Imperial college student webinar,
Current economic prospects, 12 May 2020
Some
of our Imperial College students organised a webinar last night on our current
economic prospects. They kindly invited David Shepherd, David Miles, James
Sefton and me to participate. Here are some notes on the questions that they
set us in advance and a few notes on what was said. Thanks to our talented and interested
students for organising this and participating.
Q. How does the current climate compare to previous periods
of economic turbulence e.g. Spanish flu of 1918, WW I&II, the great
depression? In your opinion what is the
optimal fiscal/monetary policy mix to confront the liquidity crunch
due to COVID?
The BBC showed on its website
the following graph saying that this was the sharpest annual downturn since
1706. So this is clearly an gigantic recession; historically unparalleled, at
least since 1706m and rolling together The Great Depression, the 2008 Financial
Crisis and the flu pandemic all in one go.
Optimal mix.
The optimal mix of money in
fiscal policy is a nice question. Perhaps the best way to think about it is the
benchmark economics competitive model. In that model economic systems are self-correcting.
If there’s a shock to a market, say to the demand for PPE, it becomes more
expensive: demand is choked off and supply is increased, as firms rush to enter
a more lucrative market. The two forces of falling demand and rising supply raise
prices and bring the market back to equilibrium.
The second feature of the
benchmark competitive economics model, is that markets are not only self
correcting, but they are what economists call complete. By complete this means
that goods can be transacted for. And, in particular, future goods can be transacted
for via future contracts. Of course
that's exactly what we see in the real world if we're thinking about let us say
oil or aluminium. Airlines buy the oil forward . And that's part of prudent
business management. But when economists think of a complete market they mean
that all items can be traded forward.
As John Kay is pointed out, in his book “The
Truth About Markets” that would mean that you could buy a futures contract
in let us say 1960 for the appearance of an iPad in 1990. The fact is of course
that nobody even knew what an iPad was in 1960, let alone were able to sign a
contract for it. But had they done so, it would have meant that the contract
could have been traded and the forces of supply and demand mentioned above
would have equilibrated the market.
Now in an economy where neither
of those two conditions hold then we potentially have a room for policy. Let's
take the first one. Many markets especially financial markets, seemed to be
complete opposite of self equilibrating, especially in periods when market
participants are panicking. That is to say uncertainty over the future, which induces
panic, often makes sellers of financial assets sell, without demanders coming
in to pull up the price (Think of somebody who are forced into crisis to sell
some asset, a so called fire sale , even when the market is very depressed).
The price of the asset falls and falls, thereby amplifying the original shock.
As for the second condition,
nobody knew what COVID19 was and nobody signed a contract on it: in this case
nobody insured themselves against its possibility. So we've had a very large
adverse shock against which nobody took out insurance.
So the role of the state in
this case , is to (1) step in if the market is in chaos and (2) to provide
insurance because of the incompleteness in that market.
One important role for monetary
policy is to step in when financial markets are in chaos and are dysfunctional.
The Monetary Policy Committee did this in the financial crisis.
As for insurance, that is
commonly the right role for fiscal policy. The benefit system ensures that
workers have unemployment benefits if they were unlucky enough to be
unemployed, and the progressivity of the tax system is such that when incomes
go down taxes are effectively cut, so-called automatic stabilisers. That
provisioning of insurance of course involves borrowing and involves perhaps
paying out large amounts of unemployment benefit now, to be funded by the
state, but then paid back by future taxing and borrowing once the economy has
been restored.
The right mix of monetary and
fiscal policy depends upon institutions that we currently have in place. The burden of insurance provision should lie
with the fiscal authorities. Note however that as part of inflation targeting
an independent central bank might want to undertake more expansionary monetary
policy than would otherwise be the case if it wanted to avoid scarring; that is
to say, if its inflation target would be imperilled if a prolonged recession
lowered the potential output in the economy. See Powell’s speech today (https://www.federalreserve.gov/newsevents/pressreleases/other20200228a.htm).
·
Do you expect a
mild recession with a V shape recovery, a greater recession with a U shaped
recovery or an L shaped deep depression? What are 'the city' thinking and
how are they modelling excess risk/uncertainty into long-term
economic models/predictions?
In our most recent monthly policy report The
Bank of England have felt that the situation is so uncertain, and the
historical parallels so difficult to discern, that it is unable to have a
definitive forecast . Instead it produced a scenario, being an outlook based on
the series of what at the time seem reasonable judgments. That scenario in
Chart 1.3 below has a very sharp fall in GDP and then a slow recovery. So overall UK GDP falls by 14% in 2020.
Activity then picks up in the latter part of 2020 and into 2021 as social
distancing measures are relaxed. That said GDP doesn't reach the pre covid
level until the second half of 2021. So in 2020 GDP falls by 14%, in 2021 it
rises by 15% and in 2022 it rises by 3%.
.
The chart below shows what other forecasters
expect for 2020 Q 2. The bank is somewhere in the middle of these averages.
The report notes a number of downside risks to
this scenario. One of course is the position of the world which is currently
extremely difficult. A second which other commentators have looked at is the
possibility of further waves of the pandemic. This is obviously a matter for
epidemiologists but it is of interest to look at the chart below, put together
by some London Business School economists pointing out that belief the death
rate from Spanish flu came in three waves. It is perhaps also worth pointing out do we
don't yet have a vaccine for AIDS, thus the question of whether we will
eventually have a vaccine is still open one .
Still another important point came out in the discussion last night. It
is that it's very difficult to know how to interpret the recent fall and death
rates because we are so uncertain as to what the level of infection in the community
might be. The range of estimates seems to be from 5 to 65%. Of course, if the
level of infection is very high, this is potentially extremely good and
important news, because it means that the lockdown can be released. We urgently
need to know what this number is. Perhaps the proliferation of tracing apps,
the national launch of the NHS app, and Professor Tim Spector’s app from Kings
College might help us.
Finally, the other sets of sensitivities would
be around scarring. As mentioned above this is the possibility that the long-term
supply potential of the economy is so damaged that it is difficult for the
economy to come back again consistent with low inflation. A number of scarring mechanisms exist. One is
obviously the idea that if there was an extended period of unemployment workers
would lose their skills and motivation. The second is that there may be a
permanent structural change in the economy such that a number of capital assets
(think airports) are simply as not usable and productive in the current economy
as before. Of course capital can be reallocated but if that takes a time then
the supplies potentially the economy can potentially be disrupted. And of course it does look like they're going
to be need to be some capital assets which will have to be increased: say, hospitals,
delivery equipment and social distancing infrastructure.
·
What will be the
long term impact of QE/Debt monetisation on interest rates and inflation
post-COVID? How will we pay-off the debt: taxation, austerity,
growth, or a combination of the three? How does this marry-up with political
decision-making and public opinion?
This raises a number of key questions. Let's go
through them one by one .
The first point is what will happen to R*. To
recap R*is the neutral rate of interest , that is to say the rate of interest
at which resources completely utilised, and unemployment and inflation are stable. It is
indeed the case that central banks can influence short term interest rates but
the long term interest rate is something typically beyond their control. So for
example the large increase in demographic ageing in the last 30 years and the
associated high demand for savings for a longer old age, is widely held to have
depressed the equilibrium interest rate. Equally there appears to have been a
fall in the demand for capital, perhaps caused by the increase of use of
intangible assets which likewise pressed down on the equilibrium long term
interest rate. So the key question is what happens to that future interest rate
after this crisis?
One possibility is that it will increase as the
demand for capital and demand for debt rises in the face of large borrowing by
central banks and governments. Against that if there were an outbreak of
precautionary savings in the face of the uncertainty around this shock , then
there will be strong pressure for the rate to fall even further. We don't know
what the balance of these forces is going to be. At least in the short run the
amount of saving is strongly correlated with unemployment and the fear of
unemployment. If unemployment rises and stays high that would typically drive saving
up comma and if that were, common throughout the world that would drive the
equilibrium real rate of return down.
So if the equilibrium interest rate falls
further or at least stays low, that of course is very good news for what will
of course be highly indebted governments. That said, we will need to boost
growth in order that even at very low interest rates the economy can grow
sufficiently to pay off what will be almost certainly a greatly increased debt
burden. And indeed was a bit of
discussion at the session as to what his oral experience can tell us. The debt
to GDP ratio was extremely high After World War One World War Two and rather
earlier the Napoleonic wars. In the case of the Napoleonic wars in World War
One the debt was reduced essentially via growth and low interest rates. That
was also the case after World War 2, although inflation did play a role. So
there is historical precedent for having high debt burdens and there is
historical precedent for their being reduced by the joint forces of economic
growth and interest rates.
In that respect QE is a minor player.
Q. The
Fed was quick and effective to launch stimulus programmes to contain the
freefall in markets by providing mass scale liquidity. Warren Buffet
recently commented that due to Fed intervention asset prices haven't bottomed
out, making investment opportunities less attractive. Do you think the market has bottomed out? What
are the asset price implications if lockdowns continue, albeit intermittently,
until 2021? i.e. returns on stocks, bond yields, ETFs, safe haven assets such
as gold. Given
the flight to safety we're seeing in capital outflows, what are
the implications for FX rates between strong currencies (e.g. dollar,
euro) and EM currencies? Could the massive scale QE cause the dollar to
depreciate?
The session finished with some discussion of the above
couple of questions. The difficulty of forecasting interest rates exchange
rates made most people rather non-committal, beyond the observation that the US
dollar always seems to stay strong in periods of panic , as people seek refuge
in the world’s reserve currency. Finally, the future of the housing market. The
interesting issue here is whether our experience of working from home, and the
possible worries about taking public transport , might get us to a situation in
which there is simply much less demand for both offices in general, but also
office space,. That fall in demand may well have important effects reducing
prices and rendering housing more affordable. Another example of an equilibrating market?
