The OBR Is Far Too Optimistic About the Economy’s Ability to Bounce Back

This article appeared on UK Telegraph on April 16, 2020.
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Office for Budget Responsibility modelling this week produced staggering forecasts for how the Government’s fiscal response to Covid‐​19 and the lockdowns will affect GDP, unemployment and the public finances. Its numbers were almost incomprehensible in historical context.

Day‐​to‐​day economic activity is expected to be down 35pc for the shutdown’s duration. Assuming a three‐​month lockdown that is then phased out over another quarter, that would see GDP fall in 2020 by 13pc — the biggest annual drop since 1709. Unemployment would immediately skyrocket by over two million people to 10pc of the labour force, the highest level since the Nineties, despite massive government payroll subsidies.

That estimated £42bn job retention scheme and the other £44bn worth of new Covid‐​19‐​related spending would result in annual government expenditure exceeding £1 trillion in the UK for the very first time. Alongside plunging tax revenues, the government budget deficit would balloon to 14pc of GDP, by far the highest level since the Second World War.

It doesn’t take a degree in economics to predict that shutting swathes of the economy will dramatically reduce GDP, nor that government relief to mothball that lost activity would lead to surging borrowing. Still, the magnitudes are astounding. Few economists could claim with certainty to know the longer‐​term consequences of an unforeseen shock of this enormity.

Another worrying aspect of the OBR analysis is that, if anything, it is far too optimistic about our medium‐​term prospects, assuming a rapid bounce‐​back once the lockdown begins to be lifted. In 2021, for example, it predicts annual growth of 18pc, bringing GDP back to the level forecast in March’s Budget for that year’s end. This, to put it lightly, seems like wishful thinking.

Don’t get me wrong: we should expect a fairly robust recovery. Temporarily dreadful though it is, this shock will not overtly destroy physical or human capital. Most workers will remain skilled, factories and offices will still exist, software will remain operational, and much pent up demand will return.

Governments have played insurer of last resort too, helping to protect as much of the business supply capacity and as many employment relationships as possible.

So, just like after a long holiday or a bad harvest, once the virus is gone, we would imagine a strong resumption in activity. Yet expecting that full bounce‐​back to occur by next year? Well, that’s just fantasy, for at least three reasons.

First, the medical innovations needed for a “return to normal” — whether a vaccine or an effective treatment – will not be ready and rolled out globally that quickly. Even if lockdowns are lifted despite this, bringing us closer to Sweden’s approach, continued “social distancing” by consumers and producers will not allow activity to “return to normal”.

Adapting to the virus is costly relative to a world without Covid‐​19. Businesses will still face considerable uncertainty too, with risks of a second infection wave and policy in other countries disrupting trade, both of which will delay business investment and hiring.

It’s certainly true that building infrastructure to move to a test‐​and‐​trace system after case numbers decline would allow a degree of reopening, easing economic pressure. But there’s little evidence that this would lead to a full rebound. Even South Korea, the poster child for test and trace, is suffering economic contraction right now.

Second, though the Government has acted to prevent business failures, some will fail and others will permanently lay off workers. The Office for National Statistics’ recent survey found that 59pc of businesses either “did not know” or “were not confident” they would survive this pandemic.

Entertainment industries, restaurants and large venues will be particularly affected. Many employer‐​employee relationships and business relationships with suppliers will be lost. Given frictions to people setting up new firms, finding new suppliers, or creating and finding new jobs, the productive capacity of the economy will be impaired for a while.

Indeed, the OBR acknowledges this on unemployment — projecting 800,000 more out of work in 2021 than in its March budget. Bizarrely, it thinks this will have no effect on GDP.

The third reason why a full, immediate rebound is unlikely is because Covid‐​19 will permanently change other aspects of our economy, whether that be working from home or spending patterns.

Though, on net, government support has probably assisted near‐​term growth prospects, relief would also have helped some businesses survive that will not be viable in the post‐​pandemic world. It will take time for locked up capital and employees to leave these zombie firms and this will drag on growth.

Polling from Kekst CNC suggests 22pc of the public will be less likely to eat out at restaurants after this is over, 30pc will be less likely to travel abroad, and 24pc will be less likely to go to concerts, for example. Anyone who thinks major shocks to the economy’s industrial composition will not affect its immediate growth potential must have been asleep for the past decade.

Now, we should not over‐​do the doom and gloom. The UK’s economy is dynamic and adaptive. Millions of jobs are created and destroyed every year. We should still expect a sharpish bounce‐​back after such a trough, when worries about the virus lift. Talk of an “L‐​shaped” GDP path is overblown.

But the OBR’s results are very much a best‐​case scenario for the coming year. Until the virus’s threat dissipates, emergency relief is removed and the cloud of uncertainty is lifted, any restart will not result in us rebounding seamlessly to our pre‐​pandemic future.

Ryan Bourne

Ryan Bourne is the R Evan Scharf Chair for the Public Understanding of Economics at the Cato Institute.