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Photo courtesy: Wikimedia Commons
Photo courtesy: Wikimedia Commons

Opinion | The potential impact of covid-19 on the cost of capital up ahead

Studies of the past suggest that real interest rates tend to decline after a pandemic but we must still watch trends closely

The Indian government announced last week that it will need to borrow 4.2 trillion more this year than what was budgeted for in February. A sharp decline in tax collections, combined with the need to support the economy through extra spending, made such additional borrowing inevitable. The bond markets reacted as expected on the first day of trading after the fiscal announcement. The yield on benchmark bonds climbed by 22 basis points, the largest single-day rise in more than three years. Is this an advance warning of higher interest rates in the coming years, in response to a growing fiscal burden?

Three economists recently published an analysis for the San Francisco Federal Reserve Bank. They examined what happened to real interest rates after some major pandemics in history. Oscar Jorda, Sanjay Singh and Alan Taylor studied the macroeconomic aftermath of 15 major pandemics that resulted in at least 100,000 deaths, a toll that the ongoing covid-19 pandemic has already crossed. One of their main conclusions was that real interest rates drifted down for several decades after a major pandemic.

There are three possible reasons why the economic dislocation caused by a pandemic would bring down real interest rates. First, precautionary savings can increase as households change their financial behaviour. The previous instalment of this column had noted that households are likely to save more if they think the income shock is permanent; and borrow more in case they think the current drop in income is temporary. They will also keep aside more money to rebuild wealth. Income uncertainty now can change the attitude towards savings even after the current economic turbulence subsides. Such an increase in precautionary savings can have profound macroeconomic implications.

Second, corporate investments could come down in case the demand shock persists for long. Utilization of industrial capacity was low in India for nearly five years before the economy was locked down in response to covid-19. The trajectory of corporate investment will depend on the nature of the country’s economic recovery next year, specifically whether it will involve a quick return to the old normal or be a gradual process.

Third, central banks are likely to be more interventionist in the coming years. The need to support larger government deficits through the creation of new money is just one part of this story. The strategy of expanding the central bank’s balance sheet runs into diminishing returns if lower interest rates do not lead to adequate growth in bank credit to the private sector. Also, the fall in interest rates could be more significant at the lower rather than upper end of the yield curve. Some central banks have now started to pivot towards managing the entire yield curve rather than just short-term interest rates. One of the many important observations made by the famous Radcliffe Committee report of 1959 was on the importance of the entire structure of liquidity in an economy.

In their paper on the sustained macroeconomic impact of major pandemics, Jorda, Singh and Taylor are careful to note that some of the major pandemics of the past led to a huge drop in the economy’s labour force. The working population of Europe fell by an estimated one third as a result of the medieval Black Death. The resulting scarcity of labour not only created incentives for the mechanization of production, but also brought down returns on capital. Meanwhile, to think of another massive supply shock, historian Tony Judt shows in his classic study of post-war Europe how much of the capital stock in the continent was destroyed during the course of World War II.

Even the most interesting study of any economic variable over many centuries suffers from one flaw—it does not take into account the changing institutional arrangements in the progress from feudalism to contemporary capitalism. The ability of governments to support aggregate demand through budgetary spending as well as the ability of central banks to support some of this fiscal expansion through money creation was not possible in the medieval era.

However, the main finding that real interest rates tend to decline after a major pandemic remains relevant in our time. It is important to add two caveats here. First, a rapid recovery from the pandemic over the next six months will ensure a return to the pre-covid world without any deep changes in macroeconomic behaviour. Second, major dislocation of supply chains as well as protectionism could result in an inflation spike along with higher nominal interest rates.

The three economists have focused on Europe because of the availability of historical data from that continent—and the unavailability of comparable data from other parts of the world. This is a gap that needs to be filled. One classic study is Money, Income And Prices In 19th Century India: A Historical, Quantitative And Theoretical Study by P.R. Brahmananda. There is a compelling reason for more research work along these lines.

Niranjan Rajadhyaksha is member of the academic board of the Meghnad Desai Academy of Economics

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