Pandemic economics: The economy of fear

“The old phrase, ‘Whatever doesn’t kill you makes you stronger’ — I think applies in spades to the economy in the aftermath of this pandemic,” says MIT economist Andrew Lo in this Knowable Magazine original video. Lo explores the immediate financial impacts of Covid-19 on the economy, comparing that with what happened in the 2008 Financial Crisis and during the 1918 influenza pandemic. He explains the different effects seen on Main Street and Wall Street, and discusses why, despite the hardships, the overall economy remains strong and may even flourish in the years following the pandemic.

READ MORE: 2008 Financial Crisis: A Ten-Year Review, a special article collection from Annual Reviews

This video is part of Reset: The Science of Crisis & Recovery, an ongoing series exploring how the world is navigating the coronavirus pandemic, its consequences and the way forward. Reset is supported by a grant from the Alfred P. Sloan Foundation.

Disclosure: Andrew Lo is coeditor of the Annual Review of Financial Economics and a member of the Board of Trustees of Annual Reviews, which publishes Knowable Magazine.

Video Transcript:

Andrew Lo (economist, MIT Sloan School of Management): “In February of 2020, we started seeing the effects of the pandemic here in the United States.”

Newscaster: “This morning stocks in the midst of their worst weeks since the financial crisis.”

Andrew Lo: “Stock markets dropped. We were all very concerned about getting Covid-19.”

Newscaster: “Major cities across the country are looking more like ghost towns.”

Andrew Lo: “So we put the economy into the equivalent of a medically induced coma.”

Newscaster: “Illinois and Ohio closing all bars and restaurants beginning tonight.”

Andrew Lo: “Which saved a tremendous number of lives, but at the cost of a significant amount of lost income. We basically shut down the economy for a period of time and it’s still not fully recovered. How is it the case that the stock market has actually done so well in 2020 and looking very strong in 2021?

“One of the biggest issues in dealing with Covid-19 is fear, and so that’s one of the reasons why, in the middle of February all the way through May, we saw some tremendous dislocation. Markets going down and then shooting up. And the so-called ‘fear index’ — the VIX, which is a measure of the implied volatility of options on stock market indexes — shot up tremendously over a very short period of time in the aftermath of Covid-19 hitting US shores.

We did put the economy into the economic equivalent of this medically induced coma, and so the loss in terms of GDP has been tremendous. At the same time, the stock market has actually done quite well, and many people are wondering about that. Well, the answer has to do with the fact that there’s a pretty big difference between a financial crisis and a public health crisis.”

A different kind of crisis: The 2008 market crash

Newscaster: “The Dow tumbled more than 500 points. Lehman Brothers, a 158-year-old firm, filed for bankruptcy.”

Andrew Lo: “2008 was in fact a financial crisis, and the source of the problems really lay in the financial sector, and so tremendous amounts of resources were devoted to propping up that sector, to dealing with weak and failing banks as well as insurance companies and other parts of that system. What we’re going through today is not a financial crisis. It is a public health crisis that has financial implications. The loss of trust and confidence in the financial system is not nearly as much of an issue today as it was in 2008. That’s one of the reasons why the stock market recovered much more quickly this time around than back in 2008, and why the number of jobs lost and the time it took to get back to the employment levels pre-2008 much, much longer than what we’re going to have to experience in dealing with employment issues in 2020 and ’21. It doesn’t mean that there aren’t winners and losers — certainly there are, and a number of businesses are pretty much gone forever — but the fact is that much of the economy is still very strong.

“So far it looks like the policies have been relatively effective on the financial side. Whether or not they’re as successful in dealing with individuals who really need help — those who are unemployed and have a difficult time making ends meet because of the pandemic — that remains to be seen. So I think that there’s still much more work to be done in making sure that the individuals that are hit hardest by the pandemic are able to deal with it. But from the point of view of the financial system, it seems to be relatively stable and resilient as we speak.

“One of the big differences between Wall Street versus Main Street is that Main Street has to deal with the present, which is very difficult in many cases, whereas Wall Street is looking to the future. The key aspect of financial markets is trust and confidence. The moment we start to fear the future, the moment we lose that confidence and trust in the system, then the entire economy begins to unravel.”

The fear index: Lessons from history

Andrew Lo: “We can learn a lot about what we’re going through today by going back in time to 1918 and studying the influenza pandemic of that year. There wasn’t a lot of fear about the 1918 pandemic because it wasn’t publicized. During 1918, a number of countries were part of World War I, and those countries — including the United States — were in a news blackout, so they did not want to publicize this pandemic, because they didn’t want to demoralize the troops. In fact, when we declared victory in November of 1918, there was tremendous celebrations in the streets. Large throngs of crowds, of people kissing each other, hugging —and you can imagine how quickly that flu spread after that day. In October of 1918, that one month, the United States lost 195,000 lives.

“The 1918 pandemic was a situation where there wasn’t a lot of fear because people simply didn’t know about it. It wasn’t written about in the media. And so the economy pretty much went on unabated for much of this time. The stock market did tremendously well from 1918 to 1929. Overall the economic impact was relatively temporary, and a year or two after the 1918 pandemic we saw a tremendous recovery in the economy and then amazing growth over the course of the following 10 years. You’ve probably heard the phrase the “roaring twenties.” Well, that was exactly what it was signifying: the amazing economic growth that occurred after the 1918 pandemic. Now as we look at what we’re going through today with Covid-19, we see that we’ve been handling the situation very differently.”

Adaptive markets: Lessons from biology

Andrew Lo: “Evolutionary biologists and ecologists often talk about a theory of punctuated equilibrium where the ecology experiences a tremendous shock. An asteroid hits the Earth, kicks up a cloud of dust, blocks the sunlight, eliminates the food sources of a number of species, and, over the course of a very short period of time in evolutionary time scales, mass extinctions. But after those periods of extinction you have the emergence of a whole new set of species — what’s called ‘adaptive radiation’ — and we’re seeing the same thing today. Covid-19 has undoubtedly destroyed a large number of businesses.”

Newscaster: “You can already see the impact here in Times Square — eerily empty.”

Andrew Lo: “We have now been tested in the fire. We know various different weaknesses of all of the businesses that have been operating during this time. And so that means that we understand now how to deal with some of those weaknesses and build a much more robust and resilient economy. The weak have been weeded out, the strong will continue to grow, and succeed, and the old phrase ‘Whatever doesn’t kill you makes you stronger’ I think applies in spades to the economy in the aftermath of this pandemic.

“So I believe that the decade following Covid-19 will probably be one of very, very strong growth and innovation — ‘adaptive radiation’ of all sorts of new economic species. However, there is a bit of a warning that one should take heed of and that is that as that economy grows in this new golden age, we’re going to be in the process of planting the seeds of the next financial crisis. Anytime you combine free will with capitalistic systems, you are going to get financial crises. We may not be able to prevent the next crisis, but we can certainly understand what conditions will lead to it, we can put out warning signs, and we protect the parts of the population that are going to be most vulnerable to its consequences. Those things we can do if we learn from the past.”