In response to the financial crisis of 2008+, the G20 came together to save the banking system and prevent a wider economic depression. The policies adopted largely did the job through quantitative easing and other monetary and fiscal measures to rebuild the banks’ capital foundations. There were costly consequences of course, not least a decade of slow growth with sclerotic productivity, as well as excess liquidity with low returns, and widespread fiscal austerity. Avoidance of a depression was a considerable benefit in 2008-10 but it is not possible to judge whether it was a net benefit compared with the alternative: a deeper but faster adjustment and recovery.
After the onset of the 2020+ pandemic crisis, the economy was helped by having a restored banking sector with a stronger capital base. Banks did not need to ‘pull’ credit lines to corporates and households aggressively. Also, equity markets collapsed but then bounced back more quickly than expected. In June, several leading share indices were higher than at the start of the year, although some have eased downwards since. Sadly, there is a comparative lack of international policy co-operation this time. Most governments have relaxed monetary and fiscal policies drastically but without much co-ordination. History will judge whether this less united approach was appropriate for avoiding depression this time.
Meanwhile, households and firms added £18bn of net deposits in June, after £53bn in May. For households, outstanding credit card balances have fallen four months in a row whereas mortgage approvals have started to rebound (after fresh stamp duty incentives from the government to stimulate the housing markets). House prices were up about 3.8% year-on-year in July (Halifax and Nationwide). In comparison, more of the larger firms are borrowing via financial markets (and repaying banks0 whereas more of the SMEs are borrowing from banks. The fear is these new finances are survival loans for recession rather than investment loans for recovery.
So, liquid funds are available to increase aggregate spending, but the worry is that they are partly frozen: precautionary saving ahead of a mounting toll of redundancies. There may be little confidence to release cash for higher expenditure as concern grows about a wintry “second wave and lockdown”. There were still 25% of workers on furlough in the first half of July, and as much as 50% in the hospitality sectors (accommodation, catering, leisure and recreation). The balance between re-hiring and firing of these individuals will go a long way to determine the shape of recovery in the final third of 2020 … and on into 2021.
There is, then, something of a disconnect between the financial markets and the real economy: a gap which cannot persist forever. Securities markets (equities and bonds) seem to expect a V-shaped recovery but real production and consumption actors are less sure. At some point, the extensive policy easing has to unravel and be reflected in financial market values. There really is no such thing as a “free lunch”. Worst fears about the immediate shock may have receded but, once again, there will be unintended consequences.
The disconnect can be resolved positively if the real economy bounces back enough to justify the financial optimism. Or, it can be resolved negatively, with money markets collapsing to reflect the real economic malaise. Q2 2020 saw real GDP decrease by 10% or more across the western world (-10% USA, -12% EU). The UK witnessed a massive decline of 20.4% with big falls for household consumption, business investment, manufacturing and services, trade and inventories. Productivity slumped in Q2: output per hour -3% and output per worker -22%.
The immediate evidence is slightly better. In June, real GDP bounced up 8.7% and UK industrial production increased 9.3% on May. The former took the level back to early 2010 level – still 17% below the January 2020 peak. The SW England composite index (PMI) shot up to 59.7 in July: indicating the first increase in output for five months. Input cost increases (56.0) and employment cuts (38.2) persisted but business confidence (71.3) was relatively good in this region, though not yet back to February levels.
Sadly, the CIPD says one in three firms will cut jobs this quarter. Although hiring activity is now growing again, CIPD talks of a “sombre autumn”. Official labour statistics point that way. In the second quarter, SW employment and unemployment rates were still 78.1% and 3.9% respectively. This forbearance, however, suggests the labour adjustment to the Covid19 recession is yet to happen, largely because of UK policies to protect jobs. (Contrast UK furlough of 7.5mn people in June - though now falling - with US unemployment surge during the crisis).
UK payrolls dropped 730,000 from March to July. Growth in self-employment collapsed. Hours worked reached record lows. Real average earnings shrank. Vacancies have more than halved (from over 800,00 to about 370,000 through 2020). Actual redundancies were 134,000 in June but tens of thousands are now in the pipeline to happen later. The national claimant count (CC) increased from 1.2mn in March to 2.3mn in July. In Dorset, the CC level jumped from 9,770 in January to 25,230 in July: i.e. from 2.2% to 5.6% of the active workforce.
Even though 94% of firms are now working and turnover is increasing, activity is still well down. Moreover, the labour market appears to be on the verge of severe retrenchment.
The financial world is vulnerable to several risks:
- Corporate and household debts are at, or close to, record highs. Insolvencies are expected to climb after the downturn, especially as short-term policies to hold things up unwind. A deeper and longer recession would put pressure on investors and financial intermediaries, even though high savings rates may offset some concerns (if those funds become active).
- A potential surge of insolvencies would weaken the banks. Their ‘core’ position is stronger than in 2008, but the risk of significant credit losses could see greater reluctance to lend. The banks and the Treasury are thought to be in detailed discussion as to how to deal with a flood of defaults this winter. Some estimates say up to 40% of the £50bn+ in the proposed ‘bounce back loan’ scheme could, eventually, fail and fall on taxpayers. Bank provisions for loan losses from bankruptcies have reached eight-year highs.
- Losses amongst the non-bank financial intermediaries (NBFIs – insurances, pensions, hedge funds and other investment houses) could yet amplify any downturn through asset downgrading and devaluing, especially where regulatory regimens are less robust.
- The emerging economies might succumb to a range of pressures from various trade spats, epidemics and other dislocations, releasing negative economic incentives. Also, UK hopes for a good post-Brexit deal and a quick American trade deal have waxed and waned in recent weeks. The uncertainty created by a failure to agree future trade conditions is bad for business confidence and decision making and, therefore, investment and employment.
There are four main areas of financial investment: commodities, equities, fixed income (bonds) and real estate. Generally, because government interventions to support jobs and incomes are helping demand to exceed supply, driving consumption growth more than production growth, there is a risk of inflation in all of these categories even as the real economy continues to put downward pressure on goods and services prices.
Beyond the near term, of course, there will also be significant inter-generational impacts. Those under 50 may be paying for this crisis for decades and those over 50 may be paying sooner (if the state tries to recoup losses from accumulated wealth and incomes). Generally, living standards will increase more slowly and end up lower than they would have done without the pandemic.
The recent increase in public deficits is a logical response to deep recession and high uncertainty about business and household prospects. But, ultimately, the way and timing of getting out of the resulting fiscal mire is as vital as the near-term rescue.
The worldwide shock of the pandemic would be better served if there were multilateral action to repair the gap between financial and real conditions. This needs to be done at all geographical levels: local to global. Money and finance have accommodated the early stages of the current crisis quite well. Longer term adjustments to the “new normal” remain problematic.
Meanwhile, the Bank of England’s MPC now projects UK real growth of -9.5% this year: not as bad as previously postulated but still a big drop by historical standards and a decline greater than they expect for the world average (-5%, PPP). Moreover, the recovery is expected to take longer, with more unemployment and scarred capital constraining growth well into 2022. The MPC assumes uncertainty steadily reduces but remains enough to continue to stall productive investment. Spare capacity persists for some time, limiting productivity growth. But, as it narrows, CPI inflation returns to target (2%) during 2021.
The Bank has left monetary policy unchanged: base rate 0.1% and a target of up to a £745bn stock of reserves purchases (QE). The Bank acknowledges a balance of risks to the downside. Nevertheless, thankfully, it has not yet moved to favour negative interest rates. Some argue a macro stimulus from negative interest rates might be worth the possible adverse effects on bank margins and lending, and the uncertain effects on household and business behaviour. The unknown impacts on investment incentives from this approach, however, could be severe.
The economic outlook remains vulnerable to adverse news and developments and will remain so through any likely shape of recovery. Without a vaccine and/or effective treatments, the Covid19 pandemic is expected to dampen economic prospects this winter. Employment and investment will be restrained and, thereby, will constrain any recovery.
Against this background, money and finance can play a supportive role but are themselves vulnerable to negative feedback loops from real behavioural conditions. Arguably, greater co-ordination of the international policy efforts would help, but the leadership required to drive that seems sadly lacking in a world of increased geo-political tensions, trade disruptions and comprehensive uncertainty.
A focus on strategies that combine effective resilience and efficiency seems advisable. I will explore some of this in my next blog.