How do they re-stimulate the economy and so reduce the effects of the recession that is coming? And how do they deal with the huge Government deficit created by the Covid-19 pandemic?
Not straightforward questions, and certainly the question about how best to mitigate a recession is not one that many leaders over the course of time have answered that well. For me though, the right “recession mitigation” answer will also be key to dealing with the pandemic related deficit. That’s because bad choices that prolong a recession will necessarily affect our ability to reduce the pandemic deficit.
So how do they get it right? Well, history may lend them a helping hand.
Before looking back in time to try and learn from past experiences, such as the Great Depression of the 1930s and the Great Recession of 2009, let’s start with some basics.
Recessions occur where a country has a fall in GDP in two successive quarters. The reason recessions happen is due to a shortfall in demand for goods and services. The reasons for that shortfall may differ in any given case, but fundamentally that is why a recession ultimately happens.
In our case, we already have a shortfall in demand in many sectors due to the effects of the lockdown – i.e. because we can’t go to restaurants, shops, the cinema or the pub etc etc.
On account of this, UK GDP is estimated to have fallen by 2% in Q1 2020. Many commentators are expecting a significantly greater fall in Q2 2020, so pushing us into recession. The Office for Budget Responsibility and the Bank of England are expecting a significant fall in UK GDP in Q2.
So what to do now?
Over the course of history, governments have generally had two levers to pull in order to try and increase spending by households, businesses and the government thereby increasing demand and so returning their economy to its pre-recession position.
These are monetary policy and fiscal policy. Here we have a third lever and it’s quite a good one…the end of lockdown! But that alone may not save us here.
So what are monetary policy and fiscal policy and how can they help us?
Monetary policy is the action a central bank can take to control:
- the level of interest rates and so how much it costs to borrow, and
- the supply of money in the economy.
In the UK, the Bank of England controls the supply of money in the economy by purchasing corporate and government bonds (quantitative easing). It also controls the supply of money by direct lending to banks so that they can on-lend to customers, eg under the Bank’s Funding for Lending Scheme. That of course depends on consumers wanting to borrow.
The Bank of England uses monetary policy for two main reasons.
Firstly, given the impact that monetary policy can have on price increases, it uses it to control inflation and to achieve the Government’s 2% inflation target.
Secondly it uses monetary policy to support the Government’s other economic aims for growth and employment. By reducing the cost of borrowing and increasing money supply in the market it hopes to encourage investment and consumer spending.
Fiscal policy on the other hand involves the use of taxes and government spending to stabilise an economy.
The right types of government spending and tax cuts can increase demand by putting more money in people’s pockets and creating or maintaining employment. The wrong type of spending or indeed tax increases can have little or disastrous effects and so cause an economy to contract – not what you want in a recession, or at all.