The Great Lockdown: International Risk Sharing Through Trade and Policy Coordination

WP/20/242 The Great Lockdown: International Risk Sharing Through Trade and Policy Coordination by Philipp Engler, Nathalie Pouokam, Diego Rodriguez Guzman, and Irina Yakadina IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management. © 2020 International Monetary Fund WP/20/242 IMF Working Paper APD, ICD, RES The Great Lockdown: International Risk Sharing Through Trade and Policy Coordination1 Prepared by Philipp Engler, Nathalie Pouokam, Diego Rodriguez Guzman , and Irina Yakadina Authorized for distribution by Alison Stuart (APD), Norbert Funke (ICD), and Oya Celasun (RES) November 2020 Abstract Voluntary and government-mandated lockdowns in response to COVID-19 have caused causing drastic reductions in economic activity around the world. We present a parsimonious two-country-SIR model with some degree of substitutability between home and foreign goods, and show that trading partners’ asynchronous entries into the global pandemic induce mutual welfare gains from trade. Those gains are realized through exchange rate adjustments that cause a temporary reallocation of production towards the economy with the lowest infection rate at any point in time. We show that international cooperation over containment policies that aim at optimizing global welfare further enhances the ability of countries to exploit trade opportunities to contain the spread of the pandemic. We characterize the Nash game of strategic choices of containment policies as a prisoners’ dilemma. JEL Classification: E1, F4, H0, I1 Keywords: Great Lockown, epidemic, COVID-19, trade, optimal containment, cooperation, SIR macro model Authors’ E-Mail Addresses: PEngler@imf.org; NPouokam@imf.org; DRodriguezGuzman@imf.org; IYakadina@imf.org 1 We thank Martin Eichenbaum, Sergio Rebelo, Mathias Trabandt, Şebnem Kalemli-Özkan, Oliver Holtemöller, Andrew Berg and seminar participants at the IMF for valuable discussions and suggestions. Any remaining errors and omissions are, of course, ours. IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management. 3 I. Introduction Governments and individuals around the world reacted to the COVID-19 outbreak with massive lockdowns, causing the largest global recession since the Great Depression. The global and unprecedented nature of the COVID-19 pandemic which has been referred to as the "Great Lockdown" (see IMF2020a) is unarguable. It has affected almost all countries in the world and has led to an unparalleled economic fallout, with the largest fraction of world economies experiencing a decline in per capita output at one point in time since 1870. In this paper, we devise a parsimonious epidemiological two-country macroeconomic model to study potential gains from international trade in the context of the Great Lockdown. Our model provides a stylized framework that illustrates two trade-offs at the heart of the policy making process underpinning governments’ decisions in the face of a pandemic. Namely, a benevolent government that has to enforce containment policies to stop the virus spread is facing a choice between lives and livelihoods and, on top of this, a choice to cooperate or not to cooperate with trade partners to achieve the optimal timing and intensity of containment measures. In our open-economy epidemiological model, governments’ policies interplay with private agents’ economic decisions to trace the course of the pandemic. Our model builds on the closed economy model of Eichenbaum, Rebelo and Trabandt (2020a), henceforth ERT (2020), to which we add a Nash game between a home government and a foreign government. Each government is committed to designing optimal containment responses to the pandemic that hits the foreign economy first and then spreads to the home country. We describe a new mechanism in which terms of trade adjustments reflect differentials in infection rates and act as safety valves that allow to cushion the global impact of the pandemic. We demonstrate that when one country’s infections are above those of the other country, the relative supply of its locally produced good plummets. This is driven by the decisions of individual agents to cut down on work hours in order to curb the risk of infection. The safety valve channel works as follows: assuming that each country produces a single good and assuming a reasonable degree of substitutability between t