There’s been much talk this week of how pessimistic the Office for Budget Responsibility are about the likely economic impact of coronavirus. Most media outlets ran with the headline that the pandemic “could see the economy shrink by a record 35%” in the second quarter, and the OBR are predicting that for 2020 overall GDP will contract by nearly 13%.
What received less attention was how optimistic the OBR’s analysis is about the ability of the economy, and with it the public finances, to return to pre-crisis performance. The OBR analysis does show a huge downturn this year, but it also shows both GDP and government borrowing returning almost immediately to what was forecast in the last Economic and Fiscal Outlook. In fact, their figures have the economy 2.8% bigger in 2021 than in 2019, exactly where it was forecast to be before the crisis – there’s just a large blip in between where it briefly contracts by 13%.
Unfortunately, I am not just pointing this out in order to find reasons to be cheerful – quite the opposite. The point I’m actually making is that such a quick and complete recovery is nigh-on impossible.
The OBR have been at pains to stress that they were setting out a ‘potential scenario’ based on a series of assumptions, rather than a forecast of what will really happen. The distinction between a ‘forecast’ and a scenario is quite confected, since forecasts necessarily involve assumptions too, but the OBR are evidently being especially cautious because of just how heroic their assumptions are in this particular publication.
The reason their model shows a quick return to trend is not because of any complex analysis of the likely impact of the pandemic in the medium-term – it is simply because they decided to assume a return to trend as part of their methodology: “for now, we assume no lasting economic hit.”
As Chris Giles of the Financial Times pithily put it: “That assumption will not last the test of time. The only question is how wrong is it.” The IMF have said even assuming a quick recovery most countries will probably lose around 5% of the output they would otherwise have been working with. The Resolution Foundation have just published a series of potential outcomes, and even in their most optimistic scenario of a three-month lockdown followed by a swift return to normality there is a long-term hit to GDP of 3%.
In the OBR’s defence, they point out that the extent of any economic ‘scarring’ depends heavily on how long the lockdown continues and whether there is a second wave of infections. But it means their analysis does little to inform the really crucial questions policymakers are going to have to face: what does the pandemic mean for the economy and the public finances in three, five and ten years’ time, and what can we do about it?
Few seem to be talking yet about the long-term impact on investor and consumer confidence, but it will surely be significant. Even for those who have kept their jobs, the crisis will have exposed insecurities for many people which they previously discounted. There will be some reluctance to spend, particularly on major commitments such as a new car, a new kitchen, a house extension and so on, and this will linger for some time.
Investors will be similarly diffident. There will be a new wariness not just of the possibility of a fresh wave of Covid-19 but of other new pandemics, and businesses will be unsure how long it will take for consumer demand to return to where it was. Planned investments and capital projects will be scaled back or cancelled. Lost 2020 profits will also mean a permanent loss to the capital stock as companies have less to reinvest.
There will be a scarring effect from businesses failing and from people losing their jobs. Even businesses which survive will take time to restore links with international supply chains. The Job Retention Scheme is performing a vital role, but many have lost their jobs already and more may do so when the scheme eventually closes. There is a lag in the economic damage from unemployment (hysteresis) and the longer people spend detached from the labour market the more their future employment prospects and earnings potential are damaged. It takes time to rematch people with employers. Some older workers will simply retire earlier than they otherwise would have.
For the Government’s part, the issue of unwinding the emergency measures will go hand in hand with the speed of recovery. At what point does the Chancellor take off the stabilisers and let the economy ride on its own steam? How does one judge whether a business will be viable once normality returns? How do you balance bringing public borrowing back down while not taking the wind out of the sails of the recovery?
On this last point, the OBR are predicting that borrowing will return quickly to where it was expected to be before and debt will stabilise. That is unlikely for a number of reasons.
Firstly, as set out above, a full recovery is likely to take much longer than the OBR’s model assumes, and there is likely to be some permanent loss of GDP, meaning lower tax receipts and higher welfare spending.
Secondly, the OBR cannot account for the political reality the Government will face when it comes to unwinding the measures it has announced. Some of the giveaways are undoubtedly permanent – for example, nearly a billion pounds of additional spending on housing benefit. Others are in theory temporary but in reality will be very difficult to reverse.
It is a lot easier for governments to give than it is to take away again. Would you want to be the Chancellor who announced he was taking £20 a week of Universal Credit from the poorest? Or returning business rates to normal when some firms are saying they cannot afford it? The large increase in NHS funding will end up being permanent, and the calls for higher spending on health and social care will be hard to resist given the likely public mood.
If you were to take the OBR’s analysis at face value, you could be forgiven for thinking ‘nothing has changed’. But things are going to change. The impact of the pandemic on both the economy and the public finances is likely to last much longer than is suggested by the OBR numbers, and policymakers need to start thinking about the implications.
As the man himself revealed in The Times this week, former Chancellor Sajid Javid will be working with the Centre for Policy Studies on a project to inform that thinking. There is going to be a lot of debate over the next year about what everything that has happened means for how we approach not just public health but also our economy, our links with the rest of the world, the public finances and the wider role of the state. As I highlighted on CapX last week, some on the left are already trying to use the situation to claim vindication for their policy platform. Those of us who believe free enterprise, openness and sound money are the best ways to deliver a free and prosperous society will need to be ready to engage with that debate, and to win it.
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