Category: Essentials of Economics: 8e Ch 10

Boris Johnson gave a speech on 30 June outlining his government’s approach to recovery from the sharpest recession on record. With the slogan ‘Build, build, build’, he said that infrastructure projects were the key to stimulating the economy. Infrastructure spending is a classic Keynesian response to recession as it stimulates aggregate demand allowing slack to be taken up, while also boosting aggregate supply, thereby allowing recovery in output while increasing potential national income.

A new ‘New deal’

He likened his approach to that of President Franklin D Roosevelt’s New Deal. This was a huge stimulus between 1933 and 1939 in an attempt to lift the US economy out of the Great Depression. There was a massive programme of government spending on construction projects, such as hospitals, schools, roads, bridges and dams, including the Hoover Dam and completing the 113-mile Overseas Highway connecting mainland Florida to the Florida Keys. Altogether, there were 34 599 projects, many large-scale. In addition, support was provided for people on low incomes, the unemployed, the elderly and farmers. Money supply was expanded, made possible by leaving the Gold Standard in 1934.

There was some debate as to whether the New Deal could be classed as ‘Keynesian’. Officially, the administration was concerned to achieve a balanced budget. However, it had a separate ’emergency budget’, from which New Deal spending was financed. According to estimates by the Federal Reserve Bank of St Louis, the total extra spending amounted to nearly 40% of US GDP as it was in 1929.

By comparison with the New Deal, the proposals of the Johnson government are extremely modest. Mostly it amounts to bringing forward spending already committed. The total of £5 billion is just 0.2% of current UK GDP.

Focusing on jobs

A recent report published by the Resolution Foundation, titled ‘The Full Monty‘, argues that as the Job Retention Scheme, under which people have been furloughed on 80% pay, is withdrawn, so unemployment is set to rise dramatically. The claimant count has already risen from 1.2m to 2.8m between March and May with the furlough scheme in place.

Policy should thus focus on job creation, especially in those sectors likely to experience the largest rise in unemployment. Such sectors include non-food retail, hospitality (pubs, restaurants, hotels, etc.), public transport, the arts, entertainment and leisure and a range of industries servicing these sectors. What is more, many of the people working in these sectors are young and low paid. Many will find it difficult to move to jobs elsewhere – partly because of a lack of qualifications and partly because of a lack of alternative jobs. The rising unemployment will raise inequality.

The Resolution Foundation report argues that policy should be focused specifically on job creation.

Policy makers should act now to minimise outflows from the hard-hit sectors – a wage subsidy scheme or a National Insurance cut in those sectors would reduce labour costs and discourage redundancies. Alongside this, the Government must pursue radical action to create jobs across the country, such as in social care and housing retrofitting, and ramp up support for the unemployed.

Dealing with hyteresis

The economy is set to recover somewhat as the lockdown is eased, but it is not expected to return to the situation before the pandemic. Many jobs will be lost permanently unless government support continues.

Even then, many firms will have closed and others will have reassessed how many workers they need to employ and whether less labour-intensive methods would be more profitable. They may take the opportunity to consider whether technology, such as AI, can replace labour; or they may prefer to employ cheap telecommuters from India or the Philippines rather than workers coming into the office.

Policies to stimulate recovery will need to take these hysteresis effects into account if unemployment is to fall back to pre-Covid rates.

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Questions

  1. What are the arguments for and against substantial increased government expenditure on infrastructure projects?
  2. Should the UK government spend more or less on such projects than the amount already pledged? Justify your answer.
  3. What are the arguments for and against directing all extra government expenditure towards green projects?
  4. Look through the Resolution Foundation report and summarise the findings of each of its sections.
  5. What are the arguments for and against directing all extra government expenditure towards those sectors where there is the highest rate of job losses?
  6. What form could policies to protect employment take?
  7. How should the success of policies to generate employment be measured?
  8. What form does hysteresis play on the post-Covid-19 labour market? What four shocks mean that employment will not simply return to the pre-Covid situation?

The recent pandemic has, and will have, serious implications for our economy with some estimating the largest drop in GDP ‘in living memory’. Expenditure from disposable income fell by 60% as social distancing policies were introduced and consumers started reducing their spending.

However, despite the impact being widespread across all sectors of the economy, workers in the gig economy are at a particular financial disadvantage. A report by Fintech firm, Portify, has found that income for self-employed gig workers fell 30% in the first two weeks of April, compared to the pre-crisis average. It is estimated that there will be a loss of £1.5bn through earnings and £6.9bn in economic contributions from gig economy workers.

Chancellor Rishi Sunak announced increased benefits for the self-employed at the daily briefing on March 20th but did not guarantee their wages. This has understandably left those people who are self-employed, e.g. freelancers, with greater uncertainty. According to the Office for National Statistics, there are 5 million self-employed people in the UK, who make up 15% of the labour market.

The government has been cautious over the financial support for the self-employed, because it is more difficult to confirm how much they are earning each month. However, many of the 5 million workers would have been among the first to be impacted by the closures and restrictions caused by the outbreak.

What is the ‘gig economy’?

The gig economy has grown significantly since the last global recession of 2008/9. After a substantial number of people lost their jobs, they turned towards self-employment. A boom in digital platforms, such as Uber and Deliveroo, has sparked a revolution in the world of work, with as many as one in 10 working-age adults now working in the gig economy, up from one in 20 in 2016. According to the Association of Independent Professionals and the Self-Employed (IPSE), prior to the coronavirus outbreak, self-employed people contributed £305bn to the British economy.

A gig economy is where workers are paid for the ‘gigs’ they do, e.g. a parcel delivery or taxi ride. They receive the money for the completed job instead of a regular wage. In the UK it is estimated that 5 million people are employed in this type of capacity. Flexible hours and controlling the amount you work is appealing for many people wanting to manage their home life and other priorities.

In the gig economy, workers are classed as independent contractors. This is also beneficial for employers as they only need to pay their workers when there is work available. Therefore, when demand drops, they don’t have to get rid of staff or have to incur unnecessary staff costs. However, this also has its drawbacks for the worker. They have no protection against unfair dismissal, no right to redundancy payments, and no right to receive the national minimum wage, paid holiday or sickness pay.

Impact of the coronavirus on the gig economy

Anybody experiencing symptoms of the virus have been told to self-isolate.  Employees who are then self-isolating can access statutory sick pay from the first day they are off. However, it is unclear if this applies to gig-economy workers. Unions that represent such workers have raised their concerns over the uncertainty and have demanded that urgent action is needed on working practices, including on sick pay. The United Private Hire Drivers (UPHD) union said:

Without access to worker rights such as minimum wage and sick pay, drivers who are infected may simply not be able to afford to stop working.

Work and Pensions Minister, Justin Tomlinson, has said that gig economy workers can apply for universal credit (which can take five weeks to come through) if they need to self-isolate. However, this is not an option for those who live hand-to-mouth. The government has indicated it wanted to do more for the self-employed but it is operationally difficult. Robert Jenrick, the Communities Secretary, said:

The purpose of our employment mechanism is to help continue the connection between employees and their business so once this is over – and it will be over – those individuals can return to their usual work and that link isn’t broken.

However, six days after the Chancellor’s initial support package was announced, he announced a new self-employed income support scheme, which will cover up to 80% of self-employed workers’ average taxable monthly profits. This taxable grant is to be paid in a lump sum in June and will no doubt provide a vital lifeline for those workers who have seen their income disappear almost overnight.

Those who are eligible will receive a taxable grant amounting to 80% of the average profits from the last three tax years. HMRC will use the total trading profit for the last three tax years and use this to calculate a monthly amount. However, annual profits are taken after expenses and capital allowances, but before pension contributions and charitable donations. Therefore, workers who have made significant investments into their businesses are likely to lose out.

What next?

The Independent Workers Union of Great Britain (IWGB), which represents gig-economy workers, has announced that it is suing the government over its failure to protect the wages and jobs of millions of workers during the pandemic. It has also accused the government of failing to ensure the health and safety of those still employed through proper sick pay. It has also argued that the lack of certainty encourages those potentially infected to continue working so they can still receive a wage.

The current scheme is only planned to cover the next three months. However, it is questionable whether this will be enough, and the government may have to extend the support.

There is also concern around how much of the gig economy (besides delivery and distribution workers) will remain once the restrictions are eased. Ryan Barnett, an IPSE economist predicts the economic impact to be far more severe than the 2008 financial crisis, pointing out that many entertainment industry workers have already had jobs cancelled until the end of 2021. Even when we can re-emerge from the current lockdown, it is likely that many workers will continue to rely on Universal Credit for a prolonged period of time.

Conclusion

There is no doubt that the current situation has had an impact on the daily lives of everyone in the economy. However, the level of uncertainty for those working in the gig economy has been concerning for many of the 5 million people.

The full impact of the crisis will not be known until some time after the lockdown. However, it is what measures are put in place in the short run that will have an impact and provide a greater level of certainty for the self-employed. It is important that the government understands the importance of supporting self-employment throughout the crisis, as the self-employed will likely play a key role in the economic activity and recovery that will follow.

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Questions

  1. Explain why many economies have seen an increase in the gig economy over the last decade.
  2. What are the advantages and disadvantages of a gig economy?
  3. How does the gig economy impact on the flexibility of the labour market in the UK?

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?