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How long a shutdown can governments afford?

If a return to work is organised after the three-month stage, there will be some rebound, but economies will not spring back into full output immediately.

Handwritten notice paper that reads "Sorry We're Closed" hangs on the door handle with used medical mask.

John Redwood

in Features


The Central Banks have responded quickly and with great force to the crisis. Led by the Fed they have produced huge amounts of cash to keep markets afloat, rescuing the government bond trades from illiquidity and fear and helping inspire a rally elsewhere. The governments have now appeared with substantial fiscal packages, recognising that only they can give money to people and companies to make up some of their losses as they stay at home, unable to work. The two are operating together, as well they must. Central Banks pledge to keep interest rates low, and governments promise to borrow eye-watering amounts to keep damaged economies turning over.

Let us look at some rough large numbers. US GDP was around $22 trillion, the Euro area around $14 trillion and Japan $5 trillion as the crisis hit. That’s a total of over $40 trillion for the three largest advanced economies. There is a lockdown preventing most work in hospitality, shop retail, entertainments. Areas like new homes and new cars have traded little, many planes have been grounded and much of non-essential manufacturing has been on leave. For a period of three months, the output of the economies as a whole may well fall by as much as a quarter prior to special government offsets of income, assuming lockdown and no work for several sectors, with much-reduced demand for many others. If a return to work is organised after the three-month stage there will be some rebound, but economies will not spring back into full output immediately even on an optimistic assumption about the course of the pandemic. Maybe for the following six months of progressive relaxation and recovery, there will be a 10% shortfall on pre-virus levels.  If we cautiously estimate an overall annual loss of 10% of output, that is some $4 trillion of missing income from a combination of larger loss during lockdown and tapering losses during recovery. Shorter periods of lockdown and faster relaxations would, of course, cut these losses.

Governments rightly conclude that such a big deflationary hit is unacceptable, and assume responsibilities to give people some income where they are no longer allowed to earn their own living. Several governments have favoured schemes to pay part of the wages to try to keep people in employment, ready for the recovery. Many have nonetheless been made redundant already as companies desperately seek to conserve cash. The sums involved will be large. The US has pledged $2trillion with more to come. Japan has offered $1 trillion. In the Euro area, sums are smaller, with some problems for individual countries under Euro debt rules, but there will be fiscal expansion with some relaxation of the controls. Whatever they offer will help offset the decline.

Another $2 trillion on US debt levels means a 9% increase in state debt, taking it well above 100% of GDP. In practice, the borrowings will likely be larger, as the downturn will undermine tax revenues and boost public spending on top of the announced special measures spending. In Japan, there could be a boost of more than 10% in state debt, already very high as a percentage of GDP.  So far this has not unduly worried markets as the Bank of Japan keeps buying up large amounts of it and keeps rates around zero. The European Central Bank has proposed an additional Euro 750 billion of Quantitative Easing which may turn out to be less than the amount of fiscal relaxation they end up creating through various national decisions.

In the short term, these large sums of additional borrowing should be acceptable. The fact that Central Banks are engaged means that indirectly if not directly they can create the money the governments need and then route it to them via the bond market. This only becomes unsustainable if inflation takes off, making it dangerous to continue with Quantitative Easing or other monetary relaxations, or if markets so lose confidence in the system that they force governments into buying up too large a proportion of the government bonds they do not already own through the Central Banks.  

In the short term, general inflation is not going to be a problem. Whilst the limited number of things people do want to buy to help live with the fight against the virus are under price pressure upwards, there are many goods and services which are banned or impractical for current circumstances where prices have just got a lot weaker. Everything from rents to air tickets and from new cars to entertainments outside the home will have weak prices in the early stages of recovery before demand and confidence builds up. The related collapse of the oil price, spurred by a price war amongst major producers at the same time, helps reduce inflationary tendencies.  It would take enormous price rises in hand gel, basic foods and medicines to offset the general price weaknesses we may see. The prices of the basics are also likely to be under considerable scrutiny during the crisis and if necessary in some places controls will be used.  

In the longer-term inflation could be an issue if Banks do not rein in excess money in good time, and if capacity has been impaired in too many markets. At the moment that would be a good problem to have, as we ask have governments done enough to offset the big hit to activity. Government borrowing is going to surge, but for the time being that is a necessary partial offset to economies in lockdown. Talk of tax rises to come to pay for the crisis is the last thing economies and people will need when they are allowed to go back to work, seeking jobs or trying to rebuild pay levels and bonuses with employers who have just lost a lot of money. The hope is the shutdowns end after not too long a period, and everyone just accepts more state debt was the cost of fighting the virus.

Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.

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