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.
Which policies or blend of policies will best serve Johnson and Sunak here?
This is where history may help them.
What we learnt from the 2009 recession and other recessions is that monetary policy on its own doesn’t really move the dial materially enough in righting an economy. Rather, it is seen by many as a support function to fiscal policy. In any event, with interest rates so low there is little room for manoeuvre there and in fact their significant reduction in 2009 had little economic effect.
Notwithstanding this, the Bank of England is even now considering the imposition of negative interest rates so that it costs us to have money on deposit at a bank, the hope being that that encourages us to spend our money rather than keep it in the bank. I can’t help but think that that will not encourage us to spend money. It will just make us cross!
So fiscal policy in the form of government spending and tax cuts is the key and needs to be the focus – this is Keynesian economics and it is no less relevant today than it was in the 1930s when it was developed.
What we also know from the 2009 recession is that the fiscal policy of austerity (spending cuts) was a disaster and a key component to a deeper and longer downturn.
We also know that the significant tax increases implemented as part of US fiscal policy in the 1930s Great Depression were likely contributors to the enduring levels of unemployment, as they stifled investment.
Other things we know from past downturns is that government spending on projects and employment has more effect than government spending on tax cuts.
Roosevelt increased US Government spending by about 6% between 1932 and 1936 and that was considered one of the key drivers in turning things around, and some say that even that wasn’t enough in terms of speed of impact.
What is also clear from prior recessions is that government spending and tax cuts have more effect when aimed at lower and middle income families who are more likely to spend the benefit and so grease the wheels of the economy to help restart demand.
The 2009 recession bore that out.
For example, in the United States funding for food programs, unemployment benefits and workshare programs (where businesses reduce employee hours instead of laying them off and the state provides unemployment benefits proportionate to the hours reduced) all performed well in terms of their contribution to increased GDP.
US defence spending and infrastructure investment also performed well in contributing to increased GDP.
Tax stimulus in the form of child tax credits and payroll tax holidays for employees (which Donald Trump is currently being criticised for suggesting this time around) also did well.
So what should Johnson and Sunak do now?
Well they need to think big and think big in fiscal policy Keynesian terms and they need to take a forward-looking approach to the deficit. ie what will the economy and so the deficit look like if we do these things, as opposed to focusing on what the deficit is likely to be post Covid-19 and trying to reduce that right now.
This will be a classic case of having to spend money to make money. That will be the best way of reducing the risk of a prolonged recession and assisting to reduce the Covid-19 deficit – a double win.
So if I was them, I would focus on spending money and on tax stimulus for low and middle income families.
This couldn’t be better for Johnson because what he needs to do to kick start the economy ties in exactly with his election promise to level up the UK in terms of opportunities for all. Perfect!
So they should be considering significant spending on:
- retaining the furlough scheme or some blend of a US workshare scheme for as long as needed,
- infrastructure projects (maybe HS2 is now a good thing…?!),
- the NHS and care homes,
- teachers and our schools,
- the armed forces,
- the police,
- manufacturing (obviously we now realise we need to be able to make things for ourselves…),
- “green growth” projects,
- housing, and
- local council funding.
The list could go on.
Maybe we should also think about some level of national service as part of assisting to recruit into some of these public services. That might also help to deal with some of the social issues we currently face, like gangs and knife crime – let’s give them a better idea.
On tax policy they should be focused on tax cuts, not tax increases.
The Treasury paper one hears of that is focused on tax increases is worrying indeed. That is the wrong approach and has been proved to be so.
So cutting taxes for low and middle income families and bolstering the Universal Credit benefit scheme would be where I would focus my tax policy efforts as well as making Universal Credit simpler and quicker to access.
If they do all of those things then they stand half a chance.
And yes there may be an increase in inflation above the 2% target rate, but that risk will have to be recognised as an acceptable consequence of returning the economy to normality. The current UK inflation rate is 0.8% which is significantly below that 2% target. It had previously sat at 1.5%, so there is plenty of sensible room for flex there.
Last history lesson
The last lesson they should take from history is a lesson learnt from the Great Depression.
That was that a lack of international co-ordination on national economic policies was detrimental to the world recovery and so to national recoveries.
Gordon Brown recognised that in 2009 and led the way. This time around just like with the response to Covid-19 it couldn’t be more in reverse.
That is something that Johnson and Sunak should look to change quickly if they can. Sadly, the likelihood of that happening with a US centric US President and with an EU who we have just left and who we are in tough trade negotiations with is not something I hold out much hope for. So they had better over achieve on their domestic policies instead in order to lead us to those greener pastures as quickly as possible and with the least financial damage.
The good news is that Rishi Sunak hasn’t really put a foot wrong yet – in fact the opposite. This, however, will be his greatest challenge. Get this right and he will go down in history, so let’s hope that he and Boris are reading their history books!
Our Reed Smith Coronavirus team includes multidisciplinary lawyers from Asia, EME and the United States who stand ready to advise you on the issues above or others you may face related to COVID-19.
For more information on the legal and business implications of COVID-19, visit the Reed Smith Coronavirus (COVID-19) Resource Center or contact us at COVID-19@reedsmith.com.
Client Alert 2020-339
