2020: The economy, upended

2021 will be a year of healing. The Office for Budget Responsibility (OBR) expects real gross domestic product (GDP) to rise 5.5 per cent next year: the consensus among private sector forecasts is for 5.3 per cent growth. This would be the fastest annual growth rate since 1988.

Economists agree that the main driver of this upturn will be consumer spending. The OBR expects this to grow 7.5 per cent in real terms next year, contributing 4.6 percentage points to that 5.5 per cent growth. Growth in retail, however, is likely to lag behind this because the strongest bounce-back in spending after Covid-19 is defeated will be outside the retail sector – in pubs and restaurants. 

Government spending will also add to growth, partly because of spending on NHS Test and Trace, but also because of a mathematical fact. This spring’s lockdown caused the closure of schools and postponement of some less essential NHS operations. That depressed government consumption this year and means year-on-year growth will look high next year as things return to normal. 

One area of spending, however, won’t be so strong – capital spending. The OBR foresees business investment rising less than 2 per cent next year, although the Bank of England is more optimistic, foreseeing a 5.7 per cent rise – although it has for years been too optimistic on this point. Super-loose monetary policy, then, isn’t doing much to raise investment. 

One word explains this: uncertainty. Uncertainty makes companies delay investment decisions in the hope the fog will lift. 

One such uncertainty is Brexit. The OBR’s forecasts assume an orderly transition to a new trading arrangement. But as I write this isn’t certain. Delays at ports could hit production and raise food prices early in the new year. Another is that we don’t know how quickly the vaccine will be rolled out sufficiently far to allow us to return to our normal lives. The OBR’s forecast assumes it will be widely available by mid-year. But there are risks either side of this: the vaccine might come sooner or later, and Test and Trace might or might not be effective in the meantime. The OBR says these risks are the difference between unemployment rising only slightly or more than doubling, to over 11 per cent. That’s reason enough for companies to delay investment decisions.  

And even when Covid-19 is defeated, there’s the question of whether demand will return to its pre-pandemic pattern or whether it has changed for good. Will we stick with online shopping to the detriment of bricks-and-mortar retailers? Will we continue working from home with the result that city-centre cafes and shops suffer? Will we return to eating and drinking out, or will we entertain friends at home more than we used to? Doubts about these questions will deter companies from investing, expanding and opening. 

It’s not just the pattern of demand that’s uncertain, however. So too is the level. One problem is that unemployment will rise: the OBR forecasts that there’ll be 800,000 fewer jobs in the economy next year than this. This doesn’t just cut the spending of those losing their jobs; the fear of job loss will cause others to tighten their belts. 

Nor do we know what impact this year’s lockdowns have had on our spending habits. On the one hand, they might have made us appreciate more our pre-pandemic way of life, with the result that we’ll spend even more on holidays and eating than we did pre-pandemic. But on the other, we might have fallen into more frugal habits such as drinking at home rather than expensive nights out. We can’t say which of these mechanisms will be stronger. We are terrible at predicting our own tastes – which should make us cautious about predicting others’. 

Falling into more frugal habits is, however, just one example of a set of possible consequences of this year’s recession, which economists call scarring effects. There are others. One arises from the likelihood that unemployment will probably stay high: the OBR foresees it remaining above February’s level until at least 2024. This causes people to lose out on on-the-job learning and training, causing them to be less productive when they return to work. David Blanchflower, a former MPC member, has shown that these effects are especially great for young people. Also, business closures reduce competition and hence the incentives for surviving firms to increase efficiency. There’s also the danger that companies that incur debt to see themselves through the downturn will be less able to grow afterwards. And then there’s the risk that the memory of this downturn will reduce animal spirits in future, by making entrepreneurs less keen to start or expand businesses. Dave Ramsden, Deputy Governor of the Bank of England, recently warned that recessions “have persistent effects on investment, innovation and productivity”. But nobody yet knows how severe or long-lasting such effects will be.

And then there are policy risks. The danger that monetary policy will be tightened too quickly is small. The Bank of England has promised to not to raise Bank rate until it is confident that inflation will stay around its 2 per cent target. Futures markets interpret this as meaning no increase until 2024. The risk of a premature tightening of fiscal policy, however, cannot be ruled out: Chancellor Rishi Sunak is reported to be more nervous about the public finances than economists think he should be. The possibility that he might tighten policy is itself yet another reason why businesses would delay expanding and hiring next year.

So, while it is likely that 2021 will see a bounce-back in activity, there are many big uncertainties about just how strong it will be. Which is troubling, because a full recovery from this year’s recession, which has seen GDP fall by around 11 per cent – the worst drop since 1709 – will take many years. Even if the OBR is right, economic activity won’t return to its pre-pandemic level until 2023. It’s going to be a long haul back.