Doing more of what it takes

Key findings

Social distancing measures are estimated to reduce economic activity initially by around one-third while they are in operation.
Depending on whether such measures are in place for three, six, or 12 months, the resulting fall in GDP in 2020 could be 10, 20 or 24 per cent, respectively. Annual falls in GDP of this magnitude have not happened in the UK for over three centuries.
Unemployment peaks at almost 2 million (5.4 per cent) under the three-month scenario but rises to almost 5 million (14.1 per cent) in the six-month scenario and over 7 million (20.8 per cent) in the 12-month scenario.
Inflation and interest rates are expected to remain low, but increases in either would represent a significant additional risk to the economic and fiscal outlook.
The contraction in economic activity, coupled with the Government’s £400 billion policy response, puts extraordinary pressure on the public finances in all three scenarios, with the costs divided roughly evenly between the economic shock and the policy response.
Public sector net borrowing reaches 11 per cent of GDP in a three-month scenario (higher than during the financial crisis), 22 per cent of GDP in the six-month scenario (higher than at any point in peacetime), and 38 per cent of GDP in the 12-month scenario (higher than the UK has borrowed in any single year its history).
Debt rises above 100 per cent of GDP in all three scenarios, peaking at 106 per cent in the three-month scenario, 129 per cent of GDP in the six-month scenario, and 167 per cent of GDP under the 12-month scenario. These are levels of public indebtedness not seen for generations.
The Government faces as an extraordinary financing requirement this year ranging from 16 per cent of GDP in the three-month scenario, to 27 per cent of GDP in the six-month scenario, to over 40 per cent of GDP in the 12-month scenario.
Despite the debt-to-GDP ratio more than doubling in the most extreme scenario, the proportion of government revenue devoted to paying debt interest actually falls below the pre-outbreak forecast under all three scenarios.
However, an unexpected rise in inflation or interest rates could significant increase the burden of servicing the Government’s higher stock of debt, at a time when fiscal policy needs to focus on supporting the economy and safeguarding long-term fiscal sustainability.

Recommendations

At the microeconomic policy level, the Government could revise the Job Retention Scheme to allow recipients to return to safe part-time work; develop sectoral public health guidelines on what activities can be safely conducted while social distancing is in place; reform business loans to reward firms that adapt their workplaces to safely resume production during lockdowns and rehire their workforces once public health restrictions are lifted; and revitalise active labour market policies to prevent a permanent increase in structural unemployment.
At the macroeconomic policy level, the Bank of England can alleviate some of the near-term pressures on the public finances during the period of lockdown, but this monetary financing needs to be transparent, temporary, and only happen when gilt markets are evidently dysfunctional.
To obviate any suggestion of fiscal dominance of monetary policy, the Government needs to commit to restoring fiscal sustainability once the outbreak is over and the economy is in recovery. This can be done by setting out a revised fiscal framework that commits to returning the current budget to a neutral setting, keeping the debt interest burden at manageable levels, and improving public sector net worth once the economy begins to recover.
This commitment would be underscored by the announcement of specific measures that help to deliver these objectives and share the burden of adjustment across society, such as a tax surcharge on higher earners who were able to continue working full time during the lockdown and recovery.

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