The COVID-19 Window

Recessions come in all shapes and sizes.

If you’re a baby boomer, you’ll remember the double-dip recession of the mid-1970s, in the midst of the oil shocks and the stagflation crisis. Millennials will remember how the 2008 downturn came to pass, with the dreaded credit crunch, the bailouts and a prolonged period of recovery that was barely underway when a new shock hit the world economy.

COVID-19 makes it a near certainty that a new recession has already started, with some of the latest estimates saying the UK will see a GDP contraction of 10 per cent in 2020, before bouncing back with an equally strong rebound in the following year or so.

Most recessions are caused by policy failures of one kind or another; often too much demand for not enough goods, or too much money chasing a limited amount of resources. In the mid-1980s, Thatcherite Chancellor of the Exchequer Nigel Lawson famously fuelled an unsustainable boom which resulted in a painful bust that took many years to recover from.

In the post-war era, numerous governments battled to keep unemployment low, while stopping inflation from eroding the value of the Pound. A more neoliberal consensus emerged by the 1980s, focusing more on inflation, with unemployment simply allowed to rise to record levels, all in the aim of keeping inflation low.

However, we now appear to be at an inflection point where inflation is no longer the enemy, but deflation. Having had a political conversation entrenched with the idea that a little bit of unemployment was seen as a necessary evil to keep prices steadier, communities have been hollowed out and key industries weakened.

With an economy undergoing massive changes and record numbers of people facing a many years on the dole, it’s no wonder that politics became so polarised.

The COVID-19 crisis has arguably exposed the flaws in the post-Thatcherite economic model, and opinion polls appear to suggest that the British public are happy to see a change in the way the economy is run. As recently as 2016, a majority of Britons thought the government should raise taxes and spend more, something which hadn’t been since the mid-2000s, according to the 34th edition of the British Social Attitudes survey by NatCen Social Research.

Even so, some remain highly suspicious of incurring greater levels of public debt in order to salvage the economy, a phenomenon which has a tendency to flare up with each economic crisis.

The false austerity narrative

The modern proponents of austerity most-likely cite an influential 2010 paper by economists Carmen Reinhart and Kenneth Rogoff, Growth in the Time of Debt. The paper, published in a non-peer-reviewed edition of the American Economic Review, argued that allowing national debt to reach over 60% of GDP could cause a country’s potential economic growth to decline by two percentage points, or be completely cut in half if debt breached 90% of GDP.

In 2013, it was found that the paper contained a number of errors, with the authors revealed has having been selective about certain data points, which implied higher debt would lead to economic growth. In actual fact, there are examples of nations which managed high public debt burdens which managed to notch up a high rate of growth: countries such as Australia, Canada and New Zealand in the years following World War Two.

The UK endured roughly a decade of belt-tightening from 2010-19, before the Conservatives started to increase government spending again last year. This is evidenced by an increasing government debt even before COVID-19 had hit, and a net contribution to GDP growth, as the UK see-sawed from Brexit deadline to Brexit deadline.

The case for spending

One of the biggest arguments in favour of more public spending and investment from here is the record lows in government bond yields. Yields on gilts with a maturity up until seven years are actually negative, meaning bond holders are going for these slices of the national debt in the knowledge that the investment will not actually give them a return of any kind for its duration.

No doubt that the billions of pounds in quantitative easing by the Bank of England will have depressed yields artificially, but even so, there is also an outpouring of demand in assets deemed to be more risk-off, including bonds and gold relative to equities. Also, negative-yielding bonds are a signal from traders that they expect interest rates to be pinned down for a significantly long period of time, possibly even turning negative at some point.

While austerity seems like the obvious solution for some in response to COVID-19, the UK has had experience of a decade-long austerity agenda and much economic growth has been lost as a result. If the incumbent office holders wish to really stimulate the economy, it makes sense to maintain as much support for as long as necessary to avoid the UK falling into a Japanese-style deflationary spiral.

The signal is clear: it’s cheap for the government to borrow to invest and spend, to support the economy through this current crisis. The benefits of intelligent spending could outweigh the decision to slash the budget prematurely, as the multiplier effect allows money to trickle down into the economy, allowing it to to reflate and generate enough steam to allow it to recover to full health quicker. Until the bond markets react adversely and bond yields jump alarmingly, the government should consider this window of opportunity.