The economy that fell to Earth

My institute’s new analysis confirms that we face an “off the scale” economic crunch. How to respond?

April 18, 2020
Photo: Chancellor of the Exchequer Rishi Sunak
Photo: Chancellor of the Exchequer Rishi Sunak

A sombre day at the virtual Institute last Thursday. We had been working through the numbers for an assessment of economic prospects in the time of lockdown. The economy has been used as a tool to control the spread of this terrible virus and the result is that we are facing the worst quarterly outcome in modern times, which will be even worse than in the second quarter of 1921, when GDP fell by some 12 per cent. The worst post-war performance was in the first quarter of 1974, with a fall of nearly 3 per cent, and even in the worst quarter of the financial crisis, at the end of 2008, output “only” fell by just over 2 per cent. If the lockdown persists for the whole of April to June, it looks like output will be some 15-25 per cent lower than at the start. The numbers are stunning and off the scale of any normal fluctuations.

In a recession when demand falls, leaving firms to go out of business, governments are normally reluctant to do much beyond letting automatic stabilisers operate, which includes helping with income supports and benefits for those who lose their jobs. But what we have today is an induced contraction. We are slowing economic growth on purpose to limit the spread of the virus; almost a medically-induced coma in many sectors. The loss of income and jobs this time is therefore not directly the result of a change in market conditions, structures or faulty business plans, but the war against Covid-19. We started combat late and without much of the required ammunition, with a long-underfunded and depleted health service. And so we now need to work very hard to limit the damage.

There are three issues for us to plot. First, the macroeconomic response. How much more support can the Treasury find through income and jobs support, extending loan facilities and providing support for those now unemployed to start businesses and volunteer for those fields now in urgent need of labour inputs: distribution, social care, teaching and health? As it happens, much can be done virtually. But much cannot. There is space to borrow some 15-20 per cent of GDP without putting any great pressure on sterling markets, particularly if the Bank of England can support these fiscal responses by ensuring that there is necessary fiscal space, re-igniting asset purchases, deploying negative interest rates, improving the way that it communicates its plans for policy rates and considering operations that would cap bond yields.

Secondly, we need to think about the extent to which lockdowns may become a persistent feature of the landscape, with the economy entering periods of complete or partial lockdown intermittently until a vaccine is found. A further related issue is that, given the global deployment of lockdowns, there will be no recovery from sourcing demand and confidence from overseas. Overlapping periods of lockdown here and abroad will hold us all back. The associated constraints on liberties we have taken for granted for several generations will have severe social consequences, as will the economic effects. Just as those graduating in a recession have their lifetime incomes degraded, the young may find their networks and life chances permanently downgraded by a prolonged lockdown.

Finally, what we can do on the exit strategy? Typically economies can rebound very quickly from recessions, as spare capacity gets quickly gobbled up by investment and the lagged stimulus provided by monetary and fiscal policy. But we will find that the supply side is in as much a state of disrepair as it was prior to the lockdowns: low levels of capital (human and physical), creaking infrastructure and shortages in the provision of public services will act to hamper the speed of any recovery. The government must work now to win the peace and start formulating plans for the development of the supply side that can start on the very day any lockdown is removed. This means setting up a development bank charged with moving ahead with plans being formulated by the National Infrastructure Commission and the Industrial Strategy Council, without delay.

Although the clear sunny days at home and the noise of bird song remind me of blissful childhood vacations in the 1970s, that bliss was mostly born of ignorance of dangers that lurked in stagnating economies and prospects. Unfortunately, I cannot claim ignorance now and it is hard not to worry. And I do. But in my more optimistic moments I am reminded of the following fact: the highest quarterly growth rate was in the third quarter of 1921 and cancelled out much of the previous quarter’s shocking fall. But that is probably the very best we can hope for. Stay safe.

Jagjit S Chadha is Director of the National Institute of Economic and Social Research