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Crisis of Confidence Over COVID-19 Could Result in Over 180% Loss of Annual GDP

Working paper from Columbia Business School quantifies impact of "Belief Scarring" on economic recovery, finds crisis could delay economic recovery for a decade

Published on April 29, 2020

As the coronavirus ravages the economy and instills fear in investors, new research shows that the path to economic recovery will hinge on the psychology of consumers and businesses. In a new study, Laura Veldkamp, Leon G. Cooperman Professor of Finance & Economics at Columbia Business School, offers the first real glimpse of a post-COVID economy, and how long recovery could take based on consumer confidence.

Veldkamp focuses on how unprecedented historical events like the coronavirus pandemic can lead to “belief scarring,” – persistent, negative changes in consumer confidence about the fate of the economy. The study refers to these historical moments as “tail events,” and argues that the events with the least precedent have the most scarring impact on behavior. The coronavirus pandemic, an event without historical precedent in our lifetimes, is expected to impact economic activity for years to come because the belief scarring could damage key economic pillars like consumption, hiring, and investment.

“The total cost of the COVID-19 pandemic is unknown and the worst could very well still be on the horizon,” says Professor Veldkamp. “Our research quantifies the scarring effect that this crisis has had on consumers’ beliefs and shows that while in any case, the short-term economic impact of the pandemic is devastating, the long-term effects are much more worrisome. It’s not the size of the initial impact of the recession that matters, but the persistence of its scars that determine whether our recovery will progress or fall into a stalemate.”

The working paper, published in the Centre for Economic Policy Research and co-written with Julian Kozlowski, Senior Economist in the Research Division of the Federal Reserve Bank of St. Louis, and Venky Venkateswaran, Associate Professor of Economics at New York University’s Stern School of Business, encourages policymakers not to underestimate the impact of the pandemic on businesses and consumers and shows how and why economic interventions (such as the $2-trillion CARES Act), will make a marked difference for our economic recovery down the line. Without policy intervention, the long-run cost of belief scarring adds up to 180% of annual output in the conservative estimate and an enormous 10 years of lost output in the worst case.

“Our analysis, while sobering, offers a productive direction forward for policymakers,” Veldkamp said. “We know that immediate economic interventions (e.g. the recent stimulus package) are expensive. But in the long-term, these kinds of interventions can be the difference between a progressive versus a sluggish recovery. Policies that help prevent capital depreciation or obsolescence, even if they have only modest immediate effects on output, can have substantial long-run benefits, mitigating the potentially catastrophic belief scarring effect.”

Key Takeaways Include:

  • The outcome of the economic recovery from COVID-19 depends on the extent to which “belief scarring” takes hold amongst consumers and businesses.
  • The pandemic could result in over 180% loss of annual GDP – and at worst, 10 years of lost output.
  • Without belief scarring, economic recovery would be quick and complete, even with a large initial impact from the recession.
  • The effects of belief-scarring can be mitigated by proactive measures from policymakers that minimize instances of capital depreciation or obsolescence – such as bankruptcy.
Finance Reporter