Julius Baer International examines how the UK has recovered from crises before, and asks what risks lie ahead and how effectively the country can push forward after the COVID-19 pandemic.
After – hopefully – the lockdowns are over and people contemplate what comes next (a potential “second wave”?) there is value in learning from past financial crises. Wealth managers trying to guide clients’ asset allocations know that the past is no guarantee of what happens in the future, but while history doesn’t repeat itself exactly, it does rhyme. In that spirit, Tom Claridge, executive director and senior portfolio manager at Julius Baer International, part of Julius Baer, has these observations.
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The coronavirus pandemic has resulted not only in a huge health crisis, but also in enormous economic damage across the globe. However, the magnitude of the economic contraction and speed of recovery depends on the government reaction from each individual country, both in terms of containing the virus and supporting the local economy. While arguably other nations have been more successful in their containment of the virus, few have been able to deal with the economic shock as well as the UK.
This is in part due to the UK’s response to the Global Financial Crisis of 2008, which resulted in reform and a healthy, well-capitalised banking sector. Imagine if 2008 had not happened and we were facing a world with a health crisis, an economic crisis and a banking crisis. We certainly would not have been able to react in the same way.
On top of this, our monetary sovereignty - which is to say having our own currency and borrowing exclusively in that currency – has given us the ability (along with the US) to enact a huge fiscal stimulus, predominantly via the furlough programme. This, along with some of the unique features of this crisis, is why I think financial markets have bounced back with such strength.
Clearly, there is a trade-off from trying to plug every employment hole through this fiscal response - some holes don’t need to be plugged and you may end up disincentivising work, as the Chancellor has acknowledged. Likewise, as we move into a more targeted response, the risk is that you leave some gaps and that will be the focus of financial markets over the coming quarters.
Centralised support required in the longer-term will depend on how structural the changes to the economy are, and that will then determine how structural unemployment is. If, for example, everyone goes back to restaurants, airplanes, gyms etc. at the same frequency as they did pre-crisis, all of the people in those sectors would need to go back to work. If, on the other hand, consumption patterns change (which is more likely), longer-term government support will need to shift from purely financial into re-training and so on.
The enforced change in behaviour from office to home-based working could be one of these structural changes. As people travel into city centres less for office work, what will the knock-on effect be for the cities themselves? Our Next Generation research team at Julius Baer believes that cities are simply sleeping giants, waiting for life to return to somewhere near normal and will be the driving force of economic growth again. Whatever the outcome, the changes will not happen by default. We will need to choose to work from home more often, do less business travel, work four-day weeks etc. Throughout history, humans have chosen to invest the gains from increased productivity into just doing more work. Keynes grappled with this in the 1930s – he thought we would save so much time by using efficient equipment and machinery that we would be working 15-hour weeks.
However we get there, as we move back to pre-COVID levels of economic activity, there is still the question of how the deficit the country has amassed in such a short period of time can be reduced. Here, it is helpful to remember that government finances are not like those of a household. Governments, certainly in the UK and the US, do not have a solvency constraint – they can produce the money to pay interest or cover bond payments, unlike the Eurozone who has a shared currency or indeed emerging market economies where much of the borrowing is in a foreign currency. In that sense, default would always be a choice for countries like the UK, rather than something imposed on them as would happen with a household or a corporation. The constraint is actually inflation, which I will come on to shortly.
The other thing to remember is that, historically at least, the debt is not paid back as such – the plan would be that the debt just gets rolled over and that economic growth and inflation erode the relative size of the debt. After World War II, debt to GDP was roughly 270 per cent, by the mid-70s it was below 50 per cent, whilst the nominal value of the debt doubled, the real debt to GDP percentage was helped by economic growth and increased inflation. Pre-crisis, we were in a much lower growth environment than the post war boom years, but our debt load is also much lower than it was in 1946 – roughly 100 per cent of GDP rather than 270 per cent.
Therefore, the better test is not solvency, but inflation. For example, I certainly would not characterise the UK’s response to the pandemic as imprudently splurging during a boom and spending to win votes with unproductive investments. This is a disinflationary environment, not a boom, and the fiscal response has been about plugging gaps in the private sector’s income. Therefore, the response thus far has not created a fiscal debt problem.
The longer-term question about inflation will come down to politics in the post-COVID world and whether there is the appetite to have another slow and shallow economic recovery as we saw post financial crisis.