Coronavirus update: Supply shocks and risks of economic scarring

The coronavirus outbreak and the public health measures taken to contain it delivered one of the largest ever shocks to the UK economy leading to a sudden and large inward shift of short run aggregate supply.

The government instructed millions of people to stay at home and social distancing rules meant that many production plants were shut down on a temporary basis. The result was a negative supply shock for the UK economy on a scale that has not been seen for many years.

As a result of this and a steep drop in consumer demand, many firms in the UK and elsewhere have been working well below half of their productive capacity.

Risks of economic scarring effects

As the UK emerges from lockdown there are hopes that production will start to recover and a loss of real GDP of more than 25% can be reclaimed.

However, there are also fears that the coronavirus pandemic will lead to longer-term economic scarring effects such as the collapse of many retail businesses and hundreds of thousands of job losses in industries such as air transport and arts and entertainment.

In this case, there might be negative effects on the UK’s long-run aggregate supply causing a fall in potential output and illustrated on a diagram by an inward shift of LRAS.

Some commercially viable businesses are likely to go bankrupt especially when government financial support during the crisis comes to an end.

Many of the newly unemployed may find it difficult to get new work and there is a danger than long-term unemployment will jump eventually leading to a rise in economic inactivity.

Young people in particular are at greater risk of losing their jobs during the crisis and research shows that long spells of unemployment early in someone’s career can have a very damaging effect on their long-term employment and earnings potential.

Long run aggregate supply might also be damaged by a large fall in planned business capital investment which might lead net investment to become negative and leave the economy with an older and less productive capital stock.

The economic crisis is also expected to cause a decline in net inward migration of labour. A contracting active labour supply would be another negative factor for the country’s productive potential.

Suggested reading

FT (May 2020): Sunak warns UK economy could suffer permanent ‘scarring’

VoxEU (June 2020): The lasting scars of the Covid-19 crisis: Channels and impacts

IMF Blog (2018): The Economic Scars of Crises and Recessions