How the UK’s economic problems began long before the pandemic

The government’s “build back better” narrative renders the pandemic an opportunity – but ignores the fact that prior to Covid-19, something was already amiss in the world economy.

By Helen Thompson

The London Stock Exchange's FTSE-100 in March 2020. (Photo By Getty)

In all probability, we are entering severe economic times, when many have already had their livelihoods wrecked by the pandemic. As the health emergency abates the deeper the present economic crisis will become, and there is no equivalent of a vaccine to reverse it.

Unfreezing the economy will produce immediate disruption. Governments will soon withdraw the financial support which has paid people’s wages and granted tax and mortgage payment holidays. Even a gradual cessation of these lifelines will expose those sectors such as hospitality and leisure where the pandemic has eviscerated demand or where the debt burden will lead to insolvency. The result will be higher unemployment, especially among the young; in the US, where unemployment rose dramatically in the spring, the increase in youth employment was more than 80 per cent higher than the overall increase.

The UK government’s “build back better” narrative renders the pandemic an opportunity to direct investment to the green energy revolution, and make it a source of long-term economic growth. But this idea ignores the fact that prior to the pandemic, something was already amiss in the world economy. More than a decade of quantitative easing (QE) and near zero, and in some cases negative, interest rates had produced stagnant growth. The “synchronised global growth upsurge” heralded by the IMF in early 2018 soon became a “synchronised slowdown”.

In response, from the autumn of 2019, the Federal Reserve and the European Central Bank initiated QE again. By doing so, they bade farewell to any hope of returning to monetary normalcy, where credit conditions encourage investment not corporate share buy-backs. The Federal Reserve’s de facto reintroduction of QE was final recognition that there were few inflationary pressures in the US economy, at least with respect to what gets measured as inflation.

The absence of inflation, in addition to weak growth, has consequences for how governments can manage the debts they have amassed in order to survive the pandemic. Without higher growth, GDP-to-debt ratios will be hard to bring under control. Nor will moderate inflation chip away at the nominal value of government debt.

Financial market investors appear oblivious to the risks that lie ahead. In the early weeks of the pandemic, the collapse of the US Treasury Bond market threatened the entire international financial system. But bond markets scarcely blinked when the second wave of Covid-19 reached Europe and forced governments to increase their borrowing and extend the support schemes installed in March and April.

Bond investors are unlikely to be immune from rising budget deficits, or the fate of the real economy, forever. This does not mean that governments will have to demonstrate their commitment to austerity to continue borrowing. But if, after any initial recovery, growth does not outpace pre-pandemic levels, governments will find that interest payments squeeze other public expenditure.

These increased budget deficits will then become entrenched while interest rates continue to fall. If investors exhaust their appetite for sovereign bonds with negative yields – even when they can sell these to central banks – then we will have a situation in which central banks will buy government debt not just as an emergency measure, as the Bank of England did this earlier year, but as the economic norm.

We have been heading towards this scenario for some time, but the speed has now hastened. Monetary financing will be inflationary in ways that make life more difficult for central banks. Their credibility as mandate-led institutions will be shot, and any attempt to recover it will lead to a contest between central banks and politicians about who should decide monetary policy. The combination of weak growth and central banks financing governments was a likely outcome pre-Covid, and has been exacerbated, not altered, by the crisis this year.

What have altered, however, are the international conditions in which the monetary fallout of high debt and low inflation is unfolding. As a result of Joe Biden’s presidential victory in November, there is now greater geopolitical uncertainty about the world economy. A second term for Donald Trump would have seen a continuation of the US-China trade and technology war. Now the future of their relationship is ambiguous. Biden has a more pragmatic attitude towards Beijing than Trump did. But in the US, domestic appetite for economic detente with China remains weak.

Here, climate politics is central to the tension that exists in Washington between China doves and hawks. A Biden administration can make bilateral Sino-American cooperation to reduce carbon emissions the cornerstone of its foreign policy. Or it can pursue a strategy of renewable energy-led growth which, to create American jobs, will require competing with China in sectors that Chinese firms dominate, such as solar panel construction.

Climate policies are not a panacea for the European and North American economies. Even on their own terms, where they promise carbon neutrality by 2050, these policies are a bet on an imagined future, and presume technological innovation that hasn’t yet happened.

Such optimism might reasonably be considered an environmental necessity. But this gargantuan hope should not be used to ignore what the recent past has already made obvious: a recovery focused on a major shift to renewables and electrification will bring more geopolitical disruption. Nor can that shift to green energy stabilise monetary conditions, which are leading us into a great political unknown.