How quickly can an economy adjust?

Economies face many events that cause firms and consumers to adjust their behaviour. New technology, demand-side shock, supply-side shock all cause a change in the priorities of the economy. In theory, the price mechanism will lead to a smooth reallocation of resources as capital and labour are deployed from unproductive areas to new areas. Some economists even argue this process of ‘Creative destruction‘ is important for more efficient economies in the long-term

However, this process of adjustment can take time and lead to substantial inefficiency and under-employment of resources. It also depends on how quickly the economic shock occurs. For example, if new technology steadily becomes available, business can adjust and retrain workers. However, with something like the Corona shut down of 2020, the economy struggles to deal with the very large shock to the way the economy runs. In this case, it will take a considerable time for labour and capital to adjust to the seismic changes in demand and supply.

Corona shutdown

The Corona pandemic has changed many fundamentals of the economy. Events which rely on close proximity of people – leisure sector, concerts, football games, are now at risk of having to be put on hold for a long-time. Many thousands of people have lost their jobs in tourism, public transport, hotels, restaurants and related service sector. Even when the lockdown is lifted, restrictions could remain in place for over a year if not longer. It may also permanently change people’s behaviour. All these industries will see significant falls in demand, firms may close, and people lose their jobs

On the other hand, we have seen a surge in demand for supermarkets, online entertainment and online voice calls. Whilst jobs have been lost tourism, new jobs have been created in online delivery for supermarkets. However, although some sectors have done well, they only represent a small share of the fall in the service sector. For every new job created in online delivery, there are many more lost. Only a small fraction of the newly employed can gain work in online entertainment or with supermarkets.

Over time, how will the economy adjust?

If people stop going to certain events, then they will spend less on events like going to football games. To some extent, we will increase spending on other forms of entertainment, let us say online e-games. However, the spending will not be fully compensated. You can spend £100 on a football game (with transport and pre-game drinks). It is unlikely you will spend anything like that on e-games. A lot of spending is impulsive. If we are more likely to stay in, we could see higher saving ratios.

Therefore, if spending is curtailed many people will have more disposable income. They might either save this or find other goods and services to spend it on. For example, we may see a growth in home deliveries of fruit and veg. Often we underestimate the potential for new business to emerge. When we see old business decline it can be hard to imagine what will take its place. But, even if social distancing lasts a considerable time, it is likely there will be ways to find new spending and new types of business.

Lost demand. The problem is that although some money gets respent in different areas, there is also a significant demand-side shock, which will be very deep. People who work in these leisure industries lose their jobs and so see a significant fall in income. They will not readjust spending but concentrate on spending on essentials. Also, there will be knock-on effects. If many traditional businesses close down, landlords will see a fall in rent. Now some landlords are very wealth, but not all. Some landlords rely on rental income to fund other business investments. A drop in rental income will also have negative multiplier effects on the economy. The high street could see widespread closures. In this climate of falling demand and investment, it becomes difficult for capital and labour to be redeployed.

How will the economy adjust to the High street which has lost many businesses?

If the traditional high street firms close down due to the shock, then we may see a fall in business rents – which make it more possible for a new business to enter. Alternatively, high streets could be transformed into residential areas, and we simply lose some town centre shopping, as we rely increasingly on direct home delivery and miss out shops.

How will the unemployed adjust to changes in the economy?

Since the economic shutdown, many millions have lost their jobs, and even when the economy re-opens, many of these job losses are likely to remain permanent for a considerable time. Often unemployment is structural – the unemployed lack skills or geographical mobility. But, in this case the unemployment is primarily demand deficient and until economy recovers, we are likely to see persistent unemployment.

The Luddite Fallacy

The Luddite fallacy is the simple observation that new technology does not lead to higher overall unemployment in the economy. New technology doesn’t destroy jobs – it only changes the composition of jobs in the economy. For example, if computers make some people redundant a superficial observation is that computers are causing unemployment, but this ignores how new jobs are created in building computers and the increased productivity creates additional demand.

Related to the Luddite fallacy is the idea that economies will struggle to adjust. We often under-estimate how quickly the economy can adjust. But, in this case of the Corona shock, it will be a real challenge to adjust because the change is so abrupt, sudden and widespread.

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