The coronavirus crisis: prospects and policy 

Patrick Minford is Professor of Applied Economics at Cardiff University Forecasters protect themselves by being gloomy. This is because their clients want the future to be bright and will tend to act on bright forecasts. The forecasters who provide those will then be blamed if things go wrong, as the firm will have overspent assuming the best. A gloomy forecast, if things turn out better, will not be remembered in the firm’s delight at events. This imparts a gloomy bias to forecasts. The virus crisis is no exception. Yet it is an unusual crisis, in being mainly created by deliberate suppression of the economy by the government. In principle the lifting of the lockdown removes that suppression, so automatically regenerating activity. This is quite unlike a typical recession brought on by say a commodity shortage price shock, or a consumer- or firm-led collapse in demand and confidence; in these cases the government has no control. It can try to offset these things; but its success is hard to predict. On this occasion the government can remove the cause because it is the cause. It is true that in addition people are fearful of the situation and may therefore spend less, while firms may also conserve cash. However, much of this fear is the result of government warnings about high chances of dying from the virus. As deaths come down and lockdown easing goes ahead, these warnings should be toned down and popular sentiment will become braver, as well as more impatient of restraint. Pre-COVID-19, people behaved robustly towards risk; but the crisis has changed that behaviour towards great timidity. This looks unlikely to last as lockdown is eased around the world and deaths continue to fall. Just as people go back to driving normally after accidents, so with attitudes to health risk as this episode winds down and the extreme alarmist forecasts of deaths prove to be false. Our early-May forecast for COVID-19 deaths in the UK is shown below. Already daily average deaths are close to zero, as forecast. In this respect it is following the standard logistic path of an epidemic, including the effects of government and personal reactions. Our causal model of the epidemic supports this pattern. Some forecasters build in a second bad wave of infection, starting in the autumn. However, we think this is unlikely because the fatal strains of the virus have been essentially eliminated in the first wave by the deaths of those infected. The other damaging non-fatal strains will have been killed off by antibodies in the surviving infected. The virus strains that survive will be those that caused less antibody creation and so created weaker symptoms. The death rate per infection of the common flu is around 0.1%; this flu virus coexists with us and we do not react to outbreaks by stopping our lives. So it will be with new waves of COVID-virus outbreak, evolutionary biology suggests. The evidence so far from countries experiencing second waves supports this view. Out of about 28 such countries, around half have succeeded in avoiding a serious second wave by using localised track/trace/isolate policies. In all second waves the death rate per reported case has fallen sharply since the peak of the first wave. Even if there is an outbreak worse than this assumes, we assume it will be responded to not by lockdown but by these effective localised responses. This is all without assuming a vaccine or a cure - both of which are possible if unlikely things to appear soon. It is for these reasons that our forecast is close to a V-shape for the UK economy. Q2, where the lockdown was at its most severe, has predictably seen a large drop in GDP; even within the quarter, June recovered by nearly 10%. Q3 will see a further rebound, and Q4 a yet further one. By the end of the year the recovery will be total. What is in prospect for the UK is similar in other countries. The very latest indicators support this interpretation. Purchasing indices for the G7 suggest already GDP has recovered to year ago levels. This is influenced by China, where lockdown started and was lifted first. But other major economies are not far behind. The fiscal and monetary policy response A key element in recovery will be policy. Fiscal policy is in bail-out mode currently, issuing huge amounts of debt. Monetary policy is in massive QE expansion mode. Effectively the Bank of England is buying all the debt the government is issuing, creating a false market in gilts; the government is borrowing from itself not the market. This QE needs to be wound down and gilts sold to the market at yields as close as possible to today’s near-zero rates, to keep long term interest costs to the taxpayer as low as possible. Maturities of issued debt need to be lengthened for the same reason. The time to do all this is in the rest of this year as recovery proceeds. The market in gilts should be able to absorb this debt; given the environment of insecurity that will prevail until the economy has fully recovered, private lenders will pay for safety. By the end of the year this will change. Confidence will have returned and with it the huge quantity of money printed and lent out will start to fuel inflation. As we go into 2021, it will be necessary to tighten monetary conditions against this. How fiscal policy copes with wars and other crises- and now the coronavirus To get an understanding of how far the public finances can stretch to cope with national crises, it is helpful to look at UK debt history. The two charts below come from Martin Ellison and Andrew Scott’s VoxEU article chronicling UK debt history. One can see that twice in UK history has the market value of debt/GDP spiked: once in 1830 after the Napoleonic wars, and once in 1945 after the Second World War. The first spike was to 200% of GDP, the second to about 150% of GDP. The chart below it is also instructive. It shows the ratio of market/par value of debt. When this is high interest rates are low, a sign that the government is in a strong position to borrow, probably because the private sector is struggling. Notice how this ratio has surged in recent years, with the financial crisis. Now look at how the bond market developed as Britain borrowed in the second half of the 18th century. The market/par ratio remained at or above unity, as the government built up debt. By the early 1800s the market/par ratio had fallen sharply. The private economy was resurgent and interest rates rose, devaluing the public debt. One can see a rather similar pattern over WWII debt. As it was accumulated during the war, the market/par ratio remained a bit below unity. By 1950, the ratio had fallen sharply; interest rates had risen as the economy recovered, devaluing the debt. How were these huge debt ratios paid off? After Napoleon, income tax was introduced. After WWII, inflation devalued debt while also taxes were raised. Application to the coronavirus crisis Apply this to the coronavirus situation. With lockdown threatening a recession lasting three months or more, the government support package has been put at £400 billion as a rough round number, about 20% of GDP. If lockdown were to go on for longer, as we now think it will not, that number would spiral upwards. To understand how high the number could go, we need to do some basic arithmetic on the government accounts. National income or GDP breaks down into tax (40%) and disposable income (60%): assume that 50% accrues to non-taxpayers. Imagine now that GDP falls by 10%. This reduces tax takings by 4% of GDP, and also reduces disposable income. But as disposable income falls, the government pays tax credits (benefits) to the 50% not paying tax: assume their 50% of income falls by 5% of GDP and the tax credit rate is 80% as now promised in the government package. Then government benefits rise by 4% of GDP. The total rise in the fiscal deficit is thus 8% of GDP when GDP falls by 10%. Now consider a lockdown lasting six months: that is half a year’s GDP, a 50% fall on the year 2020 say. The resulting fiscal deficit would be 40% of GDP. On top of the UK’s existing public debt/GDP ratio of around 80%, this would take the UK ratio to over 100% of GDP, much on a par with the situation post WWII. However, the government is greatly assisted by two interlocking factors. Interest rates today are nearly zero, with the yield on ten-year gilts around 0.4%. At the same time central banks are bound to help out during the crisis by buying gilts and printing money, keeping interest rates at this zero floor. This implies that the government can borrow for next to nothing during the crisis and for very long maturities. But afterwards interest rates will rise as the economy recovers, and this rise will lower the repayment burden sharply. To give an arithmetical example, with the UK government’s current average debt maturity of 16 years, if the government borrowed £100 billion at today’s rates of around 0.4% pa, its market value at post-crisis interest rates of say 5% pa would be only £50 billion. This implies that future taxpayers are faced with a much reduced burden of debt to pay off: one can calculate the tax rate needed to pay the debt off as £50 billion times the new interest rate of 5%. The longer the maturity at which the government borrows, the more favourable this arithmetic, which explains why the UK debt office has typically favoured long-maturity gilts. Indeed, if it were to reissue all UK debt as indefinitely lasting coupon-paying perpetuities, then £100 billion of that issue would at a post-crisis interest rate of 5% fall in value to only £8 billion. If we translate this into the need to pay off 100% debt to GDP contracted by the end of the virus crisis, it turns out the necessary tax rise is just 0.4% of GDP. This could be raised quite easily - just 1.3 pence on the standard rate of income tax. Another way of explaining this favourable arithmetic is to focus on the interest cost of all this debt after the crisis. The 100% of GDP in debt that would have been raised and rolled over before and during the crisis would have required an interest rate of around 0.4% pa. So the interest on it that must be paid by future taxpayers is very low. One can see from this the powers governments have as monopoly raisers of taxes and printers of money. During crises when people have nowhere else to put their savings, governments can borrow easily as the only safe deposit show in town - the taxpayer sits at their back as repayment guarantee. Meanwhile the central bank can print money, driving down rates of return on all assets, cheapening the cost of public borrowing. What all this implies is that a sovereign government with a reliable taxpaying public is in a powerful position to cope with the financial fall out from wars and other fiscal crises. Nevertheless, one must remember that to have a reliable taxpaying public one must have a functioning economy. That is why the most vital need in this crisis is to find a way to get people back to work, so the economy can revive. How to handle fiscal and monetary policy after the crisis Now turn to the moment the economy is released from the virus lockdown and starts to recover. Some commentators, notably those who adhere to ‘Modern Monetary Theory’ (in fact neither modern nor a coherent theory), have argued for continued monetary and fiscal stimulus, to push the economy all the faster to normal. They have suggested that this would run no risks with inflation. However, this is bad advice. It is true that inflation has been quiescent for a decade while there have been substantial fiscal deficits in spite of austerity programmes while money has been printed on a massive scale by central banks through their QE programmes. Essentially highly expansionary monetary policy has failed to prevent a world of moderate deflation. Yet it was a series of mistakes made by central banks that led to this outcome. First, they fed a credit boom in the 2000s; then as bank balance sheets weakened with rising non-performing loans, they allowed Lehman to go bankrupt, precipitating the banking crisis. After the huge consequential bailouts, when bank credit needed to expand rapidly to create recovery, central banks brought in draconian new rules for banks that stopped them lending. Their ensuing QE programme duly failed to trigger the upsurge in bank credit and broad money that was intended. Instead it drove interest rates down to zero and drove up other asset prices. In the aftermath of the coronavirus crisis it is vital these mistakes are not repeated. Coming out of the crisis, the government will hold large chunks of private equity. And banks will hold large portfolios of credit in private firms that have survived the crisis. In practice the draconian regulations restraining bank credit creation will have been lifted. To prevent a huge surge in money and credit growth, the government must sell off its private equity stakes and central banks must sell off their massive holdings of government bonds to contract the money supply. This is necessary to prevent a serious inflation from taking hold. With the government still running fiscal deficits until the economy recovers, there will continue to be substantial fiscal stimulus. With demand surging relative to a supply still getting going, prices will rise. Provided money is kept under control, interest rates will rise as well, and we will gradually return to a normal monetary environment, with interest rates around 5% and inflation controlled at around 2-3% in line with the targets that central banks are committed to. The final question to be answered is: how should fiscal policy progress after the crisis? I will use the UK as my illustration, but similar principles apply in all major rich economies. Some illustrative figures can help us with our thinking. Plainly the UK government will emerge with a large debt/GDP ratio after the crisis package has been rolled out. Our forecasts are that it will cost £300 billion overall, on top of existing debt of around 80% of GDP (which is around £2,000 billion), which we can assume is being refinanced at current low interest rates as far as possible. That would together imply a total debt of £1,900 billion at par having been issued by the end of 2020, 95% of GDP. Let us assume as above that this debt will be rolled over into very long maturity at current low interest rates and that by 2022 interest rates have risen to about 5%, with gradually tightening monetary conditions. This would imply that at market value debt would only be some 10% of GDP. What we are seeing here is that debt interest being so low on the debt that was issued, its being discounted at interest rates some ten times higher than at issue, its market value is greatly reduced. These figures reveal that ‘fiscal reentry’ is reasonably manageable after the crisis. There will be those that will focus on the new high nominal debt/GDP ratio and urge austerity to bring it down. But they will be missing the point, imposing short-run fiscal rules that make no long run sense in the light of the very low long run interest rates at which the public debt will have been issued. The UK Budget after coronavirus and Brexit No budget is yet scheduled for when the UK has left the EU at year end and the economy will have recovered from the virus recession, as we currently forecast. However, it is necessary to focus on what should be in the next set of Budget plans. In its election manifesto the Conservative party committed itself to following a fiscal rule for balancing the current budget by 2023. While that may have made sense as a tactical election decision to create clear blue water between it and the reckless spending promises in the Labour manifesto, it creates a problem for post-Brexit fiscal policy in the current economic context. The true cost of borrowing is now negative: in other words lenders are offering to pay the government to borrow from them. Furthermore, the reforms Brexit will bring in on trade, regulation and immigration promise faster future growth in the long term - even if most officials and the many private sector economists who backed Remain still take an opposing gloomy view. Finally, there is a need for fiscal policy to give the economy a boost not just to put a firm end to Brexit uncertainty, but also to cut taxes to stimulate entrepreneurs, to raise essential spending on public services, and, last but not least, to push interest rates higher to a range where monetary policy can get traction again. For all these reasons we need fiscal policy to become much more expansionary over the next decade. The tactical issue of how to square this with the manifesto commitment can in fact be dealt with quite easily, since the fiscal rules include the ‘golden rule’ that investment can be funded by borrowing. What is ‘public investment’ is in the process of being redefined potentially in ongoing technical discussions within the government. It has never made sense to limit it to infrastructure and other physical investment in this age where ‘human capital’ is ever more important: human capital is the discounted present value of people’s productivity. Much current government spending contributes to or directly creates human capital, notably the two big departments, health and education. Arguably most if not all public spending does, since its aim is to empower, train, and keep safe the country’s population, so enhancing their ability to work and produce. By redefining current spending on a par with investment spending, we can shift the focus of ‘fiscal limits’ to where they belong: the long-term sustainability of the plans for debt, spending and tax. In other words, are these plans consistent with solvency and the health of the long-term government balance sheet? All these policy areas are at the heart of democratic decision-making, so to try and short-circuit decisions on them by imposing ad hoc short-termist operating rules is both lazy and damaging in the long term. Let us therefore get back to the substantive issue of what fiscal policy should be and why. The most serious aspect of the situation we are in relates to the crisis of monetary policy, as noted above. With monetary policy powerless until interest rates get back up to normal levels where world savings do not dwarf world investment, we need a period where fiscal policy is highly expansionary, to shift the world balance back towards a savings shortage and drive up rates. Fortunately this is the approach of the US government so far and looks likely to be that of Boris Johnson’s government also. Fortunately again, there are now signs that German and so EU thinking is finally moving in this direction. Now turn to what this Conservative government could do and the long-term prospects this could help unleash. Our calculations suggest the government could spend or cut taxes by an extra £100 billion a year (about 5% of GDP) quite safely by borrowing more, and spreading it across personal and business tax cuts, and infrastructure spending. According to our UK modelling, in the Liverpool supply side model of the UK, every 2% off the average tax rate, or equivalent cost reductions via public spending, gains 1% on GDP in the long run by making the economy more competitive. On this basis we could assess that this programme would raise growth by about 1% a year over the next decade and a half. This would come on top of the gains from Brexit itself which we put at about 0.5% per annum. By achieving higher interest rates, the government would reduce the market value of its large existing, mostly long term, debt to a rather low percent of GDP as set out above. What would this programme do to the long-term government balance sheet? By the end of the 2020 decade the debt/GDP ratio at market value would be well below today’s level that is getting close to 100%, and would be around the 60% ratio usually regarded as safe. The government, with a much higher GDP, would be spending 40% of GDP on programmes including debt interest, with tax revenues running at around a higher 41%. All this is highly sustainable. It may well seem that the aftermath of the COVID virus crisis would not be a good time to launch such a bold programme. On the contrary, such economic uncertainty needs to be confronted with a strong fiscal stance, to ensure it does not become self-reinforcing. The government needs to scotch all talk of new taxes, pledge to underpin the economy with any necessary borrowing in the short term, and chart a new course along the lines above to unleash the economy’s long run economic potential.
By the end of the year the recovery will be total. What is in prospect for the UK is similar in other countries. The very latest indicators support this interpretation