The UK government has made much of its spending commitments in the UK Budget and Spending Review delivered on 27 October 2021. Spending on transport infrastructure, green energy and health care figured prominently. The government claimed that these were to help achieve its objectives of economic growth, carbon reduction and ‘levelling up’. This means that government expenditure will be around 42% of GDP for the five years from 2022 (from 1988 to 2000 it averaged 36%). Although it temporarily rose to 52% in 2020/21, this was the result of supporting the economy through the pandemic. But does this mean that the government is now a ‘Keynesian’ one?
When the economy is in recession, as was the case in 2020 with the effects of the pandemic, increased government expenditure financed by borrowing rather than taxation is the classic Keynesian remedy to boost aggregate demand and close the output gap. The increased injection of spending works through the multiplier process to raise equilibrium national income and reduce unemployment.
But is this the objective of the extra spending announced in October 2021? To answer this, it is important to look at forecasts for the state of the economy with no change in government policy and at the balance of government expenditure and taxation resulting from the Budget. The first chart shows public sector net borrowing from 2006/7 and forecast to 2026/7. The green and red lines from 2021/22 onwards give the PSNB forecasts with and without the October 2021 measures.
As you can see, there was a large increase in the PSNB in 2020/21, reflecting the government’s measures to support firms and workers during the pandemic. (Click here for a PowerPoint of the chart.) This was very much a Keynesian response, where a large budget deficit was necessary to support aggregate demand. It was also to protect the supply side of the economy by enabling firms to survive.
But could the October 2021 announcements also be seen as a Keynesian response to the macroeconomic situation? If we redraw Chart 1, focusing just on the forecast period and adjust the vertical scale, we can see that the measures have a net effect of increasing the PSNB and thus acting as a stimulus to aggregate demand. (Click here for a PowerPoint of the chart.) The figures are shown in the following table, which shows the totals from Table 5.1 in the Autumn Budget and Spending Review 2021 document:
Effects of Spending Review and Budget 2021 on PSNB (+ = increase in PSNB)
At first sight, it would seem that the Budget was mildly expansionary. To see how much so, the Office for Budget Responsibility (OBR) measures the ‘fiscal stance’ using the ‘cyclically adjusted primary deficit (CAPD)’. This is PSNB minus interest payments and minus expenditures and tax revenues that fluctuate with the cycle and which therefore act as automatic stabilisers. The OBR’s forecast of the CAPD shows it to be expansionary, but decreasing over time. In 2021/22, there is forecast to be a net injection of around 3.2% (excluding ‘virus-related’ support), falling to 2.7% in 2022/23 and then gradually to around 0.6% by 2026/27. So it does seem that fiscal policy remains expansionary throughout the period, but less and less so.
But this alone does not make it ‘Keynesian’. A Keynesian Budget would be one that uses fiscal policy to adjust aggregate demand (AD) according to whether AD is forecast to be deficient or excessive without the Budget measures. To operate a Keynesian Budget, it would be necessary to forecast the output gap without any policy measures. If was forecast to be negative (a deficiency of demand, with equilibrium output below the potential level), then an expansionary policy should be pursued by raising government expenditure, cutting taxes or some combination of the two. If it was forecast to be positive (an excess demand, with equilibrium output above the potential level), then a contractionary/deflationary policy should be pursued by cutting government expenditure, raising taxes or some combination of the two.
So what is the forecast for the output gap? The OBR states that, after being negative in 2020
(–0.4% of potential GDP), it has risen substantially to 0.9% in 2021 with the rapid bounce back from the pandemic. But it is forecast to remain positive, albeit declining, until reaching zero in 2025. This is illustrated in Chart 3. (Click here for a PowerPoint of the chart.) So fiscal policy remains mildly expansionary until 2025, after having provided a considerable stimulus in 2021.
This is not normally what a Keynesian economist would recommend. Fiscal policy should be designed to achieve a zero output gap. With the output gap being substantially positive in 2021, there is a problem of excess demand. This can be seen in supply-chain difficulties and labour shortages in certain areas and higher inflation, with CPI inflation predicted by the OBR to rise to 4.4 per cent in 2022. The combination of higher prices, the rise in national insurance from April 2022 by 1.25 percentage points and the freezing of income tax personal allowances will squeeze living standards. And the cancelling of the £20 per week uplift to Universal Credit and no increase in its rate for the unemployed will put particular pressure on some of the poorest people.
The government is hoping that the rise in government expenditure will have beneficial supply-side effects and increase potential national income. The aim is to create a high-wage, high-skilled, high-productivity economy though investment in innovation, infrastructure and skills. As the OBR states, ‘The rebounding economy has provided the Chancellor with a Budget windfall that he has added to with tax rises that lift the tax burden to its highest since the early 1950s’.
It remains to be seen whether the extra spending on education, training, infrastructure and R&D will be sufficient to achieve the long-term growth the Chancellor is seeking. The OBR is forecasting very modest growth into the longer term when the bounce back has worked through. Real GDP is forecast to grow on average by just 1.5% per year from 2024 to 2026. What is more, the OBR sees permanent scarring effects of around 2% of GDP from the pandemic and around 4% of GDP from Brexit.
- What do you understand by ‘fiscal stance’?
- What are ‘automatic fiscal stabilisers? How might they affect GDP over the next few years?
- If the government had chosen to pursue a zero output gap from 2022/23 onwards, how would this have affected the balance between total government expenditure and taxation in the 2021 Budget and Spending Review?
- Provide a critique of the Budget from the left.
- Provide a critique of the budget from the right.
- Was this a ‘Green Budget’?
- Is the Budget following the ‘golden rule’ of fiscal policy?
- Look through Table 5.1 in the Budget and Spending Review document (linked below). Which of the measures will have the most substantial effect on aggregate demand?
One of the major economic concerns about the COVID-19 pandemic has been the likely long-term scarring effects on economies from bankruptcies, a decline in investment, lower spending on research and development, a loss of skills, discouragement of workers, disruption to education, etc. The result would be a decline in potential output or, at best, a slower growth. These persistent effects are known as ‘hysteresis’ – an effect that persists after the original cause has disappeared.
In a speech by Dave Ramsden, the Bank of England’s Deputy Governor for Markets & Banking, he argued that, according to MPC estimates, the pandemic will have caused a loss of potential output of 1.75%. This shortfall may seem small at first sight, so does it matter? According to Ramsden:
The answer is definitely yes for two reasons. First, a 1¾% shortfall as a share of annual GDP for the UK … represents roughly £39 billion – for context, that’s about half of the education budget. And second, that 1¾% represents a permanent shortfall, or at least a very persistent one, on top of the impact of the immediate downturn. If you lose 1¾% of GDP every year for ten years, then in total you have lost 17.5% of one year’s GDP, or around £390bn in 2019 terms
However, as the IMF blog linked below argues, there may be positive supply-side effects which outweigh these scarring effects, causing a net rise in potential GDP growth. There are two possible reasons for this.
The first is that the pandemic may have hastened the process of digitalisation and automation. Examples include ‘video conferencing and file sharing applications to drones and data-mining technologies’. According to evidence from a sample of 15 countries cited in the blog, a 10% rise in such intangible capital investment is associated with about a 4½% rise in labour productivity. ‘As COVID-19 recedes, the firms which invested in intangible assets, such as digital technologies and patents may see higher productivity as a result.’
The second is a reallocation of workers and capital to more productive sectors. Firms in some sectors, such as leisure, hospitality and retail, have relatively low labour productivity. Many parts of these industries have declined during the pandemic, especially those with high labour intensity. At the same time, there has been a rise in employment in firms where output per worker is higher. Such sectors include e-commerce and those where remote working is possible. The greater the reallocation from low labour-productivity to high labour-productivity sectors, the more will overall labour productivity rise and hence the more will potential output increase.
The size of these two effects will depend to a large extent on expectations, incentives and government policy. The blog cites four types of policy that can help investment and reallocation.
- Improved insolvency and restructuring procedures to enable capital in failed firms to be reallocated to sectors with potential for growth.
- Promoting competition to enable the exit and entry of firms into expanding sectors and to prevent powerful firms from blocking the process.
- Refocusing policy from retaining labour in existing jobs to reskilling workers for new jobs, thereby improving labour mobility from declining to expanding sectors.
- Addressing financial bottlenecks, so as to ensure adequate access to financing for viable firms.
Whether there will be a net increase or decrease in productivity from the pandemic very much depends on the extent to which firms and workers are able and willing to take advantage of new opportunities and the extent to which government supports investment in and reallocation to high-productivity sectors.
Blogs, articles and speeches
- Can actual economic growth be greater than potential economic growth (a) in the short run; (b) in the long run?
- Give some example of scarring effects from the COVID-19 pandemic.
- What effects might short-term policies to tackle the recession caused by the pandemic have on longer-term potential economic growth?
- What practical policies could governments adopt to encourage the positive supply-side effects of the pandemic? To what extent would these policies have negative short-term effects?
- Why might (endogenous) financial crises result in larger and more persistent reductions in potential output than exogenous crises, such as a pandemic or a war?
- Distinguish between interventionist and market-orientated supply-side policies to encourage the reallocation of labour and capital to higher-productivity sectors.
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.
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.
- United Kingdom Economic Snapshot
OECD Economic Outlook (May 2021)
- UK growth forecast upgraded but pandemic economic ‘scar’ will be worst of all G7 nations, says OECD
Sky News, Ed Conway (31/5/21)
- OECD Predicts UK Economic Growth Amid Vaccine Success And Lockdown Easing
Minutehack Emma Bowden (1/6/21)
- UK growth upgraded, but OECD warns of deepest economic scar in G7
The Guardian, Graeme Wearden (31/5/21)
- UK set for stronger post-Covid recovery, says OECD
BBC News (31/5/21)
- British exports worth billions have faced EU tariffs since Brexit
BBC News, Faisal Islam (28/5/21)
- Post-Brexit: Businesses hit by labour shortages call for Brexit rules to be relaxed
Channel 4 News, Paul McNamara (2/6/21)
- Bank of England monitors UK housing boom as it weighs inflation risk
The Guardian, Larry Elliott (1/6/21)
- House prices jump 10.9% as ‘race for space’ intensifies
BBC News (1/6/21)
- Global food prices post biggest jump in decade
Financial Times, Emiko Terazono and Judith Evans (3/6/21)
- Why house prices are rising so fast in a pandemic
BBC News, Kevin Peachey and Daniele Palumbo (2/6/21)
- Inflation: why it could surge after the pandemic
The Conversation, Ian Crowther (23/4/21)
- Inflation might well keep rising in 2021 – but what happens after that?
The Conversation, Brigitte Granville (31/5/21)
- Slack in the Economy, Not Inflation, Should Be Bigger Worry
Institute for New Economic Thinking, Claudia Fontanari, Antonella Palumbo, and Chiara Salvatori (19/5/21)
Data, Forecasts and Analysis
- What determines the rate of (a) actual economic growth; (b) potential economic growth?
- What is meant by an output gap? What would be the implications of a positive output gap?
- Why are scarring effects of the pandemic likely to be greater in the UK than in most other countries?
- If people believed that inflation was likely to continue rising, how would this affect their behaviour and how would it affect the economy?
- What are the arguments for and against having a stamp duty holiday when the economy is in recession?
In a series of five podcasts, broadcast on BBC Radio 4 in the first week of January 2021, Amol Rajan and guests examine different aspects of inequality and consider the concept of fairness.
As the notes to the programme state:
The pandemic brought renewed focus on how we value those who have kept shelves stacked, transport running and the old and sick cared for. So is now the time to bring about a fundamental shift in how our society and economy work?
The first podcast, linked below, examines the distribution of wealth in the UK and how it has changed over time. It looks at how rising property and share prices and a lightly taxed inheritance system have widened inequality of wealth.
It also examines rising inequality of incomes, a problem made worse by rising wealth inequality, the move to zero-hour contracts, gig working and short-term contracts, the lack of social mobility, austerity following the financial crisis of 2007–9 and the lockdowns and restrictions to contain the coronavirus pandemic, with layoffs, people put on furlough and more and more having to turn to food banks.
Is this rising inequality fair? Should fairness be considered entirely in monetary terms, or should it be considered more broadly in social terms? These are issues discussed by the guests. They also look at what policies can be pursued. If the pay of health and care workers, for example, don’t reflect their value to our society, what can be done to increase their pay? If wealth is very unequally distributed, should it be redistributed and how?
The questions below are based directly on the issues covered in the podcast in the order they are discussed.
- In what ways has Covid-19 been the great ‘unequaliser’?
- What scarring/hysteresis effects are there likely to be from the pandemic?
- To what extent is it true that ‘the more your job benefits other people, the less you get paid’?
- How has the pandemic affected inter-generational inequality?
- How have changes in house prices skewed wealth in the UK over the past decade?
- How have changes in the pension system contributed to inter-generational inequality?
- How has quantitative easing affected the distribution of wealth?
- Why is care work so poorly paid and how can the problem be addressed?
- How desirable is the pursuit of wealth?
- How would you set about defining ‘fairness’?
- Is a mix of taxation and benefits the best means of tackling economic unfairness?
- How would you set about deciding an optimum rate of inheritance tax?
- How do you account for the growth of in-work poverty?
- In what ways could wealth be taxed? What are the advantages and disadvantages of such taxes?
At its meeting on 6 May, the Bank of England’s Monetary Policy Committee decided to keep Bank Rate at 0.1%. Due to the significant impact of COVID-19 and the measures put in place to try to contain the virus, the MPC voted unanimously to keep Bank Rate the same.
However, it decided not to launch a new stimulus programme, with the committee voting by a majority of 7-2 for the Bank to continue with the current programme of quantitative easing. This involves the purchase of £200 billion of government and sterling non-financial investment-grade corporate bonds, bringing the total stock of bonds held by the Bank to £645 billion.
The Bank forecast that the crisis will put the economy into its deepest recession in 300 years, with output plunging 30 per cent in the first half of the year.
Monetary policy and MPC
Monetary policy is the tool used by the UK’s central bank to influence how much money is in the economy and how much it costs to borrow. The Bank of England’s main monetary policy tools include setting the Bank Rate and quantitative easing (QE). Bank Rate is the interest rate charged to banks when they borrow money from the BoE. QE is the process of creating money digitally to buy corporate and government bonds.
The BoE’s Monetary Policy Committee (MPC) sets monetary policy to meet the 2% inflation target. Maintaining a low and stable inflation rate is good for the economy and it is the main monetary policy aim. However, the Bank also has to balance this target with the government’s other economic aims of sustaining growth and employment in the economy.
Actions taken by the MPC
It is challenging to respond to severe economic and financial disruption, with the UK economy looking unusually uncertain. Activity has fallen sharply since the beginning of the year and unemployment has risen markedly. The current rate of inflation, measured by the Consumer Price Index (CPI), declined to 1.5% in March and is likely to fall below 1% in the next few months. Household consumption has fallen by around 30% as consumer confidence has declined. Companies’ sales are expected to be around 45% lower than normal and business investment 50% lower.
In the current circumstances, and consistent with the MPC’s remit, monetary policy is aimed at supporting businesses and households through the crisis and limiting any lasting damage to the economy. The Bank has used both main monetary tools to fulfil its mandate and attempt to boost the economy amid the current lockdown. The Bank Rate was reduced to 0.1% in March, the lowest level in the Bank’s 325-year history and the current programme of QE was introduced in March.
What is next?
This extraordinary time has seen the outlook for the all global economies become uncertain. The long-term outcome will depend critically on the evolution of the pandemic, and how governments, households and businesses respond to it. The Bank of England has stated that businesses and households will need to borrow to get through this period and is encouraging banks and building societies to increase their lending. Britain’s banks are warned that if they try to stem losses by restricting lending, they will make the situation worse. The Bank believes that the banks are strong enough to keep lending, which will support the economy and limit losses to themselves.
In the short term, a bleak picture of the UK economy is suggested, with a halving in business investment, a near halving in business sales, a sharp rise in unemployment and households cutting their spending by a third. Despite its forecast that GDP could shrink by 14% for 2020, the Bank of England is forecasting a ‘V’ shaped recovery. In this scenario, the recovery in economic activity, once measures are softened, is predicted to be relatively rapid and inflation rises to around the 2 per cent target. However, this would be after a dip to 0.5% in 2021, before returning to the 2 per cent target the following year.
However, there are some suggestions that the Bank’s forecast for the long-term recovery is too optimistic. Yael Selfin, chief economist at KPMG UK, fears the UK economy could shrink even more sharply than the Bank of England has forecast.
Despite the stark numbers issued by the Bank of England today, additional pressure on the economy is likely. Some social distancing measures are likely to remain in place until we have a vaccine or an effective treatment for the virus, with people also remaining reluctant to socialise and spend. That means recovery is unlikely to start in earnest before sometime next year.
There are also additional factors that could dampen future productivity, such as the impact on supply chains, with ‘just-in-time’ operations potentially being a thing of the past.
There is also the ongoing issue of Brexit. This is a significant downside risk as the probability of a smooth transition to a comprehensive free-trade agreement with the EU in January is relatively small. This will only increase uncertainty for businesses along with the prospect of increased trade frictions next year.
The predictions from the Bank of England are based on many assumptions, one of which is that the economy will only be gradually released from lockdown. Its numbers contain the expectations that consumer and worker behaviour will change significantly, and continue for some time, with forms of voluntary social distancing. On the other hand, Mr Bailey expects the recovery to be much faster than seen with the financial crisis a decade ago. However, again this is based on the assumption that measures put in place from the public health side prevent a second wave of the virus.
It also assumes that the supply-side effects on the economy will be limited in the long run. Many economists disagree, arguing that the ‘scarring effects’ of the lockdown may be substantial. These include lower rates of investment, innovation and start ups and the deskilling effects on labour. They also include the businesses that have gone bankrupt and the dampening effect on consumer and business confidence. Finally, with a large increase in lending to tide firms over the crisis, many will face problems of debt, which will dampen investment.
The Bank of England does recognise these possible scarring effects. Specifically, it warns of the danger of a rise in equilibrium unemployment:
It is possible that the rise in unemployment could prove more persistent than embodied in the scenario, for example if companies are reluctant to hire until they are sure about the robustness of the recovery in demand. It is also possible that any rise in unemployment could lead to an increase in the long‑term equilibrium rate of unemployment. That might happen if the skills of the unemployed do not increase to the same extent as they would if they were working, for example, or even erode over time.
What is certain, however, is that the long-term picture will only become clearer when we start to come out of the crisis. Bailey implied that the Bank is taking a wait-and-see approach for now, waiting on the UK government to shed some light about easing of lockdown measures before taking any further action with regards to QE. The MPC will continue to monitor the situation closely and, consistent with its remit, stands ready to take further action as necessary to support the economy and ensure a sustained return of inflation to the 2% target. Paul Dales, chief UK economist at Capital Economics, suggested that the central bank is signalling that ‘more QE is coming, if not in June, then in August’.
Bank of England publication
- How could the BoE use monetary policy to boost the economy?
- Explain how changes in interest rates affect aggregate demand.
- Define and explain quantitative easing (QE).
- How might QE help to stimulate economic growth?
- How is the pursuit of QE likely to affect the price of government bonds? Explain.
- Evaluate the extent to which monetary policy is able to stimulate the economy and achieve price stability.