By Professor Paul Gregg
Lockdown artificially closed down large parts of the economy but to understand where the economy is and will be in the next year or so, it is crucial to make a distinction between economic activity that has been lost and that which has just been delayed. To make this distinction clearer, think of Easter Bank Holidays. Easter normally falls in April but in some years it is in March. In a year when it falls in March, the economic activity for March falls sharply compared to other years, because the Bank Holidays close large parts of the economy. But correspondingly April will see higher output as the economy re-opens. There is no effect here on overall output or underlying economic performance. It is merely delayed by a month.
Lockdown has the same effect. It places a dam in the way of consumer spending, but behind the dam there is a build-up of demand that is released when Lockdown ends and the economy re-opens. This creates a surge of activity. The same can be seen in terms of vacancies. Locked down firms stopped recruiting as they weren’t trading. But staff members were still leaving to start other jobs in open sectors of the economy or leaving the labour force. The positions remain unfilled until the firm re-opens, then we have a surge as 6 months of vacancies appear at once.
There is currently an economic surge building, starting in April as the economy started to re-open but just as economic activity was artificially suppressed in Lockdown, the re-opening will artificially inflate the level of activity above the underlying level. This raises a number of key questions about where the economy is now and is heading. What is the underlying level of economic activity? How much pent-up economic activity is there to be released? Over what period will the surge occur? And what does this mean for government policy, especially for the government’s fiscal position?
Where is the economy now?
The 13 months from the end of February 2020 to the end of March 2021 saw a shortfall in economic activity of 10% compared to pre-crisis levels. April to June 2021 saw the economy start to re-open, with a mix of released activity with still partial closure, meaning rapid growth in activity. So from July, hopefully, a fully re-opened economy will see economic activity not just return to underlying levels but experience a surge from the release of the pent up demand.
The US offers a useful comparator here of underlying activity levels. It has not used Lockdowns so widely as the UK, and has not used a furlough programme to preserve employment, instead focusing on supporting the incomes of people who lose jobs (more than in normal times). In the US, economic activity in the first quarter of 2021 was just 1% below that of pre-crisis levels. In the absence of the crisis the economy likely would have grown, so a reasonable figure is that economic activity stands 3% below what would have happened without the crisis. The employment rate is 3% below peak levels and unemployment just over 2% higher. Note that the employment fall has been larger than the GDP fall in the US. In the UK economic activity was down nearly 8% from pre-crisis levels in the first quarter of 2021. The US situation suggests that at most underlying activity is around 1.5% down in the UK if the artificial effects of enforced Lockdown are stripped out. This is very modest given how scary things looked last year.
How much pent-up economic activity is to come?
There are two parts to gauging the size of this pent-up demand. What has happened to disposable incomes, and the extent of excess saving from that income.
Disposable incomes are about 1.5% down on pre-crisis levels in real terms, reflecting lower employment, the effects of furlough etc. The proportion of incomes saved (the Saving Ratio) in the UK have been over 10% higher than normal since the crisis hit. So there is 10% of peoples’ annual incomes that could be spent to take savings back to normal levels. This is a bit over £3,000 per household.
Now people could consume this slowly over the lifetimes or binge-spend. Evidence from lottery wins suggest large wins see spending on durable goods like a new car but a large portion is saved. Spending more generally is unaffected. Smaller wins see proportionately more spent and less saved. So people are likely to run this excess saving down over a couple of years and because of the relief as Lockdown ends this is likely to be front-loaded starting from April this year. In the second half of this year, therefore, we can reasonably expect the surge of spending on pubs, clubs and holidays to boost economic activity to between 5 and 6% above underlying levels or around 4% above pre-crisis levels. Then as the surge eases, next year would see no GDP growth as underlying improvements in the economy are masked by the spending surge ending.
The employment story is very different. Furlough meant that Lockdown didn’t see forced job shedding, just the effects of firms not hiring or closing down. The employment rate fell by 1.6% compared to 10% for GDP. So, the employment fall has been in line with underlying lost output but not the extra driven by forcing firms not to trade and consumers not to consume. The surge will, however, boost employment rapidly. This is already appearing in the data and unemployment should be expected to return to pre-crisis levels by the end of the year.
What does this mean for government policy?
The crisis has seen government debt rise by 20% of GDP by the end of last year, when the current deficit was £65 billion in the final quarter. The coming surge in activity, ending of furlough and other crisis spending should mean that the current deficit should evaporate. The government should be looking to post a surplus by early next year. There will also be a reduction in the debt to GDP ratio because of the boost to growth from the spending surge. The government should be then keeping the deficit below the level of growth to reduce the debt burden slowly.
This still leaves the question of what to do about the large increase in debt over the last year? The answer is absolutely nothing.
The surge in activity addresses the current deficit and around 1/3 of the increase in historic debt levels has been funded by Quantitative Easing from the Bank of England. Which leaves the Bank holding one third of all government debt. There are lots of issues about how to manage these holdings, but these do not incur interest payments or require urgent financing. These holdings are a long-term issue which means that the functional debt is 2/3 of GDP, not 100%, and this level is manageable until we are firmly past the legacy of the Covid Crisis. This will help reduce the current government budget deficit and ease the historic debt concerns enough to not return to the austerity policies of George Osbourne. It still, of course, means little room for major spending boosts.
The economic fallout from the Covid Crisis has been much less than feared last year and the release of excess savings, resulting from Lockdown, will create a temporary economic boom in the second half of this year. The limited economic damage reflects in large part the successful management of the economic fallout by the Chancellor and stands in massive contrast to the extremely poor handing of the health crisis itself.
The Chancellor has in effect used a major fiscal stimulus to overcome the effects of Lockdown. But more interestingly Furlough, the main spending ticket, acted as a highly targeted stimulus, focused on the hard-hit sectors. This then stopped leakage of reduced demand to other sectors. This high degree of targeting has been rather like the German Kurzarbeit, where firms in trouble in a recession can apply for government support to put workers on part-time working. Wages are then topped up by this support but fully, as with the 80% of wages paid under Furlough. The lessons then are: Fiscal stimulus works. That it should be targeted on jobs not consumption, through say VAT cuts. Finally, it should be targeted on stressed firms, sectors or other targeting devices and provide proportionately more support for lower waged jobs. It would be good to remember these lessons for the next recession, which is due in 2031.
 Recessions have occurred every 10 years on average since 1980