Sun 9 August 2020

Ben Lewis looks at the dire economic impact of COVID-19 and dismisses fears about an excessive Government fiscal and monetary stimulus.

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Noted probability theorist and twitter troll Nassim Nicholas Taleb said of governments and crises this week that “The state should not smooth out your life, like a Lebanese mother, but should be there for intervention in negative times, like a rich Lebanese uncle”.

I’m not Lebanese and sadly lacking in rich uncles, nor am I going to take a view on whether he’s right. What I want to argue is that the British state is the uncle, not the mother. There is much talk of the unprecedented size and scope of the UK’s fiscal and monetary response to COVID-19, to the point that many are expressing worries about excessive generosity.

Surely, more money from the government means inflation, moral hazard and disasters down the road? Let’s take a look at how these claims add up.

How Big is the Hit?

The UK economy is a big beast, but COVID-19 is a big shock.

£557bn was spent in Britain in the 4th quarter of 2019. Of that, £350bn is household consumption, £95bn private investment and the rest government consumption and exports. The government spends a lot more than it consumes. Most of its so-called “spending” is really just transfers from one group to another, such as rootless immoral financial professionals like your author to grounded deserving folks such as your own selves.

Now, how big is the shock? The first thing that vanishes in bad times is investment. The 2008 financial crisis saw it fall by 20%. If repeated we’re out £20bn of spending in three months. Consumption tends to hold up better in previous recessions but this time is different because much of it is literally banned. Accommodation and Food services is another £14bn or so. Half of that’s likely gone. Transportation is £20bn. Real estate is another £20bn. All of this is going to take a big hit. So, let’s say we lose our £20bn of investment, and the same again in consumption.

That’s £40bn the government needs to spend to make up for it right? Sadly not.

The Paradox of Thrift

Everyone’s income is someone else’s expenditure but not all income is spent. Some of it is saved and some of it taxed. In a recession, everyone tries to save more which means less income for others — the paradox of thrift.

In March alone, UK consumers paid down almost £4bn of credit card debt. If they did that every month, the Government would need to spend another £12bn just to make up for it. The Office of Budget Responsibility (OBR) calculates extra coronavirus spending as around £100bn over the 2020/21 fiscal year: £25bn per quarter. Even assuming that it actually makes it to households, half of that will vanish on consumers paying off credit cards if March’s figures repeat — and that money doesn’t go anywhere. Banks create new money when they make loans and the money disappears when they’re paid off.

That leaves us £13bn of new spending to address what can easily be a £40bn decline.

The absolute best that can be said of the fiscal response is that it’s appropriate if my assumptions about consumption and investment are 2-4 times too pessimistic! The fact that UK electricity use declined 20% in April implies they are not.

Printing Money

What of the Bank of England (BoE)? Can’t they prevent a slide into depression by pumping money into the economy?

More than their job’s worth I’m afraid. The BoE does not spend money. It only ever lends it. When you or I borrow from a bank, the bank credits our bank balance and adds a debt to the other side of their ledger. It’s the same when banks borrow from the BoE – and only banks can do so. All the BoE can do is increase the balances that banks hold with them, and all a bank can do with that “money” is transfer it to another bank in exchange for something. When the BoE increases these reserves, with lending, or Quantitative Easing (QE) — all they do is make it easier for banks to settle payments with each other and change the mix of financial assets in the economy. They take out some government bonds, put in some reserves.

None of this necessarily leads to more spending.

The Bank of England does not control the amount of pounds there are in circulation. No one does. The number of pounds depends on the lending and borrowing preferences of everyone in the economy, banks, households and firms. Whilst the BoE is adding reserves that can’t be spent on goods and services, firms and households are paying back loans as they tighten their belts — reducing deposits that can be spent.

If that doesn’t sound like a recipe for inflation, that’s because it isn’t. Most commentators and economists thought when the BoE first started buying bonds that it would lead to rapid inflation, and I saw many smart people lose many millions of pounds investing as if that were true. In 2009-10 when the BoE was buying bonds for the first time, the price of Oil went from 30 to 70 pounds a barrel. High oil prices and inflation are peas in the same pricey pod. But while oil prices more than doubled at the same time as the BoE bought hundreds of billions of bonds, Consumer Price Index inflation rise from 3 to 5%. Hardly anything to write home about.

Reassessing Government Spending

All of this looks very much like crises past. Asset purchases by central banks were commonplace before the 80s, and most people now agree that government spending in a recession is a good thing. Many commentators are saying that the support for companies is unprecedented, with the BoE buying corporate bonds — but this used to be routine in the 19th century as those were the main kind of bonds around. The hand wringing and fretting lacks any historical perspective.

Building a society where the vast majority of people rely on salary income from big companies and then replacing some of that income when you force those companies to close is not generous. Encouraging enormous borrowing and then backstopping the worst effects of that borrowing unwinding is not kind.

The UK state is behaving exactly like Taleb’s rich uncle, stepping in in a time of crisis to prevent the unthinkable. The extent of the UKs economic crisis will be thrown into sharp relief by this month’s data releases, which cover the April period where the UK was under lockdown.

Don’t let anyone tell you the policy response has been generous when the evidence of your own eyes and ears is of economic ruin. It’s better than nothing. That’s all we can say for sure — and that isn’t much. 

Benedict Carey Lewis writes regularly on his own website. And can be found on Twitter at @BCLMacro

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