The LSE’s Centre for Economic Performance has just published a paper looking at the joint impact of Covid-19 and Brexit on the UK economy. Apart from the short-term shocks, both will have a long-term dampening effect on the UK economy. But they will largely affect different sectors.
Covid-19 has affected, and will continue to affect, direct consumer-facing industries, such as shops, the hospitality and leisure industries, public transport and personal services. Brexit will tend to hit those industries most directly involved in trade with Europe, the UK’s biggest trading partner. These industries include manufacturing, financial services, posts and telecommunications, mining and quarrying, and agriculture and fishing.
Despite the fact that largely different sectors will be hit by these two events, the total effect may be greater than from each individually. One of the main reasons for this is the dampening impact of Covid-19 on globalisation. Travel restrictions are likely to remain tighter to more distant countries. And countries are likely to focus on trading within continents or regions rather than the whole world. For the UK, this, other things being equal, would mean an expansion of trade with the EU relative to the rest of the world. But, unless there is a comprehensive free-trade deal with the EU, the UK would not be set to take full advantage of this trend.
Another problem is that the effects of the Covid-19 pandemic have weakened the economy’s ability to cope with further shocks, such as those from Brexit. Depending on the nature (or absence) of a trade deal, Brexit will impose higher burdens on trading companies, including meeting divergent standards and higher administrative costs from greater form filling, inspections and customs delays.
- Referring to the LSE paper, give some examples of industries that are likely to be particularly hard hit by Brexit when the transition period ends? Explain why.
- Why have university finances been particularly badly affected by both Covid-19 and Brexit? Are there any other sectors that have suffered (or will suffer) badly from both events?
- Is there a scenario where globalisation in trade could start to grow again?
- Has Covid-19 affected countries’ comparative advantage in particular products traded with particular countries and, if so, how?
- The authors of the LSE report argue that ‘government policies to stimulate demand, support workers to remain in employment or find new employment, and to support businesses remain essential’. How realistic is it to expect the government to provide additional support to businesses and workers to deal with the shock of Brexit?
Three international agencies, the IMF, the European Commission and the OECD, all publish six-monthly forecasts for a range of countries. As each agency’s forecasts have been published this year, so the forecasts for economic growth and other macroeconomic indicators, such as unemployment, have got more dire.
The IMF was the first to report. Its World Economic Outlook, published on 14 April, forecast that in the UK real GDP would fall by 6.5% in 2020 and rise by 4% in 2021 (not enough to restore GDP to 2019 levels); in the USA it would fall by 5.9% this year and rise by 4.7% next year; in the eurozone it would fall by 7.5% this year and rise by 4.7% next.
The European Commission was next to report. Its AMECO database was published on 6 May. This forecast that UK real GDP would fall by 8.3% this year and rise by 6% next; in the USA it would fall by 6.5% this year and rise by 4.9% next; in the eurozone it would fall by 7.7% this year and rise by 6.3% next.
The latest to report was the OECD on 10 June. The OECD Economic Outlook was the most gloomy. In fact, it produced two sets of forecasts.
The first, more optimistic one (but still more gloomy than the forecasts of the other two agencies) was based on the assumption that lockdowns would continue to be lifted and that there would be no second outbreak later in the year. This ‘single-hit scenario’ forecast that UK real GDP would fall by 11.5% this year and rise by 9% next (a similar picture to France and Italy); in the USA it would fall by 7.3% this year and rise by 4.1% next; in the eurozone it would fall by 9.1% this year and rise by 6.5% next.
The second set of OECD forecasts was based on the assumption that there would be a second wave of the virus and that lockdowns would have to be reinstated. Under this ‘double-hit scenario’, the UK’s GDP is forecast to fall by 14.0% this year and rise by 5.0 per cent next; in the USA it would fall by 8.5% this year and rise by 1.9% next; in the eurozone it would fall by 11.5% this year and rise by 3.5% next.
The first chart shows the four sets of forecasts (including two from the OECD) for a range of countries. The first four bars for each country are the forecasts for 2020; the other four bars for each country are for 2021. (Click here for a PowerPoint of the chart.)
The second chart shows unemployment rates from 2006. The figures for 2020 and 2021 are OECD forecasts based on the double-hit assumption. You can clearly see the dramatic rise in unemployment in all the countries in 2020. In some cases it is forecast that there will be a further rise in 2021. (Click here for a PowerPoint of the chart.)
As the OECD states:
In both scenarios, the recovery, after an initial, rapid resumption of activity, will take a long time to bring output back to pre-pandemic levels, and the crisis will leave long-lasting scars – a fall in living standards, high unemployment and weak investment. Job losses in the most affected sectors, such as tourism, hospitality and entertainment, will particularly hit low-skilled, young, and informal workers.
But why have the forecasts got gloomier? There are both demand- and supply-side reasons.
Aggregate demand has fallen more dramatically than originally anticipated. Lockdowns have lasted longer in many countries than governments had initially thought, with partial lockdowns, which replace them, taking a long time to lift. With less opportunity for people to go out and spend, consumption has fallen and saving has risen. Businesses that have shut, some permanently, have laid off workers or they have been furloughed on reduced incomes. This too has reduced spending. Even when travel restrictions are lifted, many people are reluctant to take holidays at home and abroad and to use public transport for fear of catching the virus. This reluctance has been higher than originally anticipated. Again, spending is lower than before. Even when restaurants, bars and other public venues are reopened, most operate at less than full capacity to allow for social distancing. Uncertainty about the future has discouraged firms from investing, adding to the fall in demand.
On the supply side, there has been considerable damage to capacity, with firms closing and both new and replacement investment being put on hold. Confidence in many sectors has plummeted as shown in the third chart which looks at business and consumer confidence in the EU. (Click here for a PowerPoint of the above chart.) Lack of confidence directly affects investment with both supply- and demand-side consequences.
Achieving a sustained recovery will require deft political and economic judgements by policymakers. What is more, people are increasingly calling for a different type of economy – one where growth is sustainable with less pollution and degradation of the environment and one where growth is more inclusive, where the benefits are shared more equally. As Angel Gurría, OECD Secretary-General, states in his speech launching the latest OECD Economic Outlook:
The aim should not be to go back to normal – normal was what got us where we are now.
- Why has the UK economy been particularly badly it by the Covid-19 pandemic?
- What will determine the size and timing of the ‘bounce back’?
- Why will the pandemic have “dire and long-lasting consequences for people, firms and governments”?
- Why have many people on low incomes faced harsher consequences than those on higher incomes?
- What are the likely environmental impacts of the pandemic and government measures to mitigate the effects?
Pre-Covid 19, the climate change movement had gathered momentum with climate activist Greta Thunberg regularly in the news and people around the world striking in protest of inadequate government action on the climate crisis. However, now in a world overtaken by the pandemic, climate change is no longer at the centre and appears a more distant threat. The majority of the large climate change events due to take place this year have been delayed and policy announcements are aimed at supporting the current economic hardships. This is not surprising nor debatable, but there is a risk that, as Covid-19 dominates the news, policy and debates for a long time to come, this will overshadow any environmental initiatives that were due to be implemented.
Governments around the globe are navigating their economies through the pandemic and starting to think about the future road to recovery. However, there is an argument that it doesn’t have to be a case of ‘either or’, as there is the potential for policies to address the Covid-19 crisis and climate change at the same time. How policy makers respond now could shape the fight against climate change for the future. One of the lessons from the pandemic is that quick responses to high impact risks are vital to reduce costs. With that in mind, and given the costs of climate change, it is arguable that now is the best time to address its challenges.
Climate change and Covid
It is estimated that there was a total global loss of $3tn caused by natural disasters over the past decade. By 2050, cumulative damages from climate change are predicted to reach $8 trillion, impoverishing the world as a whole by 3% of GDP and the poorest regions by more. Climate activists argue that despite the economic consequences of climate change, the action taken by governments has been insufficient. In 2015, the then Bank of England governor, Mark Carney warned: ‘Once climate change becomes a defining issue for financial stability, it may already be too late.’
However, since the pandemic struck all over the world, there have been positive consequences for the environment. Pollution levels started dropping fast as airlines grounded fleets, car travel came to a stop and industries shut down. With 2.6bn people living under restrictions under their country’s lockdown, there has also been an impact on the environment, not just the spread of the virus. Given that the lockdowns across the world have come at huge social and human costs, is now not the time to ensure that these improvements for the environment are not just temporary but ignite long-term changes?
Given the clear impacts and risks of Covid on peoples’ health, our ability to change our behaviour quickly has been striking. The importance of behaviour change has been brought to the centre and, arguably, it shows that we are capable of change when lives are at risk and are deemed more important than business-as-usual GDP growth. The application to climate change, however, is not as straightforward, as the costs to human lives are often viewed as a future problem.
Dr Laure de Preux, Assistant Professor of Economics at Imperial College Business School, highlights the important role that cooperation across borders plays in the face of a global crisis like Coronavirus, and how that can be applied to the fight against climate change.
The big challenges the world is facing, including the climate change crisis, can only be dealt with efficiently through international cooperation. We cannot only act individually; the benefits of our actions are multiplied if integrated into a global strategy. In the case of COVID-19, social distancing measures can only be truly effective if they are adopted at a large scale.
World leaders are aware that their economies now face one of the most severe recessions in history as a consequence of the coronavirus restrictions. Governments are going to have to dedicate huge budgets to enable the economic activity to resume again. This presents a unique challenge, but also a massive opportunity for global cooperation. The question to be asked, therefore, is that if these stimulus packages are a one-off chance to transform the economy, how should the government spend it and what should be their focus? Should the recovery policies focus on creating a greener economy?
The European Union unveiled what it is calling the biggest ‘green’ stimulus package in history. Ursula von der Leyen, the European Commission president, told European Parliament members that this issue is about all nations and it is bigger than any one of them. The deputy Prime Minister of Spain, Teresa Ribera, states that there is a greater risk by not acting in this way. She argues that if the recovery is not green, then it will be nothing but a short-cut to solve the current problems rather than a true economic recovery.
It is not just in Europe where the recovery has an environment focus. Joe Biden is believed to be planning a similarly huge green stimulus package for the US. The model echoes the vast investment projects of the New Deal that helped lift America out of the Great Depression in the 1930s.
There are sound economic reasons why politicians see green technology as a prudent investment. Renewable energy is now often cheaper than fossil fuels in large parts of the world and the technologies are proven and can be built at scale today. The argument for renewables providing a pathway for clean future growth is based on the logic of much of manufacturing – the more you produce, the cheaper it gets. However, China does not appear to have similar plans for their recovery. China produces almost a third of the world’s emissions, as much as the USA and the EU combined. At the annual National People’s Congress, there was no indication that the big expansion of coal-fired electricity generation would be reversed, even though it is also expanding the production of renewable energy. China expanded its coal-fired power stations as a key part of its stimulus package after the 2008 financial crisis.
The UK government receives ongoing pressure from energy companies. The boss of energy giant SSE, Alistair Phillips-Davies has warned that a failure to deal with climate change could eventually have a greater economic impact than coronavirus. SSE wants the UK government to encourage private investment in renewables by giving the green light to big new projects, such as hydrogen and carbon capture plants and boosting electric vehicles. Despite the impacts of climate change not being immediately felt in comparison to Covid-19, Phillips-Davies argues that a failure to deal with climate change could lead to great long-term impacts:
While it is still too early to predict with confidence the full human, social and economic impact of coronavirus, we can say with certainty that significant investment will be needed to rebuild the UK economy in its wake.
It is clear that any pandemic-induced financial decisions made over the next 12 months will shape the global economy for the next decade. The full impact of the virus on climate change will be determined by the world’s stimulus measures adopted post-pandemic. Following the 2008 financial crisis, the energy-intensive stimulus measures that followed, particularly in China, boosted emissions. Therefore, if we are to meet the reduction in emissions target our response needs to be green, helping to shape a sustainable future. Dr Alex Koberle, of the Grantham Institute at Imperial College London, argues that Governments should take time to reflect, learn from past mistakes and redirect development towards a sustainable future.
Shouldn’t growth be given priority?
With 1.6 billion people working in the informal economy worldwide reckoned to be in immediate danger of losing their livelihoods (according to the International Labour Organization), is now the right time to be focusing on the climate? Industries such as airlines and car manufacturing are strategic industries, employing millions of people. Headlines of longer-term environmental targets will be given less importance than headlines of job losses. Recovery relies on the government finding ways to employ lots and lots of people. There is a close relationship between real GDP, employment and energy consumption. Therefore, any policies aimed at reducing greenhouse gas emissions, unless carefully directed, could reduce economic growth and employment for both less and more developed economies. Such policies would increase the cost of conventional energy sharply.
Critics of a green energy policy for recovery argue that investing in renewable energy ignores the adverse effects of reduced investment and higher energy costs in other sectors. By governments prioritising policy to focus on the environment, they could harm the ability of most people to improve their own circumstances, especially given the terrible economic shock caused by the lockdowns.
With the majority of news in recent months providing little joy, there has been at least the positive impact on the environment. However, advocates say it not a cause for celebration and warn that any benefits are likely to be short lived. There have been some positive behavioural impacts but the true test will be what happens in the recovery phase. If the focus is returned to business as usual what happens to the targets actioned prior to Covid-19?
The immediate priority of all governments right now is to control the pandemic and to save lives. As their policy interventions have an impact and economies start to emerge from this crisis, then there is an important debate to be had about how new investments can help create a cleaner, greener recovery. We have learnt from the current pandemic that changes can be made when consequences are imminent, however, climate change is a threat that doesn’t go away, and is arguably just as urgent. Solutions to both crises can be integrated into a coherent response to propel the global economy towards sustainable growth and increased resilience.
- Are government attempts to reduce the impact of climate change beneficial or harmful to UK firms?
- What policy instruments can the government use to increase economic activity?
- How does an increase in investment affect aggregate demand?
- What are the costs and benefits of economic growth?
- Why can climate change be described as a market failure?
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’.
- How suitable is output (GDP) per hour as a measure of labour productivity?
- Compare this measure of productivity with other measures.
- According to Crafts and Mills, what is the size of the impact of each of their three explanations of the productivity slowdown?
- Would you expect the growth in productivity to return to pre-2007 levels over the coming years? Explain.
- Explain the underlying model for obtaining trend productivity growth rates used by Crafts and Mills.
- Explain and comment on each of the six figures in the Crafts and Mills paper.
- What policies should the government adopt to increase productivity growth?
The Institute of Fiscal Studies (IFS) has just published its annual ‘Green Budget‘. This is, in effect, a pre-Budget report (or a substitute for a government ‘Green Paper’) and is published ahead of the government’s actual Budget.
The Green Budget examines the state of the UK economy, likely economic developments and the implications for macroeconomic policy. This latest Green Budget is written in the context of Brexit and the growing likelihood of a hard Brexit (i.e. a no-deal Brexit). It argues that the outlook for the public finances has deteriorated substantially and that the economy is facing recession if the UK leaves the EU without a deal.
It predicts that:
Government borrowing is set to be over £50 billion next year (2.3% of national income), more than double what the OBR forecast in March. This results mainly from a combination of spending increases, a (welcome) change in the accounting treatment of student loans, a correction to corporation tax revenues and a weakening economy. Borrowing of this level would breach the 2% of national income ceiling imposed by the government’s own fiscal mandate, with which the Chancellor has said he is complying.
A no-deal Brexit would worsen this scenario. The IFS predicts that annual government borrowing would approach £100 billion or 4% of GDP. National debt (public-sector debt) would rise to around 90% of GDP, the highest for over 50 years. This would leave very little scope for the use of fiscal policy to combat the likely recession.
The Chancellor, Sajid Javid, pledged to increase public spending by £13.4bn for 2020/21 in September’s Spending Review. This was to meet the Prime Minister’s pledges on increased spending on police and schools. This should go some way to offset the dampening effect on aggregate demand of a no-deal Brexit. The government has also stated that it wishes to cut various taxes, such as increasing the threshold at which people start paying the 40% rate of income tax from £50 000 to £80 000. But even with a ‘substantial’ fiscal boost, the IFS expects little or no growth for the two years following Brexit.
But can fiscal policy be used over the longer term to offset the downward shock of Brexit, and especially a no-deal Brexit? The problem is that, if the government wishes to prevent government borrowing from soaring, it would then have to start reining in public spending again. Another period of austerity would be likely.
There are many uncertainties in the IFS predictions. The nature of Brexit is the obvious one: deal, no deal, a referendum and a remain outcome – these are all possibilities. But other major uncertainties include business and consumer sentiment. They also include the state of the global economy, which may see a decline in growth if trade wars increase or if monetary easing is ineffective (see the blog: Is looser monetary policy enough to stave off global recession?).
- Why would a hard Brexit reduce UK economic growth?
- To what extent can expansionary fiscal policy stave off the effects of a hard Brexit?
- Does it matter if national debt (public-sector debt) rises to 90% or even 100% of GDP? Explain.
- Find out the levels of national debt as a percentage of GDP of the G7 countries. How has Japan managed to sustain such a high national debt as a percentage of GDP?
- How can an expansionary monetary policy make it easier to finance the public-sector debt?
- How has investment in the UK been affected by the Brexit vote in 2016? Explain.