Sabotaging the recovery

I wrote last week about how a premature easing of lockdown in the UK would cost many more lives. This post will be about how it is also likely to create a weak recovery where some businesses will go to the wall and many jobs will be lost.

A good starting point in thinking about the kind of recovery we could have is to think about synchronized holidays, like Christmas or the summer holiday in much of France. Most of the economy closes down for a few weeks, but starts up again without any long term harm done. You get a V shaped recovery, which we never notice because it gets seasonally adjusted out of the data.

A few months is not fundamentally different from a few weeks, if the government provides sufficient support to firms, the self employed and individuals? The absence of such support gives us the first reason why a recovery might not be V shaped. Yet the UK government’s support over the last few months has been reasonably good, albeit with some notable exceptions.

After a holiday involving a few weeks, consumers’ preferences will be unchanged. Is the same true of a pandemic? If the virus has disappeared for good, or immunity against the virus is complete (with a vaccine, say), there seems no compelling reason to believe otherwise, although overseas travel will require the virus to have disappeared in other countries as well. Perhaps some consumers might initially not believe the virus has disappeared, but this might be offset by other consumers spending more time on social consumption than normal in celebration that the pandemic has ended. In some sectors this second effect could even lead to a larger recovery than the initial recession.

The main reason a V shaped recovery is not going to happen in the UK is because the virus has not disappeared. Compared to other European countries the number of new infections remains high, and as a result many consumers will be understandably reluctant to resume their normal patterns of social consumption. If the government also withdraws support from social consumption sectors, this inevitably means firm closure and firm downsizing, leading to a large increase in unemployment. Restoring confidence in countries where the virus has largely disappeared will not be easy, but that task is much harder when the risks of catching the virus are non-negligible.

There is a further hurdle in the face of a recovery that this government has created. Whatever the new number of infections are, will consumers trust the government when they are told they should resume social consumption? Almost everything the government has done to combat the virus has been a failure. The latest is withholding until recently Pillar 2 data from local authorities and the public. When people are told it’s their civic duty to resume social consumption, rather than simply being told what the risks of doing so are, they are bound to be suspicious of the government’s motives, and who can blame them.

The continuing high level of infections and lack of trust mean that many consumers will not resume social consumption. This poll shows that people’s perception of the risk from the virus has recently increased. This is the inevitable result of prioritising the economy rather than getting new infection numbers right down.

So what can be done? The government is not going to drive new infections down much lower by opening up pubs! It is not going to get trust back anytime soon. Can the Chancellor encourage reluctant consumers to resume social consumption by some means? A general fiscal stimulus, in the form of a tax cut, is unlikely to do much in this respect, because most of it will be saved. Furthermore what is spent is likely to go into sectors that can make a reasonable recovery, like clothing and consumer durables. Other forms of standard fiscal stimulus, including a VAT cut, are unlikely to avoid large scale redundancies from social consumption sectors.

The Resolution Foundation has a more interesting proposal, which is to give vouchers that are time limited that can be spent in vulnerable social consumption sectors (and which are switched off if a second wave appears and we have to go back into lockdown). This is the kind of sector specific stimulus we need. Another possibility would be a temporary cut in VAT on social consumption goods.

Even with such schemes, we are unlikely to see a full rebound in social consumption for some months to come. In a few specific areas social distancing means venues will inevitably be operating at a loss. Subsidies of various kinds to keep firms going and to avoid as far as possible large scale redundancies will be necessary.

While a general fiscal stimulus will not solve sector specific problems, if interest rates remain at their lower bound there is strong a case for economy wide fiscal support. Aggregate demand may remain low as investment is depressed by Brexit and uncertainty about a second wave. If the Chancellor is looking at ideas for what this stimulus could be, or more generally in how to meet our climate change goals, here is a report from NEF.

However unemployment will inevitably remain too high. As Paul Gregg notes, this prolonged recession will be much more unemployment intensive than the recession after the Global Financial Crisis. But just as fiscal stimulus can be regarded as an opportunity, so job losses can be seen as a chance to reskill the UK workforce, along the lines suggested by Jonathan Portes and Tony Wilson. However some of those working in areas where social consumption is low because of the pandemic may wish to remain in those sectors once demand picks up because new infections decline significantly or a vaccine is developed. It is worth noting that a Job Guarantee, if such a scheme existed, would provide an excellent chance for these people to do something useful in this enforced break in their careers.

These are all policies that will have much more work to do because this government made yet another error in their handling of this pandemic, which was to ease the lockdown while the number of new infections was still quite high. Most experts, and indeed most academic economists, understood it would be an error before it happened. It is an error that could sabotage what might have been something close to a V shaped recovery.

The economic effects of a pandemic

A little over ten years ago I was approached by some health experts who wanted to look at the economic effects of a influenza pandemic. They needed someone with a macroeconomic model to look at the general equilibrium impacts. In the 1990s I had led a small team that constructed a model called COMPACT, and these health experts and I completed a paper that was subsequently published in Health Economics. We reference to other studies that had been done earlier in that paper.

The current coronavirus outbreak will have different characteristics to the pandemic we studied, and hopefully it will not become a pandemic at all. (In terms of mortality it seems to be somewhere in between the ‘base case’ and ‘severe case’ we looked at in our work.) But I think there were some general lessons from the exercise we did that will be relevant if this particular coronavirus does become a global pandemic. One proviso is that a key assumption we made about the pandemic is that it was mainly a 3 month affair, and obviously what I have to say is dependent on it being short-lived.

It is worth saying at the start that the bottom line of all this for me is that the economics are secondary to the health consequences for any pandemic that has a significant fatality rate (as coronavirus so far appears to have). The economics are important in their own right and as a warning to avoid drastic measures that do not influence the number of deaths, but beyond that there is no meaningful trade-off between preventing deaths and losing some percent of GDP for less than half the year. 

Let me start with the least important impact from an economic point of view, and that is the fall in production due to workers taking more time off sick. It is least important in part because firms have ways of compensating for this, particularly if illness is spread over the quarter. For example those who have been sick and come back to work can work overtime. This will raise costs and might lead to some temporary inflation, but the central bank should ignore this.

This ‘direct’ impact of the pandemic will reduce GDP in that quarter by a few percentage points. The precise number will depend on what proportion of the population that get sick, on what the fatality rate in the UK turns out to be, and how many people miss work in an attempt not to get the disease. The impact on GDP for the whole year following the pandemic is much less at around 1% or 2%, partly because output after the pandemic quarter is higher as firms replenish diminished stocks and meet postponed demand.

All this assumes schools do not close once the pandemic takes hold. School closures can amplify the reduction in labour supply if some workers are forced to take time off to look after children. On the basis of the assumptions we made, if schools close for around 4 weeks that can multiply the GDP impacts above by as much as a factor of 3, and if they close for a whole quarter by twice that. If that seems large, remember nationwide school closures impact everyone with children and not just those with the disease.

But even with all schools closed for 3 months and many people avoiding work when they were not sick, the largest impact we got for GDP loss over a year was less than 5%. That is a one quarter very severe recession, but there is no reason why the economy cannot bounce back to full strength once the pandemic is over. Unlike a normal recession, information on the cause of the output loss, and therefore when it should end, is clear.

All this assumes that consumers who have not yet got the disease do not alter their behaviour. For a pandemic that spreads gradually this seems unlikely. The most important lesson I learnt from doing this study is that the pandemic need not just be a supply shock. It can also be a demand shock that can hit specific sectors very hard, depending on how consumers behave. This is because a lot of our consumption nowadays can be called social, by which I mean doing things that bring you into contact with other people. Things like going to the pub, to restaurants, to football matches or travel. Other sectors that provide consumption services that involve personal contact (e.g haircuts) and can easily be postponed may also be hit.

If people start worrying about getting the disease sufficiently to cut back on this social consumption, the economic impact will be more severe than any numbers discussed so far. One reason it is severe is that it is partly a permanent loss. Maybe you will have a few more meals out once the pandemic is over to make up for what you missed when you stayed home, but there is likely to be a net fall in your consumption of meals out over the year. What I realised when I did the analysis was just how much of our consumption was social.

This is why the biggest impacts on GDP occur when we have people reducing their social consumption in an effort not to get the disease. However falls in social consumption do not scale up all scenarios by the same amount, for the simple reason that supply and demand are complimentary. If school closures and people taking more time off work increase the size of the supply shock, the demand shock has less scope to do damage. The largest fall in annual GDP in all the variants we looked at was 6%.

Could conventional monetary or fiscal policy offset the fall in social consumption? Only partially, because the drop in consumption is focused on specific sectors. What is more important, and what we didn’t explore in the exercise, is what would happen if the banks failed to provide bridging finance for the firms having to deal with a sudden fall in demand. The banks may judge that some businesses that are already indebted may not be able to cope with any additional short term loans, leading to business closures during the pandemic.

It is in this light that we should view the collapse of stock markets around the world. In macroeconomic terms this is a one-off shock, so Martin Sandbu is right that the recent stock market reaction looks overblown. But if many businesses are at financial risk from the temporary drop in social consumption, that implies a rise in the equity risk premia, which helps account for the size of the stock market collapse we have seen. (I say 'helps' deliberately, as much of the impact will be on smaller businesses that do not find their way into the main stock market indices.)  

If I was running the central bank or government, I would have already started having conversations with banks about not forcing firms into bankruptcy during any pandemic. 

But economics can also influence health outcomes, and not just in terms of NHS resources. For a minority of self employed workers there will be no sick-pay and those without a financial cushion will be put under stress. One of the concerns as far as the spread of the pandemic is concerned is that workers will not be able to afford to self-isolate if they have the disease. So if I was in government I would be thinking of setting up something like a sick-leave fund that such workers could apply to if they get coronavirus symptoms.

The government also needs to think about keeping public services and utilities running when workers in those services start falling ill. In fact there are a whole host of things the government should now be doing to prepare for a pandemic. It is at times like these that we really need governments to act fast and think ahead. Do we in the UK, and US citizens, have confidence that the government will do what is required? One lesson of coronavirus may be never put into power politicians that have a habit of ignoring experts.