What’s happening this week in economics? Deloitte’s team of economists examines news and trends from around the world.
In its latest Financial Stability Review, the European Central Bank (ECB) expressed concern about the state of member-country finances. It noted that, in aggregate, the member countries of the Eurozone will see sovereign debt rise from 86% of GDP in 2019 to over 100% in 2020, with debt reaching especially high levels in Italy and Greece. This stems from running very large budget deficits this year, mostly in the range of 6–8% of GDP. It also stems from a very sharp decline in real GDP as economies struggle in response to lockdowns. Moreover, the ECB noted that several member states face large debt refinancing requirements in the coming year. Naturally, the debt-to-GDP ratio will decline once economies start to grow. Still, early indications suggest a slow return to normal. This comes, in part, from the propensity of European consumers to save an unusually large share of their income. In fact, the European Commission estimates that the household savings rate will rise from 12.8% in 2019 to 19% this year. That, in turn, reduces the scope for consumer spending growth even as governments ease restrictions on consumer-facing businesses. Saving has risen due to reduced opportunities to spend, declining asset values, fear about social interaction, and fear about the future. Something similar has happened in the United States as well (more on this in the next story), limiting the scope for recovery.
Meanwhile, the ECB worries that the sharp rise in sovereign debt might be unsustainable. It said that the “increase in public debt levels could also trigger a reassessment of sovereign risk by market participants and reignite pressures on more vulnerable sovereigns.” It acknowledged that the fiscal impulses under way will be helpful in mitigating the negative consequences of lockdowns. Yet it warned that “a more prolonged and severe economic downturn could give rise to debt sustainability risks in the medium term.” It said that “such a development could reactivate the negative feedback loops of the sovereign-bank nexus, especially for Italy and Portugal, as well as for Spain, where bank ratings are closest to non-investment grade.” The ECB warning comes even though the bank itself is engaged in massive purchases of memberstate sovereign debt. It also comes despite the possibility that the EU will soon borrow money to provide grants to member states. Evidently, the ECB worries that, even with large central bank purchases of debt, governments will struggle to service these debts, possibly leading to a seizing up of financial markets. One could say that this argues for greater financial and fiscal integration of the Eurozone. Conversely, one could say that this argues for member states to gain control of their own currencies, thereby enabling them to inflate their way out of a debt problem. In any event, it suggests that the Eurozone is balancing on a knife’s edge in which it must move in one direction or the other, but not retain the status quo.
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Meanwhile, amidst concern about the sovereign debt of European Union (EU) members, the EU itself is moving toward fiscal integration. Two weeks ago, Germany and France agreed on a plan for the EU to borrow EUR500 billion in capital markets and distribute the money as grants to member countries. The aim was to support troubled countries in their fight against COVID-19, by servicing the incremental debt through the membership fees paid by member countries. The plan was welcomed by southern European countries, but was viewed with suspicion by countries in the north that preferred to distribute the money as loans.
Then last week, European Commission President Ursula von der Leyen proposed to go even further than the Franco-German plan. She wants the EU to borrow EUR750 billion to assist member countries in dealing with the crisis. In addition, she vetted the idea of having the EU impose its own taxes in order to service the debts. Specifically, the EU anticipates generating funds from tapping into the carbon trading system and possibly taxing other areas of environmental degradation. In addition, there is talk about taxing large companies and tech companies. Either way, the good news is that the EU will likely be able to borrow at negative interest rates, thus assuring that it will pay back less than it receives. While the ultimate impact of this extra expenditure is difficult to measure, it is clear that if it goes forward—although that remains uncertain—this scheme will represent a significant shift in the architecture of the EU. It will be a kind of fiscal integration, making the EU more like a United States of Europe. It will surely be a source of controversy. Europhile voters will likely be pleased to see this happen, but there could be a populist backlash, especially if voters feel that they are being taxed without adequate democratic processes. Moreover, northern European voters might be averse to transferring fiscal resources to the south. The sense of nationhood that allows this to happen in the United States on a large scale will not necessarily be present in Europe.
Something very unusual and interesting happened in April in the United States. Personal income grew at the fastest pace on record, while consumer spending fell at the fastest pace on record. Evidently, the massive outlays by the Federal government led to a surge in personal income, but that money was mostly saved rather than spent. Thus, government borrowing was used to fund an increase in consumer wealth. As such, the government programs did not stimulate economic activity. Rather, they provided households with a financial cushion—which was precisely what was meant to happen. Here are some details.
Although wage income fell 8.0% from March to April, total personal income increased 10.5%. The difference was due to a massive transfer of funds from the government to households in the form of one-off transfers as well as enhanced unemployment insurance. Specifically, while wages fell at an annual rate of US$740 billion, government assistance to households increased at an annual rate of US$3 trillion. After taking account of declining tax revenue, disposable personal income was up at a rate of roughly US$2 trillion. However, consumer spending fell 13.6% from March to April, or at an annual rate of about US$2 trillion. Thus, personal savings increased at a rate of about US$4 trillion. In fact, the personal savings rate (the share of disposable income not spent) rose from 8.2% in February, to 13.7% in March, to 33.0% in April. Americans saved a third of their income in April.
Why did people save so much? There are several explanations. First, with much of the economy in lockdown, there were few spending opportunities. Second, people were averse to engaging in activities that required interaction with other people, such as visiting restaurants or flying on airplanes. Third, many people lost jobs and were uncertain as to when jobs would return. Hence, they hoarded cash. Finally, even people with jobs likely reduced spending in anticipation of possible trouble. While the decision to save was sensible for each household, the net effect was to severely dampen economic activity. Consumer spending is, by far, the largest component of GDP, and a dramatic weakening of spending augurs for a sharp drop in GDP. Indeed, our own Deloitte forecast is for a substantial decline in GDP in the second quarter. The latest report on consumer spending confirms that view.
How did people spend their money? The data shows that, after adjusting for inflation, real consumer spending fell 13.2% despite a 13.4% increase in real disposable income. The decline in spending included a 16.7% drop in durable goods, a 15.5% drop in non-durable goods, and a 12.0% drop in services. Thus, spending declined across the board. Early high-frequency data suggests that spending began to recover in May, albeit modestly. However, there are reports that spending on automobiles increased substantially in May. Still, such spending remained 25% below the pre-crisis level.
Michael Wolf, global economist at Deloitte, provides an update on Japan’s economy.
Japan’s recession may be deeper than analysts had anticipated. Both retail sales and industrial production fell more than expected in April. Industrial production dropped 9.1%, with some of the largest losses in autos and steel. Meanwhile, retail sales were down 9.6% over the month as consumers held back spending on general merchandise, apparel, and motor vehicles. Weakness likely persisted in May as well. The government placed the country in a state of emergency and the last of the prefectures, which includes Tokyo, were only given the green light to reopen on May 25. Manufacturers expect their output to fall another 4.1% in May. In addition, weekly retail sales data show that spending on discretionary items remained weak during the first three weeks of May. Economic contraction during a state of emergency was to be expected, even if the losses are a bit larger than previously expected.
Given the unprecedented amount of fiscal stimulus and the 2.6% unemployment rate in April, it is tempting to assume the economy will bounce back quickly this summer. Unfortunately, that is unlikely to be the case. The relatively low unemployment rate does not include the 4.2 million people on furlough. If all those workers were counted as unemployed instead, the unemployment rate would easily jump into double digits, which better highlights the extent of the pain workers are experiencing. In addition, the new stimulus package, which amounts to US$1.1 trillion, comes mostly in the form of loans that are meant as a lifeline to prevent bankruptcies from surging while the virus continues to limit economic output from reaching its potential. Those loans are necessary to prevent more economic damage, but they will do little to bolster demand. Plus, mobility data suggest Japan’s consumers are still cautious despite the easing of lockdown restrictions and very low rates of COVID-19 infection. We still expect Japan’s economy to begin recovering this summer, but the pace of recovery will likely be modest.
Craig Alexander, Chief Economist of Deloitte Canada, offers some thoughts on what the COVID-19 crisis could mean for productivity trends.
One of my key concerns about the post-lockdown economic recovery is the potential slowdown (or outright decline) in labor productivity. There is some evidence that, on average, workers tend to be less productive when working remotely than when physically in the office. And, since remote work is likely to remain a significant part of doing business until a vaccine is fully deployed, aggregate productivity is likely to suffer. This could be further exacerbated by physical distancing rules in retail, finance, transport, and other service-producing sectors. The new restrictions will likely increase costs and require investment in potentially non-productive capital (barriers, scanners, etc.) when maintaining an office, operating a store, or producing in a factory. In the absence of productivity gains, the rising operating cost are expected to put downward pressure on wages or upward pressure on prices and make a slow recovery scenario much more likely.
However, this somber short-to-medium term view masks the possibility of some very large long-term productivity gains, if the opportunities are realized. To illustrate this, let us consider the main macroeconomic and geopolitical trends from three distinct perspectives.
First, the global economy prior to COVID-19 was undergoing structural changes that are still affecting businesses. This includes issues such as the aging of the labor force, the rising importance of immigration to economic growth, and policies aimed at addressing climate change.
Second, some of the existing trends have been accelerated by COVID-19. The pandemic has greatly accelerated the shift toward digital adoption and consumption, and is likely to rapidly speed up the deployment of artificial intelligence (AI) and use of Big Data. The future of work is also being transformed by accelerated automation and the shift to remote work, which is likely to linger even after the economy is reopened.
Third, the pandemic has also created new trends that did not exist before, including changes in consumer behavior around health and trust.
These transformative forces are likely to lead to many business failures during the current recession and its aftermath. Closures related solely to the new disruption from the pandemic are a particular economic loss. However, many firms that fail will be those that were already being disrupted by the first two factors. For example, we are seeing firms that invested in digital prior to COVID-19 thriving, and businesses that underinvested in the shift to digital falter. With this perspective, one could argue that the process we are seeing is an acceleration of the creative destruction that is an inherent part of economic evolution—a cornerstone of economic theory since the 1950s.
We can lament the loss of businesses, but we should also be mindful that the closures will enable the opportunity to create new firms during the recovery and subsequent expansion. Indeed, I believe policymakers should establish incentives and create an environment to encourage startups, something that would greatly help the job recovery. And these new firms will be positioned to thrive in the new post-COVID environment that will be more digital, more automated, more informed by AI, and employ more flexible workers. This would make the economy more flexible, productive, and competitive.
There is also the possibility that many of the small businesses that are lost are lifestyle businesses. These are businesses where the owner’s ambition is to provide a good quality of life for their family instead of looking to grow and scale significantly. In the post-COVID world, we could have stronger, more competitive businesses if new startups are more oriented to growth and scaling.