Advanced market economies weather shocks in the 21st Century, helped by effective policy

Advanced market economies exhibit capacity to adapt to shocks, helped by effective policy that would be improved by greater emphasis on information from official administrative data.

The main feature advanced economies demonstrated in the first quarter of the 21st century is their resilience and stability in the face of great adverse shocks. Policy makers have, moreover shown that they have both the monetary and fiscal tools to significantly mitigate the damage done by huge unexpected adverse macro-economic shocks. The financial and credit crises and the Great Recession they provoked between 2007 and 2010, the public health emergency that resulted from the Covid virus between 2020 and 2021 and the shocks to commodity, shipping and energy prices resulting from the war in the Ukraine and reignition of acute tension across the middle east and its connected Islamic communities have been difficult, navigable, and effectively managed.

The stability of output in market economies that experience shocks

In many respects this resilience in the behaviour of advanced market economies was to be expected. There is a significant economic literature that has explored the stability of economic output in market economies that encounter crises. Robert Barro, the Harvard economist who formulated the neo-Ricardian equivalence theorem in the 1970s and contributed significantly to new growth theory in the 1980s and 1990s, has shown in an extensive project that examined economies in distress such as war and revolution that even in the most adverse circumstances market economies can adjust and output can stabilise. A generation earlier in the 1960s, Milton Friedman observed, drawing on the work of a colleague at Chicago University, that even during one of the worst episodes of hyperinflation the German Weimar economy functioned well because the price system remained intact and the economy was not distorted by controls of the sort that had damaged the functioning of the American economy in the 1940s.

The huge economic shocks that have affected economies in 21st century 

The managing of the credit crunch and Great Financial Crisis between 2007 and 2009 benefitted by the lessons economists had absorbed from the social and economic disaster of the US economy in the 1930s Great Depression. First governments used fiscal policy to stabilise output as the traction of monetary policy as a source of stimulus began to evaporate in the credit crisis. There was a huge turnaround in the approach that policy makers took to the role of fiscal policy in the Autumn of 2008 best illustrated by successive editions of the IMF’s World Economic Outlook. After a hesitant start in 2008 central banks and finance ministries protected banks and savers’ deposits using taxpayers money to keep banks and credit institutions open. This drew on an important observation from the Chairman of the Federal Reserve Board Dr Ben Bernanke’s academic research on the Great Depression. This can be roughly summarised as in a monetary crisis involving bank failures, if policy makers are to stabilise the monetary and banking system it is insufficient simply for the central bank to flood the financial system with liquidity, but the normal banking, saving and credit institutions that work in local communities have to be preserved in some form so that credit continues to flow. 

Policy makers have responded effectively to huge shocks avoiding malign social damage

President Obama’s administration greatly benefitted from the presence of two economists who had spent much of their academic careers studying the Great Depression and its causes. As well as Ben Bernanke at the Federal Reserve, the Chair of the Council of Economic Advisers was Chistina Romer. Her work on the Great Depression showed that US fiscal policy had been ineffective with revenue acts that raised taxes and an active fiscal response that was inadequate. She and the Council of Economic Advisers argued that there should be a decisive fiscal stimulus of around $1.8 trillion dollars, in the end the stimulus was less than half that at $800 billion.

The covid public health emergency resulted in advanced economies being placed in a protracted quarantine. Effective health curfews made it illegal for people to meet for most conventional purposes. There is now a protracted public inquiry in the UK exploring how effective policy was during covid and the costs involved with it, the merits of the timing of lockdowns and their severity. Many people have strong views on the manner in which the public health emergency should have been managed and the costs and trade offs involved. I refrained from offering any suggestions given that I am not an epidemiologist. The only observation I made was that in the public health crisis, the flu epidemic a century before, research published by the Federal Reserve Bank of New York suggested that communities that had been reluctant to impose quarantine and social distancing rules because of concern about their commercial cost, had ended up with great losses of output and cost, because the disease was perceived to be less well controlled. In a radio interview under pressure from the interviewer about what my private opinion was as a citizen, having explained that I had no worthwhile professional opinion to offer, I gave my clumsy take on matters. Which was roughly that there was no point in a public health emergency keeping a well-functioning dynamic economy going and ending up participating in it from the wrong end of the Efford Crematorium.

What was clear was that households and businesses would suffer huge losses of revenue and income. Measures needed to be taken to help them through. The only way it could be done was through the state using its balance sheet to borrow. There was a huge fiscal response with governments supporting bank lending for businesses, company payrolls and offering enhanced social security transfer payments. Swift timely action was needed and probably it was better to be more generous than overly cautious. There was always the potential for this great fiscal effort in the long term to stir advanced economies out of the relative torpor they had exhibited between 2010 and 2019 and if the measures were successful there was the possibility that they could ignite a general inflation. While monetary policy had been an ineffectual source of economic stimulus there was no reason to think that it would be ineffective as a source of restraint if disinflation is needed.

Fiscal policy is a key tool in a crisis 

The challenge in 2020 was ensuring individual and company balance sheets survived. The problems could be taken care of later. The lock downs imposed significant forced savings on the part of households. The disruption of international supply chains resulted in unusual bottle necks and shortages in a world that had become used over forty years to just in time inventory management, technology and logistics developments such as containerisation that were superficially believed to have ‘ended distance’. There was likely to be pent up demand as a result of the forced saving that would present itself in a different way from normal. And at a time when suppliers could not respond to it. This mismatch between normal demand and supply was likely to result in powerful relative price effects. In many respects that would be a sign of the economic activity recovering. When those relative price effects became apparent it would be necessary for central banks to institute a non-accommodating monetary policy to prevent a general and sustained increase in inflation. In 2021 central banks failed to take the monetary policy measures necessary to contain inflation. 

Monetary policy retains its bite when disinflation is needed

The big question that had to be addressed in 2020 is what happens if policy makers are successful in protecting households and businesses in the pandemic and there is an overheating economy and inflation. This would not be such a bad problem to have. The problem that economies had after the Great Recession was a lack of economic activity, central banks having difficulty in delivering their inflation targets because of undershooting  and an increasingly apparent stagnation or stationary state. Moreover, as Janet Yellen said at the start of 2021 central banks have the monetary tools to correct inflation. The problem was that central banks dreamt up an implausible account of inflation namely that it was largely ‘transitory’.

Structure improvements that make economies and labour markets work better

There was a further consideration that should inform any discussion of the policy response to covid. If there was a general inflation set off by the support to the economy and monetary policy could probably deal with it, how costly would it be in terms of losses of output and employment. While it would be mistaken to assume that any disinflation could be brought about without short term losses of output and employment, and it may involve a recession. However, there were good reasons to think that the costs involved would be less than in previous recessions in the last three decades of the 20^th century., particularly in the case of the UK and several European economies as a result of structural improvements in the working of product and labour markets. In the UK case the capacity of the economy to adjust to changed circumstances has been transformed by structural changes that have created a flexible labour market. For over eighty years the labour market was the Achilles heel of the British economy. Labour market institutions prevented relative real prices and wages from adjusting to change, resulting in uncomfortable quantity adjustments in the rates of employment and unemployment. In the first decades of the 21st century real wages are much more flexible resulting in economic cycles with much lower costs in terms of losses of employment.

This has turned out to be the case so far. Once central banks acted to tighten monetary conditions monetary policy exhibited a bite that began to disinflate their economies. The surprising thing is that its first effects were felt simply through higher nominal interest rates when real rates of interest remained negative. It is likely that the costs of getting back to official inflation targets will be less than had been feared by hesitant policy makers in central banks. It is also likely that central banks will find returning inflation to something close to most official targets of 2 per cent will be difficult and require protracted tight monetary conditions.

The impact of covid in terms of economic data continues to overshadow everything

In many respects we are still trying to disentangle where we are today from the consequences of the covid shock. It involved a roller coaster of falling output, falling employment, with shocks to labour supply, savings and patterns of spending. The scale of the covid shock to output is clear from a historical chart of GDP.

The challenge of understanding what has happened has been compounded by the difficulties that statisticians had arising from not being able to collect data in the normal way about prices, changes in patterns of spending that upended the normal weights used to construct index and changes in public sensibility that makes people less enthusiastic about answering survey data questionnaires. The UK Labour Force Survey’s use as a source of data has been vitiated by the low ratio of survey returns making it impossible for the ONS statisticians to get a reliable 60,000 household survey.

The UK labour market appears to remain buoyant

The latest UK labour market data suggests a strong labour market. Employment has recovered to pre-pandemic levels. The initial impact of inflation as firms began to recover some degree of pricing power was to lower real wages, supporting employment. 

This was followed by an acceleration in pay that resulted in higher real pay. Early estimates for January 2024 indicate that median monthly pay was £2,334, an annual increase of 6.4 per cent. This represents a moderation in real pay growth is further evidence that confirms the efficiency of the labour market. 

Administrative data from HMRC on PAYE payroll data shows that in January 2024 there were 30.4 million payrolled employees. This represented a rise of 1.4 percent compared with the same period of the previous year, a rise of 413,000 people over the 12-month period. The rate of growth in the number of employees on payrolls slowed throughout 2023.

The Labour Force Survey suggests that the UK employment rate is 75 percent and that the rate of unemployment is 3.8 per cent, with an inactivity rate of 21.9 percent. 

The number of vacancies in the economy that had risen to 1.3million in May 2022 continues to fall. Over most of the last forty years reported vacancies that account for around a third of total available jobs, averaged about 700,000. The reported figure now stands at 932,000. 

The number of people detached from the labour market through sickness has increased since covid. This reflects a long-standing feature of the administration of UK social security benefits that has significantly lowered the replacement ratio of benefits to wages, unless a person is too ill to work and in receipt of a disability benefit. Yet even taking account of that the UK labour market still has a high level of participation compared to other advanced economies and a relatively low inactivity rate albeit one that has gone up since covid. In Canada 20 per cent, Germany 20.2, France it is 26.1 per cent, the US the rate is 25.2 per cent, the Euro-zone 25 per cent the OECD average is 26.3 per cent. So, at 21.9 per cent the UK’s inactivity ratio remains low. 

Problems with survey data samples and accuracy of reporting

There are two lessons from the present data. The first is that we are still trying to make sense of a post-covid shock world. The second is that in terms of data much greater use should be made of the administrative data and less significance should be attached to survey data such as the Labour Force Survey and the surveys used to construct the national accounts. Moreover, the national accounts no longer offer a historically reliable account of the ups and downs of the economy given the adjustments that have had to be made to construct consistent time series data using the new UN guidance on accounting conventions employed by the New European System of Accounts over the last twenty-five years. The lived historical economic experiences of 1979 to 1981 and between 1990 to 1992 have been mitigated and significantly smoothed away. 

The case for making systematic use of the administrative data that is available 

Likewise, reliance on the Family Resources Survey to assess poverty has been hindered for example by the fact that recipients of benefits completing the survey underestimated the social security benefits they received by about 16 per cent. Administrative data on payment of transfers showed that some £37 billion of benefits were unrecorded by the survey. The Family Resource Survey data gives a rate of household poverty of 22 per cent. When the survey data is adjusted with administrative data the ratio falls to 18 per cent, which is roughly a fifth lower. Given the problems with the Labour Force Survey and the awkward under reporting of the Family Resource Survey more effort should be made to explore greater use of administrative data.

Since 2000 advanced market economies have demonstrated resilience and an impressive capacity to adjust to shocks. Policy makers have also demonstrated the ability to use the principal tools of macro-economic management to weather the greatest challenges. In doing so they have exhibited innovative approaches to supporting financial markets, credit institutions and households. This has enabled advanced economies to avoid the sort of social and economic disasters associated with the years of the Great Depression. These are huge achievements that are often lost in an economic discussion that fails to distinguish between the wood and the trees.

Warwick Lightfoot

16 February 2024

Warwick Lightfoot is an economist and served as Special Adviser to the Chancellor of the Exchequer between 1989 and 1992