What is the likely future role of the state in the UK economy?

The fall in UK economic output as a consequence of the Covid-19 pandemic and the lockdown is likely to be much bigger than after the 2008/09 global financial crisis. In response, the size of the state has increased significantly – notably via the government’s Coronavirus Job Retention Scheme (CJRS) and loans to businesses in distress. Combined with much higher levels of public sector borrowing, this means that we may have entered a new age of big government and big debt.

How will this affect the weight of the state’s role in the economy? And how effective will government policy be at managing the crisis and eventual recovery?

What does evidence from economic research tell us?

• There is a broad consensus that economic output in the Covid-19 recession will fall by much more than during the global financial crisis of 2008/09. The Office for Budget Responsibility (OBR) estimates that UK GDP could fall by as much as 13% in 2020, compared with 5% in 2009.
• Government responses, notably the Coronavirus Job Retention Scheme and loans extended to businesses in distress mean that in 2020/21, public spending is set to rise by between £85 billion and £400 billion depending on the length of the lockdown.
• There will also be much higher levels of public sector borrowing (more than £200-250 billion in the same period), with national indebtedness approaching 100% of output this year, possibly rising to 120-130% over the coming years.
• Historically there is a ‘ratchet effect’ whereby after a major downturn, the size of government does not revert to its pre-crisis level. Examples include the aftermath of the two world wars and the Great Depression of 1929-32.
• The current increase in government spending is in part temporary, linked to policies such as the CJRS, which has been prolonged to the end of October 2020 (at a cost of about £20 billion per month) but will expire along with other measures such as Coronavirus Business Interruption Loan Scheme (CBILS) and Coronavirus Large Business Interruption Loan Scheme (CLBILS).
• But higher expenditure connected with policies aimed at boosting demand (for example, via the ‘automatic stabilisers’ that cushion the impact of a sharp increase in unemployment) will continue until at least 2022 (Lenoël and Young, 2020) – not least because of the long-lasting effects of ‘scarring’ and the ‘path dependency’ of unemployment.
• Government spending is also set to rise more permanently as a result of the commitments announced in the March 2020 budget, in particular infrastructure investment as part of the ‘levelling up’ agenda and more funds for the NHS.
• Before the crisis, public investment was forecast to increase to 3% of GDP by 2022/23 and to remain at the level (Chadha et al, 2020), and it is reasonable to expect this to go up as a result of higher expenditure on health and social care.
• Substantial increases in state spending entail increasingly complex coordination problems between different tiers of government, especially at a time when the ten City-Region Authorities are key in delivering both infrastructure investment and better public services.

How reliable is the evidence?

The evidence is primarily taken from some of the most recent forecasts, by the Office of National Statistic (ONS) and others, and compared with the analysis by leading economists. Some analysts use timely indicators of economic activity, including benefit claims, flights, shipping and fishing activity, to cross check official data which are subject to unusually high data uncertainty (Leslie and McCurdy, 2020).

Most estimates concur that the impact of the Covid-19 pandemic on GDP will be unprecedented since the sharp downturn in economic output after the end of World War One and in the wake of the Great Depression of 1929-32. For the first quarter of 2020, the ONS finds that UK economic output fell by 2% and for the month of March alone by 5.8% (ONS, 2020).

In the main-case scenario outlined by the National Institute of Economic and Social Research (NIESR), GDP falls by 7% in 2020 and public sector borrowing rises above £200 billion in 2020-21 (Lenoël and Young, 2020). Since the coronavirus and the policy response are causing a severe contraction in economic activity of uncertain magnitude, GDP estimates are subject to much greater uncertainty than usual.

Much will depend on the length of the lockdown and the pace of the recovery once restrictions begin to be lifted. What we do know is that government intervention has also been unprecedented compared with earlier recessions. Both in the March budget and in a series of announcements since the start of the lockdown on 23 March, HM Treasury has enacted a series of measures aimed at supporting individuals and businesses through grants, loans and guarantees. These will have substantial budgetary costs.

In its Coronavirus Policy Monitoring Database of 14 May 2020, the OBR estimates that the direct effect of the government measures on cash borrowing in 2020-21 will be at least £123 billion (OBR, 2020). Other estimates suggest that total receipts could be down by between £100 billion and £200 billion due to lower economic activity, a fall-off in tax compliance and tax relief and payment holidays, while expenditure rises by between £85 billion and £400 billion – depending on the length of the lockdown and the scale of contraction (Pacitti et al, 2020).

By far the largest part of government intervention in the economy has been the CJRS known as the ‘furlough’ scheme. The take-up has been very extensive, which suggests that this measure has been effective at reducing lay-offs and job losses. As of 12 May 2020, when it was announced that the scheme would be prolonged until the end of October 2020, around 7.5 million workers had been furloughed by about 935,000 businesses and £10.1 billion of government wage support claimed. If this rate continues, the CJRS will cost almost £20 billion per month and possibly as much as £140 billion for 2020-21.

According to the OBR, other extra spending for the current financial year includes health services and local authorities (£15 billion), welfare (£8 billion), the self-employed (£10.5 billion) and small business grant schemes (£15 billion) and business rates package (£13 billion). The heightened uncertainty means that these estimates will subject to much larger revisions than usual.

What else do we need to know?

The extent to which the economic impact will temporarily or more permanently change the size of the state depends on two key factors: first, on how long these lockdown measures last and, second, on the path of the recovery (a relatively fast, V-shaped recovery or a slow, L-shaped one). The second factor is in part a function of the first, and since many government measures have not been tried before, we lack historical evidence or contemporary data to draw firm conclusions.

Even if the lockdown measures are gradually eased and there is no second spike in infections over the coming months, the path of the recovery is likely to require substantial government spending. A decline in human capital for the unemployed, a loss of labour market participation, weakened businesses and households with growing levels of debts, precautionary savings post-crisis and weaker global trade and foreign direct investment are all likely to reduce economic growth. While both available data and forecasts point in this direction, we will have to wait for reliable data for confirmation.

But since this will take time, the urgent question for government is about which spending to maintain. Extending the current support measures will add to the deficit and debt, thereby increasing the weight of the state in the economy, but the cost of withdrawing this financial assistance could have greater adverse effects – deepening the recession and postponing the recovery (Baldwin and Weder di Mauro, 2020).

For example, sectors that experience substantial lay-offs are more likely to be affected by economic scarring, in particular if workers are specialised and – while unemployed – lose skills and drop out of the labour market (Lenoël and Young, 2020). It is therefore advisable to unwind the support based on more readily available data, for example, surveys of business sentiment and trading conditions (British Chamber of Commerce, 2020).

Connected with the question of the growing size of the state is the effectiveness of government. Central measures aimed at cushioning the impact of the crisis have managed to limit the damage to the economy and to social wellbeing. Even excluding the Bank of England’s monetary policy actions, it is estimated that without government interventions, notably the furlough scheme, GDP would have fallen by a further 2% (Lenoël and Young, 2020) and unemployment would have grown even more substantially.

But there are questions about how effective government action has been in relation to the public health crisis and to the recovery when it comes. The lockdown restrictions and their duration have one principal cause – a lack of capacity in testing and contact tracing, which is linked to the centralised structure of Public Health England, which raises questions about its flexibility and resilience in the presence of a changing structure of demand.

This raises the wider issue of effective government and public policy: the efficacy or otherwise of centralised state direction, based on two assumptions: first, that Westminster and Whitehall know best; and second, that central control is necessary for policy coordination. Both assumptions are questionable in light of the health challenges and of the state of the UK’s infrastructure.

To tackle the task of health and social care as well as the ‘levelling up’ agenda, government will have to rethink the top-down model of public policy-making (Coyle, 2020). It will have to consider how to devolve not just responsibilities but also resources to the ten City-Region Authorities. The other question is about how to involve other regional and local institutions in boosting investment, raising the country’s skills base and drive the technological transformation.

Where can I find out more?

Mitigating the COVID economic crisis: act fast and do whatever it takes: Richard Baldwin and Beatrice Weder di Mauro have edited a collection of essays from leading economists from around the world, who make the case for decisive and coordinated fiscal stimulus to mitigate the economic damage from the global pandemic.

BCC Coronavirus Business Impact Tracker: A survey by the British Chamber of Commerce that tracks the impact of the pandemic on business.

A switch to active fiscal policy: Jagjit Chadha and colleagues at NIESR analyse the 2020 budget, which contains a large fiscal boost aimed at improving the long-term performance of the economy based on much higher public investment in the longer term, to be financed by higher borrowing.

Markets, State, and People: Economics for Public Policy: Diane Coyle’s latest book studies the complex connections between the institutions of state and market in relation to public interest and the well-being of society, including a critique of top-down models of policy-making.

Prospects for the UK economy: Cyrille Lenoël and Garry Young of NIESR analyse the outlook for UK GDP and the public finances.

The economic effects of coronavirus in the UK: utilising timely economic indicators: Jack Leslie and Charlie McCurdy of the Resolution Foundation provide an overview of a variety of different economic indicators to provide real-time data on the impact of the pandemic on the UK economy.

Coronavirus Policy Monitoring Database: The OBR’s monthly monitoring, revised significantly compared with the March and April figures.

GDP monthly estimate: The monthly estimate for GDP by the ONS, revised substantially compared with the January and February forecasts.

The fiscal costs of lockdown: three scenarios for the UK: Cara Pacitti and colleagues explore the impact of lockdown on the UK public finances, based on three scenarios for the duration of the lockdown measures.

The EU needs an independent public health authority to fight pandemics such as the COVID-19 crises: The response to the COVID-19 pandemic has varied widely across the EU. Joan Costa-Font argues that an independent public health agency could help overcome problems of collective action.

Who are UK experts on this question?

• Paul Collier, Professor of Economics and Public Policy at the Blavatnik School of Government, University of Oxford
• Diane Coyle, Bennett Professor of Public Policy, University of Cambridge
• Garry Young, Director of Macroeconomic Modelling, NIESR
• John Kay, Fellow of St John’s College, University of Oxford
• Mariana Mazzucato, Professor in the Economics of Innovation & Public Value, University College London; Founding Director of the UCL Institute for Innovation & Public Purpose

Author: Adrian Pabst