How to avoid the scars from a deep and nasty recession Posted by David Smith at 09:00 AMCategory: David Smith's other articles My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt. Anybody who was shocked by the scenario drawn up by the Independent Office for Budget Responsibility (OBR) a few days ago, the one that suggested that Britain’s economy could shrink by a massive 35% in the second quarter of the year, should perhaps not have been. Huge though the OBR’s numbers were, which included a rise to 3.4m in the level of unemployment and a budget deficit of £273bn, or 14% of gross domestic product, this year, they were the natural consequence of something I described here exactly a fortnight ago. My piece then, “Despatches from an economy
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How to avoid the scars from a deep and nasty recession
My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.
Anybody who was shocked by the scenario drawn up by the Independent Office for Budget Responsibility (OBR) a few days ago, the one that suggested that Britain’s economy could shrink by a massive 35% in the second quarter of the year, should perhaps not have been.
Huge though the OBR’s numbers were, which included a rise to 3.4m in the level of unemployment and a budget deficit of £273bn, or 14% of gross domestic product, this year, they were the natural consequence of something I described here exactly a fortnight ago.
My piece then, “Despatches from an economy at two-thirds of normal”, informed by some ingenious work the Centre for Economics and Business Research (CEBR) had carried out on my behalf, likewise had an economy down by more than 30% as a result of the lockdown.
I want to talk about some of the longer-term effects of this medical recession, known in the jargon as scarring. But let me first share some dirty little secrets of these assessments, scenarios and forecasts.
The main reason why the OBR came up with such a big second quarter drop in GDP – 35% is 10 percentage points above the biggest private sector assessment I was aware of - is that it assumes the lockdown announced on March 23 lasts for a full three months. That takes in all but a week of the second quarter, with a gradual lifting over the following three months.
Other economists have assumed shorter lockdowns, which may or may not a correct assumption, and have also built in quite a sharp drop in first quarter GDP because parts of the economy were already shutting down before the formal lockdown. Their second quarter falls thus start from a lower base.
A second thing worth saying, or in my case reiterating, is that it is perfectly possible, indeed likely, that the statistics will show a very sharp bounce in activity, as lockdown measures ease. Suppose, to take an example, the economy goes from 65% of normal in the second quarter to something approaching 85% in the third, it does not mean that things are back to normal. It does mean you get the kind of numbers the OBR has in its scenario, a 27% rise in GDP in the third quarter, and a further 21% in the fourth, as the lockdown lifts entirely (its assumption), and GDP returns to its pre-crisis path.
You may ask, if this is so temporary, concentrated in the current quarter, why the OBR also has GDP for 2020 as a whole falling by 12.8% this year. This is one time when I can say this would be biggest fall in living memory. It is three times the drop in GDP in 2009, when the global financial crisis gave use the worst year in the post-war era. Nothing like it has been seen since the Great Frost of 1709.
The answer is that we measure growth, not from the beginning of the year to the end but comparing this calendar year with the previous one. The big loss of GDP in the second quarter, and a smaller on in the third, is enough to give this very dramatic result.
Though it was not intended that way, the 35% figure is quite useful to Rishi Sunak, the chancellor, in the internal government debate about the length of the lockdown. It describes starkly the extent of the economic hit, some of which – more than £40bn over three months according to the OBR – is being funded by the furlough scheme for employees.
Further food for thought, and potential ammunition for the Treasury, is provided by the Resolution Foundation, a think tank, in a new report “Doing whatever it takes”. Its estimates are slightly different from the OBR scenario but say that a three-month lockdown would lead to a still very hefty 10% drop in GDP this year, while six months would see the economy down by 20%. A 12-month lockdown, some of which would spill over into 2021, would see the economy contract by 24% this year. For perspective, that would wipe out nearly two decades of growth, taking GDP back to where it was in the early 2000s.
The longer the lockdown, the longer it takes to get back to normal. A 12-month lockdown would result in a permanent loss of GDP of 7%, and it would take five years to get back to where we started. It would also see unemployment reaching 7m, or 21% of the workforce, next year.
The longer the lockdown, too, the bigger the scars from this episode. What economists call “scarring” is, apart from the sheer scale of the downturns that we are seeing at present, the key issue.
What is scarring? Scarring after the recessions of the recessions of the early 1980s and early 1990s was mainly in the form of prolonged high unemployment. Scarring after the global financial crisis showed itself in prolonged productivity stagnation. Austerity, many would argue, also produced its own significant scarring effects.
And this time? The OBR says it has not attempted to quantify any scarring effects, though notes that the government’s measures to support businesses and individuals are intended to minimise them. There is a kind of scarring in its scenario, however, in that unemployment remains significantly above pre-virus levels this year, next year and beyond. Its scenario also has government debt in five years’ time 10% of GDP, or well over £200bn, above its pre-virus forecasts.
How much scarring will there be? It is the big question, and it is also one of the most difficult to answer. In an ideal world every worker furloughed under the government’s job retention scheme will back to normal when the lockdown eases and every viable business, big and small, will survive this crisis. In the real world, things might be different. There will be changes in the way people and businesses behave, some of them for the better, some for the worst.
The Resolution Foundation is relatively optimistic, because of the government’s anti-scarring measures, as long as the lockdown is relatively short-lived. Severe though it is, this is not like the recession of the early 1980s, which resulted in a restructuring of the economy away from manufacturing, or the early 1990s, when the housing market hangover lasted many years. Damaging long-lasting impacts should be less of a danger if the lockdown only lasts a few months.
There is room for debate on this. Capital Economics says that the economy will struggle to get back to full health and be 5% below where it would have been without the virus by the end of 2022.
There are many moving parts, many imponderables. We do not know how long this lockdown will be, or whether it will be followed by a second if the infection rate heads higher. We cannot know with any certainty what the behavioural effects of all this will be. The aim is to avoid permanent scarring from this unprecedented recession. We can only hope it is successful.