Economics Matters - Issue 7

Economics Matters • Issue 5 • Page 1

Economics Matters

ISSUE

7

COVID-19 AND HYSTERESIS Robert Nutter and Simon Harrison

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Economics Matters • Issue 5 • Page 1

Writing in the Financial Times (5/6/20), Tim Harford said: “A recession can leave scars that last, even once growth resumes. Good businesses disappear; people who lose jobs can then lose skills, contacts and confidence. But it is surprising how often, for better or worse, things snap back to normal, like the rubber band”. (https://on.ft.com/3egiXMb) However, long term scarring of the economy is a real possibility as a result of the Covid-19 crisis – a recession not caused by oil prices or banking failures but one instigated by governments themselves through the use of lockdowns designed to control the virus. Scarring to the economy is translated into economics terminology as hysteresis. Economists would describe hysteresis as the process whereby a rise in unemployment resulting from a sharp recession leads to an increase in the natural rate of unemployment (NAIRU). Hysteresis means that the short-term effects of a recession manifest themselves into long term problems which inhibit growth and make it difficult to return to pre-recession growth trends because of changes in labour demand and supply and issues with capital allocation.

At its most serious, hysteresis causes permanent damage to the economy, contributing to a loss of productive potential and a lower trend growth rate. In short, hysteresis could cause a country’s production possibility frontier to shift inwards. A shift in the long-run Phillips curve to the right will occur, leading to a rise in the natural rate of unemployment from U1 to U2 (Figure 1). The long-run aggregate supply curve (LRAS) will shift to the left, leading to a fall in real GDP from Y to Y1 (Figure 2).

Figure 1

%

INFLATION

LRPC1

LRPC2

P1

P2 SRPC U1

U2

UNEMPLOYMENT

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Figure 2

Price Level

LRAS1 LRAS

P1

P

AD Y1

Y

Real GDP

What are the different mechanisms which explain hysteresis in a modern economy?

If workers are made redundant in a recession, then they may become demotivated and lose on-the-job training, which makes them less employable. After a period of unemployment, it is harder for them to find work as they become increasingly deskilled. Also, firms may be more reluctant to take on workers who have been unemployed for a certain period. Unemployed workers, of course, stop learning by doing, lose contact with new working practices and techniques introduced by firms, and find that their existing skills gradually deteriorate. As the economy recovers and the unemployed are finally hired, their productivity is lower than incumbent workers, reducing the overall productivity (Dosi, Pereira, Roventini, Virgillito 2018). In addition, people out of work for a relatively long period of time may give up on job searches and effectively leave the labour market, reducing the number of people who are economically active. This would slow potential growth and shift the LRAS curve to the left.

Another explanation of hysteresis involves the insider-outsider hypothesis (Blanchard and Summers NBER 1986). During a recession, as aggregate demand falls some workers lose jobs in firms, leaving a smaller workforce. Those who have lost their jobs are called ‘outsiders’ and those workers still in employment are called ‘insiders’. These ‘insiders’ are not particularly concerned about the unemployed ‘outsiders’, feeling secure in their own jobs (because they are costly to replace and are often heavily unionised). Once demand starts to pick up, the ‘insiders’ exploit their scarcity in the labour market by negotiating higher wages for themselves.

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This can also be linked to information asymmetry – employers know about insiders but not outsiders. An outsider would therefore be viewed as second best when it comes to wages.

Also, if outsiders offer to work for lower wages, this may create suspicion – why are they prepared to work for so little?

Insiders use their position of power to negotiate a wage that is much higher than the marketclearing wage rate. This sets the wage rate for the whole labour market, meaning that unemployed workers (outsiders) are hired less often, even if they are willing to work for a lower wage. Thus, some labour markets settle at a higher wage and lower employment equilibrium with the real wage at w, as shown in the diagram below (Figure 3). Naturally the unemployed outsiders suffer continued deterioration in their skills, falling further behind the employed insiders. If the insiders were more moderate in their wage demands, the real wage rate would have been closer to the equilibrium where demand and supply are equal, with more outsiders being employed.

Figure 3

Real Wage

SL

Wage set by insiders

W

DL Nd

Ns

UNEMPLOYMENT

Quantity of Labour

Source: Wikipedia Another model that might explain hysteresis is the feasible real wage/target real wage model (Griffiths and Wall 2012). In this model the feasible real wage shows what firms can afford to pay and is linked to labour productivity. The target real wage shows the wage rate that workers can negotiate through the pay bargaining system. This is negatively correlated with unemployment, because the higher the level of unemployment, the lower the wage that workers can demand. If the target real wage exceeds the feasible real wage, then this creates

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accelerating inflation – firms have to pay the target real wage but will then need to put prices up to retain profit margins. If the target real wage exceeds the feasible real wage, the wage increase is less than firms can afford to pay, reducing firms’ costs and therefore putting downward pressure on prices and inflation. Thus, where the feasible real wage equals the target real wage, inflation is stable, and this is therefore the non-accelerating inflation rate of unemployment (NAIRU).

A recession will have a negative effect on an economy’s capital stock. When aggregate demand falls, firms go out of business and investment plans are cancelled or at least postponed. This will reduce the capital-to-labour ratio and the marginal productivity of labour shifting the demand curve for labour (the MRP) to the left. This will reduce the feasible real wage, and in the diagram below (figure 4) this fall will increase the natural rate of unemployment from U1 to U2. The LRAS curve has shifted to the left, and even when output begins to pick up again, unemployment will persist because it will take time for firms to purchase new equipment and fix other capital to allow for a larger workforce.

Figure 4 Real Wage

W1

FEASIBLE REAL WAGE 1

W2

FEASIBLE REAL WAGE 2

U1

U2

TARGET REAL WAGE UNEMPLOYMENT

It is the fear of many economists that the recession created by Covid-19 will see the effects of hysteresis as patterns of employment, shopping and leisure are permanently changed as a result of the virus. The Job Retention Scheme (furloughing) has cushioned the employment effects for a while but retraining of workers has to be a priority particularly for young people, who are likely to be worst hit by the Covid-19 economic crisis. Neo-Classical economists would argue that given flexible prices and wages, the economy will find, via increased competitiveness, its way back to full employment equilibrium, but hysteresis is a

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theory developed by Keynesians to explain why such a laissez-faire economic policy may be damaging in the long run. The Keynesian argument is for increased government spending during economic downturns to restore aggregate output and prevent the hysteresis channels from taking effect.

In the UK to date, the government has announced a total of £1.6 billion to be invested in scaling up employment support schemes, training and apprenticeships to help people looking for a job. Young people will benefit most from this. This includes businesses being given £2,000 for each new apprentice they hire under the age of 25. This is in addition to the existing £1,000 payment the Government already provides for new 16-18-year-old apprentices and those aged under 25 with an Education, Health and Care Plan. A £111 million investment to triple the scale of traineeships in 2020-21 will ensure more young people have access to high quality training. However, none of the schemes mention retention of these new recruits.

It is important to point out that there is an alternative view to the hysteresis effects of a recession. The ‘creative destruction’ (Schumpeterian) view is that a sharp recession can have positive effects and that the economy can bounce back quickly. In the face of an economic crisis, new ideas and innovations emerge more quickly as previously unemployed workers become successful entrepreneurs. People and organisations are shaken out of complacency and have to think on their feet. ‘Zombie’ firms that survived the 2008-09 recession thanks to cheap money are swept away. Decisions that would have taken months to make are dealt with in days as the crisis focuses the mind of managers and leaders. Productivity picks up and economic growth accelerates. As John Collingridge said in the Sunday Times (26/7/20), “creative renewal should be the lifeblood of any market economy.”

However, most economists expect UK unemployment to rise significantly once the furlough scheme ends. Even without a second Covid-19 wave, the Organisation for Economic Cooperation and Development (OECD) predicts UK unemployment will fall from a peak of 11.7 per cent (almost 4m out of work) to only 7.2 per cent in 2021, significantly above the prepandemic level of 3.9 per cent. If there is a second wave, the OECD predicts that more than one in seven of the workforce (14.8 per cent) may be out of a job – a level far in excess of recent unemployment peaks in the 1980s and after the financial crisis. It is possible that the UK economy won’t recover its 2019 GDP until 2024. Indeed the National Institute of Economic and Social Research (NIESR) has recently estimated that real GDP in 2025 will be about £536bn per quarter compared to an estimate of somewhere near £584bn before Covid-19 became such a serious threat to growth. The NIESR estimates that if the UK economy had not suffered both the financial crisis in 2008-09 and Covid-19 in 2020, UK GDP would be £743bn per quarter in 2025, a loss of 27.86% of GDP.

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Capital Goods

Figure 5

Y

X

CONSUMER GOODS

In summary, the processes which cause hysteresis mean that unemployment could be persistently high for some time after a shock such as Covid-19. It can be seen as a leftward shift of the long-run aggregate supply curve, meaning that the economy has permanently lost a proportion of its potential output. This means that resources will need to be used to try and return the economy from X to its previous position on its production possibility frontier (Y), shown in Figure 5, and then expand it further to increase living standards. In the case of Covid-19, this could take some time given that in a ‘normal’ recession the vast majority of the population who are not out of work are free to spend as much as they wish. The government measures such as closures, restrictions and lockdowns stopped even that, thus decreasing the level of aggregate demand much more than in other recessions. Unfortunately for the UK, having a very service-based economy makes the impact of Covid-19 worse. Service sector activity – retail hospitality, entertainment – relies very much on the interaction of people.

Factories manufacturing goods are easier to re-open compared to leisure centres and night clubs. It will be a long road back to normality.

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Follow up research Investigate the Beveridge curve and why hysteresis might result in it shifting to the right.

Sources: Learneconomicsonline.com by Rhys Williams (13/08/2015).

Applied Economics by Alan Griffiths and Stuart Wall (Pearson Education 12th edition 2012) National Institute of Economic and Social Research Quarterly Review August 2020.

Hysteresis and the European Unemployment Problem: Olivier J. Blanchard, Lawrence H. Summers (NBER Working Paper No. 1950 -June 1986).

Causes and consequences of hysteresis: aggregate demand, productivity, and employment: G Dosi, M C Pereira, A Roventini, M E Virgillito.

(Industrial and Corporate Change, Volume 27, Issue 6, December 2018) Financial Times 5th June 2020.

Sunday Times 26th July 2020.

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