Category: Essential Economics for Business: Ch 11

With promises by the newly elected Conservative government to increase investment expenditure on health, education, innovation and infrastructure, it was expected that Rishi Sunak’s first Budget would be strongly expansionary. In fact, it turned out to be two Budgets in one – both giving a massive fiscal boost.

An emergency Budget

The first part of the Budget was a short-term emergency response to the explosive spread of the coronavirus. An extra £12 billion is to be spent on the NHS and other public services. Whether this will be anything like enough to cope with the effects of the pandemic as businesses fail and people lose their jobs remains to be seen. (See the blog A global supply-side shock: the impact of the coronavirus (COVID-19) outbreak.)

A key issue is just how quickly the money can be spent. How quickly can you train health professionals or produce more ventilators or provide extra hospital beds?

This emergency part of the Budget was co-ordinated with the Bank of England’s decision to cut Bank Rate from 0.75% to 0.25%.

This combined fiscal and monetary response to the crisis was further enhanced by the agreement of central banks on 15 March to boost world liquidity by increasing the supply of US dollars through large-scale quantitative easing. The US central bank, the Federal Reserve, also cut its main federal funds rate by one percentage point from 1–1.25% to 0–0.25%.

The planned Budget

The second part of the Budget is to raise government investment by 9% in real terms over the next four years, bringing overall government expenditure to 41% of GDP, financed largely by extra borrowing. As the IFS observes, “That is above its pre-crisis level and bigger than at any point between the mid 1980s and the start of the financial crisis.”

But despite this rise in the proportion of government spending to GDP, in other respects the spending plans are less expansionary than they may appear. Increases in current spending on health, education and defence had already been promised. This leaves other departments, such as social security, facing cuts, or at least no increase. And when compared with 2010/11 levels, if you exclude health, government current spending per head of the population will around 14% lower, or 19% lower once you account for spending that replaces EU funding.

The Chancellor’s hope is that, by focusing on investment, there will be a supply-side effect as well as a demand-side boost. If increases in aggregate demand are balanced by increases in aggregate supply, such a policy would not be inflationary in the long run. But in the light of the considerable uncertainty of the effects of the coronavirus, the plans may well require significant adjustment in the Autumn Budget – or earlier.

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Questions

  1. To what extent is this Budget ‘Keynesian’?
  2. Is the extra government expenditure likely to crowd out private expenditure? Explain.
  3. Demonstrate the desired long-term economic effect of the infrastructure policy using either an AD/AS diagram or a DAD/DAS diagram.
  4. How is the coronavirus pandemic likely to affect potential GDP in (a) the short run (b) the long run?
  5. Why is public-sector debt likely to soar over the next four years while annual government debt interest payments are likely to continue their gentle decline?
  6. What is missing from the Budget that you feel ought to have been included? Explain why.

The global economic impact of the coronavirus outbreak is uncertain but potentially very large. There has already been a massive effect on China, with large parts of the Chinese economy shut down. As the disease spreads to other countries, they too will experience supply shocks as schools and workplaces close down and travel restrictions are imposed. This has already happened in South Korea, Japan and Italy. The size of these effects is still unknown and will depend on the effectiveness of the containment measures that countries are putting in place and on the behaviour of people in self isolating if they have any symptoms or even possible exposure.

The OECD in its March 2020 interim Economic Assessment: Coronavirus: The world economy at risk estimates that global economic growth will be around half a percentage point lower than previously forecast – down from 2.9% to 2.4%. But this is based on the assumption that ‘the epidemic peaks in China in the first quarter of 2020 and outbreaks in other countries prove mild and contained.’ If the disease develops into a pandemic, as many health officials are predicting, the global economic effect could be much larger. In such cases, the OECD predicts a halving of global economic growth to 1.5%. But even this may be overoptimistic, with growing talk of a global recession.

Governments and central banks around the world are already planning measures to boost aggregate demand. The Federal Reserve, as an emergency measure on 3 March, reduced the Federal Funds rate by half a percentage point from the range of 1.5–1.75% to 1.0–1.25%. This was the first emergency rate cut since 2008.

Economic uncertainty

With considerable uncertainty about the spread of the disease and how effective containment measures will be, stock markets have fallen dramatically. The FTSE 100 fell by nearly 14% in the second half of February, before recovering slightly at the beginning of March. It then fell by a further 7.7% on 9 March – the biggest one-day fall since the 2008 financial crisis. This was specifically in response to a plunge in oil prices as Russia and Saudi Arabia engaged in a price war. But it also reflected growing pessimism about the economic impact of the coronavirus as the global spread of the epidemic accelerated and countries were contemplating more draconian lock-down measures.

Firms have been drawing up contingency plans to respond to panic buying of essential items and falling demand for other goods. Supply-chain managers are working out how to respond to these changes and to disruptions to supplies from China and other affected countries.

Firms are also having to plan for disruptions to labour supply. Large numbers of employees may fall sick or be advised/required to stay at home. Or they may have to stay at home to look after children whose schools are closed. For some firms, having their staff working from home will be easy; for others it will be impossible.

Some industries will be particularly badly hit, such as airlines, cruise lines and travel companies. Budget airlines have cancelled several flights and travel companies are beginning to offer substantial discounts. Manufacturing firms which are dependent on supplies from affected countries have also been badly hit. This is reflected in their share prices, which have seen large falls.

Longer-term effects

Uncertainty could have longer-term impacts on aggregate supply if firms decide to put investment on hold. This would also impact on the capital goods industries which supply machinery and equipment to investing firms. For the UK, already having suffered from Brexit uncertainty, this further uncertainty could prove very damaging for economic growth.

While aggregate supply is likely to fall, or at least to grow less quickly, what will happen to the balance of aggregate demand and supply is less clear. A temporary rise in demand, as people stock up, could see a surge in prices, unless supermarkets and other firms are keen to demonstrate that they are not profiting from the disease. In the longer term, if aggregate demand continues to grow at past rates, it will probably outstrip the growth in aggregate supply and result in rising inflation. If, however, demand is subdued, as uncertainty about their own economic situation leads people to cut back on spending, inflation and even the price level may fall.

How quickly the global economy will ‘bounce back’ depends on how long the outbreak lasts and whether it becomes a serious pandemic and on how much investment has been affected. At the current time, it is impossible to predict with any accuracy the timing and scale of any such bounce back.

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Questions

  1. Using a supply and demand diagram, illustrate the fall in stock market prices caused by concerns over the effects of the coronavirus.
  2. Using either (i) an aggregate demand and supply diagram or (ii) a DAD/DAS diagram, illustrate how a fall in aggregate supply as a result of the economic effects of the coronavirus would lead to (a) a fall in real income and (i) a fall in the price level or (ii) a fall in inflation; (b) a fall in real income and (i) a rise in the price level or (ii) a rise in inflation.
  3. What would be the likely effects of central banks (a) cutting interest rates; (b) engaging in further quantitative easing?
  4. What would be the likely effects of governments running a larger budget deficit as a means of boosting the economy?
  5. Distinguish between stabilising and destabilising speculation. How would you characterise the speculation that has taken place on stock markets in response to the coronavirus?
  6. What are the implications of people being paid on zero-hour contracts of the government requiring workplaces to close?
  7. What long-term changes to working practices and government policy could result from short-term adjustments to the epidemic?
  8. Is the long-term macroeconomic impact of the coronavirus likely to be zero, as economies bounce back? Explain.

With many countries experiencing low growth some 12 years after the financial crisis and with new worries about the effects of the coronavirus on output in China and other countries, some are turning to a Keynesian fiscal stimulus (see Case Study 16.6 on the student website). This may be in the form of tax cuts, or increased government expenditure or a combination of the two. The stimulus would be financed by increased government borrowing (or a reduced surplus).

The hope is that there will also be a longer-term supply-side effect which will boost potential national income. This could be through tax reductions creating incentives to invest or work more efficiently; or it could be through increased capacity from infrastructure spending, whether on transport, energy, telecommunications, health or education.

In the UK, the former Chancellor, Sajid Javid, had adopted a fiscal rule similar to the Golden Rule adopted by the Labour government from 1997 to 2008. This stated that, over the course of the business cycle, the government should borrow only to invest and not to fund current expenditure. Javid’s rule was that the government would balance its current budget by the middle of this Parliament (i.e. in 2 to 3 years) but that it could borrow to invest, provided that this did not exceed 3% of GDP. Previously this limit had been set at 2% of GDP by the former Chancellor, Philip Hammond. Using his new rule, it was expected that Sajid Javid would increase infrastructure spending by some £20 billion per year. This would still be well below the extra promised by the Labour Party if they had won the election and below what many believe Boris Johnson Would like.

Sajid Javid resigned at the time of the recent Cabinet reshuffle, citing the reason that he would have been required to sack all his advisors and use the advisors from the Prime Minister’s office. His successor, the former Chief Secretary to the Treasury, Rishi Sunak, is expected to adopt a looser fiscal rule in his Budget on March 11. This would result in bigger infrastructure spending and possibly some significant tax cuts, such as a large increase in the threshold for the 40% income tax rate.

A Keynesian stimulus would almost certainly increase the short-term economic growth rate as inflation is low. However, unemployment is also low, meaning that there is little slack in the labour market, and also the output gap is estimated to be positive (albeit only around 0.2%), meaning that national income is already slightly above the potential level.

Whether a fiscal stimulus can increase long-term growth depends on whether it can increase capacity. The government hopes that infrastructure expenditure will do just that. However, there is a long time lag between committing the expenditure and the extra capacity coming on stream. For example, planning for HS2 began in 2009. Phase 1 from London to Birmingham is currently expected to be operation not until 2033 and Phase 2, to Leeds and Manchester, not until 2040, assuming no further delays.

Crossrail (the new Elizabeth line in London) has been delayed several times. Approved in 2007, with construction beginning in 2009, it was originally scheduled to open in December 2018. It is now expected to be towards the end of 2021 before it does finally open. Its cost has increased from £14.8 billion to £18.25 billion.

Of course, some infrastructure projects are much quicker, such as opening new bus routes, but most do take several years.

The first five articles look at UK policy. The rest look at Keynesian fiscal policies in other countries, including the EU, Russia, Malaysia, Singapore and the USA. Governments seem to be looking for a short-term boost to aggregate demand that will increase short-term GDP, but also have longer-term supply-side effects that will increase the growth in potential GDP.

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Questions

  1. Illustrate the effect of an expansionary fiscal policy with a Keynesian Cross (income and expenditure) diagram or an injections and withdrawals diagram.
  2. What is meant by the term ‘output gap’? What are the implications of a positive output gap for expansionary Keynesian policy?
  3. Assess the benefits of having a fiscal rule that requires governments to balance the current budget but allows borrowing to invest.
  4. Would there be a problem following such a rule if there is currently quite a large positive output gap?
  5. To what extent are the policies being proposed in Russia, the EU, Malaysia and Singapore short-term demand management policies or long-term supply-side policies?

Since the financial crisis of 2008–9, the UK has experienced the lowest growth in productivity for the past 250 years. This is the conclusion of a recent paper published in the National Institute Economics Review. Titled, Is the UK Productivity Slowdown Unprecedented, the authors, Nicholas Crafts of the University of Sussex and Terence C Mills of Loughborough University, argue that ‘the current productivity slowdown has resulted in productivity being 19.7 per cent below the pre-2008 trend path in 2018. This is nearly double the previous worst productivity shortfall ten years after the start of a downturn.’

According to ONS figures, productivity (output per hour worked) peaked in 2007 Q4. It did not regain this level until 2011 Q1 and by 2019 Q3 was still only 2.4% above the 2007 Q4 level. This represents an average annual growth rate over the period of just 0.28%. By contrast, the average annual growth rate of productivity for the 35 years prior to 2007 was 2.30%.

The chart illustrates this and shows the productivity gap, which is the amount by which output per hour is below trend output per hour from 1971 to 2007. By 2019 Q3 this gap was 27.5%. (Click here for a PowerPoint of the chart.) Clearly, this lack of growth in productivity over the past 12 years has severe implications for living standards. Labour productivity is a key determinant of potential GDP, which, in turn, is the major limiter of actual GDP.

Crafts and Mills explore the reasons for this dramatic slowdown in productivity. They identify three primary reasons.

The first is a slowdown in the impact of developments in ICT on productivity. The office and production revolutions that developments in computing and its uses had brought about have now become universal. New developments in ICT are now largely in terms of greater speed of computing and greater sophistication of software. Perhaps with an acceleration in the development of artificial intelligence and robotics, productivity growth may well increase in the relatively near future (see third article below).

The second cause is the prolonged impact of the banking crisis, with banks more cautious about lending and firms more cautious about borrowing for investment. What is more, the decline in investment directly impacts on potential output, and layoffs or restructuring can leave people with redundant skills. There is a hysteresis effect.

The third cause identified by Crafts and Mills is Brexit. Brexit and the uncertainty surrounding it has resulted in a decline in investment and ‘a diversion of top-management time towards Brexit planning and a relative shrinking of highly-productive exporters compared with less productive domestically orientated firms’.

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Questions

  1. How suitable is output (GDP) per hour as a measure of labour productivity?
  2. Compare this measure of productivity with other measures.
  3. According to Crafts and Mills, what is the size of the impact of each of their three explanations of the productivity slowdown?
  4. Would you expect the growth in productivity to return to pre-2007 levels over the coming years? Explain.
  5. Explain the underlying model for obtaining trend productivity growth rates used by Crafts and Mills.
  6. Explain and comment on each of the six figures in the Crafts and Mills paper.
  7. What policies should the government adopt to increase productivity growth?

A lack of productivity growth has been a major problem for the UK economy over the past decade (click here for a PowerPoint of the chart). Is it possible that the new decade may see a pick-up in the growth in output per hour worked?

One possible solution to low productivity growth is to reduce working hours and even to move to a four-day week, but not to reduce total pay. If people work fewer hours, they may well be more productive in the hours they do work. In fact, not only may output per hour increase, but so too may output per worker, despite fewer hours being worked. What is more, the quality of output may increase with people being less tired and more motivated.

Several companies have experimented with a four-day week, including Microsoft in Japan, which employees 2300 workers. It found that, despite a 20% reduction in hours worked, output per hour worked increased by 40%, with total output thereby increasing. Workers were generally happier and more motivated and asked for fewer days off.

And it is not just a question of output: fewer hours can result in lower costs. The effect on costs will depend on the nature of new work patterns, including whether everyone has the same extra day off.

But a four-day week is only one way of cutting working hours for full-time employees. Another is to reduce the length of the working day. The argument is that people may work more efficiently if the standard working day is cut from eight to, say, five hours. As the first Thrive Global article article (linked below) states:

Just because you’re at your desk for eight hours doesn’t mean you’re being productive. Even the best employees probably only accomplish two to three hours of actual work. The five-hour day is about managing human energy more efficiently by working in bursts over a shorter period.

If people have more leisure time, this could provide a boost to the leisure and other industries. According to a Henley Business School study:

An extra day off could have a knock-on effect for the wider society. We found 54% of employees said they would spend their day shopping, meaning a potential boost for the high street, 43% would go to the cinema or theatre and 39% would eat out at restaurants.

What is more, many people would be likely to use the extra time productively, undertaking training, volunteering or other socially useful activities. Also family life is likely to improve, with people spending less time at work and commuting and having more time for their partners, children, other relatives and friends. In addition, people’s physical and mental health is likely to improve as they achieve a better work-life balance.

So, should firms be encouraged to reduce hours for full-time workers with no loss of pay? Many firms may need no encouragement at all if they can see from the example of others that it is in their interests. But many firms may find it difficult, especially if their suppliers and/or customers are sticking with ‘normal’ working hours and want to do business during those hours. But, over time, as more firms move in this direction, so it will become increasingly in the interests of others to follow suit.

In the meantime, should the government introduce incentives (such as tax breaks) or regulations to limit the working week? Indeed, it was part of the Labour manifesto for the December 2019 election that the country should, over time, move to a four-day week. Although this was a long-term goal, it would probably have involved the use of some incentives to encourage employers to move in that direction or the gradual introduction of limits on the number of hours or days per week that people could work in a particular job. It is unlikely that the new Conservative government will introduce any specific measures, but would probably not want to discourage firms from reducing working hours, especially if it is accompanied by increased output per worker.

But despite the gains, there are some problems with reduced working hours. Many small businesses, such as shops, restaurants and firms offering technical support, may not have the flexibility to offer reduced hours, or may find it hard to increase productivity when there is a specific amount of work that needs doing, such as serving customers.

Another problem concerns businesses where the output of individuals is not easy to measure because they are part of a team. Reducing hours or the working week may not make such people work harder if they can ‘get way with it’. Not everyone is likely to be motivated by fewer hours to work harder.

Then there is the problem if reduced hours don’t work in boosting productivity. It may then be very difficult to reintroduce longer hours.

But, despite these problems, there are many firms where substantial gains in productivity could be made by restructuring work in a way that reduces hours worked. We may see more and more examples as the decade progresses.

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Questions

  1. Distinguish between different ways of measuring labour productivity.
  2. Give some examples (from the linked references) of employers which have tried introducing a four-day week or reduced hours for full-time workers. What has been the outcome in each case?
  3. In what ways may reducing working hours reduce a firm’s total costs?
  4. What are the advantages and disadvantages of the government imposing (at some point in the future) a maximum working week or a four-day week?
  5. What types of firm might struggle in introducing a four-day week or a substantially reduced number of hours for full-time employees?
  6. What external benefits and costs might arise from a shorter working week?