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It is one of the sad ironies of economics that productivity improvements can massively improve living standards in the long run, but in the short run can cause significant pain. Consider the industrial revolution, more than 200 years ago. The massive increase in output per worker that took place early in the 19th century because of new technologies eventually created a level of well-being later in the century that would have astonished people prior to the revolution. Yet when the revolution was under way, the displacement of workers led to declining incomes, unemployment, inequality, and miserable working conditions. Would the world have been better off without the industrial revolution? Probably not. Because of that revolution, an ordinary worker today often enjoys a standard of living better than a mid-19th century monarch.
This brings us to the COVID-19 crisis and the potential impact on our economy. This crisis will likely cause an acceleration of trends that will significantly increase productivity, potentially allowing our children and grandchildren to enjoy living standards we can only imagine—and perhaps wiping out poverty and inequality. Yet in the short and medium run, this process will be enormously disruptive and will exacerbate some of the worst problems in our society. Why is that?
Just prior to the current crisis, unemployment was low in most advanced economies. Working-age populations were starting to decline. New technologies offered the promise that we could produce more with less labor, enhancing living standards without too much displacement of workers. Then came COVID-19. The need for social distancing led us to work, shop, and be entertained remotely using technology. It allowed many of us to produce more with fewer inputs. It also led to the demise of countless small and relatively low-productivity businesses, with their market share likely to be captured by larger more productive enterprises. In part, these changes are likely to persist beyond the virus—with both positive and negative consequences.
Consider working from home. Prior to the crisis, the average American spent 225 hours per year traveling to and from work. Millions traveled by air frequently, including most of us, to attend meetings. The shift to remote work means that tasks can be accomplished with fewer resources and time expended. This is a productivity improvement and implies producing the same or greater output at much lower cost, which is potentially beneficial to everyone. Yet society will still pay a price. Less demand for office space, air travel, hotels, restaurants, and public transportation will mean that countless low-wage workers will be displaced. Existing real estate will lose value, companies will fail, asset holders will lose wealth, and social problems could explode.
Meanwhile, COVID-19 will likely cause many companies to accelerate efforts to automate processes, if only because it will enable greater social distancing. With the demise of 73,000 small businesses in the United States since March, large enterprises will take market share and will have the resources to make these large investments. Again, this will mean significant productivity gains. But it might also mean a reduction in entrepreneurial opportunities for small business owners, often a vehicle for immigrant populations to escape poverty.
In the past, the demise of low-productivity jobs was eventually accompanied by the creation of new jobs in industries that no one had anticipated. When the automobile displaced workers that were responsible for tending to horses, new jobs were created in motels, fast-food restaurants, highway construction, and automotive insurance—all industries that came about because of the automobile. Today, the shift toward a digital world, intensified and accelerated by COVID-19, is expected to displace many low‑productivity workers once again. Yet new jobs will emerge as new technologies create opportunities no one has yet anticipated. What we can reasonably anticipate, however, is that the jobs of the future will require skills that many of today’s displaced workers lack. Unless the skills imbalance is addressed, it is possible that a generation of workers and their families will suffer hardship even as technologies ultimately lead to massive gains in living standards. On the positive side, the shift to a more online world will likely have positive consequences for the physical environment, helping to reduce pollution and carbon emissions.
Finally, there are two important caveats to the view that productivity growth is likely to accelerate. First, it is possible that this crisis will fuel “deglobalization.” We have already seen a sharp drop in trade and, even before the crisis, there were significant threats to the global trading system. Just last week US President Trump suggested that “we don’t have to” do business with China, adding that “we get nothing from China” except “some goods that we could produce ourselves.” This view now permeates much of US politics and bodes poorly for the kind of globalization that has, in the past, played a key role in fueling productivity gains.
Second, it is possible that the intensification of remote work will stymie productivity growth. An argument can be made that people need to directly interact in order to generate new ideas. The comedian Jerry Seinfeld wrote, “You ever wonder why Silicon Valley even exists? I have always wondered, why do these people all live and work in that location? They have all this insane technology; why don’t they all just spread out wherever they want to be and connect with their devices? Because it doesn’t work, that’s why. Real, live, inspiring human energy exists when we coagulate together in crazy places like New York City.” He has a point. If we all decamp to our remote homes and never actually get together, our creativity might wilt.
For many years, the stated policy of the US Federal Reserve has been to target inflation at 2.0%. It was often stated that the target was meant to be an average and not a ceiling. Yet investors have generally seen the 2.0% rate as a ceiling and have expected the Fed to act accordingly. Moreover, in recent years, inflation has barely budged above 2.0% and core inflation (which excludes the impact of volatile energy and food prices) has mostly remained below 2.0%.
Last week, however, the Fed announced a new policy, or at least a clarification of the old policy. At this time of year, the Federal Reserve Bank of Kansas City usually hosts a big shindig in Jackson Hole, Wyoming, where leading central bankers and economists from around the world converge near the Grand Teton mountains to discuss big issues. This year, the event is taking place virtually. As usual, the most eagerly awaited event is the speech by the Chairman of the Fed, who often provides some new insight into the direction of Fed policy. Chairman Jay Powell did not disappoint. He said that, from now on, the Fed will see the 2.0% rate as intended to be an average inflation rate over time. Thus, the Fed expects to periodically see inflation rise above 2.0% for an extended period of time. In addition, Powell said that the Fed will adjust its view of the labor market. Under US law, the Fed is mandated to target both inflation and unemployment. Powell said, “Going forward, employment can run at or above real-time estimates of its maximum level without causing concern, unless accompanied by signs of unwanted increases in inflation or the emergence of other risks that could impede the attainment of our goals.” In other words, the Fed will base policy on “shortfalls of employment from its maximum level” rather than “deviations from its maximum level.” This nuanced shift means that the Fed will not easily move toward fighting inflation simply because the job market tightens. Traditionally, it was assumed that Fed policy was largely driven by a recognition of the trade-off between inflation and unemployment. Now the Fed is saying that it will likely be biased toward reducing unemployment and less focused on suppressing inflation. As Powell put it, the policy “reflects our view that a robust job market can be sustained without causing an outbreak of inflation.”
The implication of Powell’s speech is that policy interest rates are likely to remain low for a prolonged period of time. Investors reacted by modestly boosting equity prices and bond yields and pushing up the value of the US dollar. The rise in equities reflects an expectation that interest rates will remain low for longer. The rise in bond yields likely reflects an expectation that long-term inflation will be higher than previously expected. In fact, market expectations of long-term inflation are now up to the highest level since January. The rise in the value of the dollar reflects expectations of higher bond yields and faster economic growth.
Although Powell’s remarks were newsworthy and drove markets, they will not likely lead to a change in policy anytime soon. That is because inflation remains low and is likely to remain low for a while, especially so long as the economy is disrupted by the virus. Unemployment is historically high, a factor that will suppress wages and inflation. Moreover, despite a massive increase in the money supply due to Fed asset purchases, the private sector continues to hoard cash, meaning that the increased money supply is not leading to excess demand. If and when this changes, there could be an inflationary surge in demand. At that point, the Fed’s new policy will kick in and inflation might run higher than previously anticipated. Yet at that point, the Fed’s evident goal will be to boost employment. In the past, recessions have sometimes come about due to the Fed tightening monetary policy too soon or too severely. Today’s announcement suggests that the Fed is keen to avoid that error in the future.
Finally, the importance of this announcement is largely in the impact it has on investor expectations. As stated above, policy won’t soon change. But a change in investor view about future Fed behavior could have an impact on asset prices. That, in turn, could influence the path of inflation and the path of consumer and business spending.
Michael Wolf, a global economist with Deloitte, analyzes the latest high frequency data on the European economy.
Europe has seen a resurgence in infection rates in recent weeks. The worst of it has been in Spain, which averaged 143 new daily confirmed COVID-19 cases per million people the week through August 23, about the same number as the United States. In France, the number was 49, though infections have grown sharply in recent weeks. The United Kingdom, Germany, and Italy all had just 15 or less per million; however even those low numbers are higher than what was seen earlier in the summer. Rising infection rates raise concerns over the sustainability of economic growth in the region. So far, high-frequency data suggests more of a pause in the recovery than an outright decline, but economic conditions could deteriorate should contagion worsen.
The most straightforward example of the pause in recovery is the euro area Purchasing Managers’ Index for service sectors, which slipped from 54.7 in July to just 50.1 in August. A reading barely above 50 indicates that economic activity is still rising—but just barely. Mobility data shows a similar trend. The largest four economies in continental Europe (i.e., France, Germany, Italy, and Spain) have all seen mobility near retail and recreation establishments stagnate. In Spain, mobility remains far lower relative to its baseline compared with the other three countries. By contrast, UK mobility near retail has continued to rise unabated, though it was still nearly 20% below its baseline as of August 21, slightly worse than Spain.
Although Spain and France have the highest rates of infection, they have the best box office sales when compared to their January averages. In Germany, Italy, and the United Kingdom, average weekly box office sales were down at least 95% between January and the first two weeks of August. Meanwhile, box office sales in France were down just 75%, while in Spain sales were down 81% over the same time period.
This doesn’t mean service sector spending was completely absent in other countries. The numbers for restaurants were more promising. Seated diners were up more than 20% from a year earlier in Germany this week. In the United Kingdom, diners were up nearly 70% on Monday thanks to a scheme to increase restaurant spending in the early part of the week.
Tourism-related spending, on which Spain and Italy depend heavily, remains far below what would normally be expected at this time of year. The number of July hotel stays in Spain was down 73% from last year, and hotel occupancy was about half of what it normally is in July. Italy’s tourism picture is similar, with 5-star hotel stays down almost 80%. Air travel across Europe improved since April, and at the beginning of August traffic was down just 50% relative to a year earlier. However, air traffic has since posted a small decline, adding to worries that the European recovery is slowing.
Fiscal stimulus has supported household consumption, but weak labor markets are likely contributing to the low level of consumer confidence. Germany arguably has the strongest labor market, but the number of job postings on August 7 was still about 15% lower than the number seen February 1. In France, postings were nearly 25% lower, and in the UK they were down more than 50%. The number of job postings in Germany and the United Kingdom has only inched higher in recent weeks, while in France postings have moved sideways. Government support for furlough schemes in Spain and the United Kingdom is set to expire this fall, which clouds the outlook for employment and consumption in those countries.
Although largely limited to Spain and France, a second wave of infections is already hampering economic activity in Europe. More widespread contagion threatens to worsen the outlook and reverse early progress in some of the hardest hit service sectors.
Since the pandemic began, there has been a very large increase in the unemployment rate in the United States, but not in Europe. Looking at the data from Europe, one would be forgiven for thinking that there is no economic problem. But that is not the case. Rather, governments across Europe have engaged in so-called “furlough schemes,” which have involved massive government subsidies to companies that retain workers on their payrolls. These people are effectively unemployed, but not counted as such. Across Europe, such programs are set to expire soon, creating a risk that the unemployment rate will soar and personal income will plummet.
Moreover, there is now a concern that unemployment will increase not only because of the expiration of furlough programs, but also because companies in key industries will be compelled to restructure in ways that lead to the dismissal of workers. In such industries as airlines, hotels, retailing, and aerospace, companies are planning to significantly downsize. They are recognizing that this crisis is likely to last much longer than previously anticipated. As such, they are not planning for a quick return to normal. Many are likely expecting a permanent shift in consumer and business behavior. For example, more online conference calls will mean less business travel, thereby reduced overall demand for travel and hospitality services. Meanwhile, there has been a resurgence of the virus in some parts of the Europe, especially Spain, raising questions about the ability to businesses to return to normal.
A sharp increase in unemployment in the months ahead will hurt the economic recovery and could create conditions for a more traditional recession. More business failures, bankruptcies, and restructurings could have a negative impact on credit market conditions. The European Central Bank and the Bank of England might be required to further ease monetary policy and inject more liquidity into financial markets. Governments, already stretched, will debate whether to engage in further stimulus, fearful that excessive levels of debt will be difficult to service in the future. The European Union, which has already earmarked 750 billion euros to assist member states, might debate whether to do more. The development of a successful vaccine, however, would surely be a game changer and enable a return to economic normalcy.
The topic of equity prices is clearly on the minds of many business leaders. The most common question I get when discussing the economy with clients concerns how to explain the surprising behavior of equity prices. Yet is equity price behavior really so notable? In the United States, the benchmark S&P500 is up 54% since bottoming in March, but it is roughly where it was prior to the crisis. One could argue that the massive decline in prices early in the crisis reflected concern that the economy was severely contracting, leading to a sharp decline in profitability. Then, once it became clear that there was a path to recovery, investors bet on a return to normalcy. So, is this a bull market or simply the end of a detour? Moreover, is the market behaving rationally? After all, the forward-looking price-to-earnings ratio for the market is now at the highest level since the tech boom early in this century. Either investors correctly expect a surge in profits or this is a bubble. Or, investors are discounting expected future profits using an unusually low discount factor, a reflection of historically low interest rates.
Additionally, which factors are likely contributing to the rise in equity prices? An important factor is central bank policy. The massive Federal Reserve purchases of assets have led to a surge in US money supply. Similarly, the European Central Bank’s policy has led to a surge in Eurozone money supply. With borrowing costs at an historic low and money not being spent on goods and services, investors are seeking better returns. The equity market is an attractive alternative to interest-bearing assets. In addition, investors are evidently confident about the recovery of the economy. Various surveys have found that investors expect profits to continue increasing as the economic recovery fully takes hold. This, in turn, is expected to boost equity prices. Finally, equity prices have been fueled, in part, by strong demand for technology stocks. While the S&P 500 was up roughly 17% in August 2020 versus a year earlier, information technology shares were up 47%. The pandemic has led to more activities taking place remotely from home, including working, shopping, and entertainment. This trend has been highly beneficial to the equity prices of a variety of highly capitalized technology companies.
The surge in equity prices, however, has made some investors nervous. Indeed, Norway’s sovereign wealth fund, the world’s largest, has expressed concern about a perceived disconnect between equity prices and economic fundamentals. A leader of the bank that manages Norway’s fund said, “We’ve seen an unexpectedly sharp recovery in the financial markets but maybe we haven’t seen the full effect on the real economy.” He said that he was concerned about the fact that the pandemic is not yet under control, thereby boding poorly for a robust recovery. This raises the question: What potentially negative factors might investors be ignoring?
First, investors appear to be relatively confident that a vaccine will soon emerge, setting the stage for a more robust recovery. But this might not happen. Perhaps investors have not adequately discounted the risk of vaccine failure?
Second, without a vaccine, economic success depends on suppression of the virus, which has largely happened in Europe and East Asia, but not in the United States. Are investors assuming that the United States will get the virus under control? And, if so, is that a reasonable expectation given the lack of a cohesive national policy on lockdowns, testing, and tracing? There is a strong case to be made that the United States faces economic weakness owing to lack of virus suppression and failure of the Congress to extend stimulus.
Third, the increasingly fraught relationship between the United States and China could have negative economic consequences. After all, both the world’s two largest economies benefit from interaction. A reduction in such interaction will likely mean less trade, less cross-border investment, less sharing of ideas, higher costs, and ultimately slower economic growth.
The bottom line is that equities have been a terrific investment during the last few months. Yet past performance is no guarantee of future success. There are substantial risks and it is possible that the market is exhibiting the characteristics of a bubble, with investors willfully blind to serious risks.
A prolonged period of almost no international business travel will not only hurt airlines and hotels, but will also stymie global economic growth by limiting the transfer of knowledge. So says Ricardo Hausmann, a noted economist at Harvard University and former chief economist of the Inter-American Development Bank. According to Hausmann, business travel was about 1.7% of global GDP before the crisis and had been growing three times faster than GDP prior to the crisis. Many people now argue that, because of online conferencing software, we’ve learned that we needn’t travel as much as before. However, the reality is that similar technologies existed before the crisis. Yet we travelled anyway. Were we unaware of the benefits of technology? Were we simply enjoying the perks of travel? The answer is no. There were good economic reasons for travel, as Hausmann has empirically demonstrated. Specifically, he and a group of researchers found a strong correlation between international business travel and productivity, employment, and exports in the recipient country over the subsequent three years. The idea is that, when people travel overseas on business, they cause a diffusion of knowledge that contributes to better economic outcomes. It is not sufficient to talk on Zoom. In-person consultation and observation are far more impactful. As Hausmann pointed out, “To run a firm, you need not only information, but also the capacity to figure things out. You need knowhow. One of the advantages of multinational corporations and global consulting, accounting, and law firms is that they can move that capacity to different points in their network.”
Hausmann and team found that the countries that have been the biggest beneficiaries of “inflows of knowhow” through business travel are Austria, Ireland, Switzerland, Denmark, Belgium, Hong Kong, and Singapore. In addition, they found that the countries that “share their knowledge most profusely” are Germany, Canada, the United States, the United Kingdom, South Korea, France, and Japan. They found that emerging countries have played only a secondary role in this process. Perhaps the most stunning result of their research is their estimate that, even though business travel accounts for 1.7% of global GDP, a complete and sustained shutdown of global business travel would likely cut global GDP by 17%. To me, this makes sense. If one considers the role that migration and cross-border investment have played in economic history, it should not be surprising that an absence of travel would ultimately have a severe negative impact on the transfer of knowledge. Such transfers influence innovation, productivity, and growth. And, according to Hausmann, online conference calls cannot fully compensate for the absence of travel. Meanwhile, I look forward to eventually getting back on the road, both to diffuse knowledge and to enjoy the perks.
With supply chains having been disrupted by the virus and other factors, it is useful to consider the future of supply chains. Mike Wolf, an economist with Deloitte Touché Tohmatsu Limited, takes a look at some of the key issues facing global business:
Recent events have caused large disruptions to the flow of goods that are forcing businesses and policymakers to rethink how supply chains function today. Although past disruptions may not be the best gauge of future ones, they provide some clues as to how businesses and policymakers may alter supply chains. In addition, businesses will have to choose the best risk-mitigation strategies within the confines of the macroeconomic and regulatory environment.
One of the more persistent disruptions to supply chains is natural disasters, which are increasing in frequency due to climate change. In addition, the United States and China are competing for hegemony, which is raising tariffs, restricting foreign investment, and decoupling technology between the world’s largest economies. Natural disasters and geopolitical risks could lead to even more regionalized supply chains. Producers may want to move closer to their customers to mitigate the risk of supplies getting caught in severe weather events. Plus, a decoupling of the US and China could create divergent technology systems with parts for Chinese technology largely sourced from Asia and parts for US and European technology increasingly sourced from the Americas and Europe.
The pandemic is of course another major disruption to supply chains. Efforts to limit the spread of COVID-19 have forced factory closures around the world, and governments have hoarded goods through export controls. Worries over national security in the event of another global supply disruption could cause policymakers to require a larger share of goods to be produced and consumed within countries. Medical equipment, food products, and technology are some of the most likely candidates. Reshoring production to rich countries would come with higher labor costs, which should encourage more investment and innovation. As companies innovate, production costs would fall and high-income countries’ manufacturers would become more competitive globally. Global trade would initially fall as reshoring efforts begin but would rise again as the United States and Europe become larger exporters even to middle- and low-income countries.
It is also important to note that a drastic change in supply chains is not inevitable. Recent disruptions could be viewed as extraordinary events that are unlikely to occur again as the pandemic ends, US-China tensions ease, and post-Brexit life becomes the norm. Although tensions between the United States and China are unlikely to disappear altogether, risk mitigation efforts could be limited to incrementally adding redundancy to the supply chain, which would slowly shift some production away from China and toward mostly low-cost countries within Asia.
How businesses ultimately choose to reorganize their supply chains and mitigate risks will largely depend on sector- and company-specific factors. However, macroeconomic forces and regulations will put bounds around the various options businesses face. The first of those bounds is capacity constraints, which will slow the speed of supply chain adjustments. Southeast Asian countries such as Vietnam have been popular among firms looking to diversify away from China. However, as the world’s largest manufacturer, China adds about US$2 trillion of value to its exports every year. Relocating just 13% of that production value from China to Vietnam would require Vietnam to double its annual output. Shifting a sizable portion of China’s export production outside of the country is possible, but it will take time for other countries to build up the infrastructure and capacity to absorb it.
Labor considerations will be a key determinant for where a company chooses to relocate production. Low labor costs will continue to attract suppliers to developing countries, such as Vietnam and Mexico, where wages are even lower than they are in China. However, finding workers with the requisite skills is also critically important. Research shows that increases in the share of skilled labor in a country leads to higher participation in global value chains. However, some companies and industry associations have successfully provided their own training to overcome skills deficits in low labor-cost countries.
Just as labor endowments are a draw for producers, resource endowments also play a part. Unfortunately, many resource endowments, such as commodities, are inflexible. For example, producers of lithium ion batteries will struggle to diversify their supply chains away from the Democratic Republic of Congo, which produces about 60% of the world’s cobalt, a critical component in these batteries.
Regulatory issues will also affect how supply chains are reworked. Moving some production to a new country may change the status of the final good’s compliance with free trade agreements. For example, rules of origin require a certain percentage of a good’s components to have been sourced from within the region. Moving one part of production to a new region could therefore encourage other parts of the supply chain to move to the same region to take advantage of the lower trade costs when becoming compliant with the rules of origin. Other regulatory burdens and the general ease of doing business in a new country may add more challenges. For example, Indonesia, the Philippines, and Thailand all have more restrictive foreign direct investment regulations than China.
As companies look to create more resilient supply chains in the face of rising risks of disruption, they will need to consider capacity constraints, labor costs, skill attainment, trade agreements, and the ease of doing business in other parts of the world. How companies navigate these as well as their own sector- and company-specific issues will determine how global supply chains eventually develop.
In the second quarter, Japan’s real GDP fell 7.8% from the previous quarter or at an annualized rate of 27.8%, the biggest decline since records began in 1955. Japan was the last major economy to report second quarter GDP. With the exception of China, which saw a major decline in the first quarter instead, every other major economy also suffered a sharp decline in the second quarter—with many reporting much worse decline than Japan’s. What distinguishes Japan is that, unlike the other economies, it did not have a major outbreak of the virus. Still, economic activity declined sharply in April and May due to a government-ordered state of emergency. Moreover, the Japanese economy was already facing headwinds prior to the crisis owing to the trade dispute between the United States and China. Japan’s manufacturers play a major role in supply chains that feed into Chinese production of exportable final goods. In addition, Japanese consumer spending had been hit by the late-2019 increase in the national sales tax. This was the third consecutive quarterly decline in real GDP.
Although real GDP fell 7.8% from the first to the second quarter, the decline varied by category. Real consumer spending fell 8.2%, accounting for more than half of the decline in GDP, while business investment fell only 1.5%. The decline in consumer spending far exceeded the decline in employee compensation, indicating that Japanese consumers significantly boosted their saving. Exports of goods and services fell a catastrophic 18.5% while imports fell only 0.5%. The result was that the decline in net exports contributed 3.0 percentage points of the decline in real GDP. The decline in exports included the near collapse of the increasingly important Japanese tourist sector.
On the positive side, government investment increased 1.2% in the second quarter. Moreover, there are indications that, by June (the third month of the second quarter), things were starting to turn around. The government reported that, after falling sharply for three consecutive months, Japanese industrial production increased modestly in June, rising 1.9% from May but remaining 18.2% below a year earlier. The modest monthly increase was largely driven by a massive increase in automotive output, rising 28.6% from the previous month. Contributing to the rebound in economic activity is the fact that the state of emergency was lifted in May. Plus, China’s economy is bouncing back quickly, which should ultimately have a positive impact on Japan. In addition, Japan’s government has implemented stimulus measures that should have positive short- and long-term effects. Meanwhile, the virus situation is worsening. However, the government is not reverting to new lockdowns. Thus, the economic picture is relatively benign.
In 2020, the governments of the largest economies have increased spending by a volume not seen since the end of World War II. In the United States, for example, the budget deficit this year will be roughly 18% of GDP, a figure only ever surpassed on three occasions during the War in the early 1940s—and at that time, the government implemented wage and price controls to limit inflation. Meanwhile, central banks of the leading economies have engaged in massive asset purchases, boosting their balance sheets and helping to fund the large budget deficits. Money supply has grown at a rate not seen in decades. All of this sounds like a recipe for horrendous inflation. And yet the behavior of investors does not indicate any such concern. In fact, key indicators suggest that investors don’t expect any spike in inflation in the next decade. Are investors ignoring important information? Or is it possible that, after more than 40 years of low inflation, the developed world is about to see a new round of high inflation, fueled by a combination of monetary and fiscal policy that cannot be sustained? The answer is that there is a growing debate about this.
First, the facts. Money supply growth has accelerated sharply in both the United States and the Eurozone. This is different from what happened in 2008 ̶ 10 when, despite a huge increase in the balance sheets of central banks, money supply actually decelerated as banks became less willing to lend in the face of serious nonperforming assets. In this case, however, there is no systemic problem with banks. Thus, as central banks have massively purchased assets, this has led to a massive expansion of money supply. In the Eurozone, broad money supply is up around 9% from a year earlier, the fastest rate since just before the last financial crisis. In the United States, broad money is up more than 23% from a year earlier, the fastest pace on record. Also, during this crisis, government debt has grown sharply as government spending soared while tax revenue fell. With central banks buying government bonds, much of the incremental debt is being financed by monetary growth—normally a recipe for inflation.
The investor community, however, appears not to be concerned. The best measure of market expectations of inflation is the so-called breakeven rate. It is the difference between the yield on a government bond and the yield on a bond that is protected from inflation. In the United States, this is the Treasury inflation-protected security, also called the TIPS. The yield on TIPS is the real, or inflation-adjusted, yield. Thus, the gap between the two yields is the market’s expectation of inflation. The breakeven rates in the United States and Europe fell sharply at the start of the crisis and have since risen but remain below the pre-crisis level. In other words, investors today expect that inflation over the next decade will be lower than they had expected prior to the crisis. This suggests that many investors are not concerned about the mix of monetary and fiscal policy. That said, the price of gold has soared in recent months. In the past, gold has sometimes been driven by investor worries about inflation. It is often seen as a hedge against inflation. Thus, it seems some investors are worried about inflation and some are not. Meanwhile, although actual inflation in the United States and Europe remains low, it has accelerated somewhat lately.
What are the arguments for and against much higher inflation?
The late great economist Milton Friedman once wrote that inflation is always and everywhere a monetary phenomenon. With money supply increasing rapidly, Friedman’s view suggests that inflation is just around the corner. It means that there will soon be too many dollars or euros chasing too few goods. Of course, it also depends on the velocity of money (the number of times money gets exchanged), which has declined dramatically in the last year. Meanwhile, the massive shift in fiscal and monetary policy that we have seen lately is reminiscent of what transpired during the two world wars. After each war, there was a brief period of very high inflation in major economies. In Germany, after the first war, the inflation was catastrophic.
The main argument against the likelihood of much higher inflation is that the economy is likely to remain weak for a prolonged period of time. Activity is currently well below capacity and, even if there is a relatively robust growth path in the next few years, it will take at least until 2022 before economic activity returns to a pre-crisis trajectory. In the interim, there would not be a general inflationary impulse. Also, given that consumers are saving an unusually large share of income, and assuming that this will persist until a vaccine or treatment emerges, it is hard to see how there will be strong excess demand that could drive inflation. Instead, much of the extra money being created is being hoarded. Thus, inflation is likely to remain muted. Moreover, even when the economy returns to normal activity, the Federal Reserve has sufficient tools to reverse course and remove excess liquidity. Plus, the extra government borrowing would quickly unwind as revenue rebounds and spending returns to normal levels.
Nonetheless, governments could choose to finance massive debts through inflationary monetary expansion. That is, high inflation would help to quickly reduce the debt-to-GDP ratio, thereby making it easier to finance the debt without having to resort to higher taxes or onerous cuts in expenditures. Of course, the central banks of the United States, United Kingdom, and the Eurozone are meant to be independent of political concerns, at least for now. Still, the longer the COVID-19 crisis goes on, and the longer governments feel compelled to engage in dramatic spending increases, the greater the likelihood that inflation will be more appealing to policymakers.
Finally, we have been through a prolonged period of very low inflation, which started in the early 1980s. This has led investors, consumers, workers, and businesses to expect low inflation. Moreover, expectations of inflation have a major impact on actual inflation. For example, if businesses expect low inflation, they will be less likely to raise prices, even in the face of strong demand. Consumers will be less willing to pay higher prices. Thus, a move to higher inflation would require a change in expectations, something that doesn’t happen easily. Recall that the high inflation of the 1970s was only ended after central bank policy managed to break people’s expectations of high inflation.
As predicted, the British economy contracted at a record pace in the second quarter, according to the government’s data released last week. From the first to the second quarter, real GDP fell 20.4%, or at an annualized rate of 59.9%. Real GDP in the second quarter was 21.7% below the year earlier level. Looking at it another way, real GDP fell to a level last seen in 2003. Not only was this the worst decline in British history, it was also the worst decline in Europe. By comparison, real GDP fell at an annualized rate of 55.8% in Spain, 41.0% in Italy, 44.8% in France, and 34.7% in Germany. The catastrophic decline in the United Kingdom was almost entirely due to what happened in the first month of the quarter, April. After that, activity began to rebound in May and June. In fact, the government estimates that real GDP increased 8.7% from May to June. This was attributable, in part, to the phased reopening of the economy that took place in the latter part of the quarter.
The British government reports GDP growth both from the supply side and the demand side. Regarding demand, while real GDP fell 20.4% in the second quarter, real household spending fell 23.1% and gross capital formation fell 25.5%. The latter includes business investment that fell 31.5%. The decline in household and business spending was partly offset by an increase in government purchases. In addition, imports fell far more quickly than exports, meaning that trade made a net positive contribution to GDP growth.
On the supply side, output of services fell 19.9%, disproportionately driven by the collapse of the food service and accommodation sector which fell 86.7%. Production output fell 16.9%, driven largely by a sharp decline in manufacturing. The latter included a 49.1% decline in production of transport equipment. Finally, output by the construction sector fell 35.0%.
Going forward, it is likely that third quarter growth will appear strong given the rapid rebound in many areas of economic activity. Still, it will take some time before the economy returns to a pre-crisis level. Part of the problem is fear of the virus. Even with the removal of restrictions, many consumers are wary of social interaction. The government is offering subsidies to get people to visit restaurants. Moreover, Chancellor of the Exchequer Rishi Sunak warned that there are likely to be job losses in the near future, even without a second wave of the virus, which itself remains a possibility. Plus, the government program to provide subsidies to employers that retain workers on the payroll is set to expire in October, potentially leading to a sharp rise in unemployment and a commensurate decline in personal income. The program currently supports roughly nine million people. The government says it is not likely to be extended. Thus, Britain is by no means out of the woods.
The efforts of the two major US parties to find common ground on a new fiscal stimulus have so far failed. The enhanced unemployment insurance benefits, loans for small businesses, and restrictions on evictions have all expired. Recently, President Trump took unilateral action meant to support the economy, saying that his actions will “take care of, pretty much, the entire situation.” However, presidential powers are limited and the actions he announced are likely to have only limited impact. To avoid a severe contractionary effect from the expiration of Congressionally mandated expenditures will still require new action by Congress. The danger now is that some people in Congress and the administration will see the latest announcement as sufficient to deal with the problem. It is not. Meanwhile, Treasury Secretary Mnuchin is urging all sides to return to the negotiating table. Here are the details.
Following the expiration of the US$600 per week Federal benefit for unemployed workers, the Congress debated what to do next. Democrats supported a continuation of the US$600 benefit while Republicans suggested US$200 per week. President Trump announced that he will take funds currently allocated for emergencies, such as hurricanes, floods, and earthquakes, and provide a US$400 per week payment to unemployed workers. There are two caveats, however. First, states will be required to contribute US$100 of the US$400 benefit, something that might not be feasible for most states given their fiscal troubles. New York Governor Cuomo has already said it is a nonstarter. Ohio Governor Mike DeWine, a Republican, said, “We’re looking at it right now to see whether we can do this.” Moreover, it could take quite some time for states to set up a new program to do this. Second, even if the benefits are paid, the funds the president is tapping will last for no more than five weeks.
The president also announced that the government will temporarily stop collecting payroll taxes from workers earning less than US$104,000 per year. He lacks the power to cut taxes, so this would simply be a deferral and the taxes would eventually have to be paid. If not, then it would represent a decline in the amount of funds available to the Social Security and Medicare trust funds. The deferred tax money would not mean a temporary tax cut for unemployed workers, so it would not likely have much impact on the economy. Already middle-income workers are saving an unusually large share of their income. Boosting their take-home pay would probably not cause them to increase spending, especially because they would know that the deferred tax would eventually have to be paid. Also, although the president can defer collection of payroll taxes, employers might still choose to withhold taxes from employee paychecks. Thus, not all workers will see the impact of the tax deferral.
Although the Congress debated extending the restriction on evictions of people from homes where the mortgage is held by a government entity, the president merely ordered the government to “consider” whether evictions should be banned. He also ordered officials to examine whether money can be found to assist renters. Consequently, there could be a flood of evictions in the coming months, especially for unemployed workers who will not be receiving government support.
Finally, even the limited actions taken by the president raise constitutional questions. Under the US constitution, the Congress has the sole authority to spend money. Shifting money from hurricane relief to unemployment insurance might not pass muster with the courts—and this will surely be adjudicated quickly. From a political perspective, the president’s announcement enables him to say that he has taken action while the Congress failed to do so. From an economic perspective, however, his actions, even if fully implemented, are not likely to have a significant positive impact on the economy. Meanwhile, Congressional leaders still intend to seek a deal. Democrats have sought a US$3.5 trillion package while Republicans have sought US$1.5 trillion. Among the issues under debate are support for unemployed workers; support for small and large businesses, especially airlines; support for fiscally troubled state and local governments; and funding for vaccine production and distribution. Federal Reserve officials continue to urge Congress to act. Chicago Federal Reserve Bank President Charles Evans said, “Fiscal policy has been unbelievably important in supporting the economy during the downturn.”
In China, economic activity nearly collapsed in the first quarter and then rebounded very strongly in the second. Now, as the third quarter is well under way, there are mixed signals about the strength of the economy. On the one hand, industrial production continued to grow strongly in July. On the other hand, retail sales remained below the level from a year earlier. In addition, fixed asset investment in the first seven months of the year was below the level seen a year earlier, largely due to a sharp drop in private sector investment. The revival of China’s economy has largely involved public sector investment and a surprising boost to exports. Here are the details.
China’s industrial production was up 4.8% in July versus a year earlier, the same as in the previous month, driven largely by a boost to manufacturing output. There was a strong increase in some categories including machinery (up 15.6%), communication equipment (up 11.8%), and general equipment (up 9.6%). However, production of transport equipment declined 1.4%.
Meanwhile, retail sales were down 1.1% in July versus a year earlier. This compared to a decline of 1.8% in the previous month. It was the best performance so far this year. Still, it is clear that consumers remain cautious. Given that retail spending was growing at a rate of about 8% last year, sales are now roughly 9% below where they would otherwise have been. Although many retail categories experienced a decline in spending, some did well. For example, sales were up 12.3% for automobiles, 11.3% for telecoms equipment, and 7.5% for jewelry. Spending at restaurants and theatres continued to be below the levels seen last year.
Fixed asset investment in the first seven months of the year was down 1.6% from a year earlier. Private sector investment fell 5.7% while public sector investment grew 3.8%. Investment in manufacturing declined. Interestingly, investment in infrastructure declined 1.0%.
There is growing belief within the US Federal Reserve system that a sustained economic recovery will only come about if the virus is sufficiently suppressed. As such, Minneapolis Fed President Neel Kashkari said that, in order to set the conditions for a sustained recovery, the country should “lock down really hard” for four to six weeks. He said, “If we don’t do that and we just have this raging virus spreading throughout the country with flare-ups and local lockdowns for the next year or two, which is entirely possible, we’re going to see many, many more business bankruptcies. That’s going to be a much slower recovery for all of us.” He also said that, if there is another lockdown, the Congress ought to spend heavily to relieve households and businesses. Unlike some of his fellow Republicans, he does not appear to be concerned about large deficits or growing government debt. The reason is that the massive dissaving by the government is being offset by massive saving by the private sector. As such, the government need only dip into the large pool of private savings. As is already evident, the massive government borrowing has not boosted borrowing costs or expectations of inflation. Kashkari said, “Those of us who are fortunate enough to still have our jobs, we’re saving a lot more money because we’re not going to restaurants or movie theaters or vacations. That actually means that we have a lot more resources as a country to support those who have been laid off.”
With respect to government spending, Charles Evans, president of the Federal Reserve Bank of Chicago, said, “Trouble is brewing with the expiration of these relief policies. If we go very long without somehow addressing the reduction and evaporation of that support, I think it’s going to show up in lower aggregate demand. And that would be very costly for the economy.” Evans reiterated what has already been said by other Fed leaders—the ultimate path of the economy will be determined by the path of the virus. Thus, getting the virus under control is the most important economic policy. Yet until that happens, he said that “it was very important for aggregate demand that additional fiscal policy relief be forthcoming.” He concluded, “If we make further progress on the virus … then I think economic activity and greater consumer confidence would be forthcoming.”
Meanwhile, among Republicans there is a debate about this. Senate leader Mitch McConnell and the Trump administration want to spend more, while a significant number of Republican members of the Senate are wary of any more spending for fear of driving up debt to an unsustainable level. Treasury Secretary Mnuchin said, “There is obviously a need to support workers and support the economy. On the other hand, we have to be careful about not piling on enormous amount of debts for future generations.” Kashkari has countered, saying that “if we got the economy growing, we would be able to pay off the debt.” In any event, negotiations between the White House and Congressional Democratic leaders continue, but as of this writing it is reported that the two sides remain apart, boding poorly for passing a new stimulus bill in the near term.
The world’s leading affluent economies (the United States, European Union, Japan, etc.) have significantly boosted government spending during this pandemic, piling up debt on a scale not seen since World War Two. Although many business and political leaders have expressed alarm about this, many economists, including me, have not. Rather, many economists have argued that the increase in government borrowing has been offset by a surge in private sector saving. Thus, governments are not crowding out private sector investment. That is why bond yields have remained low. Moreover, the argument is that, once the crisis ends, spending can return to normal levels. If economies grow at a normal rate, and if there is a modicum of inflation, then the debt-to-GDP ratio will quickly fall as happened after World War II. That is, assuming societies become richer over time, the debt will be less of a burden. In addition, assuming that inflation remains low and that, due to demographics, interest rates remain low, the burden of debt servicing will be relatively low.
However, one leading economist differs with these arguments. Raghuram Rajan, a professor at the University of Chicago and former head of India’s central bank, says that the sharp rise in debt in affluent countries will have serious negative consequences for a long time to come. Nonetheless, he thinks that affluent governments have no choice but to spend the money and accumulate debt. However, he believes it would be a mistake not to recognize the cost involved.
First, Rajan questions whether some of the above assumptions will hold. That is, he suggests that economies might grow more slowly than in the past, due to changing demographics, weak public investment, and possibly continued weak productivity growth. If economies grow slowly, the debt-to-GDP ratio will not fall quickly and the debt burden is expected to remain high. This might require higher taxes, lower public investment, and the fraught political debates that this would entail.
Second, Rajan worries that, with the debt burden remaining high for a long time, future governments will not have fiscal space to react to the next crisis. That, in turn, might exacerbate the extent of the next crisis. There could be too much of a burden on monetary policy, either leading to higher inflation or to such low interest rates that assets are allocated inefficiently.
Given these arguments, Rajan suggests that, although a high level of spending is currently warranted, it must be done carefully and in a manner that addresses longerterm issues. For example, with respect to government support of small businesses, he says, “Authorities should be more discriminating in the firms they support, allowing the market to do most of their job. For example, in normally flourishing neighborhoods, small businesses start up and shut down all the time. While failure is painful for the proprietor, there is little permanent damage to the economy.” And with respect to larger companies, Rajan says, “Authorities should not offer grants or subsidized loans so that distressed large businesses like airlines and hotel chains can retain their employees. These businesses will keep excess employees only so long as they get the subsidies. It will be far cheaper for the government to support laid-off workers through unemployment insurance than to pay employers to retain them indefinitely when their work has clearly disappeared.”
Finally, Rajan suggests that some government spending should be used to invest in helping young people develop the skills needed for the next economy. He concludes, “Government spending is necessary today. But just because sovereign-debt markets have not yet reacted adversely to extremely high levels of borrowing and spending, we must not—for our children’s sake—throw caution to the wind.”
The global manufacturing industry is growing again, albeit slowly. The latest purchasing managers’ indices (PMIs) from IHS Markit signal a renewal of growth in global activity for the first time in six months. The PMIs are meant to signal the direction of activity in the manufacturing industry. They are based on sub-indices, such as output, new orders, export orders, employment, pricing, inventories, pipelines, and sentiment. A reading above 50 indicates growth; the higher the number, the faster the growth. The global PMI for July, at 50.3, indicates growth at a slow rate. Still, it is the highest level in six months. The only sub-indices below 50 were export orders and employment, both of which evidently continued to decline. Markit reports that, of the 27 countries analyzed, 13 had readings above 50. However, these included most of the world’s major economies with the exceptions of Japan, India, and Mexico.
The July PMI for the United States, at 50.9, was the first to exceed 50 since February. The PMI indicates a modest level of growth after a prolonged period of rapid decline. Thus, the industry still has some way to go before it returns to normal. Markit commented that “much of the recent improvement in output appears to be driven merely by factories restarting work rather than reflecting an upswing in demand. Growth of new orders remains lackluster and backlogs of work continue to fall, hinting strongly at the build-up of excess capacity. Many firms and their customers remain cautious in relation to spending in the face of re-imposed lockdowns in some states and worries about further disruptions from the pandemic.”
In Europe, the PMI for British manufacturing bounced back to a 16-month high. Still, activity continues to take place below the pre-crisis level. Output and domestic orders were up while export orders continued to fall. Markit commented that “the employment situation remained bleak.” For the Eurozone, the PMI returned to positive territory for the first time in a year and a half. Growth was relatively stronger in France and Spain and more modest in Germany and Italy. However, Italian businesses expressed especially strong confidence about the future. In much of the Eurozone, the July PMIs were the highest in roughly two years. There was strong growth of output and new orders. On the other hand, the manufacturing industry continued to shed jobs at an alarming rate as businesses struggled to cut costs in response to weak demand and added constraints of the virus.
In Asia, India’s manufacturing PMI in July was only 46.0, indicating a continued decline in activity. The July PMI was worse than in June, suggesting that India’s manufacturing sector had a setback amidst the growing pandemic crisis. Markit commented that “firms were struggling to obtain work, with some of their clients remaining in lockdown, suggesting that we won't see a pick-up in activity until infection rates are quelled and restrictions can be further removed.” Meanwhile in neighboring China, the PMI continued to increase, hitting 52.8 in July, the highest level since 2011. Output and domestic orders were up sharply while export orders declined at a decelerating pace. The decline in export orders reflects continued weak overseas demand and is likely to restrain the PMI in the coming months. Finally, Japan’s PMI remained below 50 at 45.1, indicating a continued sharp decline in activity. Still, the July figure was the best since February. The weakness of Japanese manufacturing stemmed from weak domestic demand as well as weak overseas demand, all owing to the crisis. Production of consumer goods stabilized but capital goods remained very weak.
The broad services industry is also in recovery globally, but to a more modest degree. Services encompasses most nonmanufacturing, nonmining, and nonconstruction activities. It includes finance, telecoms, retailing, wholesaling, transportation, tourism, entertainment, utilities, healthcare, and education. The global services PMI increased from 48.0 in June to 50.5 in July, a 13-month high, indicating very modest growth after several months of decline. While output and new orders were up slightly, export orders and employment continued to decline. The industry grew strongly in Europe and China, failed to grow in the United States, and declined in Japan and India. Here are the details.
The US services PMI increased from 47.9 in June to 50.0 in July, meaning that activity in the industry was stalled but was no longer declining. Markit reports that output in consumer facing businesses continued to decline, likely due to consumer aversion to social interaction. Indeed, Markit notes that the surge in infections has had an impact. It commented that “the US was the only major economy to see COVID-19 containment measures tighten again in July, and this is reflected in the data, with new business inflows falling at an increased rate to hint at the possible start of a double dip in business activity.” Then again, it said that the survey found increased optimism on the part of service company leaders. Indeed, it reports that service companies boosted employment in anticipation of increased demand.
The Eurozone services PMI increased considerably, rising from 48.3 in June to 54.7 in July, a two-year high and a number indicating strong growth of activity. Growth was stronger in Germany (55.6) and France (57.3) as opposed to Italy (51.6) and Spain (51.9). The relative weakness in Southern Europe is not surprising given the disproportionate size of the tourism and related industries in those countries. Indeed, Markit reports that exports of services, which includes selling tourist services to foreigners, continued to decline in the Eurozone in July. Still, the overall growth of services, combined with the rising health of manufacturing, “bodes well for the economy to rebound in the third quarter after the unprecedented slump seen in the second quarter.”
In Asia, India’s services PMI went from 33.7 in June to 34.2 in July, a level indicating a continued sharp decline in activity. This was due to lockdowns and fear of the virus. There was a decline not only in output, but also in new orders and employment. Markit commented that there is no indication that the economic downturn is easing. It said, ultimately, restrictions will have to be eased and businesses reopened. Still, it said that “any substantial recovery will take many months, if not years.”
China’s services PMI actually declined in July, but from a very high level. Specifically, China’s services PMI fell from 58.4 in June to 54.1 in July—still a level indicating strong growth. Output and new orders rose strongly, but employment fell as service companies sought to boost productivity through investment in labor-saving technology. Export orders fell as well. Finally, Japan’s services PMI continued to show declining activity. The PMI went from 45.0 in June to 45.4 in July, a marginal change. There was a modest decline in output and new orders and a very large decline in export orders. The collapse of the tourist sector, which had been growing rapidly in recent years, likely contributed to trouble for Japanese services.
Job growth decelerated sharply from June, although the US economy generated more new jobs in July than many analysts had predicted. A large share of the job growth took place in industries that had been disrupted by the crisis and that are now facing headwinds once again. The level of employment remains far below the pre-crisis level. Labor force participation declined and the ratio of employment to population remained far below the normal level. Given these caveats, it is not surprising that investors barely reacted to this news. Here are the details.
The US government releases two reports on employment: one based on a survey of establishments, the other based on a survey of households. First, let’s consider the establishment survey. To put things in context, it is helpful to step back a few months. Recall that 20.8 million jobs were lost in April. In May, the economy added 2.7 million jobs. In June, it added 4.8 million. Now we learn that, in July, the economy added 1.76 million jobs. Thus, the pace of jobs growth has clearly slowed. Moreover, total payroll employment remains 12.9 million jobs below the level in February, which was when the crisis was beginning.
The 1.76 million increase in July employment was largely driven by a small number of consumer-facing industries that had been affected by the crisis. There were 502,000 new jobs at restaurants; 100,000 jobs in amusement, gambling, and recreation; 258,000 new jobs at retail establishments (including 121,000 at clothing stores); 144,000 jobs with temporary help services; 191,000 jobs in health care; and 119,000 jobs in personal services, such as laundry. Those categories alone accounted for more than three quarters of job growth. The latest high-frequency data shows that, in recent weeks, activity has stalled at consumer-facing industries, such as retail, restaurants, and transportation. This does not bode well for further jobs gains in these industries. Keep in mind that the establishment survey was completed during the week of July 12. Highfrequency data suggests that conditions in consumer-facing industries worsened in the intervening weeks due to the surge in COVID-19 infections.
The separate survey of households found that there was a small decline in labor force participation in July. This, combined with increased employment, meant that the employment-to-population ratio increased from 54.6 in June to 55.1 in July. Keep in mind, however, that the ratio was 60.7 a year ago. The unemployment rate fell from 11.1 in June to 10.2 in July.
Going forward, there are two things that will determine the path of the job market. Foremost is the path of the virus. If the outbreak weakens, it is likely that consumers will feel more comfortable engaging in social interaction. This would likely have a positive impact on employment—and vice versa. Another important factor will be the action or inaction of the Congress. If the enhanced unemployment insurance benefit, which has expired, is extended, it will have a positive impact on consumer income. If the Congress fails to act, or acts minimally, there could be a sharp decline in income, a consequent decline in spending, and therefore a negative impact on employment. Also, of importance will be what the Congress does with respect to troubled small businesses.
To no one’s surprise, real GDP in the European Union (EU) fell at a record pace in the second quarter, declining even faster than was the case in the United States. In the 27-member EU, real GDP declined at an annualized rate of 39.8% from the first to the second quarter. In the 19-member Eurozone, real GDP declined at a rate of 40.3%. By comparison, US real GDP declined at a rate of 32.9%. The sharp second-quarter decline in Europe followed a steep decline in the first quarter. Specifically, Eurozone real GDP declined at a rate of 13.6% in the first quarter while EU real GDP declined at a rate of 12.2%. This compares to a decline of 5.0% in the United States. Thus, in the first half of 2020, Europe’s economy collapsed as governments imposed severe economic restrictions in order to contain the virus. Restrictions only began to be lifted in May, and then only gradually.
The good news is that the severe decline in economic activity was successful in suppressing the spread of the virus. By the end of the second quarter, the number of new infections in the EU was very modest. Moreover, there are indications that economic activity is starting to expand rapidly without generating a massive outbreak of the virus—although there have been isolated outbreaks. There are two factors that are helping to avoid a second general outbreak. First, it appears that rules about social distancing are mostly being followed. Second, most countries in Europe have testing and tracing regimes that enable quick suppression of isolated outbreaks. Still, considerable risk remains, as evidenced by the troubling outbreak now taking place in the Catalonia region of Spain, which is wreaking havoc with the key tourist industry. However, what likely distinguishes Europe from the United States is that, after a catastrophic decline in activity in the second quarter, Europe can expect relatively strong growth in the third quarter, something not likely to take place in the United States where a large outbreak is already having a negative impact on consumer spending and mobility.
By country, real GDP declined at a rate of 34.7% in Germany, 44.8% in France, 41.1% in Italy, and 55.9% in Spain. For the Eurozone, activity in the second quarter remained 15.0% below the level from a year earlier. Our Deloitte forecast calls for a return to a normal level of GDP by 2023. Spain’s decline in the second quarter was clearly the worst. Indeed, its GDP in the second quarter was 22.1% below a year earlier, more than wiping out all the gains of the last decade. Spain’s decline largely reflects the severity of its lockdowns. Italy’s decline was not as bad. However, given that Italy’s economy barely grew in the last decade, GDP has fallen to a level not seen since the 1990s. Germany did better, possibly due to an early implementation of testing and tracing capacity. Early reports suggest that Germany is returning to pre-crisis levels of consumer activity more quickly than its southern European counterparts. Indeed, it was just reported that German retail sales in June were 5.9% above the year earlier level. However, retail sales fell 1.6% from May to June after having increased 12.7% in the previous month. In Italy, nonetheless, retail sales increased 12.1% from May to June after having increased 24.0% in the previous month. Despite such strong monthly growth, June sales remained 2.2% below the level a year earlier. Other data point to Germany’s relatively better situation. For example, the number of job vacancies relative to pre-crisis levels, while low, is much higher in Germany than in France, Spain, or Italy.
Part of the problem is that the three latter countries are each heavily dependent on tourism. Recent new outbreaks in these countries have scared tourists away, causing a sharp decline in tourist-related revenue after an initial resurgence. Meanwhile, there is concern about a second wave of the virus in Europe, with outbreaks in various places. Of most concern right now is the outbreak in Spain. This has led the United Kingdom to require that tourists returning from Spain be quarantined. Germany is warning its citizens against travel to Spain. These decisions, in turn, will surely hurt Spain’s economic recovery. Britain’s Health Secretary, Matt Hancock, said, “I think you can see a second wave starting to roll across Europe, and we've got to do everything we can to prevent it from reaching these shores and to tackle it. It's not just Spain ... but there are other countries too where the number of cases is rising. And we are absolutely determined to do everything that we can to keep this country safe.” Hancock’s comments come as Britain reports the highest rate of excess deaths in Europe. That is, the number of deaths in the past few months in proportion to the norm from the past five years is very high relative to other European countries.
As far back as March, it was widely expected that US real GDP would decline at a historic pace in the second quarter. Early estimates from various Wall Street firms predicted annualized declines in the 20-40% range. Our own Deloitte forecast has evolved over time. At one point we were exceptionally pessimistic, predicting that second quarter GDP would fall at an annual rate of 57%. Our view at that time was that activity would decline very sharply in April and then stay down for a few months, rebounding strongly in the third quarter after the virus had been suppressed. We were right about April but failed to see that activity would rebound in May and June, in part due to early reopening by many US states. Over time our forecast was adjusted to account for what we were observing through high-frequency data. A few weeks ago, our prediction was that second-quarter GDP would fall at an annual rate of 35%. Last week we learned that second-quarter GDP fell at an annual rate of 32.9%. It was the sharpest quarterly decline since the US government began keeping records more than 70 years ago. Note that second-quarter GDP fell less than previously expected due to an early rebound in economic activity. Yet that early rebound has contributed to a second wave of the virus which, in turn, is already having negative economic consequences. Hence, third-quarter GDP is likely to be worse than previously expected.
The latest report indicates that consumer spending declined at an annual rate of 34.6%. This was despite the fact that real disposable personal income increased at a rate of 44.9% due to massive transfers from the Federal government. Notably, real Federal government nondefense purchases increased at a rate of 39.7%. This was not due to the cash transfers to households. Rather, this reflected purchases meant to support the fight against the virus. In any event, the divergence of spending and income meant that consumers saved a great deal. In fact, the amount that households save tripled from the first to the second quarter. The savings rate increased from 9.5% in the first quarter to 25.7% in the second quarter. As for consumer spending, the lion’s share of the decline was due to a reduction in spending on services. Spending on durable goods only fell 1.4% and spending on nondurables fell 15.9%. Yet spending on services fell at a rate of 43.5%. There were especially sharp declines in spending on health care, recreation services, and food services and accommodations (restaurants and hotels). These three categories alone accounted for 60% of the decline in GDP. So long as the virus remains a threat, spending on recreation, restaurants, and hotels is likely to remain suppressed. Also, the sharp decline in spending on health care might seem surprising, but it reflects people not visiting their doctors and dentists during the crisis.
There was also a sharp decline in investment spending. nonresidential business fixed investment fell at a rate of 27.0%. Investment in structures fell 34.9% and investment in equipment fell 37.7%. However, investment in intellectual property only fell 7.2%. Evidently businesses were keen to pay software engineers to write code while working from home. Residential investment was also down, falling at a rate of 38.7%.
International trade took a big hit early in the crisis, and this is reflected in a sharp decline in US exports and imports in the second quarter. Real exports of goods fell at a rate of 67.6% in the second quarter and real imports of goods fell 48.8%. The only major category of GDP to increase significantly was Federal government spending.
The GDP report is a look back at history. Events are moving rapidly. The GDP report tells us little about where we are right now. For a better understanding of the current situation, it is useful to look at initial claims for unemployment insurance that was reported last week. The report indicates that, in the prior week, there were 1.434 million new claims for unemployment insurance, a slight increase from the previous week. It was the second consecutive of week-on-week increases and the first time this has happened since early April. As such, it indicates that the US job market is stalling. That is not surprising given that, with the rebound of the virus, there has been an evident decline in consumer time spent at restaurants, retail establishments, and entertainment venues. It is likely, therefore, that employment at such locations is now declining. The government will release its jobs report for July on Friday and there is a good chance it will show a decline in employment and an increase in the unemployment rate. Meanwhile, what happens in August will depend, in part, on whether the US Congress passes another spending package. For now, it seems unlikely that a compromise will be reached any time soon. As such, it is likely that personal income will decline, contributing to a further decline in spending and a weaker third quarter GDP number.
In response to last week’s news, there was a decline in US equity prices while bond yields fell. Most likely investors were not responding to the GDP report, which was not unexpected. Rather, the increase in initial claims for unemployment insurance signaled the growing weakness of the US economy, boding poorly for the quick recovery many had hoped for. The yield on the US government’s 10-year bond fell to 0.54%, the lowest level since March and the second-lowest ever. This reflects expectations of weak credit demand rather than expectations of lower inflation. In fact, the so-called “breakeven” rate, which is an excellent proxy for expectations of inflation, has risen in recent weeks. The 10-year breakeven rate is now 1.53%, meaning that investors expect average annual inflation to be 1.53% during the next 10 years. This is the highest breakeven rate since the crisis began but remains below the pre-crisis level of about 1.7%.
The main focus of government policy in multiple countries has been to give money to businesses while they shut down and to households while they stay at home. The idea is to allow people and businesses to survive while, at the same time, encouraging social distancing in order to suppress the spread of the virus. The hope is that, as in Europe and much of East Asia, this suppression will be accomplished quickly so that the economy can get back to work. This did not happen in the United States; instead, the outbreak is continuing and accelerating. The effect of this is a suppression of economic activity as consumer fear of the virus leads to reduced spending and mobility.
Now, the US Congress is in the midst of a debate about another round of assistance to households and businesses. Yet it is clear that the focus of the two parties is very different. The Democrats want to provide funds to support households while they stay home from work and engage in social distancing. The Republicans want to use government to encourage people to return to work and to make it easier for businesses to reopen. The latter policy is predicated on the belief that the economy can function well even if the virus is not yet under control. The Republican plan provides much more limited unemployment insurance in order to encourage people to return to work, liability protection for businesses that rehire workers, subsidies for small businesses that reopen, subsidies to communities that reopen their schools, subsidies for businesses to clean their facilities, and full expensing of business meals to encourage people to return to restaurants. The Democrats, in contrast, provide uninterrupted enhanced unemployment insurance, aid to state and local governments, and additional forgivable loans to small businesses that remain closed. Both sides want money for testing and tracing.
Philosophically, the two sides are far apart even though they both intend to spend a large amount of money. It can be argued that both sides have a point, but there is a discrepancy about timing. The Democrats want to enable the economy to be shut down again in order to attempt to suppress the virus. This makes sense now while the virus remains a big problem. Provided such a policy succeeds in the manner that happened in Europe, at that point the Republican proposal would make sense to implement. That is, once the virus is suppressed, the government can attempt to reignite economic activity Meanwhile, so long as consumers are nervous about the virus, government efforts to boost economic activity might fail. The good news, however, is that the so-called reproduction rate, known as R(t), has fallen in the United States in recent weeks, signaling that consumer fear might have been effective in stymying the spread of the virus by enforcing social distancing. If so, then the future might be more promising in the medium term.
The Republican plan to cut unemployment insurance benefits, predicated on the idea that this will encourage people to return to work, will not necessarily generate increased employment in industries that face weakened demand such as restaurants, movie theatres, and airlines. Instead, it could lead to significantly reduced personal income which, in turn, could cause a sharp decline in consumer spending. Meanwhile, the Republican plan is sufficiently controversial that a significant number of Republican legislators oppose the plan.
In any event, the two sides will negotiate with the goal of quickly reaching some sort of agreement. Yet not only are there differences between Democrats and Republicans, there also remain differences among Republicans and differences between the White House and Congressional Republicans. This may bode poorly for a quick resolution of the problem.
Meanwhile, the US Federal Reserve left monetary policy unchanged last week and pledged to continue aggressive action in order to keep credit markets open and functioning. Investors reacted positively, driving up equity prices. However, Fed Chairman Powell reiterated that the Fed’s ability to drive the economy is limited and that “the path of the economy is going to depend to a very high extent on the course of the virus, on the measures that we take to keep it in check. We can’t say it enough.” Indeed, the recent surge in new infections and deaths was soon met by a downward shift in economic activity. The virus and the economy cannot be delinked.
Powell also noted that the economy appears to be weakening. He said that data on consumer spending and hiring indicates as much. The jobs report for July will be released later this week and, given that initial claims for unemployment insurance are now rising, there is a significant chance it will show a decline in US employment in July. If so, it could signal that real GDP might not grow at all in the third quarter. The weakening began a few weeks ago following a sharp rise in new infections that was followed, in turn, with a sharp rise in deaths. Powell suggested that the best solution is to suppress the virus by implementing policies that enforce social distancing. He said that “social distancing measures and fast reopening of the economy actually go together. They’re not in competition with each other.”
With the Fed having cut interest rates to near zero and having engaged in massive asset purchases and injections of liquidity, there is not much more it can do. Rather, Powell suggested that fiscal policy is now key, saying “fiscal policy can address things we can’t address.” Yet, as noted above, the debate continues about fiscal action.