Wednesday 16 September 2020

In case you missed it - 'Macroeconomics of Covid-19'


For those who were unable to attend, we compiled the key takeaways of the presentation given by Lukasz Rachel, Affiliate of the London School of Economics.

“Covid 19 has led to a striking avalanche of research in economics,” said Rachel during his presentation to Inquire Europe members last week. “It has become clear that it is important for economists to contribute to the current debate surrounding the pandemic.” 

Rachel wasted no time in doing so, beginning by explaining a rudimentary epidemiological model from the perspective of an economist, using tools that are widely known in applied economics. A SIR (susceptible, infected, recovered) model illustrated how it is possible to detect the 'herd immunity threshold'. This threshold signifies the difference between stable and unstable steady states of infection in the population.

Rachel proceeded to chart the path an epidemic follows if there is no lockdown; in this respect, he likened it to how things would progress in an animal population. Animals don’t change their behaviour during pandemics, and they are not governed by policies that drastically impact the infection rate. The more people become infected with the disease, the faster the system moves towards reaching the herd immunity threshold. In this trajectory, the disease is extinguished after just 22 weeks. To put that into perspective, the UN World Health Organization announced the global pandemic approximately 26 weeks ago. 

Optimal policy  

By enforcing lockdowns, governments are ensuring that there will be a second wave of the virus. This is because peak infections are reached before herd immunity threshold can be achieved (Diagram 1). Once the population emerges from lockdown, there will be a second wave of infections. The severity of the second wave depends on how strict the initial lockdown was: the more austere, the more collosal the wave. Essentially, human behaviour flattens the epidemic curve, but prolongs it for an extended time (Diagram 2). “The system dynamic is very slow, taking a very long time for the disease to extinguish itself…It is very important for economists to keep the endogenous reaction of people into account. But we can design a policy that is better.”

Diagram 1


Diagram 2

Governments face the task of creating a policy that improves on the "homo-economicus", or rational human. This is done by reaching herd immunity faster, by allowing more infections along the way  (Diagram 3). “Optimal policy allows the infection rate to grow substantially, and then takes action to implement the lockdown at the right time, meaning that the disease is extinguished once the herd immunity threshold is reached.”

Diagram 3


Consequences of the Covid-19 pandemic on the economy and real interest rates 

There is prolonged, negative impact on consumption during equilibrium; it takes a very long time for recovery to take place because social distancing persists for a very long time. This is not the case if optimal policy is used. Rachel estimates that in that scenario, the economic impact subsides in about 30 weeks.

According to Rachel, we have observed a decline in real rates across developed economies for the last 40 years, and fiscal policy will be an important factor in helping to stop this from continuing. “The long- term interest rates have continued to decline, but the macro(economic) theory is not very clear on which way the rates should go. The sign is ambiguous. There is certainly some downside pressure, considering persistent uncertainty associated with cautionary saving or a private debt overhang that hinders economic expansion going forward meaning that the real rate will continue to decline.

However, a lot of governments have dramatically increased their deficits which have signified a rise in debt ratios. Large increases in government debt can place upward pressure on interest rates over time. Rachel referenced a recent study (Jorda, Taylor, Singh (2020)) analysed the historic response of interest rates following pandemic episodes. “This shows that rates were low, for a very prolonged period but the deepest decline was observed two decades after the pandemic. Hopefully we don’t see such a persistent negative effect on rates and that policy will assist in avoiding it.”

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