The Trade-off between Public Health and the Economy in the Early Stage of the COVID-19 Pandemic

Federal Reserve Bank of Kansas City

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Ivan Jaccard, European Central Bank

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June 15th 2022

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Overview

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1. Introduction/Motivation

• One of the largest recessions on record
• But different in that it caused several millions of fatalities globally
• Implications for the design of stabilization policies
• Lockdowns necessary to contain the pandemic
• But also significant economic cost
• Inevitable trade-off between the severity of the recession and health consequences (i.e. Eichenbaum, Rebelo and Trabandt, 2021)

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A cursory look at the data (2020q1-2021q1)

1. Introduction/Motivation

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Different strategies across countries

• Trade-off not a priori evident
• Rather laissez-faire approach in countries like Sweden
• Very strict containment in other countries
• Zero COVID strategy in AU, JP, KO and NZ (e.g. Aghion et al. 2021)
• Success could also be due to good luck, geography
• Structural model to evaluate different policies

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1. Introduction/Motivation

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What we do

• SIR agents into an otherwise standard business cycle model
• Pandemic shocks, standard macroeconomic shocks
• Derive first-best allocation
• Compare pandemic shocks with other shocks
• Second best policies
• Focus on first phase of the pandemic, until beginning of 2021
• Vaccine not available in the EA
• Delta variant and Omicron phases not studied

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1. Introduction/Motivation

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Main takeaways

• Fluctuations induced by pandemics inefficient relative to first-best
• Full stabilization and epidemics quickly contained under first-best allocation
• No trade-off in a first-best world
• Second-best policies vs. laissez-faire
• Overall, only a weak trade-off
• Alveda, Ferguson and Mallery (2020): “To Save the Economy, Save People First”

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1. Introduction/Motivation

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Literature

• Eichenbaum, Rebelo and Trabandt (2021a, 2021b)
• Krueger, Uhlig and Xie (2021)
• Alvarez, Argente and Lippi (2020)
• Glover, Heathcote, Krueger and Rios-Rull (2020); Kaplan, Moll and Violante (2020)
• Guerrieri, Lorenzoni, Straub and Werning (2020)
• Garriga, Manuelli and Sanghi (2020); Glover, Heathcote and Krueger (forthcoming)
• King and Rebelo (1999)
• Andreasen et al. (2018)

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1. Introduction/Motivation

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Overview

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2. The laissez-faire equilibrium

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• S, I and R agents
• Hand-to-mouth agents (e.g. Weil, 1992; Eichenbaum et al., 2020a)
• Entrepreneurs
• Own capital stock, make hiring and investment decisions
• Stochastic model with capital and evolution of types
• Pandemic shock as an exogenous increase in new cases

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Susceptible agents

2. The decentralized equilibrium

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• Effect of other susceptible agents not taken into account

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Difference relative to ERT

2. The decentralized equilibrium

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• Kermack and McKendrick (1927) term
• Infections exogenous with respect to economic choices
• But no clear rationale for this term
• Kaplan et al. (2020), Krueger et al. (2020),…
• Significant policy implications

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Optimality conditions

2. The decentralized equilibrium

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Infected agents������������������

2. The decentralized equilibrium

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Optimality conditions:

• No effect of contagion risk on behaviors of infected under laissez-faire

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Recovered agents������������������

2. The decentralized equilibrium

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Optimality conditions:

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Entrepreneurs������������������

2. The decentralized equilibrium

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Optimality conditions:

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Law of motion S,I and R and market clearing������������������

2. The decentralized equilibrium

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Solution method�����������������

2. The decentralized equilibrium

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• System of 21 endogenous equations and 21 variables
• 4 endogenous state variables
• Closed form solutions for deterministic steady state
• Perturbation methods
• 3^rd order, pruning (e.g. Andreasen et al., 2021)
• Dynare

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Overview

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Calibration

3. The COVID shock under laissez-faire

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• Quarterly model, calibrate steady state
• Infected work twice less than susceptible
• Weekly incidence rate of 2/100’000 before shocks hits
• Around 40% of the population susceptible
• Shock raises incidence rate from 2 to 20
• Recession lasts 8 quarters

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Pandemic shock

3. The COVID shock under laissez-faire

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Consumption, hours of I agents and type evolutions

3. The COVID shock under laissez-faire

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Labor supply or labor demand?

3. The COVID shock under laissez-faire

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• Hourly compensation and productivity, EA

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• Consistent with main model mechanism

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Overview

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4. The planner’s equilibrium

4. The planner’s equilibrium

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• First-best solution
• Introduce utility weights
• Same steady state consumption, partial risk sharing
• Same steady state hours worked
• Simulate effect of exact same pandemic shock

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The planner’s problem

4. The planner’s equilibrium

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2 key optimality conditions

4. The planner’s equilibrium

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Where:

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Pandemic shock in the first-best allocation

4. The planner’s equilibrium

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Epidemic contained very quickly, effect on output imperceptible

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Consumption and hours of I agents

4. The planner’s equilibrium

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• But first-best policy also implies partial risk-sharing

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Overview

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5. The case of technology shocks

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Number of infected agents

5. The case of technology shocks

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• Planner tolerates an increase in infections to allow boom in consumption and output
• Small trade-off under first-best policy in this case

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Overview

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6. Second-best policies

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• Plausible predictions under first-best
• In reality, cannot discriminate healthy from infected agents
• Second-best policies
• Zero-COVID strategy
• Mandatory testing
• Health insurance
• Compare second-best with laissez-faire

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Zero COVID

5. Second-best policies

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• Set uniform tax on labor supply

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• Cannot discriminate healthy from sick workers

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• Set tax rate to ensure that infections remain constant

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• Similar to a rule that reacts to epidemic shocks

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• Transfers chosen the offset effect of tax, proxy for lockdown

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Uniform tax without the possibility to discriminate

5. Second-best policies

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5. Second-best policies

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Laissez-faire vs. zero COVID

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5. Second-best policies

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Implicit tax rate to reproduce zero-COVID strategy

• Australia, 2020q1-2021q1

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• Implicit tax rate on labor supply

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• Key is to act early

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• Once infection dynamics set into motion, too late

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Mandatory testing

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• No incentive for entrepreneurs to detect infected workers
• Same hourly wage
• Introduce mandatory testing
• Firms need to pay a fine if infected workers

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• Reduce demand for infected workers

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Comparison with laissez-faire

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Health insurance

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• Imperfect risk sharing between infected and healthy workers
• Different marginal utility in laissez-faire equilibrium
• Transfers:

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Risk sharing

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• Partial risk sharing
• Set transfers so that marginal utilities proportional

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• Transfers are temporary, equal to zero on average
• Akin to health insurance

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Comparison with laissez-faire

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• In laissez-faire, same wage for infected and susceptible

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• Reduce demand for infected workers by introducing fine

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Overview

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7. Conclusion

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• SIR structure also affects propagation of standard shocks
• Planner tolerates increase in infection in response to a TFP shock
• Pandemic shock inefficient relative to first-best
• Second-best strategies vs. laissez-faire
• Only a weak trade-off under second best policies
• Reproduce dynamics observed in AU under zero COVID
• Health insurance better than laissez-faire (Sweden)

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Limitations

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• First phase of the pandemic
• Coordination among countries, regions
• Long-term side effects of confinements
• Stronger trade-off depending on industrial structure
• See literature on heterogeneity, vaccination

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Extensions

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• Optimal monetary policy during a pandemic
• Very unfavorable trade-off if monetary policy is the only game in town, with G. Vermandel (Polytechnique) and G. Benmir (LSE)
• Ramsey optimal policy implies a tightening of monetary policy
• When contagion risk appropriately addressed by confinement policies, monetary policy should concentrate on price stability

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