Reprint of the economic costs of pandemics

Most economists believe that policy actions should be based on a cost benefit analysis leading to a go-slow approach even in the face of a potential pandemic. Several years ago the Congressional Budget Office estimated the economic costs of a pandemic when considering the potential impact of the bird flu.

The CBO found that the likely cost of pandemics were small. The CBO report did not contain policy recommendations but this view continues to guide government policy.

The issue is reemerging because of the Coronavirus.

Below I discuss the CBO view of pandemics outlined in the bird flu report, a view that continues to inform policy choices.

A Discussion of the Report:

The CBO provides an assessment of the likely impact of an avian flu outbreak on the U.S. economy. The CBO forecasts the likely impact of two pandemic scenarios on GDP:

(1) A severe epidemic similar in size and scope of the 1918 pandemic

(2) A milder scenario that resembled pandemics in 1957 and 1968.

The CBO found that the severe pandemic could produce a short run impact on the worldwide economy similar in depth and duration to that of an average postwar recession in the United States. The CBO also found that a milder pandemic would have a much smaller impact, “which might be indistinguishable in the macroeconomic data.”

The CBO projects that in a severe pandemic 30% of workers in each sector (except for the farm sector) would get ill and that 2.5% of these workers would die. The death rate is assumed to be lower in the farm sector because of the lower social interaction in this sector. This disease rate and death rate is consistent with the death of more than 2 million people in the United States alone. The CBO assumes that in this scenario, survivors would miss three weeks of work either because they were sick or because they needed to care for someone who was sick.

The CBO projections for the mild scenario assume that 25% of workers (except in the farm sector) got sick and that 0.1% of these workers died. This death rate is consistent with the death of 100,000 people. The CBO assumes that in this scenario survivors missed 4 days of work again either because they were sick or taking care of others who were sick.

The projections of changes in GDP from the pandemic involve a supply and a demand effect. The supply effect is simply a function of the lost employment for the year. Workers who die are assumed to lose the entire year. Workers who survive lose 3 weeks for the severe pandemic and 4 days for the mild pandemic.

The demand effect is based on an examination of GDP by industry. CBO assumed different declines in demand for different industries based on judgments about the degree of social interaction in each industry. The report acknowledges that this process is subjective.

“Given that there is little historical evidence available to form these estimates, they are admittedly extremely rough.” (Page 42 of the CBO report.)

Table A2 lists the assumed demand effects by industry. The demand impacts for the severe scenario are:

  • 80% decline for arts and recreation, accommodations and food service.
  • 67% decline for warehousing.
  • 10% decline for most other private industries.
  • 5% decline in government services.
  • 0% change in information, finance, professional services, and education.
  • 15% increase in the utilization of health care.

The CBO subtracted the supply-side impact of the pandemic from the demand-side impact for each industry in order to avoid double counting.

A Discussion of Issues Raised by

The CBO Report

Comment One: The CBO report does not allow for any involuntary unemployment. The entire supply effect is the result of voluntary employment stemming from missed work attributable either to personal or family illness. However, some industries, (hotels, amusement parks, casinos, movie theaters, and life theater) are assumed to experience an 80 percent drop in demand. Substantial layoffs would occur in these industries. Involuntary unemployment will be larger than direct absenteeism due to health effects.

Comment Two: The CBO report does not consider the impact of large regional impacts in particular regions, which would further exacerbate the declines in output. The regional impacts would be especially large in cities and states that specialize in tourism and recreation. In the midst of an epidemic that was killing 2 million people few people would travel to Las Vegas and visit a crowded casino and few families would travel to Orlando for an amusement park. Epidemic rates would be especially high in crowded cities. Involuntary employment could be substantial in the cities most affected by a pandemic. The health situation and economic impacts of a pandemic might, like the impacts of Katrina, be highly concentrated in a few states and cities.

Comment Three: The report does not allow for the pandemic to cause decreased real estate prices and defaults on mortgages. The severe pandemic scenario would adversely impact housing markets through several channels. First, the pandemic increases the number of empty houses through the 2 million flu-related deaths. Second, increased unemployment from absenteeism or involuntary unemployment will increase mortgage defaults, especially among homes with little equity. Third, decreased wages will lead to reduced demand for homes. Fourth, mortgage default would increase because of household solvency problems attributable to increased health problems. House values and other forms of wealth have a direct impact on consumption, the key component of aggregate demand. The negative impact of pandemics on housing would further reduce consumption, the primary component of aggregate demand because consumption is a function of wealth.

Comment Four: The report does not consider the possibility that a pandemic will decrease stock prices or cause corporations to default on their bonds. A decrease in demand of 60% to 80% in some industries would lead to massive corporate defaults. This increase in corporate defaults would increase the cost of capital and decrease investment. An increase in corporate defaults and decreased stock prices reduce wealth and decrease consumption. These corporate defaults could impact the solvency of life insurance companies, which could in turn impact mortgage defaults. The CBO does not consider any of these potential impacts in their assessment of the potential impacts of a pandemic.

Comment Five: The CBO analysis assumes that an increase in the demand for health care will partially offset decreased demand in other sectors. However, the CBO report on page 28 to 32 points out that there is little or no excess capacity in the health care system and that a pandemic would reduce capacity because many health care providers would become sick. The CBO discussion on strategies for providing additional health care includes increased training of home health care providers and an increased role for the military. Neither of these channels results in increased GDP. Home health care services are a non-market based transaction that is not included in GDP. The military, as part of government spending, has already been included as part of GDP. The inclusion of increased demand for health care results in the CBO overestimating GDP in a recession.

Comment Six: The CBO assumption of a 0% change in demand for information, finance, professional services and education is unrealistic. Even if demand for media remains unchanged this sector is impacted by decreased advertising revenue. Second, large layoffs by industry will decrease demand for health insurance policies 401(k) enrollment and group life insurance sales. Individual life insurance sales could rise because of the pandemic. Third, the demand for education will fall because schools and universities are places where the virus can easily spread.

Comment Seven The calculation on the supply effect assumes that the pandemic increases real wages. However, the impact of a pandemic on real wages is theoretically weak. Why would workers be able to claim wage increases over inflation during a disaster when corporate profits were down?

Comment Eight: The report says “the analysis ignores the possibility that productivity among workers who remain on the job would be likely to rise.” (Page 42.) In fact, firm productivity could fall in a pandemic even if the actual productivity of survivors rose. The replacement of key workers will lead to productivity decreases because of the resources needed to train the replacement. Also, productivity could decrease because firms will spend resources to insure that infections are not transmitted on the job.

Comment Nine: The decrease in GDP is only one of the economic costs associated with a pandemic. It would be useful to calculate the impact of the pandemic on wealth, corporate and personal bankruptcy, and most importantly the value of the lost life.

Comment Ten: The cover letter attached to this report refers to impacts on the worldwide economy. The analysis inside the report pertains to the U.S. economy. Presumably worldwide impacts could be much larger if avian flu is more severe in Asia and the Middle East.

Comment Eleven: The CBO assumes a lower death rate in the farm sector because of the lower social interaction in this sector. However, the farm sector is where the birds are and cases to date have involved bird to human transmission.

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