Any letter you like - except V

It has become clear in recent days just how much damage the sudden stop in economic activity triggered by the COVID-19 crisis is likely to cause. The services PMIs across Europe collapsed sharply in March with the UK recording an all-time low on data back to 1996 which represents five standard deviations from the mean. The release of today’s US initial jobless claims data showed an extraordinary rise which was 33 standard deviations from the mean on weekly data back to 1967 (chart).  This is an economic collapse the likes of which none of us has seen. It can be likened to the economic equivalent of hitting a wall at high speed: Not only does the car get smashed up but it will take time to recover from any injuries sustained.

It is for this reason that my doubts about a V-shaped recovery continue to mount. The BoE noted in the UK context that “given the severity of that disruption, there is a risk of longer-term damage to the economy, especially if there are business failures on a large scale or significant increases in unemployment.” Many companies have effectively been forced to cease business as a result of the lockdown implemented earlier this week, which will have major implications for cashflow, and a number of them may not resume trading when restrictions are finally lifted. To give some idea of how much the collapse in spending is going to impact on the economy, UK restaurant bookings have slumped to zero over the second half of March based on data from Open Table. On average, restaurant traffic is 55% below levels in March 2019 and with a weight of 9.5% in total spending this alone will reduce consumer spending by 5% relative to a year ago. Assuming restaurants do not reopen in April, the drag on annual spending will double. Notions of a 10% collapse in Q2 GDP suddenly do not look so fanciful.

A measure of the swing in expected 2020 economic growth against the 2019 outturn gives us an idea of where the Covid-19 effect is likely to hit hardest. Assuming Italian GDP falls by 5% this year following a small gain of 0.3% last year this produces a total swing of 5.3 percentage points. By contrast, Chinese growth is only expected to slow from around 6% to 4%, producing a total swing of 2 percentage points. In the UK I currently expect something like a 4.5 percentage point swing. Naturally, forecasts at this stage are little more than guesswork so we should not read too much into the numbers, but given the severity of the crisis in Italy it is reasonable to assume it will take a major economic hit.

Obviously we have no clear idea about the duration of the crisis but the standard assumption is that the bulk of any output contraction is concentrated in the first half of the year. That is itself a huge assumption, but even if turns out to be true, many businesses will not survive the current hit despite the huge amount of support that the government is prepared to give. This will prove to be a searing economic experience for many of us, and that is without discussing the human costs associated with coronavirus. But it will not only be small firms that change their behaviour. Large firms will also be more circumspect given the impact that this year’s recession will have on earnings which will act to hold back investment, and in any case they are likely to hold off on big spending plans until they are confident that demand is once again on an upward path.

It is, of course, too easy to extrapolate the bad news out into the future without taking account of the resilience shown by western economies. On the basis of what we know about the coronavirus now, there will be an economic recovery and probably sooner rather than later. But to give some idea of the impact of economic shocks, I looked at the three major recessions in the UK over the past 40 years and discovered that on average it takes almost four years for output to recover its pre-recession peak. An output collapse of 4% this year followed by three years of trend growth of 1.5% indeed means the usual four year cycle will hold. Matters will be all the more difficult for many western economies given that potential growth today is far slower than prior to 2008 as a consequence of an ageing population and the sluggish nature of productivity growth over the past decade. Recall that in the wake of the Lehman’s collapse it took an awful long time to be convinced that the economy had turned the corner. I suspect the same may also happen this time around.

That said, the 2020 recession will be a catalyst to revisit many areas of the economy that have been ignored over the past decade and I will deal with them in more detail another time. But to throw out a few ideas at random, we are likely to find ourselves paying a lot more attention to the lessons of Keynes than we did a decade ago. Whatever else we take away from the 2020 experience, it is that there is a role for the state as an agent of last resort to step in when there is deficient demand. State capitalism is thus going to be higher up the agenda in many countries and it will be difficult for governments to introduce austerity programmes when this is all over. After all, we have had a decade of it in the UK and where has it got us? We will also have to have a public debate about how much state we want and how we plan to pay for it. I suspect the era of tax cutting may be over for a long time to come.

However, the future can make fools of us all so we should revisit some of this blue sky thinking in future to see whether it stacks up. Nonetheless I am struck by the fact that just as the post-1945 era was very different to the pre-1939 world, so we might look back at the unprecedented events of 2020 as the point at which the world economy changed.

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.

It is not irrational to be concerned

If we thought that Brexit was a major economic challenge it pales into insignificance compared to the threat posed by COVID-19. As the days unfold, the spread of the disease is following the normal pattern associated with infections, which in the early stages follows an exponential curve until it begins to level off. It is quite obvious that things are going to get worse before they get better which is going to result in a lot of human misery, never mind the economic consequences.

If we can take a step back, however, it provides a fascinating test bed for many of the theories put forward by behavioural economics, which applies psychological insights to the economic actions that we take, and which is in stark contrast to the assumption of rationality which underpins much of conventional thinking. I was reminded of this by the signs which began to appear reminding us all to wash our hands in a bid to spread the disease. This is a classic application of nudge theory which attempts to provide positive reinforcements to encourage a particular course of action. Supermarkets have known for years that prominently displaying a particular type of item encourages sales and it has also been used by various health campaigns (recall the famous 1980s campaign designed to combat AIDS “Don’t die of ignorance”). Nudge theory works up to a point, in as much as it does have an impact on short-term behaviour although its usefulness as a determinant of long-term behaviour is open to debate. However, as this study noted just a month ago, the case for hand washing as a first step to control the spread of epidemics appears indisputable.

Perhaps one of the most contentious issues in the early stages of the outbreak is the extent to which people are stocking up on provisions in case they will be needed. This led to the bizarre situation last weekend whereby shops were completely sold out of toilet rolls and other forms of sanitary wipes, whilst hand sanitizers are virtually impossible to get hold of. The government’s advice is that people should not panic buy. But can we really describe the current situation as panic buying?

Panic can best be described as taking irrational actions in the face of extreme stress. However, as an economist, the notion of taking preventive action strikes me as a perfectly rational forward-looking response. Whilst I am less sure about the need for such huge quantities of toilet rolls, there is a case for having some emergency food provisions. Indeed, the Swiss government has long recommended that each household should have a stock of drinks and food for a period of seven days in the event of a disaster (not that they all do). If you believe that a major problem is about to be visited upon you, which in the worst case will prevent you from leaving your home, a sensible forward-looking economic actor will make some sort of contingency rather than trust to luck. You certainly do not have to be some hardline survivalist (or prepper, if you prefer) believing in the imminent collapse of society to anticipate that the information given by governments today will change in future in response to changed circumstances. However, there is also an element of herd instinct driving some of the recent actions by individuals. We may not in the end need the huge quantities of toilet roll that have been purchased, but in the event we do, you certainly do not want to be the individual who has ignored the actions of the rest of the herd.

Human history is littered with examples of catastrophe, from plagues to harvest failures which once upon a time were a regular occurrence.  These required societies to set aside a store of food to tide them through the hard times, but modern societies which rely heavily on just-in-time inventory management are unable to cope with shocks of this magnitude. Many western societies are unused to making such provisions and it feels very alien to our way of living to have to think in such terms. It ought to act as a wakeup call on so many levels. Our supply chains are long and easily broken and should force us to think more carefully about the limits to globalisation. As I noted in this post in 2016, my views on weighing the costs and benefits of globalisation have changed over the years. The current episode has also made people realise the benefits of international cooperation. Admittedly the rapid spread of COVID-19 has been made possible by the extent to which borders have opened up but equally the solution to what is now a global problem will also have to be global.

As for recent market moves, investors’ actions of late have not been entirely irrational. Financial investors always have to deal with decision making under uncertainty, but today the uncertainty levels have risen to unprecedented levels. I have long extolled the virtues of the distinction between risk and uncertainty which was made by the economist Frank Knight in his magnum opus Risk, Uncertainty and Profit  a century ago. In his words, “risk means in some cases a quantity susceptible of measurement, while at other times it is something distinctly not of this character.” A known risk “is easily converted into an effective certainty” while “true uncertainty … is not susceptible to measurement.” Accordingly it makes perfect sense for markets to sell off in what is the biggest shock to markets since 2008. The unknowable economic consequences are such that we cannot predict what will happen to corporate earnings other than to say there is no near-term upside, and it is impossible to call the bottom of the current slide. However, most investors believe things will get worse before they get better.

And they have certainly been bad of late. On the basis of UK data going back to 1709, the performance of the FTSE All Shares so far this month has been worse than at any time since the collapse of 1720 following the bursting of the South Sea Bubble when prices declined by 38% in September and a further 25% in October of that year. The 1720 episode was the response to a good old-fashioned bubble. The collapse of 1987 (which was bad enough) was attributable to global monetary tensions and exacerbated by automatic trading systems which contained no circuit breakers. Today, it is attributable to genuine concerns about life and death and in the grand scheme of things, market moves can often seem somewhat trivial.

The storm before the tsunami

To say it has been a wild market ride today would be an understatement. Based on daily data back to 1985 (a total of 9179 observations) the 7.7% decline in the FTSE100 is the fifth largest correction in recent history, beaten only by double digit declines in the wake of Black Monday in 1987 and two days of correction in October 2008 as the Lehman’s fallout continued to reverberate. The 7.9% decline in the DAX was also the fifth largest correction in the German equity market although the US correction did not even make the top 10.

I have been through a few market corrections in my time, and each of them was triggered by a unique set of circumstances. Today’s moves, however, were only partly initially related to equities. They were triggered by the 30% collapse in the oil price following Saudi Arabia’s decision to launch an oil price war and were exacerbated by coronavirus concerns. The Saudi decision came after Russia refused to join OPEC countries in extending existing production curbs in a bid to drive oil prices higher and the Saudis are clearly trying to force the Russians back to the negotiating table. This is bold and risky strategy. Whether or not it works, the shock decline in oil prices put initial pressure on the oil majors and triggered a broader market selloff at a time when sentiment was already extremely nervous. Momentum effects then took hold as equities competed to go ever lower.

Faced with this kind of environment, there is nothing anyone can do but stand back and watch the carnage unfold. Interest rate cuts will be of no real help, even though the Fed, ECB and BoE are likely to deliver additional monetary easing before the month is out. Policymakers can perhaps impose bans on short-selling or impose circuit breakers on the market which will temporarily limit the downside but they are on the whole powerless. The flip side of the equity selloff has been the surge into safer havens such as government bonds and gold, with the US 10-year Treasury yield falling to a new all-time low of 0.5% and the 10-year German Bund trading at -0.86%, implying that investors are so keen to preserve their capital that they will accept a negative return on their holdings of sovereign German debt because the expected loss of principal is greater than the negative yield on Bunds. Without wishing to be too gloomy, a lot of countries are now apparently at much greater risk of recession than perhaps we thought a week ago.

In the face of an equity correction of today’s magnitude, it is easy to extrapolate into the future and make the case for further huge declines. But much depends on the nature of today’s shock. If it merely represented a kneejerk reaction to the oil collapse which got out of hand, markets could easily rebound a little in the near-term. But if it reflects concerns about the impact of the coronavirus on the wider economy, which is more likely, I would expect a lot more downside before we reach the bottom. I noted in this post that the US market had the potential for another 10-20% downside. The market is already 7% below where it was when I wrote that, and as the number of non-Chinese virus cases continues to increase, the potential for economic disruption continues to grow.

The fiscal response

With monetary policy all but exhausted, governments will have to step up to the plate to deliver measures to support the economy. We will have a great chance to see what the UK government is made of when it delivers its post-election Budget on Wednesday. Much of the very good pre-Budget analysis prepared by NIESR or the IFS has now been overtaken by events. It was originally planned that this would be a Budget which attempts to deliver more spending, particularly for those regions which have been left behind by austerity. This was to be a reset of policy – the so-called “levelling up”. But now it will be dominated by efforts to limit the impact of COVID-19.

There are essentially three areas that the government will have to address: (i) ensuring liquidity-constrained businesses can continue to operate; (ii) providing support for individuals who lose income and (iii) maintain the delivery of public services. There are various things the government can do: In the case of (i) more generous payment terms in areas such as employer social security contributions would help to limit the burden (e.g. a payments holiday whereby firms do not have to pay contributions for those workers who are sick with the coronavirus). To tackle issue (ii), the government could reduce the time it takes to get access to Universal Credit payments (as I argued here) and addressing (iii) might involve significant increases in the budget for the National Health Service.

As the IFS points out, in fiscal years 2008-09 and 2009-10, the government’s fiscal expansion package was equivalent to 0.6% and 1.5% of GDP respectively. That is a high benchmark but the UK does have the fiscal headroom to try something similar today. Other governments across Europe will have to follow suit. The German government, for example, has previously dragged its feet but there are indications that it is now prepared to boost spending to support companies which apply for aid to offset wage costs during labour layoffs. As the UK examples cited above show, fiscal policy does not necessarily have to take the form of big infrastructure spending programmes: tweaks to the tax and benefit system can provide much more targeted help.

The time for waiting is over with action required to at least prepare the economy for the worst case outcomes. There is after all, no point in the likes of Germany continuing to run surpluses for the sake of it. We should welcome any moves towards fiscal easing. For too long, governments have been absent from the fiscal policy fray and have left it to central banks to manage the economy. Whether it will mark the start of a more targeted approach, or whether we will soon revert to a period of retrenchment remains to be seen. But whatever else governments do, they must act soon. If nothing else, markets will ultimately punish them for failing to act.

Accounting for tail risks

Today’s announcement by the Fed of a 50 bps rate cut – the first intra-meeting rate cut since 2008 – is an indication of the extent to which it is taking seriously the potential for corona virus-related economic disruption. The die was cast yesterday when the OECD reduced its outlook for global growth in 2020 from 2.9% to 2.4% (chart) – just below the 2.5% rate which is considered to be consistent with global recession. There is little doubt that COVID-19 has left an impression on the Chinese economy during Q1, with the OECD cutting the 2020 growth projection from 6.1% to 4.9%, which would be the third slowest growth rate since 1980. 

It might yet turn out worse: As the OECD noted, “a longer lasting and more intensive coronavirus outbreak, spreading widely throughout the Asia-Pacific region, Europe and North America, would weaken prospects considerably. In this event, global growth could drop to 1½ per cent in 2020, half the rate projected prior to the virus outbreak.” Markets are certainly looking to the downside, with US equities down almost 3% following the Fed’s actions. So much for shoring up market confidence.

Just to put the coronavirus issue in perspective, the WHO’s latest Situation Report suggests that China has recorded 80304 cases out of a population of 1.428 billion. That’s an infection rate of 0.0056%. Based on the reported number of deaths (2946) this implies that (so far) the chance of an individual dying from the disease is 0.0002%. This is roughly a 1 in 490,000 chance which compares with a 1 in 10,000 chance of being involved in a fatal auto accident in China. Obviously the authorities have put in place some draconian measures to restrict movement which has significantly slowed the rate of new infections but which have had significant adverse consequences for the economy.

But without wishing to downplay the seriousness of the threat posed by the virus, it is important to keep the risks in proportion. Much of what the authorities are preparing for in Europe and the US represents the worst case outcomes and it is important to distinguish these tail risks from outcomes at the centre of the distribution. We have, of course, learned to our cost the failure to prepare for worst case outcomes. The failure to identify tail risks ahead of the Lehman’s bust arguably contributed to the severity of the downturn and on the basis of the old adage, “fail to prepare, prepare to fail” it makes sense to take precautions. If such measures save lives they are clearly worthwhile but we must be careful to avoid talking ourselves into a panic. 

The statement by G7 Finance Ministers and central bank governors early today suggested they would “use all appropriate policy tools to achieve strong, sustainable growth and safeguard against downside risks.” It was only a matter of hours later that the Fed decided to act. Whilst the G7 was correct to suggest that greater use of fiscal measures was appropriate, it is questionable how useful interest rate cuts will prove to be. This is not to say they are unwelcome but the fact is that many central banks, including the ECB and BoE, have very little scope to cut, unlike in 2008 when there was plenty of downside for rates. This highlights the point that many of us have been making for some years that failure to normalise interest rates as the emergency conditions of 2009 eased, has left many central banks with little policy space to counteract the next downturn.

Moreover, it is widely accepted that the virus will act as a supply shock, as people are unable to work, rather than a demand shock where interest rate cuts can have more of an impact. To the extent that people’s demand patterns are altered, this is more likely to reflect a conscious change in behaviour rather than a  response to financial conditions. Where monetary policy can be more effective is in ensuring that business cash flow is not affected by a short-term breakdown in activity. Thus central banks may be able to make more capital available to banks by cutting the countercyclical capital buffer, in a bid to maintain the supply of credit.

On the assumption that the virus effects are relatively short-lived, it is imperative that central banks quickly take back their emergency easing measures in order that they do not become permanent. Fed Chairman Powell sidestepped this question at his press conference today, and whilst it is understandable that he does not want to telegraph the future course of policy, it is equally important for the long-term health of the financial system that markets do not continue to live on the fresh air provided by an overly lax monetary policy. In the event that the ECB cuts rates again, which is a realistic possibility, removing the stimulus as soon as is practicable will help to alleviate some of the damage which negative rates are doing to the fabric of the euro zone banking system. 

On the fiscal front, health services will obviously need the resources to ensure that they can function properly and governments are making the right noises to ensure that this will be forthcoming. Another issue which has come to light in recent days is to ensure that there is an adequate form of employee insurance in place. One of the problems for workers, particularly at the low end of the income scale, is that they do not get paid if they do not turn up for work. But if infected people turn up for work in order to collect their pay cheque they run the risk of infecting others. The last thing that hospitals need is for infected porters or cleaning staff to be running around the place. In the UK, those who are self-employed, who account for 15% of total employment, are not entitled to sick pay. Some form of temporary scheme to compensate them for loss of earnings is certainly an option worth considering, even though the practicalities of such a scheme are quite daunting.

But when all is said and done, the best thing the authorities can do to minimise the economic impacts of COVID-19 is to ensure that infection rates are held down. So far as China is concerned, there are hopeful signs that things are improving. The rate at which infections are increasing has not exceeded 2% for the past 9 days as the draconian measures put in place start to take effect. Outside of Hubei Province, the epicentre of the outbreak, there are only 13,000 confirmed cases and just 112 deaths – less than in the rest of the world (166). Prevention is always better than cure but preparedness runs it a close second.