Excess capital after a plague

I do believe that the world is going to be different after the Covid-19 crisis is over. And with different, I don’t mean different in the sense of us being more careful about social gatherings and the like. I think the Covid-19 crisis will have long-lasting effects on the fundamental way economies work for many years to come. Take interest rates, for example. I have written about the long-term downward trend in the real rate of interest here. If the data cited there is correct, then we are not living in a time of abnormally low interest rates, but instead have come out of a period of abnormally high interest rates in the 1980s and 1990s and are now simply back at the trend.

Now add to this the potential effects of the Covid-19 pandemic. Òscar Jordà, Sanjay Singh and Alan Taylor from the UC Davis are well-known for their studies of historical trends in interest rates and other variables and I have used their data before. Now, they have investigated the long-term impact of pandemics on real interest rates and wages. They collected data for the worst pandemics since the Middle Ages, all of which killed at least 100,000 people. The two worst events were the Plague and the 1918 flu.

What they show is that a plague that kills many people leads to decades-long declines in real interest rates and a multi-decade increase in wages. They also show that this decline in real rates is most pronounced in countries that are more impacted by the plague and less industrialised. The explanation is simple (at least to me): Plagues historically killed a lot of younger people and thus led to a shortage of labour relative to capital. The less industrialised an economy is, the more it depends on labour as an input factor and the more this imbalance between capital and labour matters. 

The reaction of real rates to plagues is notably different from wars. Because wars destroy factories and other forms of capital, there typically is a relative shortage of capital vs. labour after a war. And where capital is scarce, real rates tend to increase.

The long-term impact of wars and plagues on real rates in Europe

Source: Jordà et al. (2020).

What is interesting to see is that this effect on real rates doesn’t last just for a couple of years. Quite the opposite, the maximum impact is felt by the next generation, about 20 to 30 years after the event. This makes sense since the death of many people in a plague leads not only to a shortage of labour in the subsequent decade but then also to a shortage of new births and lower population growth in the next generation. Hence, the impact of a plague is exacerbated for the next generation before birth rates can pick up again and the economy can find a new equilibrium between labour and capital.

Is this going to be similar after Covid-19? I think we have to be careful about that. Covid-19 is different from the 1918 flu or the plague in that it kills mostly older people who already had children and are no longer part of the workforce. This means that the relative shortage of labour vs. capital is likely less disturbed this time around. Also, we live in a highly industrialised world where labour as an input factor is much less important than in the past. So, the impact of lower population growth is likely going to be limited. On the other hand, there is one effect that will contribute to a lower real rate, and that is changing savings behaviour. We do not know yet if people will change their savings behaviour after the crisis, but I think having lived through two major crises in a little more than ten years, many Millennials will likely increase their savings ratio from now on. And if savings ratios pick up over the coming decade or two, the relative supply of capital vs. labour will shift once more in favour of labour and real rates will experience additional downward pressure.