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The UK Autumn Statement 2022

The Autumn Statement was announced by Jeremy Hunt in Parliament on Thursday 17th November. This was Hunt’s first big speech since becoming Chancellor or the Exchequer a few weeks ago. He revealed to the House of Commons that there will be tax rises and spending cuts worth billions of pounds, aimed at mending the nation’s finances. It is hoped that the new plans will restore market confidence shaken by his predecessor’s mini-Budget. He claimed that the mixture of tax rises and spending cuts would be distributed fairly.

What is the Autumn statement?

The March Budget is the government’s main financial plan, where it decides how much money people will be taxed and where that money will be spent. The Autumn Statement is like a second Budget. This is an update half a year later on how things are going. However, that doesn’t mean it is not as important. This year’s Autumn Statement is especially important given the number of changes in government in recent months. The Statement unfortunately comes at a time when the cost of living is rising at its fastest rate for 41 years, meaning that it is going to be a tough winter for many people.

Statement overview

It was expected that the Statement was not going to be one to celebrate, given that the UK is now believed to be in a recession. The Office for Budget Responsibility (OBR) forecasts that the UK economy will shrink by 1.4% next year. However, Hunt said that his focus was on stability and ensuring a shallower downturn. The Chancellor outlined his ‘plan for stability’ by announcing deep spending cuts and tax rises in the autumn statement. He said that half of his £55bn plan would come from tax rises, and the rest from spending cuts.

The Chancellor plans to tackle rising prices and restore the UK’s credibility with international markets. He said that it will be a balanced path to stability, with the need to tackle inflation to bring down the cost of living while also supporting the economy on a path to sustainable growth. It will mean further concerns for many, but the Chancellor argued that the most vulnerable in society are being protected. He stated that despite difficult decisions being made, the plan was fair.

What was announced?

The government’s overall strategy appears to assume that, by tightening fiscal policy, monetary policy will not have to tighten as much. The hopeful consequence of which is that interest rates will be lower than they otherwise would have been. This means interest-rate sensitive parts of the economy, the housing sector in particular, are more protected than it would have been.

The following are some of the key measures announced:

  • Tax thresholds will be frozen until April 2028, meaning millions will pay more tax as their nominal incomes rise.
  • Spending on public services in England will rise more slowly than planned – with some departments facing cuts after the next election.
  • The state pensions triple lock will be kept, meaning pensioners will see a 10.1% rise in weekly payments.
  • The household energy price cap per unit of gas and electricity has been extended for one year beyond April but made less generous, with typical bills then being £3000 a year instead of £2500.
  • There will be additional cost-of-living payments for the ‘most vulnerable’, with £900 for those on benefits, and £300 for pensioners.
  • The top 45% additional rate of income tax will be paid on earnings over £125 140 instead of £150 000.
  • The UK minimum wage (or ‘National Living Wage’ as the government calls it) for people over 23 will increase from £9.50 to £10.42 per hour.
  • The windfall tax on oil and gas firms will increase from 25% to 35%, raising £55bn over the period from now until 2028.

The public finances

A key feature of the Autumn Statement was the Chancellor’s attempt to tackle the deteriorating public finances and to reduce the public-sector deficit and debt. The following three charts are based on data from the OBR (see data links below). They all show data for financial years beginning in the year shown. They all include OBR forecasts up to 2025/26, with the forecasts being based on the measures announced in the Autumn Statement.

Figure 1 shows public-sector current expenditure and receipts and the balance between them, giving the current deficit (or surplus), shown by the green bars. Current expenditure excludes capital expenditure on things such as hospitals, schools and roads. Since 1973, there has been a current deficit in most years. However, the deficit of 11.5% of GDP in 2020/21 was exceptional given government support measures for households and business during the pandemic. The deficit fell to 3.3% in 2021/22, but is forecast to grow to 4.6% in 2022/23 thanks to government subsidies to energy suppliers to allow energy prices to be capped. (Click here for a PowerPoint of this chart.)

Figure 2 shows public-sector expenditure (current plus capital) from 1950. You can see the spike after the financial crisis of 2007–8 when the government introduced various measures to support the banking system. You can also see the bigger spike in 2020/21 when pandemic support measures saw government expenditure rise to a record 53.0% of GDP. It has risen again this financial year to a predicted to 47.3% of GDP from 44.7% last financial year. It is forecast to fall only slightly, to 47.2%, in 2023/24, before then falling more substantially as the tax rises and spending cuts announced in the Autumn Statement start to take effect. (Click here for a PowerPoint of this chart.)

Figure 3 shows public-sector debt since 1975. COVID support measures, capping energy prices and a slow growing or falling GDP have contributed to a rise in debt as a proportion of GDP since 2020/21. Debt is forecast to peak in 2023/24 at a record 106.7% of GDP. During the 20 years from 1988/89 to 2007/8 it averaged just 30.9% of GDP. After the financial crisis of 2007–8 it rose to 81.6% by 2014/15 and then averaged 82.2% between 2014/15 and 2019/20. (Click here for a PowerPoint of this chart.)

Criticism

The government has been keen to stress that Mr Hunt’s statement does not amount to a return to the austerity policies of the Conservative-Liberal Democrat coalition government, in office between 2010 and 2015. However, Labour Shadow Chancellor, Rachel Reeves, said Mr Hunt’s Autumn Statement was an ‘invoice for the economic carnage’ the Conservative government had created. There have also been some comments raised by economists questioning the need for spending cuts and tax rises on this scale, with some saying that the decisions being made are political.

Paul Johnson, the director of the Institute for Fiscal Studies has commented on the plans, stating that the British people ‘just got a lot poorer’ after a series of ‘economic own goals’ that have made a recovery much harder than it might have been. He went on to say that the government was ‘reaping the costs of a long-term failure to grow the economy’, along with an ageing population and high levels of historic borrowing.

Disapproval also came from Conservative MP, Jacob Rees-Mogg, who criticised the government’s tax increases. He raised concerns about the government’s plans to increase taxation when the economy is entering a recession. He said, ’You would normally expect there to be some fiscal support for an economy in recession.’

Economic Outlook

High inflation and rising interest rates will lead to consumers spending less, tipping the UK’s economy into a recession, which the OBR expects to last for just over a year. Its forecasts show that the economy will grow by 4.2% this year but will shrink by 1.4% in 2023, before growth slowly picks up again. GDP should then rise by 1.3% in 2024, 2.6% in 2025 and 2.7% in 2026.

The OBR predicts that there will be 3.2 million more people paying income tax between 2021/22 and 2027/28 as a result of the new tax policy and many more paying higher taxes as a proportion of their income. This is because they will be dragged into higher tax bands as thresholds and allowances on income tax, national insurance and inheritance tax have been frozen until 2028. Government documents said these decisions on personal taxes would raise an additional £3.5bn by 2028 – the consequence of ‘fiscal drag’ pulling more Britons into higher tax brackets. The OBR expects that there will be an extra 2.6 million paying tax at the higher, 40% rate. This is going to put more pressure on households who are already feeling the impact of inflation on their disposable income.

However, this pressure on incomes is set to continue, with real incomes falling by the largest amount since records began in 1956. Real household incomes are forecast to fall by 7% in the next few years, which even after the support from the government, is the equivalent of £1700 per year on average. And the number unemployed is expected to rise by more than 500 000. Senior research economist at the IFS, Xiaowei Xu, described the UK as heading for another lost decade of income growth.

There may be some good news for inflation, with suggestions that it has now peaked. The OBR forecasts that the inflation rate will drop to 7.4% next year. This is still a concern, however, given that the target set for inflation is 2%. Despite the inflation rate potentially peaking, the impact on households has not. The fall in the inflation rate does not mean that prices in the shops will be going down. It just means that they will be going up more slowly than now. The OBR expects that prices will not start to fall (inflation becoming negative) until late 2024.

Conclusion

The overall tone of the government’s announcements was no surprise and policies were largely expected by the markets, hence their muted response. However, this did not make them any less economically painful. There are major concerns for households over what they now face over the next few years, something that the government has not denied.

It has been suggested that this situation, however, has been made worse by historic choices, including cutting state capital spending, cuts in the budget for vocational education, Brexit and Kwasi Kwarteng’s mini-Budget. It is evident that Britons have a tough time ahead in the next year or so. The UK has already had one lost decade of flatlining living standards since the global financial crisis and is now heading for another one with the cost of living crisis.

Articles

Videos

Analysis

  • Autumn Statement 2022 response

    • Institute for Fiscal Studies, Stuart Adam, Carl Emmerson, Paul Johnson, Robert Joyce, Heidi Karjalainen, Peter Levell, Isabel Stockton, Tom Waters, Thomas Wernham, Xiaowei Xu and Ben Zaranko (17/11/22)

  • Help today, squeeze tomorrow: Putting the 2022 Autumn Statement in context

    • Resolution Foundation, Torsten Bell, Mike Brewer, Molly Broome, Nye Cominetti, Adam Corlett, Emily Fry, Sophie Hale, Karl Handscomb, Jack Leslie, Jonathan Marshall, Charlie McCurdy, Krishan Shah, James Smith,
    Gregory Thwaites & Lalitha Try (18/11/22)

Government documentation

Data

Questions

  1. What do you understand by the term ‘fiscal drag’?
  2. Provide a critique of the Autumn Statement from the left.
  3. Provide a critique of the Autumn Statement from the right.
  4. What are the concerns about raising taxation during a recession?
  5. Define the term ‘windfall tax’. What are the advantages and disadvantages of imposing/increasing windfall taxes on energy producers in the current situation?
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From Reaganomics to Trussonomics

In her bid to become Conservative party leader, Liz Truss promised to make achieving faster economic growth her number-one policy objective. This would involve pursuing market-orientated supply-side policies.

These policies would include lower taxes on individuals to encourage people to work harder and more efficiently, and lower taxes on business to encourage investment. The policy would also involve deregulation, which would again encourage investment, both domestic and inward investment from overseas. These proposals echoed the policies pursued in the 1980s by President Ronald Reagan in the USA and Margaret Thatcher in the UK.

On September 23, the new Chancellor, Kwasi Kwarteng, presented a ‘mini-Budget’ – although the size of the changes made it far from ‘mini’. This, as anticipated, included policies intended to boost growth, including scrapping the 45% top rate of income tax, which is currently paid by people earning over £150 000 (a policy withdrawn on 3 October after massive objections), cutting the basic rate of income tax from 20% to 19%, scrapping the planned rise in corporation tax from 19% to 25%, scrapping the planned rise in national insurance by 1.25 percentage points, a cut in the stamp duty on house purchase and scrapping the limit placed on bankers’ bonuses. In addition, he announced the introduction of an unlimited number of ‘investment zones’ which would have lower business taxes, streamlined planning rules and lower regulation. The policies would be funded largely from extra government borrowing.

Theoretically, the argument is simple. If people do work harder and firms do invest more, then potential GDP will rise – a rise in aggregate supply. This can be shown on an aggregate demand and supply diagram. If the policy works, the aggregate supply curve will shift to the right. Real GDP will rise and there will be downward pressure on prices. In Figure 1, real GDP will rise from Y0 to Y1 and the price level will fall from P0 to P1. However, things are not as simple as this. Indeed, there are two major problems.

The first concerns whether tax cuts will incentivise people to work harder. The second concerns what happens to aggregate demand. I addition to this, the policies are likely to have a profound effect on income distribution.

Tax cuts and incentives

Cutting the top rate of income tax would have immediately given people at the top of the income scale a rise in post-tax income. This would have created a substitution effect and an income effect. Each extra pound that such people earn would be worth more in post-tax income – 60p rather than 55p. This would provide an incentive for people to substitute work for leisure as work is now more rewarding. This is the substitution effect. On the other hand, with the windfall of extra income, they now would have needed to work less in order to maintain their post-tax income at its previous level. They may well indeed, therefore, have decided to work less and enjoy more leisure. This is the income effect.

With the diminishing marginal utility of income, generally the richer people are, the bigger will be the income effect and the smaller the substitution effect. Thus, cutting the top rate of income tax may well have led to richer people working less. There is no evidence that the substitution effect would be bigger.

If top rates of income tax are already at a very high level, then cutting then may well encourage more work. After all, there is little incentive to work more if the current rate of tax is over 90%, say. Cutting them to 80% could have a big effect. This was the point made by Art Laffer, one of Ronald Reagan’s advisors. He presented his arguments in terms of the now famous ‘Laffer curve’, shown in Figure 2. This shows the total tax revenue raised at different tax rates.

If the average tax rate were zero, no revenue would be raised. As the tax rate is raised above zero, tax revenues will increase. The curve will be upward sloping. Eventually, however, the curve will peak (at tax rate t1). Thereafter, tax rates become so high that the resulting fall in output more than offsets the rise in tax rate. When the tax rate reaches 100 per cent, the revenue will once more fall to zero, since no one will bother to work.

If the economy were currently to the right of t1, then cutting taxes would increase revenue as there would be a major substitution effect. However, most commentators argue that the UK economy is to the left of t1 and that cutting the top rate would reduce tax revenues. Analysis by the Office for Budget Responsibility in 2012 suggested that t1 for the top rate of income tax was at around 48% and that cutting the rate below that would reduce tax revenue. Clearly according to this analysis, 40% is considerably below t1.

As far as corporation tax is concerned, the 19% rate is the lowest in the G20 and yet the UK suffers from low rates of both domestic investment and inward direct investment. There is no evidence that raising it somewhat, as previously planned, will cut investment. And as far as individual entrepreneurs are concerned, cutting taxes is likely to have little effect on the desire to invest and expand businesses. The motivation of entrepreneurs is only partly to do with the money. A major motivation is the sense of achievement in building a successful business.

Creating investment zones with lower taxes, no business rates and lower regulations may encourage firms to set up there. But much of this could simply be diverted investment from elsewhere in the country, leaving overall investment little changed.

To assess these questions, the government needs to model the outcomes and draw on evidence from elsewhere. So far this does not seem to have happened. They government did not even present a forecast of the effects of its policies on the public finances, something that the OBR normally presents at Budget time. This was one of the reasons for the collapse in confidence of sterling and gilts (government bonds) in the days following the mini-Budget.

Effects on aggregate demand

Cutting taxes and financing them from borrowing will expand aggregate demand. In Figure 1, the AD curve will also shift to the right and this will push up prices. Inflation is already a serious problem in the economy and unfunded tax cuts will make it worse. Higher inflation will result in the Bank of England raising interest rates further to curb aggregate demand. But higher interest rates, by raising borrowing costs, are likely to reduce investment, which will have a negative supply-side effect.

The problem here is one of timing. Market-orientated supply-side policies, if they work to increase potential GDP, will take time – measured in years rather than months. The rise in aggregate demand will be much quicker and will thus precede the rise in supply. This could therefore effectively kill off the rise in supply as interest rates rise, the exchange rate falls and the economy is pushed towards recession. Indeed, the mini-Budget immediately sparked a run on the pound and the exchange rate fell.

The rising government debt may force the government to make cuts in public expenditure. Rather than cutting current expenditure on things such as nurses, teachers and benefits, it is easier to cut capital expenditure on things such as roads and other infrastructure. But this will have adverse supply-side effects.

Effects on income distribution

Those advocating market-orientated supply-side policies argue that, by making GDP bigger, everyone can gain. They prefer to focus on the size of the national ‘pie’ rather than its distribution. If the rich initially gain, the benefits will trickle down to the poorest in society. This trickle-down theory was popular in the 1980s with politicians such as Margaret Thatcher and Ronald Reagan and, more recently, with Republican presidents, such as Goerge W Bush and Donald Trump. There are two problems with this, however.

The first, which we have already seen, is whether such policies actually do increase the size of the ‘pie’.

The second is how much does trickle down. During the Thatcher years, income inequality in the UK grew, as it did in the USA under Ronald Reagan. According to an IMF study in 2015 (see the link to the IMF analysis below), policies that increase the income share of the poor and the middle class do increase growth, while those that raise the income share of the top 20 per cent result in lower growth.

After the mini-Budget was presented, the IMF criticised it for giving large untargeted tax cuts that would heighten inequality. The poor would gain little from the tax cuts. The changes to income tax and national insurance mean that someone earning £20 000 per year will gain just £167 per year, while someone earning £200 000 will gain £5220. What is more, the higher interest rates and higher prices resulting from the lower exchange rate are likely to wipe out the modest gains to the poor.

Podcast

Articles

Analysis

Questions

  1. Distinguish between market-orientated supply-side policies and interventionist ones. Consider the advantages and disadvantages of each.
  2. Explain why bond prices fell after the mini-Budget. What was the Bank of England’s response and why did this run counter to its plan for quantitative tightening?
  3. How might a tax-cutting Budget be designed to help the poor rather than the rich? Would this have beneficial supply-side effects?
  4. Find out about the 1972 tax-cutting Budget of Anthony Barber, the Chancellor in Ted Heath’s government, that led to the ‘Barber boom’ and then rampant inflation. Are there any similarities between the 1972 Budget and the recent mini-Budget?
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The economic fallout from war

The suffering inflicted on the Ukrainian people by the Russian invasion is immense. But, at a much lower level, the war will also inflict costs on people in countries around the world. There will be significant costs to households in the form of even higher energy and food price inflation and a possible economic slowdown. The reactions of governments and central banks could put a further squeeze on living standards. Stock markets could fall further and investment could decline as firms lose confidence.

Russia is the world’s second largest oil supplier and any disruption to supplies will drive up the price of oil significantly. Ahead of the invasion, oil prices were rising. At the beginning of February, Brent crude was around $90 per barrel. With the invasion, it rose above $100 per barrel.

Russia is also a major producer of natural gas. The EU is particularly dependent on Russia, which supplies 40% of its natural gas. With Germany halting approval of the major new gas pipeline under the Baltic from Russia to Germany, Nord Stream 2, the price of gas has rocketed. On the day of the invasion, European gas prices rose by over 50%.

Nevertheless, with the USA deciding not to extend sanctions to Russia’s energy sector, the price of gas fell back by 32% the next day. It remains to be seen just how much the supplies of oil and gas from Russia will be disrupted over the coming weeks.

Both Russia and Ukraine are major suppliers of wheat and maize, between them responsible for 14% of global wheat production and 30% of global wheat exports. A significant rise in the price of wheat and other grains will exacerbate the current rise in food price inflation.

Russia is also a significant supplier of metals, such as copper, platinum, aluminium and nickel, which are used in a wide variety of products. A rise in their price has begun and will further add to inflationary pressures and supply-chain problems which have followed the pandemic.

The effect of these supply shocks can be illustrated in a simple aggregate demand and supply diagram (see Figure 1), which shows a representative economy that imports energy, grain and other resources. Aggregate demand and short-run aggregate supply are initially given by AD0 and SRAS0. Equilibrium is at point a, with real national income (real GDP) of Y0 and a price index of P0.

The supply shock shifts short-run aggregate supply to SRAS1. Equilibrium moves to point b. The price index rises to P1 and real national income falls to Y1. If it is a ‘one-off’ cost increase, then the price index will settle at the new higher level and GDP at the new lower level provided that real aggregate demand remains the same. Inflation will be temporary. If, however, the SRAS curve continues to shift upwards to the left, then cost-push inflation will continue.

These supply-side shocks make the resulting inflation hard for policymakers to deal with. When the problem lies on the demand side, where the inflation is accompanied by an unsustainable boom, a contractionary fiscal and monetary policy can stabilise the economy and reduce inflation. But the inflationary problem today is not demand-pull inflation; it’s cost-push inflation. Disruptions to supply are both driving up prices and causing an economic slowdown – a situation of ‘stagflation’, or even an inflationary recession.

An expansionary policy, such as increasing bond purchases (quantitative easing) or increasing government spending, may help to avoid recession (at least temporarily), but will only exacerbate inflation. In Figure 2, aggregate demand shifts to AD2. Equilibrium moves to point c. Real GDP returns to Y0 (at least temporarily) but the price level rises further, to P2. (Click here for a PowerPoint of the diagram.)

A contractionary policy, such as raising interest rates or taxes, may help to reduce inflation but will make the slowdown worse and could lead to recession. In the diagram, aggregate demand shifts to AD3. Equilibrium moves to point d. The price level returns to P0 (at least temporarily) but real income falls further, to Y3.

In other words, you cannot tackle both the slowdown/recession and the inflation simultaneously by the use of demand-side policy. One requires an expansionary fiscal and/or monetary policy; the other requires fiscal and/or monetary tightening.

Then there are other likely economic stresses. If NATO countries respond by increasing defence expenditure, this will put further strain on public finances.

Sentiment is a key driver of the economy and prices. Expectations tend to be self-fulfilling. So if the war in Ukraine undermines confidence in stock markets and the real economy and further raises inflationary expectations, this pessimistic mood will tend in itself to drive down share prices, drive up inflation and drive down investment and economic growth.

Articles

Questions

  1. If there is a negative supply shock, what will determine the size of the resulting increase in the price level and the rate of inflation over the next one or two years?
  2. How may expectations affect (a) the size of the increase in the price level; (b) future prices of gas and oil?
  3. Why did stock markets rise on the day after the invasion of Ukraine?
  4. Argue the case for and against relaxing monetary policy and delaying tax rises in the light of the economic consequences of the war in Ukraine.
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Bounce back for the UK economy but with cloudy horizons

The OECD has recently published its six-monthly Economic Outlook. This assesses the global economic situation and the prospects for the 38 members of the OECD.

It forecasts that the UK economy will bounce back strongly from the deep recession of 2020, when the economy contracted by 9.8 per cent. This contraction was deeper than in most countries, with the USA contracting by 3.5 per cent, Germany by 5.1 per cent, France by 8.2 per cent, Japan by 4.7 per cent and the OECD as a whole by 4.8 per cent. But, with the success of the vaccine roll-out, UK growth in 2021 is forecast by the OECD to be 7.2 per cent, which is higher than in most other countries. The USA is forecast to grow by 6.8 per cent, Germany by 3.3 per cent, France by 5.8 per cent, Japan by 2.6 per cent and the OECD as a whole by 5.3 per cent. Table 1 in the Statistical Annex gives the figures.

This good news for the UK, however, is tempered by some worrying features.

The OECD forecasts that potential economic growth will be negative in 2021, with capacity declining by 0.4 per cent. Only two other OECD countries, Italy and Greece, are forecast to have negative potential economic growth (see Table 24 in the Statistical Annex). A rapid increase in aggregate demand, accompanied by a decline in aggregate supply, could result in inflationary pressures, even if initially there is considerable slack in some parts of the economy.

Part of the reason for the supply constraints are the additional barriers to trade with the EU resulting from Brexit. The extra paperwork for exporters has added to export costs, and rules-of-origin regulations add tariffs to many exports to the EU (see the blog A free-trade deal? Not really). Another supply constraint linked to Brexit is the shortage of labour in certain sectors, such as hospitality, construction and transport. With many EU citizens having left the UK and not being replaced by equivalent numbers of new immigrants, the problem is likely to persist.

The scarring effects of the pandemic present another problem. There has been a decline in investment. Even if this is only temporary, it will have a long-term impact on capacity, unless there is a compensating rise in investment in the future. Many businesses have closed and will not re-open, including many High Street stores. Moves to working from home, even if partially reversed as the economy unlocks, will have effects on the public transport industry. Also, people may have found new patterns of consumption, such as making more things for themselves rather than buying them, which could affect many industries. It is too early to predict the extent of these scarring effects and how permanent they will be, but they could have a dampening effect on certain sectors.

Inflation

So will inflation take off, or will it remain subdued? At first sight it would seem that inflation is set to rise significantly. Annual CPI inflation rose from 0.7 per cent in March 2021 to 1.5 per cent in April, with the CPI rising by 0.6 per cent in April alone. What is more, the housing market has seen a large rise in demand, with annual house price inflation reaching 10.2 per cent in March.

But these rises have been driven by some one-off events. As the economy began unlocking, so spending rose dramatically. While this may continue for a few months, it may not persist, as an initial rise in household spending may reflect pent-up demand and as the furlough scheme comes to an end in September.

As far as as the housing market is concerned, the rise in demand has been fuelled by the stamp duty ‘holiday’ which exempts residential property purchase from Stamp Duty Land Tax for properties under £500 000 in England and Northern Ireland and £250 000 in Scotland and Wales (rather than the original £125 000 in England and Northern Ireland, £145 000 in Scotland and £180 000 in Wales). In England and Northern Ireland, this limit is due to reduce to £250 000 on 30 June and back to £125 000 on 30 September. In Scotland the holiday ended on 31 March and in Wales is due to end on 30 June. As these deadlines are passed, this should see a significant cooling of demand.

Finally, although the gap between potential and actual output is narrowing, there is still a gap. According to the OECD (Table 12) the output gap in 2021 is forecast to be −4.6 per cent. Although it was −11.4 per cent in 2020, a gap of −4.6 per cent still represents a significant degree of slack in the economy.

At the current point in time, therefore, the Bank of England does not expect to have to raise interest rates in the immediate future. But it stands ready to do so if inflation does show signs of taking off.

Articles

Data, Forecasts and Analysis

Questions

  1. What determines the rate of (a) actual economic growth; (b) potential economic growth?
  2. What is meant by an output gap? What would be the implications of a positive output gap?
  3. Why are scarring effects of the pandemic likely to be greater in the UK than in most other countries?
  4. If people believed that inflation was likely to continue rising, how would this affect their behaviour and how would it affect the economy?
  5. What are the arguments for and against having a stamp duty holiday when the economy is in recession?
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The macroeconomic outlook over the next few years: a Covid hangover

Back in June, we examined the macroeconomic forecasts of the three agencies, the IMF, the OECD and the European Commission, all of which publish forecasts every six months. The IMF has recently published its latest World Economic Outlook (WEO) and its accompanying database. Unlike the April WEO, which, given the huge uncertainty surrounding the pandemic and its economic effects, only forecast as far as 2021, the latest version forecasts as far ahead as 2025.

In essence the picture is similar to that painted in April. The IMF predicts a large-scale fall in GDP and rise in unemployment, government borrowing and government debt for 2020 (compared with 2019) across virtually all countries.

World real GDP is predicted to fall by 4.4%. For many countries the fall will be much steeper. In the UK, GDP is predicted to fall by 9.8%; in the eurozone, by 8.3%; in India, by 10.3%; in Italy, by 10.8%; in Spain, by 12.8%. There will then be somewhat of a ‘bounce back’ in GDP in 2021, but not to the levels of 2019. World real GDP is predicted to rise by 5.2% in 2021. (Click here for a PowerPoint of the growth chart.)

Unemployment will peak in some countries in 2020 and in others in 2021 depending on the speed of recovery from recession and the mobility of labour. (Click here for a PowerPoint of the unemployment chart.)

Inflation is set to fall from already low levels. Several countries are expected to see falling prices.

Government deficits (negative net lending) will be sharply higher in 2020 as a result of government measures to support workers and firms affected by lockdowns and falling demand. Governments will also receive reduced tax revenues. (Click here for a PowerPoint of the general government net lending chart.)

Government debt will consequently rise more rapidly. Deficits are predicted to fall in 2021 as economies recover and hence the rise in debt will slow down or in some cases, such as Germany, even fall. (Click here for a PowerPoint of the general government gross debt chart.)

After the rebound in 2021, global growth is then expected to slow to around 3.5% by 2025. This compares with an average of 3.8% from 2000 to 2019. Growth of advanced economies is expected to slow to 1.7%. It averaged 1.9% from 2000 to 2019. For emerging market and developing countries it is expected to slow to 4.7% from an average of 5.7% from 2000 to 2019. These figures suggest some longer-term scarring effects from the pandemic.

Uncertainties

In the short term, the greatest uncertainty concerns the extent of the second wave, the measures put in place to contain the spread of the virus and the compensation provided by governments to businesses and workers. The WEO report was prepared when the second wave was only just beginning. It could well be that countries will experience a deeper recession in 2000 and into 2021 than predicted by the IMF.

This is recognised in the forecast.

The persistence of the shock remains uncertain and relates to factors inherently difficult to predict, including the path of the pandemic, the adjustment costs it imposes on the economy, the effectiveness of the economic policy response, and the evolution of financial sentiment.

With some businesses forced to close, others operating at reduced capacity because of social distancing in the workplace and with dampened demand, many countries may find output falling again. The extent will to a large extent depend on the levels of government support.

In the medium term, it is assumed that there will be a vaccine and that economies can begin functioning normally again. However, the report does recognise the long-term scarring effects caused by low levels of investment, deskilling and demotivation of the parts of the workforce, loss of capacity and disruptions to various supply chains.

The deep downturn this year will damage supply potential to varying degrees across economies. The impact will depend on various factors … including the extent of firm closures, exit of discouraged workers from the labour force, and resource mismatches (sectoral, occupational and geographic).

One of the greatest uncertainties in the medium term concerns the stance of fiscal and monetary policies. Will governments continue to run large deficits to support demand or will they attempt to reduce deficits by raising taxes and/or reducing benefits and/or cutting government current or capital expenditure?

Will central banks continue with large-scale quantitative easing and ultra-low or even negative interest rates? Will they use novel forms of monetary policy, such as directly funding government deficits with new money or providing money directly to citizens through a ‘helicopter’ scheme (see the 2016 blog, New UK monetary policy measures – somewhat short of the kitchen sink)?

Forecasting at the current time is fraught with uncertainty. However, reports such as the WEO are useful in identifying the various factors influencing the economy and how seriously they may impact on variables such as growth, unemployment and government deficits.

Report, speeches and data

Articles

Questions

  1. Explain what is meant by ‘scarring effects’. Identify various ways in which the pandemic is likely to affect aggregate supply over the longer term.
  2. Consider the arguments for and against governments continuing to run large budget deficits over the next few years.
  3. What are the arguments for and against using ‘helicopter money’ in the current circumstances?
  4. On purely economic grounds, what are the arguments for imposing much stricter lockdowns when Covid-19 rates are rising rapidly?
  5. Chose two countries other than the UK, one industrialised and one developing. Consider what policies they are pursuing to achieve an optimal balance between limiting the spread of the virus and protecting the economy.