COVID-19 and the Phillips curve

iangunn Nov 4th, 2020

I am grateful to Emerita Professor Victoria Wass of Cardiff University Business School for drawing my attention to a thought-provoking blog by Simon Wren-Lewis, Emeritus Professor of Economics at Merton College, University of Oxford.

Professor Wren-Lewis uses Phillips curve analysis as a way of looking at policy responses to the Covid-19 pandemic.In 1958, economist A.W. Phillips published his study of UK data on wage growth and unemployment between 1861 and 1957. Phillips found an inverse relationship between the level of unemployment and the rate of change in wages: this shows up in the form a curve when the data is plotted on a chart. Subsequently, the Phillips curve relationship has been extended to the rate of change in prices. Lower unemployment is associated with higher inflation, and higher unemployment is associated with lower inflation.

Furthermore, and crucially, the extra inflation that comes from a rate of unemployment that is too low (sub-optimal) for a given level of economic growth feeds on itself, and will rise again. In other words, the relationship is not only inverse it is dynamic: ‘kicking the can down the road’ seems to provide some immediate relief but it simply stores up a bigger future problem.

There is a point on a Phillips curve that represents the rate of unemployment that provides the most stable rate of inflation, i.e. the one that does not accelerate: this is referred to as ‘NAIRU’ (the non-accelerating inflation rate of unemployment).

Can this approach be applied to another pair of evil twins, namely the trade-off between health and the economy?

Professor Wren-Lewis suggests there is a close analogy between NAIRU and the reinfection rate (“R”) of Covid-19. Therefore, attempting to balance health and the economy is a fool’s errand: such an exercise ignores the dynamics of the disease (that infections will increase if R is allowed to rise above 1).

Professor Wren-Lewis argues political pressures to try and balance health and the economy are leading to short-sighted decisions which will ultimately come back to bite us in the future, i.e. more economic damage in the long run will result from attempts to balance health and the economy than would result from getting the disease under control and having an effective track, test and isolate system (so that those who are not infected can get on with their everyday lives).

In other words, Professor Wren-Lewis suggests attention should focus wholly on keeping “R” below 1, through a combination of economic restrictions and track/trace/isolate mechanisms that are effective when spikes in disease occur.

This conclusion aligns with advice the UK government has been receiving from the scientists on ‘SAGE’ but not with government policy, which persists in seeking to balance health and the economy.