of COVID-19? While the virus will eventually pass, an event of this magnitude could leave lasting effects. A shift in confidence and fear could prevent firms and consumers from rebounding to their old investment and spending habits. A recent paper (Kozlowski, Veldkamp, and Venkateswaran, 2020a) formalizes this discussion and quantifies these effects. The authors use a standard economic and epidemiological framework, with one novel channel: a “scarring effect.” Scarring is a persistent change in beliefs about the probability of an extreme, negative shock to the economy.  


The work by Kozlowski, Veldkamp, and Venkateswaran (2020a) embeds a belief-updating tool in a macroeconomic model with epidemics. Belief updating can generate large and persistent economic losses well after an epidemic is over because agents think that epidemics are more likely after seeing one. The figure shows predictions about the response to the COVID-19 crisis. GDP drops 9 percent in 2020 and recovers gradually but does not go back to its previous trajectory. It persistently remains 4 percent below the pre-COVID steady state. The discounted value of the lost output over the future is almost 10 times the 2020 drop, and belief revisions account for the bulk of the losses. 

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.


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