To think about the possible path of the economy from here, I think it is helpful to look at components of the economy and consider how COVID and the response to it have affected them. It may be disappointing to some readers as I’m not looking to give definitive forecasts, but as I explained in my earlier post on economic forecasting, I think this is not a useful thing to do here.
Impact on workers and consumers
It is striking and initially surprising that the fall in incomes has been limited so far. Given the various schemes in Europe, such as the UK Furlough, people’s incomes have been at least temporarily protected. In the US largely lower-paid workers have been laid off and many are currently on enhanced unemployment benefits, getting more than they were getting from their previous jobs.
Shock to spending
Although incomes have been protected by governments, this has not supported spending which has fallen sharply and, as a result, there has been an unprecedented rise in the savings rate.
Short term outlook
Given that shops are reopening in the US and will reopen in a few weeks in the UK, to the extent that spending had fallen because people could not leave their homes and no shops were open, we will see an increase in spending. The negative risk here is that savings rates have risen not from a lack of opportunity to spend, but from an increased level of caution or a genuine change in lifestyle with limited socialising. Both of these may well persist, and spending will not come close to returning to pre-crisis levels in the short term.
There is a large negative risk on the income side as well. Various income support schemes are due to be phased out over the summer, this will likely lead to rising unemployment as firms do not take furloughed staff back into their workforce. In the US, the phasing out of the enhanced unemployment benefit in early summer will directly impact the tens of millions of people who currently depend on it.
It is interesting to note that from employment surveys in the US, a large majority of people laid off believe their job loss is temporary. Current behaviours are based on an expectation of going back to the old job and the old life. To the extent this is not true, we will see a big change in their spending behaviour and confidence. Recent caution on spending may have been entirely rational amid an uncertain economic future, and people may retrench even further once they realise their income will be falling.
Do we have a huge amount of pent-up demand or a cautious population?
My guess is that we will see a rebound in spending in Q3, but the risk is that it is far less than economists are currently predicting. The unknowns in consumer behaviour and the large forces in opposing directions from income swings and the saving rate make the picture very unclear but the data as we end lockdown will be critical and I will be watching it closely.
For workers and consumers – long term effects
The effect of recessions is generally that labour markets take a long time to recover. The deeper and longer the recession, the longer the recovery. There is a serious, long-term risk of scarring with a permanent shift in employment in some sectors with some workers never returning to the workplace in the same way.
There is good evidence that maintaining a connection for employees to their old jobs makes it far more likely that they get their old job back, hence the sense in ‘furlough’ like schemes. It is also true that the longer lockdown lasts, the more likely we are to have a permanent break in employment so there is a strong economic rationale to end things sooner. However, it is also true that millions may not be able to re-join their old sector. A broad array of services industries, especially tourism and hospitality, may take a long time to ever employ the same numbers of people again. We have seen from previous recessions that this transition of the labour force is very difficult and takes many years if at all. Coal miners in the UK did not seamlessly find alternative employment in the 1980s.
Impact on business
Many businesses have seen a severe revenue shock, in fact seeing revenue goes to zero. Hopefully, much of this will be temporary but it seems at least some of this reduction will be permanent. Optimists will note that part of this is a sector shift, a rotation away from in-person services towards tech. The share of online purchases has risen enormously, driving shares in firms like Amazon ever higher. But while Amazon is getting a larger slice, the overall size of the pie is shrinking.
As we move to reopen business, many are noting additional expenses in making workplaces safe. Social distancing requires more space and physical separation can reduce productivity. Even Amazon announced that it may report a loss in Q2 despite higher revenues because it will cost so much to make their warehouses safer for employees.
When will we know?
Companies announce earnings with a lag, so it will not be until September to get a first look. Many firms are saying they will not be giving guidance on their earnings due to the difficulty of forecasting in such an environment. It is possible that it may be a long time before equity markets are forced to deal with the reality of the impact of a recession on corporate earnings.
What about Second round effects?
These are hard to identify in advance, but in crises are often far larger than the initial catalyst. The Great Recession was triggered by trouble in low quality mortgage bonds. Fed Chair Bernanke was clear at the time that the size of these bonds was very small compared to the US economy and so would not form a significant risk. He was completely wrong because he failed to understand the link between these bonds and the rest of the financial system. The bursting of the late 90’s Dot Com bubble and the fall in confidence after 9/11 were important economic drivers, but by late 2002 it was clear it was the balance sheet vulnerability of the US corporate sector that was the real problem.
I do not want to predict what the second-round effects of this crisis will be but they could be very important. For example, a blow to retailers is also a blow to their landlords. A blow to owners of commercial real estate is also a blow to those who lent them the money, including the banking sector. All balance sheets look good during a bull market and can look very much worse in a recession.
Impact on government
Governments around the world have responded rapidly with enormous fiscal and monetary stimulus. After the sluggish response in 2008, policymakers know the playbook to avoid a repeat of that credit crunch and are doing a good job of providing unlimited credit to support banks and corporates. If that were the main crisis we were facing then we could be confident.
Unfortunately, this crisis is not (yet) at heart a credit or financial crisis. The blow is to real economic activity and thus is about incomes and revenue, zero rates and unlimited credit do not do much to help. If you are running a business that has large fixed overheads and no prospect of sufficient revenue to cover it, taking on more debt is not going to help you.
The support schemes we have seen have been very effective, such as ‘Furlough’. But they are also hugely expensive and with government debt and deficits at challenging levels even before this crisis, it is unclear how long they will be willing or able to continue with this level of support.
Longer term concerns
My focus above has been on the large short-term challenges and uncertainties we face. We can also note that the longer-term impact on how our economies are organised may be very significant. During the Great Depression, we saw a rise in economic nationalism and trade wars. The recent rhetoric out of the US has been strongly moving in that direction. If the downturn is severe and prolonged, we should not assume the structure of the global economy will be unchanged. Some will aim to reverse globalisation e.g. building a TMC factory in the US. Some will aim to rein in, break up and tax the tech global monopolies who will be seen as profiting while the world is suffering. Some will aim to restructure the economy to introduce universal income and more social ownership. Others will aim to further reduce regulation and taxes. Economic turmoil leads to political turmoil and it is far too early for me to speculate on how this may turn out.
I view the current economic consensus as being too particular and too narrow a path. It is one in which there is no second wave of infection, no further lockdown and no material change to our behaviours. We go back to working and spending in a very similar way to we did before with no second-round effects on economic life. Of course, I would like it to be the case, but given that so many other scenarios are less optimistic, I would say that as a forecast it is not a good central case.
What will happen?
I have laid out some of the key drivers and how things may unfold. I am certainly far more pessimistic than the average economic forecast, but all conclusions are tentative, and I will be watching the data over the next few weeks. The infection data of course as we see how the virus develops, and the economic data as we see how far consumers and workers return to their previous habits. The key is the extent to which we can have an economic recovery without a resurgence of the virus.