Sunday, March 22, 2020
The deeper the dive, the longer the way back
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on This is an excerpt.

If you can keep your head when all about are losing theirs, to paraphrase Rudyard Kipling, then you are the right person for a crisis. Britain has gone into this one with a new chancellor and a new Bank of England governor and it is only fair to say that both deserve congratulation for both keeping their heads and their speed of response.

Rishi Sunak is having a good crisis and has shown a sure touch in extraordinary circumstances. When he says “whatever it takes” he means it. He and the Bank’s Andrew Bailey, some of whose emergency measures were done with outgoing governor Mark Carney, are safe hands and bring confidence.

It is important to see the Treasury and Bank’s measures working in tandem. Friday’s huge commitment by the chancellor, to meet 80% of the wages of staff - from March 1 - if employers agree to keep them on, up to £2,500 a month, and in theory £30,000 a year, will be costly. It is a gamble worth taking, to limit some of the inevitable rise in unemployment that we will see in coming weeks and which, indeed, is already happening. The more that the rise in unemployment can be contained, the better the economy will recover once the public health emergency eases.

Sunak also announced a boost to universal credit, direct help for renters and other measures adding up to a further £7bn.

His actions need to be seen in the context of Thursday’s announcements by the Bank of England. The least important bit of that announcement, though historic, was the cut in Bank rate to 0.1%. The most important was the £200bn of additional quantitative easing (QE), mainly in the form of purchases of gilts (UK government bonds) and probably front-loaded.

The significance of this, at a time of jittery financial markets, is that the Bank will buy from the markets the extra gilts issued by the government to fund the substantial extra borrowing that its measures will require. And this is effectively interest-free borrowing for the government, because any interest due to the Bank on gilts is returned to the Treasury.

It would be easy to get punch drunk with the speed and size of the Treasury and Bank announcements. As well as the rate cut and extra QE, the Bank announced an expansion of the newly created term funding scheme for smaller firms, and a scheme of large-scale commercial paper purchases by the Bank, intended to support larger firms.

Even in the financial crisis, interest rates were not cut this low, the lowest ever, while the extra £200bn of QE is the same as the inaugural amount announced during the crisis in March 2009. This is big stuff.

It is worth remembering, amid these historic moves by the Bank, how quickly all this has come about. At the end of January the Bank’s monetary policy committee (MPC) voted 7-2 to keep Bank rate on hold at 0.75%. Since then there have been two emergency packages and rate cuts. The new governor’s first scheduled MPC meeting was not supposed to be until this Thursday.

As for the Treasury, it is true that its response has been done in stages, and as with designing direct income support for workers forced to stay at home and suffering a loss of income, has sometimes appeared slow-footed. But there is no point in announcing schemes until the details have been worked out, and some of these things are easier said than done.

With so many big numbers around, and they genuinely are very big - a monetary and fiscal bazooka – a word of explanation might be useful. There is tendency to confuse apples and pears when describing some of the actions that Sunak has announced.

Many newspapers reported his second coronavirus package (the first being in the budget, the third on Friday) as a £350bn lifeline, or rescue, for the economy. I do not blame them. But £20bn of this was an additional short-term fiscal boost, to be added to the £12bn announced in the budget, and which will be added to further. The bulk, £330bn, was in the form of loan guarantees. Things would have to go really badly wrong for these guarantees to eventually cost the government anything more than a tiny fraction of that, though anything is possible..

People can debate whether the measures announced by the Bank and the Treasury are the right ones, though they seem to me to press the right buttons, but it is worth setting out what the aim of it all is.

The Bank described what is happening as “an economic shock that could be sharp and large but should be temporary”. The shock has three components; the initial supply disruptions from the first outbreak in China, the reduction in activity resulting from the government’s actions in shutting down or discouraging normal activities; and decisions by businesses and individuals, some of them arising from government advice, some independent of it.

The result is a dive in economic activity, gross domestic product, which will show through first in the surveys and official data for this month, but which will be particularly pronounced in the second quarter. In a briefing call with journalists following the Bank’s move, Bailey said the decision was driven by the risk that the markets were becoming disorderly, including a rise in the yield, or interest rate, on gilts (UK government bonds). But the authorities also want to provide a “bridge” to more normal times, preventing the lasting damage that would be done by the failure of fundamentally strong companies, and by a surge in unemployment.

The governor appeared to accept that there is not much that can be done about the short-term drop in economic activity, some of which is a direct consequence of government actions to increase social distancing.

Limiting the scale of the immediate decline, however, if that is a side-effect of the Bank and the Treasury’s actions, could be very important. The arithmetic of sudden declines in economic activity can be very challenging, leaving aside the practical effects on businesses struggling to survive a period of indeterminate length and unprecedented severity.

That arithmetic means that if GDP were to fall by 20% in a quarter, it would take a 25% rise to get back to where we started. Capital Economics does not have a 20% drop but it is expecting GDP to fall by 15% in the April-June period compared with a weak first quarter. It expects a recovery thereafter, with quarterly GDP rises of 5%, 8.5%, 2% and 1% over the following four quarters. But that still means it takes more than year – beyond the middle of 2021 – to get back to where we were. The good news is that that is a lot shorter than after the financial crisis.

It is reassuring to hear the Bank and the Treasury say that the shock to the economy will be temporary, a view shared by most economists. But we will be talking about this period for years to come, even after the virus has been brought under control. It will change the way businesses operate and it will change the way that people think about health, and their vulnerabilities to it. The hangover for the public finances will also be a lasting one.

What will be the lasting economic effect? Neil Shearing, Capital’s chief economist, offers a choice of three scenarios. The first and most optimistic is that the spending not being done now is fully made up for later, with no overall loss. It is also unlikely, some of what is being foregone now is lost forever. We will not make twice as many commuter trips to make up for the ones not being done now.

More realistic is the idea that, come next year, or later this year, we will do what we have always done, in terms of visits to pubs and restaurants, holidays, leisure, and so on. This year’s fall in GDP is not repeated; growth returns to what it would have been.

Finally, there is the gloomy view, that even when the public health crisis is over, there is lasting economic damage from a further retreat for globalisation, skills atrophying because of a rise in unemployment, the actual or feared return of the virus and, possibly, the need for governments to introduce new austerity programmes to deal with the fiscal costs of this crisis.

We have to hope that, while the economy should recover much more quickly than after the financial crisis, the lasting effects will not be as damaging. That is the real test for the interventions we have seen from the Treasury and Bank.