The COVID-19 pandemic has given the economy the largest negative shock since the Great Recession of 2008. Without an effective long-term economic response, the effects of the pandemic could be permanent, writes Colgate University Professor of Economics Thomas R. Michl in “Path Dependence and Stagnation in a Classical Growth Model.”

The paper, cowritten with Colorado State University Professor Daniele Tavani and published by the Political Economy Research Institute at the University of Massachusetts–Amherst, began as a series of lectures that Michl taught in his Growth course at Colgate. It melds a technical progress function with a classical growth model to study the effects of permanent changes in parameters and temporary shocks such as pandemics. 

A key concept in the model is path dependence, a term that describes a system that can achieve many different equilibria depending on its past history.

Michl and Tavani write that a “business-as-usual approach” to demand management will not be enough to shift the economy out of the shock of the pandemic, which has seen negative level effects on productivity in both capital and labor. The temporary shock of the pandemic may very well have a permanent effect on employment, distribution, technical change, and accumulation, they posit.

Even pre-COVID, the economy still had not recovered fully from the global financial crisis (GFC), entering a state of “secular stagnation” under neoliberal capitalism — a period of low economic growth, leading to a reduced wage share for workers, income inequality for working families, and increasing wealth inequality in the U.S., Michl explains.

Consequently, the economy is still struggling with “hysteresis,” a key tenet of Michl’s work, in which an economic state persists even after the shock. In this case, the GFC had permanent effects on the supply side of the economy. Even innovative changes from the Fed haven’t overcome those effects. 

“If there isn’t any policy response, then the model says there will be negative effects on things like productivity growth, distribution will get more unequal, and employment will fall.” 

Michl explains that there is an attitude that the economy is “like a billiard ball in a large bowl” and that a single push will always return it to the same spot (or equilibrium): ultimate stability. But that is inaccurate, Michl says — an erroneous attitude grounded in the Solow growth model, developed in the 1950s, an era of economic stability that the U.S. has not seen since.

Instead, the economy really has multiple equilibria. And when a negative shock happens, such as a pandemic, Michl says, “employment falls, workers are in a weaker bargaining position, so they get a smaller share of output and income, and as a result of this productivity mechanism, you get slower productivity growth.” This leads to more inequality due to lower employment and lower productivity growth and lower general economic growth.

Michl and Tavani’s model suggest that the kind of neoliberal capitalism that has led to the secular stagnation has been driven by a combination of diminished investment and a reduction in worker bargaining power, and that a temporary “unfavorable shock” to the output-capital ratio, such as the pandemic, could permanently reduce the employment rate (percent of working-age people in jobs). This would lead to reduced rates of technical change, capital accumulation, and population growth while further undermining workers’ bargaining power.

“If there isn’t any policy response, then the model says there will be negative effects on things like productivity growth, distribution will get more unequal, and employment will fall,” Michl says. 

This is called “wage-led” growth, because lower wages lead to less growth (and, conversely, higher wages lead to more growth). “The growth rate of output is the sum of the growth rate of productivity (output per worker) and the growth rate of employment (the number of workers),” Michl says. “Our model predicts wage-led growth as long as the growth rate of employment does not change too much, since it works through the productivity growth effects.”

That’s the worst case scenario. But since they first wrote this paper in 2020, Michl has begun to feel more optimistic due to policy changes from the federal government. He believes that the Biden administration’s additional stimulus funds and proposed infrastructure program may be aggressive enough to undo some of the damage. 

“Political and institutional changes are really important. That’s not in the model,” Michl says.

Additionally, the Fed has accepted the idea that, in a recovery, they must let the inflation rate go above their 2% target. “They’re committed to running a high-pressure labor market, where workers are in a stronger bargaining position. That also makes me feel it’s not clear what the long term effects will be,” Michl says. “The best-case policy response is that we actually reach a turning point and get out of this period of secular stagnation, where there’s no productivity growth and the labor market is really weak. Maybe we get into a new era of a much more dynamic form of capitalism.”