Rising to the challenge

After another week of market drama, with big price corrections and a drying up of market liquidity, central banks and governments are stepping up to the plate to provide the biggest support package in modern times. We should not be under any illusions about the nature of the economic shock that is unfolding before us and as a response risk is being socialised to an unprecedented degree. This is a recognition that the coming shock is likely to be significantly worse than Lehman’s for the simple reason that COVID-19 is affecting everybody’s daily lives, not just a small section of the community. 

The market position 

From a market perspective, the wild movements we have seen in recent days represent attempts to find an equilibrium based on a complete absence of information. Precisely because we have no idea of how bad the COVID-19 infection rate will be nor how badly the economy will be impacted, investors cannot make even the roughest of guesses as to where the bottom is. We hear lots of reports from investors keen to put their funds to work, arguing that there are bargains to be had. But whilst this is understandable, it may be totally wide of the mark. What appear to be solid businesses today might suffer significant knock-on effects in future as they emerge from the other side in worse shape than we thought. 

Take airlines as an example. Admittedly they were operating on thin margins anyway, so they were always going to be badly affected by the collapse in international travel. But the risk is that people will change their post-crisis behaviour, perhaps because they are less willing to travel or because they start to pay more heed to the environmental implications of air travel. As a result, investors looking for bargains today may be disappointed if they back the wrong horse.

This underpins my view that we should be wary of accepting the consensus view that there will be a V-shaped economic recovery. In a sense, a lot of displaced activity in the coming months will be “permanently” lost. After all, people will not visit restaurants or bars twice as frequently in future to make up for the activity that they will be forced to forego during the spring. And in the early stages of any recovery, the crisis mentality is likely to persist with the result that the rebound may be much slower than supposed. Thus, rather than taking a year to recoup lost output it may take up to two (or even more). Suggestions that this may mark the start of a second Great Depression may sound alarmist, but the idea that we are about to return to business as usual strikes me as overly sanguine. Without wishing to sound trite, recall that 10 years after the crash of 1929, the world was hit by another shock in the form of World War II which resulted in the biggest expansion of the state in history. Dark times indeed! 

Monetary policy has acted with what limited scope it had left 

The policy response was a little bit slow to get off the mark at first but the authorities have reacted decisively in recent days to do “whatever it takes” to provide support. Central banks have committed to pumping in huge amounts of liquidity, in the form of direct asset purchases to ensure markets can continue to function and in the form of loan guarantees for businesses to ensure their continued operation during the worst of the crisis period. The renewed bond buying is an easy way to provide liquidity to banks but this is a blunt instrument to support the overall economy. However, it will support the bond market following a period last week when it wobbled following concerns at the sheer amount of debt that governments will be forced to issue. 

Whilst loan guarantees are a positive step, they are still loans, which means that many companies operating with already-stretched margins will have to take on additional debt in order to survive. Many small businesses are going to take a major hit as their income flows dry up and there will inevitably be staff layoffs which will hit people particularly hard at the lower end of the income scale. Governments have increasingly realised this and have moved quickly to adopt unconventional fiscal solutions. 

But fiscal policy is where the action is

The UK acted swiftly on Friday to unveil its Coronavirus Job Retention Scheme (CJRS), in which the government has committed to pay up to 80% of the wages of furloughed workers, up to a limit of £2,500 per worker each month. This will cover the period March to May and will be extended if necessary. It will not be cheap. Some back of the envelope calculations suggest that if 10% of employees are laid off, this could cost up to £8bn per month if all workers are paid the maximum amount. This will obviously vary according to the average payout and the proportion of furloughed workers and the table below shows some illustrative monthly fiscal costs.

In addition to these measures, the UK government has announced a deferment of business VAT payments due between now and the end of June and has extended the period of interest free loans to small businesses from 6 to 12 months. It has also raised the standard rate of Universal credit and Tax Credits for one year from 6 April, with the result that claimants will be up to £1040 per year better off, and has committed to providing an additional £1bn of support to renters. As one who has called for many years for greater use of fiscal instruments to support the economy, it is gratifying to see the government act decisively in this way. There are those who have pointed out the irony that it is a Conservative government which has acted to leverage up the UK national balance sheet, having criticised Labour governments for doing just that. But in truth, this is the right thing to do. People are being asked to make sacrifices and need support to help them do so.

A question which has been put to me by non-economists is who is going to pay for all this largesse. In truth, we are – maybe not immediately, but in the longer run. The UK government will have to significantly raise borrowing – it is too early to determine by how much – and if other governments around the world follow suit, there is going to be a lot of competition for bond investors’ attention. Under normal circumstances, bond yields would be expected to rise sharply in anticipation of big increases in national debt, which would in turn imply a rising proportion of tax revenue being used to service debt. Governments would thus be expected to respond with fiscal tightening. After a decade of austerity, this will clearly not be a vote winner. However, we can expect central banks to continue bond buying in an effort to keep interest rates low as we enter a period of intense financial repression. Low interest rates appear set to stay in place for years to come.

Future historians will likely look back at this week in 2020 as the point at which the world changed. Hopes that we would resume our march towards pre-2008 normality appear to have been dashed for good. We are now on a different economic and social path, and nobody knows where it will lead.