Who will pick up the pieces of the post-Covid recovery?
The complexity of the crisis means we cannot change much until we plug the gaps
The UK appears to have had the worst recession of any leading nation during the pandemic so far, despite a strong short-term bounce in the summer. A drop of 9.9 per cent in 2020, the highest in the G7, is likely to be followed by just 4 per cent growth in 2021, once the vaccine deployment has taken hold. The IMF’s latest World Economic Outlook in late January and the Office for Budget Responsibility (OBR) accompanying the budget of 3rd March both agreed that, on current projections, the UK would take until at least mid-2022 before returning to pre-pandemic levels. Others would get there much faster, having contracted less sharply in the first year of the pandemic. Outside the G7, China was the only G20 country to have shown any growth last year, of some 3 per cent. But although this is the exception rather than the rule, the UK also did worse against most EU countries, though Spain saw an even bigger drop of 11 per cent.
What went wrong
The UK’s overdependence on the financial sector was believed to be the explanation for why the country saw a sharper early decline than many of its competitors during the financial crisis of 2008-2009. It is now suggested that the reason for the relatively poor UK performance during this current Covid crisis is the greater share of services in GDP, which necessitate much more face-to-face contact and which were therefore worst hit by successive lockdowns. Germany for example, which has done better overall economically throughout the pandemic, has benefited from a pickup in manufacturing activity across the globe, especially from China. So, although its own direct stimulus was just 4.3 per cent of GDP compared to over 12 per cent in the UK, its output loss last year was almost half that of the UK. But the fact is that there are countries with similar services dependencies as the UK that have suffered less of a contraction. Take the US, which went through a health crisis comparable to the UK and which in 2020 injected roughly the same amount of fiscal stimulus as the UK as a percentage of GDP—and yet experienced a contraction in activity of just 3.5 per cent. Instead it seems more likely that it was the lateness of response, the many policy U-turns and lack of clarity that exacerbated the UK hit. The end of the Brexit transition period on 31st December last year and the uncertainty over the likely Brexit deal may well have added to the malaise, affecting both confidence and investment. There is a general consensus that, by the end of 2019, GDP was probably at least some 2.5 per cent below where it would have been if the referendum vote had been to remain. It would be surprising if that trend didn’t continue through 2020, though the enormity of the Covid health crisis has made it difficult to disentangle the Brexit impact.
What about the longer term?
When it comes to Britain’s economic future, much will depend on whether the issues faced by firms trading with the EU in the early post-transition days are just teething problems, or whether they will worsen as various temporary arrangements end. Early evidence, such as the shortages on the shelves in Northern Ireland and the row over the movement of vaccines from the south into the north, have exposed the difficulty of having one part of the UK effectively still in the EU, which was the condition for approving the Johnson deal. There are reports of substantial rises in export and import bureaucracy and in delivery costs into and out of the UK. Shockingly, it seems that 65 per cent of trucks leaving the UK for the continent were empty, with exports to the EU falling by 40 per cent and imports by 29 per cent this March. Customs declaration requirements apply now that Britain is outside the customs union and the single market. HMRC estimates annual costs to UK exporters may amount to some £8bn a year. That’s the same as Britain’s net annual contribution to the EU budget.
It seems clear that trade will suffer now the UK is classed by the EU as a “third country”—and not just for goods. Non-tariff barriers on services are a real threat—with haulage firms and airlines losing many privileges; professionals, with some exceptions, finding that their qualifications are not automatically accepted across the EU; data agreements only temporarily granted pending negotiations; and financial organisations losing the “passporting” arrangement that allowed them to sell their products more or less uninhibited across Europe. The City of London Corporation has been protesting that the financial sector (7 per cent of GDP) was overlooked during the negotiations in favour of fish (0.2 per cent of GDP).
The National Institute of Economic and Social Research has estimated that, as a result of leaving the single market and the customs union, UK-EU goods trade could be some 40 per cent lower and UK-EU services trade some 60 per cent lower over the next 10 years, compared to what they would have been with continued EU membership. New trade deals are expected only to dent rather than offset this shortfall. Their analysis of the Johnson deal suggests that output would be some 3.5 per cent below where it would otherwise have been in 10 years’ time due to lower foreign direct investment, smaller migration flows and reduced productivity. Government revenues will also suffer. The OBR declared that the early trade problems with the EU post transition were worse than had been expected, and would weigh on the economy more heavily this year. No wonder that the UK has unilaterally decided to extend for a further three months the light touch regime for goods coming into the UK from the EU—even though the EU will be applying all the checks the other way round. The UK government has also temporarily stopped checks on goods from the British mainland to Northern Ireland, with the EU starting legal actions against us in response.
Things will get better—but by how much?
The first quarter of 2021—and possibly also the second quarter—won’t be good for Europe or for the UK. Many EU countries are entering further lockdowns faced with a resurgence of Covid cases, as the rate of vaccinations lags behind. The threat of a double-dip recession looms. But the second half of the year should see a bounce back in activity. The IMF is forecasting recovery of some 5 per cent for the world economy for 2021, though the advanced nations will lag behind.
What about further ahead? Can the aftermath of the financial crisis provide any answers? After 2008, although there was a quick return to growth in the UK, the path from then on was modest, with weakness in business investment accentuated by austerity policies to restore public finances. Unemployment fell to its lowest levels in decades, but the new jobs created were generally of lower value, many with low security. Real weekly wages only returned to pre-financial crisis levels a few months before the pandemic struck. Productivity growth never recovered to pre-crisis levels.
Like last time, private firms will of course come to the rescue. A large part of the economy has continued to function through the crisis, and not just the public sector. Manufacturing and construction have been in positive territory pretty much since the summer. The digital sector, online retail, delivery and distribution, supermarkets and life sciences have also done well. After a brief interruption, the housing market was boosted by the temporary cut in stamp duty. The government support for small and medium-sized businesses and others, via business rate holidays and grants, has helped, as have the extra measures to boost incomes during lockdown. There is hope for a big boost to the economy, once vaccine rollout allows households lucky enough to receive government or employer support the opportunity to spend again. The savings ratio—how much households save as a percentage of their resources—rose to a historic high of 29.1 per cent in the summer, up from 6.8 per cent a year earlier, before falling back to some 15 per cent since—still at levels not seen since records began. Andy Haldane, the Bank of England’s chief economist, estimates that there is a pool of some £100bn to £250bn of excess savings waiting to be unleashed to meet huge pent-up demand.
“In the longer term we will need an industrial strategy that ensures many of the remnants of this crisis are dealt with”
But many have suffered: leisure and tourism, the creative and hospitality sectors, transport. Retail footfall has experienced a sharp decline. And there will still be the fear, as there was after the previous crisis, of a loss of skills, a perennially unproductive economy with rising individual and regional inequalities and a loss of competitiveness. The current unemployment rate of 5.1 per cent has been flattered by the furlough scheme and many—including women, older workers and many self-employed—have suffered disproportionately. The true underlying rate may be anywhere between 6 and 7 per cent. Headline unemployment is bound to rise as support is eventually phased out.
And then there is the impact on the young and lower paid who have either had their education disrupted or have been in insecure, low-paid jobs that cannot be done from home. On the wider front there are concerns about mounting debt, the credibility of Britain’s fiscal stance in the long-term and our future financial stability. What will happen to the firms that have taken bank loans, backed by government guarantees, but end up unable to make repayments? And, indeed, the impact of Brexit itself may linger. Although Covid-19 is causing more job losses than Brexit in the short term, as well as greater swings in output, most academic studies suggest that the long-term costs of Brexit are likely to be considerably bigger than those caused by the pandemic.
What has changed?
The UK will have borrowed some £355bn in the financial year ending in April 2021, some 16 per cent of GDP, compared to just £55bn in the previous financial year. In recent months the debt-to-GDP ratio has risen to above 100 per cent. Another £234bn will need to be borrowed in 2021-2022. The latest OBR forecast suggests that the UK will still need to be borrowing some £74bn a year in 2025-2026. But on the positive side, this has been relatively cheap to finance. Although concerns about inflation are beginning to be reflected in higher bond yields, the UK and most developed countries, even heavily indebted ones, have generally been able to borrow at near-zero interest rates, at times even negative ones through the pandemic. It has also helped that the regulatory framework has been strengthened all across the world since the financial crisis and that bank balance sheets were in a better position this time round when the crisis hit.
Additionally, as a result of the depth of the crisis, the EU seems much more willing now to share risks, rather than leave each country to fend for itself. A €750bn Recovery Fund, to be spread across all member countries in the form of loans and grants, has been approved. Meanwhile central banks, including the ECB and BoE, have used monetary policy and quantitative easing (QE) in a procyclical way during the crisis, reinforcing the fiscal stimulus. Often framed as “printing money,” QE actually involves buying bonds in the secondary market, which keeps yields and hence long-term interest rates low.
But most importantly, there has been a volte-face by the IMF and the World Bank. Instead of preaching—and often enforcing—rapid fiscal consolidation, as they did in 2010, they are now urging economies not to withdraw stimulus too early. The emphasis is now on ensuring growth resumes. So far, some $12 trillion has been spent globally to combat the crisis, mostly by the developed world. The US under new president Joe Biden has just announced an extra $1.9bn stimulus package, which the OECD estimates will by itself push global growth this year up by an extra 1 per cent. Emerging markets have also been supported with debt holidays and at times unconditional extra financing to help them get through these difficult times. Amazingly, it also looks like the restrictive Growth and Stability Pact, which constrained development for years in the eurozone after the financial crisis, will be reformed. It is at present suspended while the crisis persists. With interest rates so low, the notion of what constitutes a sustainable debt level has at last shifted considerably.
And looking ahead…
The hope is that market sentiment will stay positive as the vaccine rollout intensifies. In this, at least, the UK seems to be ahead of the game, having vaccinated more than 40 per cent of its adult population already. But uncertainty will remain. Although borrowing next year will come down sharply as the economy recovers, it will still stay at historically high levels for years to come. In the short term, the economy will be sustained by the further extension of the furlough scheme and other support packages for individuals and businesses announced in the 3rd March budget. The extra time limited capital allowances may see a temporary resurgence in business investment before the sharp rise in corporation tax from 19 to 25 per cent planned for 2023.
But worries for the longer term remain. We appear to have abandoned the Industrial Strategy run by the Business Department (BEIS) and replaced it with a more nebulous Plan for Growth which seems to reside more within the Treasury. The challenging Industrial Strategy Council, chaired by BoE chief economist Haldane, has just been abolished. And although some infrastructure money has been set aside, including for green public transport, its full impact remains unclear. There is serious doubt on how achievable the government’s net zero carbon emissions ambitions in fact are.
There are also unfortunately very few quick fixes for the individual and regional inequalities that have emerged during this crisis. Brexit could in fact make things worse. A recent survey has found that an extra 3.5m people in the UK are now under financial stress. Freeports, spread around the country and announced with great fanfare by the chancellor Rishi Sunak, will do little except displace activity from other parts of the UK. Extra funds for towns and moving a few civil servants to the north will achieve very little in “levelling up” regions. In any case, a recent report by the Centre for Cities warned that the cost of levelling up has risen during the pandemic and there are worries that in fact the south may be “levelling down.” This has its own dangers. It is always worth remembering that London, the southeast, and to a very small extent the east of England are the only parts of the UK that contribute positively to the Exchequer. All other regions tend to suck money in.
For the moment, therefore, the uncertainties are too large as to what a post-Covid, post-Brexit world may look like. Much will depend on whether policy can make a difference. But looking at the latest OBR forecasts the picture being painted is a depressing one. Yes, we will see a bounce back—7.3 per cent growth next year. But after that, the economy reverts to just middling growth of 1.6 to 1.7 per cent per annum. It is difficult to discern a productivity miracle in these figures.
This article is featured in Prospect’s new “The Road to Recovery” report, published in partnership with Lloyds Banking Group, the Government of Jersey and Jersey Finance. Read the full report PDF here.
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