Whistling in the dark or shining a light?

The global picture

As the official bodies begin to put out their growth forecasts for 2020 and 2021 the magnitude of the hit facing the global economy following the Covid-19 shutdown is becoming increasingly clear. The IMF’s latest projections suggest that global GDP will contract this year by 3%, rebounding by 5.8% in 2021. We have not seen anything like it in 90 years since the Great Depression, when world activity is estimated to have fallen by 10% between 1930 and 1932 with three successive annual declines of 3% or more. For the record, it took six years for output to regain its pre-crash highs. The IMF is suggesting that next year we will be able to put all of this behind us and push output back above pre-crash levels. I remain highly sceptical.

The good news, as the IMF points out, is that we do not currently have the degree of protectionism and beggar-thy-neighbour policies of the early-1930s which made the downturn so much worse than it needed to be. But economic nationalism is clearly back in fashion, and Donald Trump’s decision to halt US funding to the World Health Organisation during the greatest public health threat in a century is indicative of the febrile sentiment currently at play (not to mention the fact that it is probably one of the dumbest of petty acts and says a lot about Trump’s way of doing business, but in the interests of politeness to my American friends I will leave it there). Interestingly, the IMF’s forecast makes it clear that whilst output in emerging markets will rebound quickly, the advanced economies will not recoup their output losses in 2021. Indeed, EM economies take a relatively small hit with output projected to fall by only 1% this year and surging by 6.6% next year. My concern with this is that many EMs are export-driven economies, and if the developed world is growing relatively slowly, the demand for EM exports may not recover sufficiently quickly to drive the expected global growth surge.

The big imponderable is how deep will be the scars left by the current shutdown? The cause of the economic collapse is simply that much economic activity is prohibited as lockdowns came into force which has resulted in many people having to remain at home. Such impacts will ripple throughout the economy in as-yet unpredictable ways, and whilst fiscal and monetary policies have been turned up to the max they can only mitigate and not totally offset the economic damage. For example, even though interest rates are at rock bottom levels everywhere, this is no guarantee that people will want to borrow when the worst of the crisis is past. Nor will lenders necessarily be willing to grant credit to those individuals and businesses who are struggling to stay afloat if they are perceived to be a bad credit risk. This puts banks in a difficult position. Whilst they were perceived as the bad guys a decade ago, they want to be seen to be making a positive contribution today. But they also have a duty to their shareholders whose returns have taken a beating, and who will not thank them for any big rise in loan-loss provisions.

So far, all of this has been predicated on the assumption that the Covid-19 crisis can be compressed into the second quarter of 2020. This is far from a certainty. Much will depend on what form of exit strategy is adopted by governments: How long will it take to reopen the economy even if the threat passes relatively quickly if the process is staggered over several stages? Then there is the question of whether the viral threat will indeed pass so suddenly. Scientific evidence suggests that social distancing measures may have to remain in place until 2022 and vigilance maintained until 2024, neither of which are conducive to a sudden pickup in activity. For the record, the IMF did conduct alternative scenarios. In one of the worst case outcomes, the assumption of a longer Covid-19 outbreak in 2020 together with a renewed outbreak in 2021, results in a level of GDP next year which is 8% below the baseline discussed above. This would imply an output loss of more than 5% over two years which starts to look more like a 1930s outcome.

The local picture

Closer to home, the UK Office for Budget Responsibility came out with an illustrative scenario earlier this week which suggested UK GDP could collapse by 13% in 2020, with a 35% contraction in Q2 alone, which is followed by a rebound of 18% in 2021 (chart below). To put that into context, this would be the largest annual contraction in GDP since 1709 when the Great Frost wiped out agricultural output. The projected rebound in 2021 would also be the largest since 1704 (apparently). Even allowing for the fact that the historical data are subject to a huge degree of uncertainty, the OBR figures suggest the most volatile swings in output for over 300 years. Like the IMF (whose predictions for UK growth in 2020 and 2021 are a more modest -6.5% and +4.0% respectively), the OBR figures effectively assume that there will be no economic scarring although I doubt very much that if the OBR’s awful 2020 forecast is realised there will be much of a rebound next year.

Predictably, the IMF and OBR projections were met with the usual scepticism from those who have nothing better to do than criticise the forecasting efforts of others. I am not going to jump on that bandwagon. After all, these forecasts are produced because there is a need to have some basis for planning. What would the sceptics rather we do? Produce nothing and trust to luck by making it up as we go along? Just imagine the howls of rage if governments were not prepared for the worst case outcomes. But it does raise a question as to how such analysis should be treated at a time when predicting the future is little more than guesswork. The OBR made it clear that its analysis was a scenario, not a forecast, yet the media treated it as if it were a forecast. You may ask what is the difference? The answer is that a scenario is a conditional assessment based on a “what-if” approach whereas a forecast is typically viewed as an unconditional, what-will-happen event.

Obviously this is a fine distinction but it is important. The OBR is not suggesting in its analysis that it believes the outcome will necessarily be realised but it is an attempt to highlight the economic risks. Arguably there are better ways to do it. It could, for example, have prepared a range of outcomes along the same lines as the IMF and not chosen to discuss one illustrative case which runs the risk of being treated as an unconditional forecast. As former BoE insider Tony Yates pointed out on Twitter, the criticism levelled at the OBR is “the kind of thing that makes policy bodies nervous about being as transparent as they should be to help us hold them to account.  The BoE was paralysed by this nervousness, and made themselves hard to scrutinise.”

The one thing we know is that all forecasts produced in the current uncertain environment will be wrong in some way. They should be viewed as an attempt to shine some light in the dark, however feeble. In truth, the ordinary voter does not care about GDP growth but when you tell them it is a proxy for the path of employment and incomes, we are then talking about something meaningful for them. As a final thought, when the IMF and OBR are so far apart in their views on the UK, this is an indication that the light cast by the forecast insight is dim indeed.

Playing the long game is the only game in town

The support programmes implemented by governments have barely got off the ground but already central banks are stepping in to lend their support. The US Federal Reserve plans to offer an extra $2.3 trillion of credit and support the market for high-yield corporate debt in a bid to ensure that small and medium-sized businesses can access the central bank’s largesse. Meanwhile the UK government will borrow from the Bank of England to meet its financing needs via its long-established Ways and Means facility. This will allow the government to sidestep the bond market in order to ensure it has access to its funding needs. Since the amount borrowed is due to be repaid by the end of the year it does not constitute monetary deficit financing. But given the current strong demand for safe haven securities – a gilt auction this week had a bid-to-cover ratio of more than 3 – we have opened the floodgates to such unconventional financing measures much earlier than I expected.

In the BoE’s case, the irony is that the latest announcement came just a few days after the new Governor wrote a column in the FT making it clear that the BoE is not and will not be engaged in monetary financing. Andrew Bailey emphasised that “the UK’s institutional safeguards rule out this approach … [and] the MPC remains in full control” of the policy instruments designed to increase the central bank balance sheet. Simply put, if the BoE buys financial assets this is purely in line with the BoE’s inflation remit. But the element that is often overlooked is that the remit is “to maintain price stability; and subject to that, to support the economic policy” of the government, where the government’s policy objectives include a “credible fiscal policy, returning the public finances to health, while providing the flexibility to support the economy.” The BoE’s policy remit is about far more than simply controlling inflation – whatever it says in public.

But what is monetary deficit financing and why is it so “bad”? In simple terms, it amounts to central banks creating money to pay off the government’s creditors. The conventional argument is that it results in excessive liquidity creation that eventually results in higher inflation (too much money chasing too few goods). The textbook example of such a policy is the action of the Weimar government in Germany following World War I which chose to inflate away its debt by printing money but which instead resulted in the great hyperinflation of 1923. Admittedly it was successful as a debt reduction strategy but disastrous in terms of its other economic side effects. A century on from this experience, Germany remains scarred by the memory and was instrumental in writing the provision into the Maastricht Treaty that prohibits monetary deficit financing in the euro zone. More recently, it was practiced by Zimbabwe and the policy was only stopped when the currency became so devalued that the government was reputedly unable to pay for the ink required to print more banknotes.

It is thus generally accepted that allowing governments to control the monetary printing press is a bad idea for it may encourage them to over-expand the money supply. The conventional narrative is that allowing central banks to enjoy a degree of autonomy over monetary policy in the last two decades is one of the key factors helping to curb inflation. I have argued before that this is far from the whole story but it has certainly played a role. However, over the past decade central banks have bought huge amounts of government debt which has led to a massive rise in central bank reserves (i.e. liquidity creation) but not resulted in higher inflation. Indeed, the BoJ and ECB have struggled to push inflation towards their target goal of 2% despite a balance sheet worth 100% and 40% of GDP respectively (see chart, taken from the St Louis Fed). This is in part because the institutions which sold their securities to the central bank have simply gone out and bought other assets, notably equities, thus pushing up their price. There may not have been too much money chasing too few goods but there was a lot of it chasing a dwindling pool of high yielding assets. I have little doubt that liquidity creation will be inflationary in some form. It will surely push up asset prices although whether it inflates consumer prices remains to be seen.

The actions of the Fed and BoE in recent days confirm my suspicion that we will be engaged in financial repression for a long time to come (i.e. central banks will do everything in their power to keep interest rates low). They are likely to go further: The BoJ has been buying assets on an industrial scale for almost 20 years and both the Fed and BoE have a lot of headroom to ramp up their balance sheets without necessarily sparking CPI inflation if the Japanese experience is anything to go by. As it currently stands, central banks buy debt in the secondary market (i.e. not directly from the issuer) and for the foreseeable future they are going to be buying a lot of assets. Past experience suggests that at some point they will call a halt to the process. At that point, they can sit on their bond holdings indefinitely. As bonds mature, they can roll over the debt by cashing in the proceeds and use them to buy an equivalent amount of additional securities. In this way, the central bank balance sheet remains unchanged and it continues to hold the same amount of government debt.

Technically, this is not monetary deficit financing because the presumption is that at some point the central bank will sell its debt holdings back to the private sector. A small complication arises from the fact that in the UK, the BoE hands over the interest it earns from its bond holdings back to the Treasury so it is in effect monetising the interest payments, but that is small beer. A bigger issue is whether at some point the central bank will simply write off its government debt holdings. It is not going to happen anytime soon, so we can rest easy on that score. But they may surreptitiously be able to do so in the longer term. The BoE plans to hold £645 bn of bonds, which amounts to around 30% of annual GDP. Suppose that in the long-term nominal GDP growth averages 3.5% per year and that the BoE rolls over its debt holdings ad infinitum. After 25 years, the bond holdings are worth 13% of GDP and in 50 years just 5% of GDP.

Is anyone going to complain if in 50 years’ time, the BoE writes off (say) half of these holdings? The current generation of central bankers will be long gone and I certainly won’t be around to do so! Therefore, the issue of whether central banks are likely to monetise the debt holdings built up over the last decade is something we will only be able to judge long after the current crisis is past. Sometimes playing the long game really is the only game in town.

Real time economic reality

As the Covid-19 horror unfolds before us, it becomes clear with each passing day that this is a humanitarian crisis the like of which none of us have experienced in our lifetime. The economic consequences are a second order issue but over the coming weeks and months we will realise just what a huge hit the economy has taken. Central banks and governments are doing their best to mitigate the worst impact of the downturn, but they can never do enough. But just how bad is the downturn likely to be?

I have spent the last week trawling through up-to-date high frequency data to get a sense of where the UK economy stands. It does not make for pretty reading. Without going through all the indicators, one of the obvious places to start is with electricity output, taken from the National Grid at four hourly intervals. It is difficult to draw direct inferences for output given that factors such as temperature play a significant role in determining demand, but the fall in output following the introduction of the UK lockdown on the evening of 23 March is very marked (chart below). It is particularly noticeable that output during the day has fallen sharply whereas off-peak output has not, which is indicative of the collapse in demand from businesses that would otherwise be open and consuming electricity, such as shops and offices not to mention the power hungry manufacturing sector. A rough estimate suggests that output is down by around 3-4% compared with pre-lockdown trends, which I reckon is consistent with a GDP decline of up to 15%.

Wherever you look there is evidence of an economy which has simply hit the buffers. Rail journeys are down 95% on this time last year whilst the number of bus passengers is down 88%. People are also using their cars much less, with overall traffic numbers down 71%, though on the plus side those that do have to travel on the roads find that congestion has eased considerably (chart below).

The retail sector has also taken a significant hit. Footfall is down by around 80% compared to a year ago whilst the collapse in spending in the leisure sector has been almost total, with restaurants and pubs having been shut for two weeks. My calculations suggest that consumer spending in Q2 could fall by up 20% which is likely to mean a double-digit collapse in GDP growth. As workers are laid off, some temporarily but some perhaps permanently, we are likely to see an unprecedented rise in unemployment. We already know that the number of claimants for Universal Credit rose by almost a million in the second half of March, although since this includes people claiming in-work benefits as well those making unemployment claims, it is difficult to know how this will impact on the labour market figures. However a conservative estimate suggests that the jobless figures for April could show a rise of up to 2% in the unemployment rate. We have never seen such a sharp jump: the usual pattern once an economy falls into recession is for unemployment to pick up with a lag as the corporate sector adjusts slowly.

My guess is that this will lead to an annual reduction of around 6.5% in real GDP this year. To put this into context, based on the BoE’s long-term historical databank which contains GDP data back to 1700, this would represent the sixth worst output decline in the 319 years for which estimates are available. We have to go back to the immediate aftermath of WW1 for anything remotely like it. Faced with an output reduction of this magnitude, my concern remains that any economic recovery will be a protracted affair. Company earnings will take a huge hit which will shape their business practices for a long time to come. In many instances this will force a strategy rethink with attendant consequences for investment and employment. Unlike the post-2008 period which was characterised by companies being propped up by low interest rates and the substitution of labour for capital, the coming years may well see a more pronounced period of Schumpeterian creative destruction. 

Business models which rely on complex supply chains will likely be overhauled. If we had concerns about rolling back the globalisation trend before, the post-crisis world will almost certainly produce a sea change. The inability of countries like the US and UK to produce sufficient personal protection equipment for front line medical staff can be expected to spark a debate about the extent to which western economies rely too heavily on foreign producers to provide the manufactured goods they need. Suggestions that the likes of India are withholding drugs for use at home that they would otherwise export will further fan the flames of economic nationalism.

I will deal with the fiscal fallout in more detail another time but it is clear that we are going to be awash with government debt for years to come. It is unlikely we will be able to grow fast enough to significantly reduce the debt-to-GDP ratio given that we are faced with an ageing population, which leaves us with two alternatives. Either governments will have to embark on a policy of major austerity, which is likely to be highly unpopular given the experience of the past decade, or the real value of debt will have to be inflated away. Central banks have spent the past 20 years lauding their achievement of taming inflation and tell us today that they have no intention of relaxing their vigilance. I would not be so sure: Policymakers have a habit of changing their mind if the circumstances demand it.

Flexibility will be the name of the game in future as electorates make different demands of their governments than they have in recent years. We should be no illusions as to the profound social and economic changes that are to come. But first we have to get through the current crisis!

Divided we stand

The euro zone’s credibility took a significant beating in the wake of the Greek debt crisis which began to spiral out of control a decade ago. By 2012 it was clear that the monetary union project would have to be reformed, with more emphasis on building internal shock absorbers if it was to avoid the fate of previous attempts to create a union based on fixed exchange rates. Despite all the warm words, however, little progress has been made to create any form of fiscal union. Indeed, the efforts of Emmanuel Macron after he assumed office in 2017 have fallen on deaf ears, particularly in Germany. We now find ourselves faced with the deepest economic crisis since 2008 and arguably the most severe social crisis since WW2 with a fiscal framework which is not fit for purpose. This will be an existential test for the euro zone which cannot afford a rerun of the events of the past decade.

One of the most contentious issues in European economics right now is the prospect of issuing coronabonds – a common debt instrument that will enable the hardest hit countries, such as Italy and Spain, to issue securities guaranteed by all euro zone nations, including Germany. It is, as one might imagine, a hard sell in Germany where the idea of debt mutualisation contravenes the spirit of what the German public thought they had signed up to when agreeing to a single currency (not that they were ever asked). We have been here before: It was a major topic of discussion in 2012 when the prospect of Eurobonds was floated – and rejected – as a solution to help out highly indebted euro members.

To understand today’s concerns we need to recall our history. Whilst it is true that a number of euro zone members were heavily indebted, they were financed by capital flows from surplus countries prior to 2008. But when the music stopped, their creditors decided no longer to play ball. This was understandable but we should not overlook the fact that the heavily-indebted southern nations were allowed to become members of EMU despite not fulfilling the excessive debt criterion. Their creditors actually gave them the keys to the kingdom only to throw them away a few years later. Part of the reason for this lax attitude was because in the late-1990s, the EU only paid lip service to sovereign debt issues. After all, it had been on a downward trend relative to GDP for the preceding 50 years. The real focus was on deficits. Yet when France and Germany continually flouted the 3% of GDP deficit threshold just after the turn of the millennium, they escaped without any fiscal sanctions. Then the bust came and governments started to worry about debt again. Greek anger at the way they were treated in the wake of the 2008 bust is not without foundation.

Today’s problems are different. The world faces a humanitarian crisis and nowhere is suffering more at the present time than Italy or Spain, where coronavirus-related deaths continue to rise. The measures required to curb the spread of the disease are expensive, entailing massive wage subsidies and potentially a nationalisation programme as states are forced to prop up large parts of the economy. Italian anger at Germany’s refusal to sanction coronabonds is thus understandable. But as Lorenzo Bini Smaghi, a former ECB Council member, pointed out whilst coronabonds are a great idea in theory, in practice they “entail a major political choice to transfer sovereignty, on a whole range of issues, from the national to the European level.” He has a point: If the euro zone is to act as guarantor for debt, it needs to be backed up by tax raising powers. As Bini Smaghi put it, “Eurobonds cannot be issued to finance current expenditure, unless such expenditure and the resources to cover it are brought under the responsibility of the EU.” Moreover, if we introduce such mutual bonds today, what is to stop countries from issuing them in future to finance pet projects backed by Germany’s excellent credit rating?

Instead, Bini Smaghi and large parts of the northern European establishment prefer the idea of using the European Stability Mechanism, established in 2012, to disburse the funds. Unfortunately, any funds disbursed by the ESM are conditional on an adjustment programme, whereby borrowers must agree to abide by a series of conditions. Some form of legal change would thus be required to make it acceptable to Italy because as it currently stands, the ESM has a stigma attached to it.

Whilst the arguments against coronabonds have a sound legal basis, this is not the time to be hiding behind the letter of the law. Something has to give, and the longer northern European EMU members drag their feet, the more pressure will build up inside the euro zone. And as I have pointed out before, Italy is not Greece – it has the largest sovereign bond market in the euro zone which is five times that of Greece, and it will not be so easy to intimidate. And if we do not get some form of common bond and Italy is forced to issue BTPs and significantly expand its debt-to-GDP ratio, it will certainly not accept a period of austerity after the crisis has passed, simply to placate those who believe its debt level is too high.

It may be stretching it too far to suggest that failure to act on this issue will precipitate a breakup of the single currency. But the bloc simply does not have the automatic stabilisers which are necessary to combat shocks in a fixed exchange rate system. And the longer this problem is ignored, the greater will be the problems in the longer term. As the German economic historian Albrecht Ritschl has pointed out  “Germans prefer to let their history start with the zero hour of 1945“. But German historians know the price of failing to tackle deep-seated economic problems, particularly when it comes to debt.