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Back to a grim normal

Investors who are looking forward to economies returning to normal are forgetting how bad the old normal was.
Back to a grim normal

We’re all looking forward to things returning to normal. Which would be great for our lives, but not so much for the economy – because normal wasn’t up to much.

In the UK, US and eurozone, industrial production was declining in the months even before the pandemic struck. Which reflected a longer-term trend for stagnation. In the UK, for example, productivity barely grew between 2008 and early 2020 with the result that real wages before the pandemic were actually lower than 12 years’ previously. We entered the pandemic with negative real interest rates around the world precisely because central bankers were desperate to support ailing economies.

Of course, when the pandemic allows activity to return to normal there’ll be a bounce in activity as pent-up demand is released. But this might just be a blip upwards. Why should the pre-pandemic trend of near-stagnation be altered?

Actually, there is a reason. It lies in what is otherwise a grim fact – that many businesses are likely to go bust. This could, ultimately, raise growth simply by reducing competition thereby raising the profits of survivors – and higher profits increase both the motive to invest and the means to do so. Returns on capital can rise because of a cut in the denominator, not a rise in the numerator. Insofar as stagnation was the result of low (expected) profits reducing investment and innovation, the pandemic might therefore be the solution to it.

This is of course an old-fashioned view. Before the 1930s, most mainstream economists thought that recessions served to liquidate excess or mistaken investments, thus giving surviving firms rooms to expand. Although this view was discredited by the Great Depression of the 1930s, it might well apply to other recessions.

But but, but. There are two big problems with it.

One is that whereas normal recessions might sometimes cleanse the economy of inefficient firms, this recession is not normal. As I write this, the best and most efficient pubs and restaurants are just as closed as the least efficient. What determines whether a firm will survive is not just its quality but its balance sheet. And a bad business that was generating cash because its owners weren’t investing might well have more chance of surviving than a good business which entered the pandemic with debts incurred by otherwise rational expansion plans. Yes, some recessions can raise productivity growth by killing lame ducks. But this recession might not be one of them.

Secondly, the pandemic might have a long-lasting scarring effect upon animal spirits. Entrepreneurs (and potential entrepreneurs) might reasonably ask: why should I risk expanding if demand will collapse because of events beyond my control? Yes, the pandemic might be a once-in-a-century event. But are you prepared to bet your house or business on this?

Escaping stagnation requires much more than a brief upward blip in demand. Support from loose monetary and fiscal policy might be necessary – but it might not be sufficient: the idea that economies will grow well if only the right policies are in place might be an out-moded one.

Which poses a danger for investors. It’s possible that the end of the pandemic will bring a burst of euphoria that raises equities – perhaps to levels which economic fundamentals do not justify.