Union bashing

There has perhaps never been a point in the last 300 years when the union between England and Scotland has looked so strained and there is increased speculation that Boris Johnson will be the prime minister who presides over a breakup of the Union. From differences over Brexit to concerns about how the pandemic is being handled, there are many issues over which governments in London and Edinburgh are not seeing eye-to-eye. Some of these issues may, however, be overdone by an excitable media.

Scottish rumblings about home rule have existed since Victorian times but it was only in the 1970s that it started to make its presence felt in a big way. The discovery of oil in the North Sea off Scottish shores gave impetus to calls for independence and the failure to bring about a Scottish Assembly in a 1979 referendum, due to a wrinkle in the law, was rectified following a second plebiscite in 1997. A further referendum was held in 2014 on whether Scotland should secede from the UK altogether, which failed by a margin of 55% to 45%. But in the last six years much has changed and calls for a second independence referendum are gathering pace. Like all good macro topics, the politics and the economics are intertwined and I take a look at some of the issues here. 

The politics are unfavourable … 

The Scottish National Party, which has formed the government north of the border since 2007, has enshrined the goal of independence in its party creed. But it believes in doing so as part of a consensual process in which the Westminster government collaborates. David Cameron’s government granted the SNP its wish for an independence referendum which took place in September 2014 but failed to get over the line. Having failed in its objective six years ago the SNP’s attempt to reopen the question has so far fallen on deaf ears in London. Indeed, when the UK government sets itself against a second referendum, as Boris Johnson’s has done, it becomes virtually impossible for the Scottish government to achieve its goal of independence in the manner that it would like.

Recent newspaper headlines have focused on the fact that those supporting independence are now ahead in the opinion polls, with a survey released earlier this month giving them an 11 percentage point lead over the unionists. But as chart 1 illustrates it is only in recent months that pro-independence supporters have started to build up a lead. With around 9% of voters apparently undecided, it is far too soon to conclude that the independence camp has built up an unstoppable head of steam. A big contributory factor to recent trends is the increased opposition to Boris Johnson’s government. Ever since the days of Margaret Thatcher, support for the Conservatives in Scotland has wavered between lukewarm and hatred. Given the Scots’ opposition to Brexit and the fact that the prime minister is its public face, Johnson is not exactly Scotland’s favourite Englishman to start with. His handling of the Covid pandemic has made the situation worse, with a recent poll giving him a net approval rating in Scotland of -43 compared to +61 for First Minister Nicola Sturgeon.

As it is, the Conservatives have only six MPs in Scotland which has stoked resentment that they do not have a mandate to take executive decisions north of the border. But the fact that they captured 345 of their 365 seats in England at the last election means that on a nationwide basis it is very difficult to prevent them from assuming overall parliamentary control. Latest comments from Johnson suggesting that Scottish devolution has been a “disaster” have further added to his unpopularity north of the border and fuelled concerns that whilst Scottish nationalists may form a government in Edinburgh, English nationalists do so in London. The upshot of all this is that it is difficult to disentangle dislike of Johnson from genuine support for independence. If the Brexit referendum of 2016 taught us anything, it is that we have to separate opposition to the government from the issue at hand. For this reason a referendum in the near-term may not be a good idea as it risks conflating a number of issues. 

… the economics even less so 

In many ways the economics of an independent Scotland are even less favourable than they were in 2014 at the time of the last referendum. My view at that time was that the pro-independence lobby significantly understated the economic costs of going it alone. Nothing that has happened in the last six years has changed my view. The Scottish government’s assumption was that the revenue from oil resources would provide a significant safety cushion. Without going through all the calculations here, my 2014 analysis concluded that Scotland had 40-50 years of viable reserves. But since the costs of extraction will rise as the most easily accessible reserves are exhausted, a lot of what is in the ground may not be worth recovering, particularly if oil prices remain low. Six years ago the government assumed a long-term oil price of $100/barrel: It is currently trading at just above $40 and has averaged $55 since 2015. The switch away from fossil fuels will likely put further downward pressure on prices, suggesting that Scotland may not be able to reap the benefits of its oil reserves in the way its government hoped.

Such revenue shortfalls will have significant fiscal implications. In fiscal year 2019-20, the UK recorded a fiscal deficit equivalent to 2.5% of GDP whereas Scotland reported a figure of 8.6% (including Scotland’s share of oil revenues – chart 3). Whilst revenues are lower than the UK average, the real problem is that Scottish spending levels are far higher than the national average accounting for 46% of GDP versus a UK average slightly below 40%.

This does not mean that Scotland will necessarily be unable to fund itself but it may not be able to maintain its spending pledges without significantly raising taxes elsewhere. Since an independent Scotland would be a smaller and more open economy than the rest of the UK, it would have to rely more heavily on taxing immobile factors such as property. It is beyond the scope of this post to cover all of the other economic issues but an independent Scotland would also have to figure out how to meet its share of fiscal liabilities accrued whilst it was part of the UK and would also need to decide on its monetary arrangements. Suffice to say there are a whole lot of economic questions which require answers. And whilst many Scots are keen to see their country re-join the EU, their application would face significant opposition from Spain which has no wish to set a precedent by allowing regions which secede from their former country, such as Catalonia, to join the bloc. 

And yet … 

Whilst there are significant economic costs associated with Scottish independence which have not been fully thought through, the idea of controlling one’s own destiny is an increasingly attractive one at a time when many Scottish voters feel they are being ignored by a government whose ambitions do not coincide with theirs. My position thus remains the same as in 2014 which is that an independent Scotland will fare rather better than the unionists believe but will endure considerably more pain than the secessionists are prepared to admit. With Labour leader Keir Starmer refusing to rule out a second referendum, my long-standing prediction that the Scottish position could echo that of Canada where a second referendum on Quebec was held 15 years after the first could yet come about.

Deal him out

Cutting it fine

It is now less than seven weeks until we reach the end of 2020 – a year that many of us will be only too glad to see the back of. It will also mark the point at which the UK exits the Brexit transition period. You will need no reminding that as of now the UK has still not reached a trade agreement with the EU. This means that businesses have less than seven weeks to scramble together a business plan allowing them to cope with the changed border arrangements for EU trade. Although the government has increasingly tried to blame the business community for its lack of preparedness, this argument wore thin many months ago. Irrespective of whether there is a deal or not, exporters need some certainty on the nature of the arrangements to which they are expected to transition. The only certainty is that everything remains uncertain.

Last month the National Audit Office released a report that concluded “preparations to manage the border at the end of the transition period remain very challenging … [However] there remains significant uncertainty about whether preparations will be complete in time, and the impact if they are not. Some of this uncertainty could have been avoided, and better preparations made.” The last sentence is an understatement. In 2019 the government complacently assumed that leaving the EU on WTO terms would be no big deal. By September 2020 it was using statutory powers to allow it to build lorry parks wherever it wanted, irrespective of objections by local councils. We are now hearing a rising number of reports from industry groups increasingly concerned that their business will suffer as a consequence of the lack of transparency on the arrangements for 2021.

A trade deal is possible but it comes at a cost

I maintain that some form of trade arrangement will be agreed between the UK and EU before year-end. This may yet prove overly optimistic: Time is after all running out. Moreover, the best that can be achieved at this late stage is a deal covering a narrow range of goods. The fact that the service sector has been largely ignored reflects wilful neglect since the UK runs a large surplus in services trade which partially makes up for the shortfall in goods trade. At a bare minimum, any deal agreed with the EU this year should be the first step in a long-running series of negotiations designed to fill in the many gaps in trade negotiations.

As it is, whilst the BoE’s forecast released last week assumes that a free trade agreement is reached before the end of 2020, it will still imply the introduction of customs, rules of origin and some regulatory checks on goods trade. In addition “some cross-border provision of services is also likely to be affected by new barriers to trade” and as a result “trade and GDP are temporarily lower in the near term as firms adjust to the new arrangements.” All in all, the BoE forecasts that net trade will subtract almost three percentage points from GDP growth next year. In a “normal” year when GDP growth might be expected to run at around +1.5%, this would imply a rate closer to -1.5%. Were it not for the distortions to GDP posed by Covid which will hide much of the statistical impact, serious questions would be asked of a policy which causes such economic damage.

Whatever happened to "they need us more than we need them"?

Looking back four years, this is not what Brexit proponents promised. Recall we were told that doing a trade deal with the EU would be the “easiest deal in human history”; that we would have the “exact same benefits” that we have now and that we could “have our cake and eat it?” Many of us pointed out that none of these statements were true and that those making them were deceiving the electorate. Anyone who voted for Brexit on the basis that cross-border arrangements would remain largely the same has reason to feel cheated and the survey evidence continues to suggest that the electorate has changed its mind.

An excellent essay in Prospect Magazine by Anand Menon and Jill Rutter looks at the factors which have caused the Brexit promises made in 2016 to morph into today’s confrontational negotiations in which the UK government prioritises sovereignty above all other considerations. None of the points come as any surprise – indeed, I have covered them all at one time or another over the years – and the authors conclude with a point I made long before the referendum that a soft Brexit was always the worst of all worlds, “where you are locked out of the room but still locked into most of the rules.” They also highlight that a “soft Brexit always carried within it the seeds of its own destruction.” That being the case, none of the economic promises made in 2016 was ever achievable (again, no surprise). But it does raise the question of what exactly is the point of Brexit? (Hint: It isn’t about the UK gaining the fictional degree of control over its laws that the ultras believe).

Removing an obstacle

At this stage in the proceedings, a rational government ought to conclude that when a policy promise becomes undeliverable it should rethink the basis of its strategy. This is not necessarily to say that Brexit should be reversed (although that would be nice) but at least the clock should be stopped in order to give both sides time to work out what is realistically achievable. Either way, something has to give and the announcement that Boris Johnson’s senior adviser, Dominic Cummings, has left his position suggests something is afoot. Indeed over the past couple of days, a number of Brexiteers on Johnson’s backroom staff have left their posts (not all willingly). The fact that the composition of the Downing Street team is changing is an indication that the government realises its approach up to now has not worked and that a change of tack is needed.

Cummings’ departure has garnered the most headlines. Recall that he was the campaign director of Vote Leave and is a hardline proponent of Brexit, and the fact he is no longer in post has given rise to suggestions that Johnson is preparing to offer more concessions to secure a deal with the EU. Naturally the government insists that it is not going to back down in negotiations but that should be viewed as the smokescreen that it undoubtedly is. The breakup of the Brexiteer cabal at the heart of government can only be a good thing for it ought to allow more rational voices to be heard.

But the damage they have caused in the last 16 months should not be forgiven or forgotten. From proroguing parliament to breaking international law in order to achieve their aims, theirs has been a scorched earth policy devoid of compromise and it has failed. Perhaps now Johnson will finally accept the reality of the position he finds himself in and sign on the dotted line to avoid a no-deal Brexit at the start of January. However, it will still be a bad economic deal. Once upon a time the government used to tell us that no deal is better than a bad deal. Once upon a time, people also believed the Earth was flat.

Markets keen on the vaccine

2020 has proven to be the year from hell, yet two pieces of good news have today given markets a rocket-propelled surge. Markets were overjoyed enough with the news that the uncertainty surrounding the US election is effectively over but the news that a promising vaccine has been developed against Covid-19 sent them into ecstasy. The vaccine has been developed by Pfizer Inc. and BioNTech and is 90% effective, according to the manufacturers. It is obviously very early days to be talking about a solution to the pandemic which has produced the biggest collapse in global activity in 90 years. The vaccine may yet prove to be a damp squib, and it will not prevent the next few months being exceptionally difficult for the European and US economies. But it does represent a potential game changer. 

Market implications 

In terms of the market reaction the FTSE100 today recorded its 17^th largest daily increase on data back to 1984 (9437 observations); the rise in the CAC40 was the 10^th largest on data back to 1969 (13528 data points) whilst the IBEX recorded its 6^th biggest increase since 1987 (8829 observations). That said, all three markets remain heavily underwater for the year (chart). Interestingly, sectors which have been particularly badly ravaged over the past six months have been amongst the strongest performers. The stock price of International Airlines Group rose by 25% in the course of today, although it is still 70% below the 2020 peak recorded in January. By contrast, companies whose business model has thrived during the lockdown have underperformed. Ocado Group Plc, which provides grocery home delivery services, was down 12%. On the other side of the Atlantic, Zoom’s price was down 14% at the time of writing and even Amazon was down 2%. All this strikes me as a little premature. A lot of international business meetings will likely continue to be conducted via Zoom rather than people jetting off for a one hour face-to-face as companies continue to bear down on costs.

Whilst it may be a little early to swap your Zoom stocks for IAG, there is some method in the market madness even though it is questionable whether it should be factoring in all the good news immediately. A combination of extremely low interest rates and the prospect of an economic recovery ought to support equities in the medium-term. Accordingly investors may reduce some of their exposure to safe haven assets such as fixed income and gold and position into equities, although a prudent investor who missed today’s rally may be advised to buy on the dips since some of today’s gains will undoubtedly be given back before long. 

Economic implications 

The prospect of a vaccine has major economic implications. After all there is a lot of pent-up demand which has been postponed since the spring. But the vaccine is nowhere near ready for widespread use and even if it does get approval before year-end, as has been suggested, it is unlikely to be widely available until the second half of next year at the earliest. Accordingly the impact on the wider economy is unlikely to be felt before 2022. Over the coming months governments will thus have to continue providing support to those who have lost their jobs or whose jobs are at risk. But the prospect of a vaccine changes the calculus by resolving the duration mismatch problem which governments have faced in the course of this year.

Whilst governments want to provide as much support to the economy as possible, they are also acutely aware of the costs The UK government has in recent months been particularly hesitant to open the taps further. Only last month Chancellor Rishi Sunak suggested that “we have a sacred responsibility to future generations to leave the public finances strong and … this Conservative government will always balance the books.” But if a vaccine is in the offing governments will not face an open-ended commitment to provide fiscal support: They can act in the near-term with a high degree of confidence that an economic recovery lies ahead.

This does not change my long-held view that there will be a considerable degree of economic scarring. It is highly likely that the pandemic will prove to be a watershed for the economy. Part of the change in economic behaviour observed over the last eight months will prove to be permanent with the result that there will be a period of resource reallocation as the economy transitions to a new structure. Such an outcome could be driven by a change in tastes (e.g. a preference for online shopping rather than physical shopping, which will have major implications for the retail sector). This in turn will almost certainly result in frictional unemployment which will take some time to be eliminated. It could also mean that the sectoral distribution of capital which prevailed prior to the pandemic will have to be significantly changed, implying a faster rate of capital scrapping in those areas where it is no longer required which turn will depress the economy’s potential growth rate (at least temporarily).

The UK will find itself in a worse position than other European economies. It is becoming increasingly evident that the form of Brexit the government is intent on delivering will be a much harder variant than imagined even a year ago (I will come back to this in a future post). Accordingly it is likely that even in the absence of the restrictions imposed by Covid-19 the UK will take longer to get back to pre-recession levels of output than elsewhere.

For all today’s optimism there is still the potential for the path out of the pandemic to prove torturous and uneven. However it represents the first piece of genuinely good news in the fight against Covid-19. As The Queen put it in her April broadcast “while we may have more still to endure, better days will return: we will be with our friends again; we will be with our families again; we will meet again.” But as the old song has it, “Don’t know where, don’t know when.”

It's over, yet it isn't

At the time of writing we still do not know who has won the 2020 US Presidential election. Whilst it matters profoundly who gets the keys to the White House, many of the issues raised during the election campaign will remain unresolved. Above all else the election reminded us just how split the US is along cultural lines. It is not my intention to get into the details of how Trump might react if he were to narrowly lose the election or the actions Biden might take if he were pipped at the post. Such issues are well covered in the press (here for example). I wish to focus instead on what the election tells us about the nature of the economic and political system in the US (and maybe also the UK) and what the next four years are likely to bring.

We should start by pointing out that the US is not the only country going through some sort of existential political crisis. I have been highlighting such issues in the UK on this blog for quite some time, but the splits on the other side of the Atlantic have existed for longer and are more entrenched. Indeed almost 15 years ago – long before most people had ever heard of Obama – the academics Mark Brewer and Jeffrey Stonecash argued that the cultural split on social and religious lines is only half the story. Division is also fuelled by differences in income and economic opportunity, as I pointed out a few weeks ago.

With the benefit of hindsight I am not sure whether Obama’s message of hope in 2008 would carry the same resonance today, even though many of the problems remain the same. Perhaps what the US election makes clear is that we are not about to return to a world of consensus anytime soon. Trump is not an outlier representing a deviation from the norm. He is the embodiment of a large slice of the electorate that wishes to overturn the status quo because it has not worked for them. I have made the point repeatedly in recent years that governments promised a quick return to the good times following the GFC in 2008 but have on the whole been unable, or unwilling, to deliver. This was partly a consequence of deliberate actions, with the likes of the UK introducing a policy of fiscal austerity which made such a major contribution to the Brexit vote. In the euro zone it was more by accident than design but simmering tensions between southern Europe and their northern neighbours remains a fault line at the heart of monetary union.

In the US the widening gap between the haves and the have-nots is the result of benign neglect. Trickle-down economics, a corner stone of Ronald Reagan’s policies in the 1980s, has never been repealed but it increasingly appears to be leading to adverse outcomes. Research into US wealth and income equality conducted by the Pew Research Center throws some light onto why people are so dissatisfied. Average household incomes in real terms have basically stagnated over the past 20 years, growing at a miserable 0.25% per annum. In the preceding 30 years they grew at an average rate of 1.2% per year. To put it another way, real incomes are more than 20% lower than they would be had the trend over the period 1970 to 2000 been sustained. Moreover the data also show that households at the upper end of the earnings scale have continued to outperform those lower down the scale.

A similar story holds for wealth where growth in the wealth holdings of upper income families has outstripped that of lower income families. Indeed the disparity has widened in recent years, with the real value of wealth holdings for upper income families having risen since the turn of the century whilst those lower down the scale have seen the real value of their wealth holdings decline (chart). The Pew Center makes the point that high income households are less dependent on the value of their homes to generate wealth and are more likely to hold financial assets whose value has been boosted in the low interest rate environment. It does therefore seem to be the case that policies to boost the stock market really do benefit the already-rich at the expense of the less well off.

It seems obvious that the widening disparity between the rich and the less well-off is a key reason why people continue to vote for Trump. Whatever people may think of him, his electioneering is touched by genius – a multi-millionaire pretends to be on the side of the little guy, promising them they will be better off under his presidency whilst the policies he espouses, such as tax cuts, benefit Trump and his ilk. Throw in the smokescreen of blaming foreigners (in this case the Chinese) for US economic woes and he has it made. However, Trump has done nothing to make life better for his core voters. The way to alleviate some of their problems is to apply a redistributive fiscal policy but that is not going to fly in a country which sees such options as heretical socialism. Indeed, the Republicans hate Obama’s signal policy on healthcare reform because it seems so un-American.

Whoever is the next President is unlikely to redress the balance by raising taxes on higher earners. Bernie Sanders tried to popularise such a policy and look where it got him. However, under a Democratic President there might be a move towards increasing spending. Modern Monetary Theory (MMT) is popular on the left wing of the Democratic Party and may make small steps towards the mainstream. This policy (which I looked at here) in effect suggests that because governments are the monopoly supplier of money they can provide unlimited quantities of liquidity without creating inflation. There is a lot wrong with the economics of MMT – it’s the Democratic equivalent of trickle-down – but it might spark a bigger debate about how to boost public spending to benefit those left behind. The Republicans do not appear to have any new economic ideas other than more of the same. However, this will not help the left-behind and will likely lead to greater stridency as both sides continue to shout at each other across the divide.

There is little doubt that the US, like the UK, needs a radical economic and political overhaul. This is simply not going to happen. As the neoconservative commentator Bill Kristol noted in an article today, the day after the election can be characterised as a mixture of the good, the bad and the ugly. In his view, the good news is that Joe Biden is more likely to be president than Donald Trump – and this from a leading light of the neocon movement. The bad is that the election will leave both the Republicans and the Democrats worse off than before, since the fairly even showing of both parties does not suggest any incentive to rethink their strategy. The ugly is that “after four years of seeing Donald Trump govern … the American people rewarded President Trump with an increased share of the overall vote. To some very real degree … We have met the enemy and he is us.” Whoever occupies the White House in January will continue to face a restive electorate.

Lockdown: The sequel

When the history of Britain in 2020 is written historians may well look back at Saturday 31 October as the point at which something changed. Not only did it mark the last weekend before the most momentous Presidential election in modern US history, which will have a big bearing on the UK (see below), but it was the day something else snapped. It was the day Boris Johnson was forced to introduce a second lockdown in England – a policy so deeply unpopular that he spent weeks denying it would be necessary despite calls from the scientific community that it was inevitable.

We can debate whether it is the right thing to do. My own view is that it is, and in the absence of effective medical treatment the government has little choice. But it represents yet another U-turn by a government which has continued throughout this year to follow a particular policy course despite evidence suggesting it was on the wrong track, only to do a 180 degree turn at the last minute. I suspect yesterday was the point when the government lost much of the little credibility it had left.

Other European governments have, of course, introduced second lockdowns and they are also unpopular. But the UK situation is different because it is led by a prime minister who is deeply distrusted by a large part of the electorate, despite winning a convincing victory in an election just over 10 months ago. Johnson carries so much baggage as a result of Brexit that he has to over-deliver in order to persuade his critics that he is up to the job.  Unfortunately for him, he has spent the last year over-promising and under-delivering. 

The domestic context 

Twelve months ago it was very different. Johnson had finally secured the go-ahead for the election he craved and went on to win a thumping majority in December, allowing him to deliver on his promise to "get Brexit done." The Conservatives promised to "level up" the regional imbalances in the UK, which gave a glimmer of hope to those outside the south east that they would finally get a fairer share of the national economic pie. It all sounded very promising. Then along came Covid-19.

Any government would have struggled in the face of this event. It represents the sort of exogenous shock that is talked about in economic textbooks with blithe authority but the reality of dealing with such shocks is a very different matter. It was inevitable that mistakes would be made. But it is the nature of the mistakes that has so undermined trust, giving rise to accusations of a lack of joined-up thinking.

One of the criticisms aimed at Johnson's government is that as the pandemic took hold the lockdown should have been introduced earlier. Maybe it should. But the scientific evidence at that time was not unanimously in favour and I would give the government a pass. But what was less forgivable was the decision to empty hospitals to make space to treat Covid cases without adequately testing whether those being sent out into the community were Covid positive. This allowed the disease to take hold in old age care homes and contributed to the UK's high mortality rate (this mistake was also repeated in Belgium). Nor did the government recover from the Dominic Cummings incident which gave the impression that there was one rule for those who were part of the inner circle and another for those who were not. The moral authority of the lockdown was at this point shot through.

Over the summer the government was understandably desperate to get the economy back on its feet. The policy of gradual reopening appeared to be working as case numbers continued to fall. But the Eat Out to Help Out scheme is now viewed as one of the catalysts of the second wave, with an economic paper by Thiemo Fetzer providing evidence that it “had  a  large  causal  impact  in  accelerating the  subsequent  second  COVID19 wave,” whilst the reopening of schools has accelerated the process. To some extent there is an air of retrospective criticism involved. However, whilst cautiously opening the economy was not necessarily a bad policy at the time, it may have been pursued too aggressively.

More damaging for the government has been the dispute between urban centres in northern England and the Westminster government about the introduction of regional lockdowns and the degree of financial support they can be expected to receive in return. The Mayor of Greater Manchester’s call for a package of measures costing a mere £65 million was rejected as being too expensive. But yesterday the government extended for another month the national furlough scheme, covering 80% of the wages of furlough workers, which is likely to cost around £10bn. To compound the problems, the footballer Marcus Rashford’s campaign to persuade the government to provide free school meals during holiday periods to children of low paid families has generated a huge groundswell of support. This comes after Tory MPs voted against the proposal on 21 October. In terms of the signals being sent, the electorate does not like what it sees. 

The international context 

This brings us inevitably to Brexit. The government has already achieved its aim of leaving the EU but so far has not secured the trade deal with the EU that it claimed a year ago was “oven ready.” What is more concerning is that its handling of the Covid crisis betrays a government that is not fully in control of its brief. Worse still, people are now beginning to wake up to the prospect that it cannot be trusted to deliver a Brexit that delivers what its proponents promised, as latest survey evidence suggests. Whilst not absolving the EU for part of the blame, the UK’s petulant negotiating tactics have made things far more difficult than they need have been. I have long believed that the government would be forced to do a deal with the EU because not to do so would be economic suicide. But the “skinny” Brexit deal which is the best the government is likely to get, is insufficient to help large parts of the economy even in the absence of Covid. In the words of former civil servant Ivan Rogers “we are talking about the difference between a very hard Brexit and an ultra-hard Brexit.”

And so to the US election. You may think this is tangential to the UK but it is not. A Biden presidency would likely seek to normalize relations between the US and its traditional European allies. But the UK is increasingly out of step with the rest of the EU and the current British government is viewed with deep suspicion by the Biden camp. Johnson leads a government with a nationalist, (semi) populist agenda which is viewed favourably by Donald Trump. This is one factor likely to count against it. Biden has also come out in favour of supporting the Good Friday Agreement which the UK’s Internal Market Bill threatens to undermine. With Joe Biden in the White House, the UK can forget any preferential treatment in getting a trade deal with the US, which makes it all the more imperative that it can reach an agreement with the EU.

The bottom line 

It is difficult to make any objective assessment of how well the current UK government has performed against its predecessors or indeed against its peers in other countries. But the degree to which the electorate is split on important issues such as Covid and Brexit is in my experience unprecedented. That said, four decades of polling evidence suggest that the government’s approval ratings have not suffered as much as the headline writers might have us believe (chart above). Indeed the current approval/disapproval rating is bang in line with the average on data back to 1977 (at 30% and 60% respectively). Do not forget that in summer 2019 the government’s approval rating fell to an all-time low of just 8% yet six months later it secured a big election win. Whilst it is too early to write off Boris Johnson this early in his term of office, he needs some good news if he is to have any chance of leading his party into a second election.

A second wave comes crashing down

Markets have been unsettled for some time about the prospect of a second Covid wave and they finally capitulated this week. The market collapse on Wednesday, which saw the S&P500 fall more than 3.5% and the DAX fall more than 4%, came on the day that Germany introduced a stringent set of national lockdown restrictions involving a one-month shutdown of bars and restaurants which is due to come into effect on Monday. France also announced a national lockdown which came into effect today. It may not be quite as stringent as that enforced earlier in the year but it is still pretty drastic. As President Macron said in his TV address, “the virus is circulating in France at a speed that even the most pessimistic forecast didn’t foresee … The measures we’ve taken have turned out to be insufficient to counter a wave that’s affecting all Europe.” Given the renewed spread of the disease, it seems only a matter of time before the UK is forced to follow suit.

What does a second wave mean for the global economy? Throughout this year, most reputable forecast institutions have presented a range of alternative scenarios around the baseline and it is worth digging into some of the details of the IMF’s forecast released last week. The IMF baseline looks for a 4.4% contraction in global GDP this year followed by a rebound of 5.2% in 2021 (in my humble opinion this sounds like a stretch since it implies that all the damage done to output in 2020 will be recouped next year). However, whilst the downside scenario garnered rather fewer headlines it was nonetheless illustrative. It is based on the assumption that Covid proves difficult to contain, with a significant drag on activity in the second half of 2020 extending into 2021. In addition, the IMF assumes that progress on finding effective treatment is rather slower than currently assumed, with a delay in the process of finding a vaccine and the requirement that social distancing measures have to remain in place for a long time to come.

Under these circumstances the global growth rate next year could come in as low as 0.9% versus the baseline projection of 5.2% and it takes until 2025 before output is back on the path implied by the baseline (chart 1). It is also notable that in this scenario emerging markets take a larger than proportional hit. This accords with my long held view that since EMs are acutely dependent on a recovery in their main export markets, the IMF is too optimistic on how quickly output in Asia will rebound in the baseline projection.

As far as markets are concerned , we have been here before. The equity declines registered on Wednesday may not be the biggest daily falls this year but they are not far away from some of the dramatic swings recorded in March. On the one hand there is some scope for cautious optimism in that we have a rather better idea of what we are letting ourselves in for. Accordingly, equity indices may not fall as sharply since we are operating in less unfamiliar territory. Against that, markets may be on the verge of capitulation as the pandemic proves not to be the short, sharp shock that was expected in the spring. As is usual at times of equity market stress the tech sector comes in for the closest scrutiny (chart 2). In addition to concerns that the pandemic may take the edge off demand, the fact that Apple’s iPhone sales and Twitter’s user growth both missed estimates added to the sense of market uncertainty. Next week’s US Presidential election may have longer-lasting consequences for the tech sector if Joe Biden is elected to the White House and embarks on a programme of cutting the tech companies down to size.

However, for the time being I tend to take a more optimistic line. For one thing we should not read too much into equity volatility just a few days ahead of the most important US election for years. Part of the recent wobbles may reflect some position squaring ahead of the main event. Moreover,  central banks are pumping in liquidity on an unprecedented scale. The Fed has increased its balance sheet by two trillion dollars this year, primarily due to purchases of Treasury securities which will suffice to keep bond yields at ultra-low levels. Here in Europe, current estimates suggest that EMU governments will issue €1.2 trillion of gross debt next year but maturing bonds and interest payments could reduce the net figure to €405bn. Even without the promised monetary expansion the ECB is expected to buy €460bn of debt in the secondary market – more than planned issuance. This downward pressure on global yields when plugged into a simple discounted cash flow model ought to be enough to put a floor under equity markets.

But even if markets do hold up, the economy will take a long time to recover from the scarring effects of Covid. In the US, for example, the unemployment rate currently stands at 7.9%, twice as high as in February prior to the pandemic whilst employment is around 11 million below pre-recession levels. What makes me somewhat uneasy is that we have entered a period where there is a mounting disparity between what is happening to markets and conditions in the real economy which underpin them.

This will be manifest in elevated P/E ratios. I have frequently referred to the Shiller trailing 10-year P/E ratio for the S&P500 as a measure which smooths out cyclical variations and have noted that over recent years it has remained very high in a historical context (chart 3). In just the last few months it has rebounded back to pre-recession highs following a dip in the wake of market panic in March. This is a clear illustration of the extent to which traditional valuation metrics no longer apply and for the foreseeable future the equity market will be running on the back of the support given by central banks. Given the lack of clarity from the normal pricing metrics it could be a very bumpy few months for markets.

Learning to live with the economics of Covid

Without any shadow of a doubt the biggest problem governments face at present is how to balance the benefits from measures to curb the pandemic against the economic costs of efforts to limit its spread. As the second wave of Covid-19 emerges it is clear that countries have coped in different ways. But what are the factors underpinning the differing performances and have countries learned from past mistakes which will prevent a repeat of the surge in mortality rates that we saw during the first wave?

An excellent paper in The Lancet looked at the varying approaches to assessing the criteria adopted by a number of industrialised economies for introducing lockdowns in the first place and the criteria for easing them. As is apparent from the differing infection and mortality rates across countries, there has been a wide diversity of responses. The authors of the study identify a number of factors which are necessary to ensure effective control of the spread. In the first instance we need some idea of the current status of infection rates which requires a surveillance system to be in place allowing us to track the reproduction number (R number) in real-time. A second prerequisite is community engagement which gives greater flexibility to local communities to take decisions to protect themselves. This has become a particularly fraught issue in the UK where government is highly centralised but where the four nations have increasingly adopted different approaches to easing the lockdown. Even in England there is now increasing tension between the London government and urban areas in the north, which threatens to have significant long-term political repercussions.

The authors note that “with few exceptions, such as Germany, New Zealand, Norway, Scotland, and South Korea, political leaders have struggled to secure public trust and thus support for continued lifestyle changes. More generally, countries with female leaders have done better at securing public confidence and adherence to new measures than have countries with male leaders.” Readers interested in the latter point can refer to the original paper (here).

One of the features of the past seven months across many countries has been the series of mixed messages which have sown confusion. This is evident, for example, in advice on how many people can congregate in confined spaces. More particularly it is evident in advice on wearing face coverings. At the start of the pandemic the World Health Organisation argued that masks would encourage a false sense of security and would deprive medical professionals of badly needed protective equipment. It also argued that there was insufficient evidence to suggest that healthy people should wear them. The WHO finally changed this advice in June. Whilst numerous Asian countries long ago adopted the practice of wearing masks in public places, it has been slower to catch on in Europe and North America and we have witnessed demonstrations in a number of countries against the requirement to wear a face covering. To add insult to injury, the UK government has recently confirmed that it will end the VAT waiver on personal protective equipment from 1 November. British households will thus have to pay 20% more for the masks which they are legally obliged to wear in shops and on public transport.

But by far the biggest factor determining the differences in performance across countries is the capacity of the heath system, most notably the track and trace system. Singapore and South Korea have mortality rates of 0.5 and 0.9 per 100,000 of population respectively compared with 66.9 in the UK, 68.1 in the US and 93.0 in Belgium. Singapore has a rigorously enforced system which has led some to complain about its personal data implications but its success cannot be denied. South Korea has introduced a mass testing regime and uses electronic health records, credit card transactions data and mobile phone-based GPS data to determine peoples’ movement. It also relies on tracers with detailed local knowledge to observe localised outbreaks. The UK’s experience has been much less impressive: after it abandoned its initial attempts at track and trace it attempted to develop its own smartphone app but later abandoned this approach and switched to an Apple–Google system – an approach which cost valuable time.

As the second wave intensifies, many industrialised countries have taken on board the lessons learned during the spring. Full lockdowns did prove to be effective in curbing the spread of the disease but they come at an enormous economic cost and they would only be repeated as a very last resort. There is thus a general recognition that over the coming winter, we are going to have live with Covid and keep the economy afloat as best we can, for even if we are close to a breakthrough in finding a vaccine it is not going to be widely available until the second half of 2021 at the earliest.

The epidemiologists who authored The Lancet article thus make a series of recommendations for the conduct of Covid policies:

i)             In the first instance governments should be transparent about which factors are being taken into account when assessing the threat level and “ideally, these … should explicitly state the levels or phases of easing restrictions, the criteria for moving to the next level or phase, and the containment measures that each level or phase entails.”

ii)            Lockdowns should not be eased until the infection situation can be adequately monitored which requires an emphasis on local conditions rather than simply the national average picture.

iii)           Since it is obvious that distancing restrictions will have to remain in place for quite some time to come, “governments should educate, engage, and empower all members of society, especially the most vulnerable, to participate in the pandemic response. Rather than crafting these measures on the basis of assumptions about what communities can or cannot accept, citizens should be directly involved in the process of coproducing tailored solutions appropriate for the local context.”

iv)           Most importantly, it is crucial to introduce an effective track, trace and isolate system. As the authors point out, “preliminary data for testing suggests that identifying and isolating mild and asymptomatic cases can significantly reduce R, health-care burden, and overall fatality.” Once the system is in place, it is important to ensure effective takeup, with some research suggesting that an overall participation rate of 56% is sufficient to stop transmission.

European governments have largely learned the importance of adhering to these conditions although they are complicated by differing forms of government with countries with decentralised government (e.g. Germany and Switzerland) posting better outcomes than more centralised systems such as France and the UK. 

They may also work better if people find it in their interests to comply with more rigorously enforced rules when they have a stake in their success. An under-appreciated economic consequence is the distributional impact of lockdown measures with some sectors expected to take a much bigger hit than others. As MPC member Gertjan Vlieghe noted in a speech last week “we are really not all in this together. It is far, far worse for some than for others.” Accordingly, the measures may be more likely to work if governments can give reasonable assurances that there will be work for people to go back to when the pandemic subsides. That alone may be a good reason for governments to continue providing labour market support over the winter months.