Think at London Business School
What are the trade-offs policymakers must strike to successfully coax life from the UK economy?
By Will Grahame-Clarke
How bad is the economy, really? How worried should we be?
Of course it is a moving picture with new data coming in all the time. But research carried out by Andrea Galeotti, Professor of Economics and Paolo Surico, Professor of Economics, suggests we should be truly concerned. They recognise the need for bold and substantial interventions from both governments and central banks around the world.
In another webinar in the LBS series looking beyond the pandemic at how we can emerge from the crisis, Professor Surico took us through the theory and evidence which points to the need for action.
An important aspect to grasp straight away is the systemic impact that uncertainty and nervousness can have on overall economic activity. Doubts about the short and medium term future can have a chilling effect on decision-making and consumer choices. And the stark and dramatic rise in joblessness can trigger what Professor Surico calls a “cashflow spiral”.
It works like this. First, general uncertainty increases at a time like this. We cannot know the future and it looks highly uncertain. This uncertainty leads households to reduce their spending and consumption. People are worried about their job prospects and future income. This fall in demand leads many firms, especially small and medium sized businesses, to close down. And this then leads to more workers losing their jobs, and thus the spiral continues, deepens and worsens.
The job losses stem from a basic cashflow crisis. If customers aren’t buying, cash is not coming in. And clearly there is a direct link – a continuum really – between worker income and household consumption, Professor Surico says. Middle and lower income households consume a very significant portion of what they earn. So the impact of a fall in wages is dramatic.
It is hard to avoid all the talk of uncertainty at the moment. A study of media coverage in the US found that Covid-19 has already received more attention, in terms of its impact on the economy, than all other recent crises: 9/11, the financial crisis of 2008-9, Brexit, Donald Trump’s election and continued presidency, and the simmering US/China trade war. “Covid-19 is off the scale in terms of media coverage,” Professor Surico says. By comparison: 9/11 got half as much coverage in this context as Covid-19 is receiving.
You can see consumers’ response in the US data. Initially consumption rose in anticipation of the lockdown phase – the stockpiling moment. Then there was a large decline, with less spending everywhere: air travel, groceries, restaurants, retail, public transport. Households were suddenly very cautious. By the end of March there was half the spending seen in January, a massive contraction of aggregate demand.
This sort of process hits small businesses especially hard. Many small businesses rely on their cashflow to survive. They have few assets to draw on. And these small, private (unlisted) businesses account for 60% of total employment. The credit available to them from banks is based on sales and cash flow. Almost overnight these firms cannot operate normally. And as asset values contract these small firms find themselves in an even weaker position.
The huge job losses in the US (and the large furlough programme in the UK) reflect the scale of the damage done to employment levels. In the US, among firms with under 500 employees, 43% are temporarily closed citing employee health concerns or a lack of demand.
On average workforces have been reduced by 40% since January. Three quarters report having only enough cash to cover expenses for the next two months or less. Seventy percent are interested in the government-subsidised aid programme but worry about bureaucratic hassles or the challenge of proving eligibility.
Some sectors are being hit harder than others. While 60% of banks and finance companies believe they will still be in business by the end of the year only 15% of restaurants do.
Failing businesses are visible and their failure rate can be measured. But an unseen consequence of this recession will be all the businesses that do not get started in the first place. “Most of the job creation in the economy comes from startups,” Professor Surico says. “But we will see much less of this in the next six months.”
New business applications in the US in March were 42% lower compared with the same month in 2019. This is a very sharp decline. Lots of jobs will not be created, on top of the massive job losses seen in the US already.
The degree of financial hardship experienced by people varies according to their cost of housing. For about a third of the housing market the situation is good: people own their own homes and have paid off their mortgage. These people are inevitably less squeezed at a time like this.
Many in the rental sector have little in the way of savings. They may depend on credit card debt to manage their day-to-day cost of living. This is an expensive option and can lead to greater debt problems in due course.
Those with mortgages can also be stretched. They also have very little spare cash and pay a significant portion of their monthly income to service the mortgage. If such households are hit by unemployment there can be serious problems, although the UK government has offered support to some mortgage holders who are struggling to meet monthly payments.
The cash squeeze is real for many, and was already becoming serious before Covid-19 struck. In a 2018 survey of UK households, one third said they were “finding it difficult” or “just about getting by”. Forty-eight percent of renters, 32% of mortgage holders and 18% of the mortgage free are on the brink of severe financial difficulty. And stopping the flow of income means stopping the flow of spending.
Watch: Paolo Surico and Elias Papaioannou discuss the likely economic impact of Covid-19
This crisis is very much a race between supply and demand, Professor Surico says. At first sight it looks like a classic supply side shock – disruption in China and global supply chains, followed by quarantine and social distancing reduce the number of hours worked.
But uncertainty – in people’s health, their finances and their business prospects – stops people spending, and so demand is hit also. Firms are wary of investing, and also lack the funds to do so. In this way a recession becomes a depression, and prices start to fall.
Sadly, this is not the end of the story, Professor Surico adds. Firms close down, and this brings aggregate supply down. Consumers (workers) are forced to reduce consumption even further.
If we assume a drop of 50% of output for a month and 25% in the two following months, that would amount to a 10% drop of GDP in a quarter, which would be “humungous”, according to Professor Surico. And that would apply if the lockdown only lasts three months. This could spiral to more than 15% if it continues. By way of contrast, total output lost globally in the great recession of 2008-9 was 4.5% over two years (which has not yet been fully recovered, by the way). So this fall could be three times bigger.
The impact will be felt not only in GDP figures but in people’s lives. We have already seen a big rise in demand for mental health services. Stress levels for people at home with children, trying to work and home-school, can be high. Alcohol consumption seems to have spiked in March, with drink being both stockpiled and consumed. Higher drinking can of course be stimulated both by mental health problems or worries about unemployment.
A 3% rise in unemployment can lead to a 25% rise in alcohol abuse. And then there is the question of domestic abuse, which could have risen as much as 30%, and not all cases are reported.
For children, too, inequality can rise. Not all will have access to home schooling and the internet, so their education will suffer. There seems to be a clear link between household income levels and educational chances and attainment. In low income families children do worse in times of home schooling. So the crisis adds to disadvantage. There is a risk of “double inequality” – parents can’t look after them and there is also a lack of internet access, so education gaps will grow.
Workers do not suffer equally either. Higher earners are more likely to be able to work from home. Lower skilled workers are more likely to lose their jobs. They are more likely to be put on furlough, more likely to be laid off, and less likely to be able to work from home.
The extremity of the situation calls for significant and large scale policy measures, Professor Surico says. More spending on public health has become inevitable. Tax reliefs and tax holidays have been tried, even a de facto temporary universal basic income under the furlough programme, with the government paying 80% of people’s salaries. Interest rates have been cut and there is the possibility of more quantitative easing.
“Tax rebates, cash grants and some form of temporary universal basic income are the most effective intervention for now,” Professor Surico suggests, as they puts real cash into people’s hands, which they spend. We could even experiment with a pre-paid debit card which expires whether a person has spent the money or not – to encourage a kind of compulsory spending.
Whatever mix of options is chosen, policies need to be “now and massive”. A 15% loss of GDP is an immense hit. Action will have to be global and co-ordinated, Professor Surico says.
Politics used to be needed to fix the economic cycle, he says, but now the economics is needed to try and fix the political problem.
Debt should not scare us as growth will eventually restore public finances, Professor Surico adds. He concludes: “I never thought in my life I would ever advise governments to do this, but it is time to print money. Deflation is the problem, not inflation.”
Central banks can raise rates and withdraw liquidity in due course at the right time to deal with any inflationary pressures. Bad government can lead to hyperinflation, he says, but that is not our immediate concern.