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Pandemic costs underestimated as COVID-19 'scars' economy – Fed economist

The COVID-19 pandemic has permanently scarred the U.S. economy, economists plan to tell the Kansas City Fed's annual economic policy symposium on Aug. 27.

Even if the pandemic ends this year, belief changes caused by the coronavirus will cause lasting economic damage multiple times greater than the immediate consequences, according to a paper authored by a team led by Julian Kozlowski, a senior economist with the St. Louis Fed.

"Long after the direct effect of the shock has passed, the knowledge of that tail event affects beliefs and therefore, continues to restrain economic activity," the economists wrote. "Our point is not to make a forecast of the coming year's events but that ... whatever you think will happen over the next year, the ultimate costs of this pandemic are much larger than your short-run calculations suggest."

The paper, Scarring Body and Mind: The Long-Term Belief-Scarring Effects of COVID-19, was written by Kozlowski, Laura Veldkamp, a finance professor at Columbia University's Graduate School of Business, and Venky Venkateswaran, an economics professor at New York University’s Stern School of Business.

'Scarring effect'

In it, Kozlowski, Veldkamp, and Venkateswaran caution that the lasting effects of the pandemic are likely greater than the near-terms ones due to the "scarring effect" of consumers and businesses, or the shift in the perception of the probability of an extreme, negative shock in the future. In short, now that Americans have lived through a pandemic, they will always expect and plan for another one, creating negative economic impacts, potentially for decades, these economists argue.

"Before 2008, few people entertained the possibility of a financial crisis in the U.S.," they wrote. "Today, more than a decade after the Global Financial Crisis, the possibility of another run on the financial sector is raised frequently, even though the system today is probably much safer. Likewise, businesses will make future decisions with the risk of another pandemic in mind."

This scarring will create "large, persistent adverse effects" on the U.S. economy. U.S. GDP, for example, is expected to decline between 6% and 9% this year, but the long-term scarring could cause GDP declines of five to six times that, the paper states.

Consumer collapse

"This suggests that, even if a vaccine cures everyone in a year, the COVID-19 crisis will leave its mark on the U.S. economy for many years to come," they wrote.

The virus has already caused an unprecedented consumer collapse as social distancing measures and widespread business closures have driven unemployment to record highs.

On Aug. 25, The Conference Board reported that its Consumer Confidence Index fell to 84.8 in August, down from 91.7 in July, a second consecutive monthly decline.

Lynn Franco, The Conference Board’s senior director of economic indicators, said that while U.S. consumer spending has rebounded recently, spending will likely "cool in the months ahead" due to widespread and increasing concerns from U.S. consumers about the economic outlook and their financial well-being.

"Households are becoming more cautious in their outlook for continued healing of the economy," Kathleen Bostjancic, head U.S. financial market economist at Oxford Economics, said in an Aug. 25 note on the index’s fall. "This could slow consumer spending relative to the rather strong rebound over the past few months."

The University of Michigan's Index of Consumer Sentiment fell in July to 73.2%, down from 78.1% in June and 98.4% in July 2019, according to preliminary data released July 17.

The U.S. personal saving rate — the ratio of personal saving to disposable personal income — jumped to a record high of 33.5% in April and fell to 24.2% in May and 19% in June, according to the U.S. Bureau of Economic Analysis. The previous record was 17.3% in May 1975.