Quarterly Economic Commentary, Spring 2020

McQuinn, Kieran; O'Toole, Conor; Allen-Coghlan, Matthew; Coffey, Cathal Research Report Quarterly Economic Commentary, Spring 2020 ESRI Forecasting Series Provided in Cooperation with: The Economic and Social Research Institute (ESRI), Dublin Suggested Citation: McQuinn, Kieran; O'Toole, Conor; Allen-Coghlan, Matthew; Coffey, Cathal (2020) : Quarterly Economic Commentary, Spring 2020, ESRI Forecasting Series, ISBN 978-0-7070-0518-8, The Economic and Social Research Institute (ESRI), Dublin, https://doi.org/10.26504/qec2020spr This Version is available at: https://hdl.handle.net/10419/237296 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by/4.0/ QUARTERLY ECONOMIC COMMENTARY SPRING 2020 KIERAN MCQUINN, CONOR O'TOOLE, MATTHEW ALLEN-COGHLAN AND CATHAL COFFEY MACRO ECONOMIC FORECASTING MARCH 2020 E V I D E N C E F O R P O L I C Y QUARTERLY ECONOMIC COMMENTARY Kieran McQuinn Conor O’Toole Matthew Allen-Coghlan Cathal Coffey Spring 2020 The forecasts in this Commentary are based on data available by 19 March 2020 Draft completed on 19 March 2020 A subscription to the Quarterly Economic Commentary costs €327 per year, including VAT and postage. © The Economic and Social Research Institute, Whitaker Square, Sir John Rogerson’s Quay, Dublin 2. ISBN 978-0-7070-0518-8 ISSN 0376-7191 DOI https://doi.org/10.26504/qec2020spr This Open Access work is licensed under a Creative Commons Attribution 4.0 International License, which permits unrestricted use, distribution, and reproduction in any medium, provided the original work is properly credited. ABOUT THE ESRI The Economic and Social Research Institute is an independent research institute working towards a vision of ‘Informed policy for a better Ireland’. The ESRI seeks to support sustainable economic growth and social progress in Ireland by providing a robust knowledge base capable of providing effective solutions to public policy challenges. The Institute was founded in 1960 by a group of senior civil servants, led by Dr T.K. Whitaker, who identified the need for independent and in-depth research to support the policymaking process in Ireland. 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Quarterly Economic Commentary – Spring 2020 |i TABLE OF CONTENTS Summary Table ......................................................................................................................... i CHAPTERS The Irish Economy – Forecast Overview ................................................................................... 1 The Domestic Economy ........................................................................................................... 3 General Assessment .............................................................................................................. 13 ii | Quarterly Economic Commentary – Spring 2020 SCENARIO RESULTS SUMMARY TABLE 2017 2018 2019 2020 Output (Real Annual Growth %) Private Consumer Expenditure 3.0 3.4 2.8 -3.8 Public Net Current Expenditure 3.9 4.4 5.6 6.5 Investment -6.8 -21.1 94.1 -8.1 Exports 9.2 10.4 11.1 -5.0 Imports 1.1 -2.9 35.6 -3.6 Gross Domestic Product (GDP) 8.1 8.2 5.5 -7.1 Gross National Product (GNP) 5.2 6.5 3.3 -8.1 Labour Market Employment Levels (ILO basis (‘000)) 2,194 2,258 2,322 2,145 Unemployment Levels (ILO basis (‘000)) 158 137 121 307 Unemployment Rate (as % of Labour Force) 6.7 5.8 5.0 12.6 Public Finance General Government Balance (€bn) -0.9 0.2 1.4 -12.7 General Government Balance (% of GDP) -0.3 0.1 0.4 -4.3 Quarterly Economic Commentary – Spring 2020 | 1 The Irish Economy – Overview COVID-19 poses the single largest challenge to the Irish economy since the financial crisis. The response of authorities both domestically and internationally to the spread of the virus, while absolutely necessary from a general health perspective, will result in millions of jobs being lost globally in the coming weeks and months and a sharp contraction in global economic activity. The limitations on international travel and the effective sealing-off of entire countries will have profound implications for cross-country trade and commerce. The swiftness of the economic deterioration is unprecedented in modern times and in many respects exceeds that of the financial crisis. It is clear that both monetary and fiscal authorities across the globe must act with conviction and speed to smooth the economic and financial effects of the crisis. Fiscal authorities must support the income levels of those made unemployed and ensure that those commercial enterprises financially viable prior to the crisis are able to operate after it. The European Central Bank (ECB) will have a key role to play in both stabilising debt markets in the short run in response to the increased fiscal pressures on member states, and in mitigating the effects of the crisis on economic growth in the months and years to come. This may require an extensive expansion of the ECB’s balance sheet. Given the unprecedented uncertainty concerning the virus, we conduct a scenario analysis as opposed to a traditional forecast. Mainly through demand-side channels, we examine the impact of the current restrictions on economic life on the assumption that the restrictions are in place over a period of 12 weeks. Under such a scenario, the domestic economy would register a recession in this year with output contracting by 7.1 per cent. This constitutes a significant reversal of the preCOVID-19 related economic trends. Crucially, this scenario assumes that economic activity both domestically and internationally begins to recover significantly in Q3 and Q4 of the present year. If this does not occur, then the results will be even more adverse for the domestic economy. 2 | Quarterly Economic Commentary – Spring 2020 All sources of growth such as consumption, investment and exports are substantially impacted under the scenario. Under the scenario, the unemployment rate is set to increase significantly with the rate increasing from 4.8 per cent in February to 18 per cent in Q2 2020 before falling back to just under 11 per cent by the end of the year. This speed of change in the fortunes of the domestic and international labour markets is unprecedented. Consequently, there will be significant pressure on the Irish public finances. The combination of the extra expenditure on health and social welfare allied to the sharp decline in certain taxation revenues means a deficit of nearly 4.5 per cent is now likely to occur in 2020 and could be higher. Greater expenditure may still be required in order to meet this threat to public health. The path to recovery for the Irish economy is complicated by its extremely open nature. While the domestic authorities may be successful in limiting the spread of the virus, the performance and recovery of the Irish economy will now also depend on the effectiveness with which other countries deal with COVID-19. It is clear that a coordinated response across the European institutions is required to address the economic fall-out from dealing with the virus. In particular, lessons must be learned from the manner in which European institutions dealt with the aftermath of the financial crisis. Beyond a European context, the global economic shock is going to require extensive, coordinated fiscal and monetary expansion to mitigate the effects of the economic shock. Quarterly Economic Commentary – Spring 2020 | 9 fixed capital is irreversible (other than re-sale of the assets) and second, it is highly dependent on companies’ expectations for future revenue streams. In the current environment, with an immediate and sharp adjustment in aggregate demand from households and firms, and an exceptionally high degree of uncertainty about the future trading landscape, it is likely that companies will pare back investment significantly. Furthermore, given the administrative controls introduced for public health reasons, physical barriers to undertaking investment will also be present for the duration of the outbreak. However, the degree to which investment will recover will be highly dependent on the duration and scale of the public health crisis. In previous simulations of pandemic scenarios, Keogh-Brown et al. (2010) simulate that while investment drops during the pandemic, it fully recovers in the quarter afterwards. The scale of the current crisis may lead this to be too benign a scenario. We therefore make the following adjustments to investment spending, taking into account that the rebound in the following quarter is unlikely to entirely make up for the loss in the impacted quarter: • Dwellings – investment falls to zero for the period but an 80 per cent rebound occurs; 5 • Improvements – households cut spending to zero in the quarter and an 80 per cent rebound occurs; • Other building and construction – investment to fall by 50 per cent, and half of the lost investment is recovered; • Transfer costs are unchanged; • Machinery and equipment and R&D – all investment stops for the quarter with 50 per cent of the lost investment being made up in the following quarter (net loss of 50 per cent of one quarter). The impacts are presented (for a full year) in Table 4. 5 For investment in dwellings and improvements, our net loss is calibrated to be proportionate to the labour market shock facing households. Given that we predict an unemployment rate of close to 20 per cent in the quarter, we parameterise the scenario net loss as 20 per cent for investment in dwellings and improvements. 10 | Quarterly Economic Commentary – Spring 2020 TABLE 4 PANDEMIC IMPACT ON INVESTMENT Base Case (€million) With One Quarter Pandemic (€ million) Change % Modified Gross Domestic Fixed Capital Formation 39,528 36,290 -8.2 Gross Domestic Fixed Capital Formation – Dwellings 4,511 4,285 -5.0 Gross Domestic Fixed Capital Formation – Improvements 2,687 2,553 -5.0 Gross Domestic Fixed Capital Formation – Other Building and Construction 15,965 14,967 -6.3 Gross Domestic Fixed Capital Formation – Transfer Costs 1,324 1,324 0.0 Machinery and equipment and R&D 15,041 13,161 -12.5 Source: Authors’ calculations. Investment in other buildings and construction, which primarily relates to commercial building, falls in the impacted quarter by about half of what it would be in the base case. However, in the following quarter about half of this loss is recovered leading to an annualised loss of 6.3 per cent. Under the scenario, investment in dwellings and improvements comes to a complete halt in the quarter of the pandemic but much of this investment is then deferred to the following quarter offsetting a significant amount of the original loss. The annual loss of investment in dwellings and improvements is estimated to be 5.0 per cent. A similar scenario is estimated for other machinery and equipment and R&D with a complete fall in investment during the pandemic quarter, though less of the investment is made up in the next quarter. Investment in these items is forecast to fall by 12.5 per cent on an annual basis. Investment related to transfer costs is not forecast to be impacted by the pandemic. Overall, under our scenario, investment is down 8.1 per cent for 2020 compared to the previous year. LABOUR MARKET AND PUBLIC FINANCES Labour market results An inevitable consequence of the decision taken by the authorities to restrict the spread of the virus has been an almost total decline in certain types of economic activity from mid-March onwards. Many outlets particularly in the retail, food and hospitality sectors have simply stopped trading. Under our scenario we assume a 12-week period during which the restrictions and controls on public life continue. This will inevitably result in a dramatic increase in the numbers of workers in these sectors being made unemployed. In particular, the wholesale and retail trade and the accommodation and food service activities, which together employed over 480,000 people in Q1 2020, look set to lose a substantial number of workers over a very short period of time. While the domestic labour market experienced a rapid Quarterly Economic Commentary – Spring 2020 | 11 increase in unemployment in the period between early 2008 and 2009 (from 5.3 per cent to 14 per cent), such an increase in the present context could take place in a matter of weeks. Under our scenario, we assume that normal economic activity both domestically and internationally will have commenced by Q3 of the present year. Overall, the unemployment rate increases from 4.8 per cent in Q1 to 18 per cent in Q2 before falling back to 16.5 per cent in Q3 and 10.7 per cent in Q4. The increase in the unemployment rate through Q2 and Q3 is equivalent to approximately 300,000 workers losing their jobs during this period. Under our scenario we also assume that net migration into Ireland declines significantly during the course of 2020. Clearly, policy interventions that ensure inherently viable businesses survive the crisis, and that secure income levels for those households most affected, will lower the impact of the crisis on the labour market. However, the increase in unemployment could be greater if economic activity does not return to normal in the latter half of the year. Public finance results Given the impacts of COVID-19 on consumption, trade and the labour market in our scenario, it is evident that certain tax headings such as income tax, VAT, corporation taxes and PRSI receipts are all likely to experience significant declines in 2020. The substantial increase in unemployment in Q2 inevitably results in a dramatic fall-off in revenues across a number of tax headings for that quarter. Under the scenario, for example, total receipts for income tax fall by 5 per cent in the present year, with VAT receipts also declining by 8 per cent. The decline in income taxation receipts is consistent with our scenario results for the labour market, while the decline in VAT receipts reflects the sharp decline in consumption detailed above. Overall, under the scenario, taxation receipts are reduced by almost 7 per cent. This is in sharp contrast to recent trends in taxation receipts. Similarly, on the expenditure side, the Government has committed significant additional resources to addressing the outbreak of the virus. We assume that the funds which had been set aside to deal with a hard Brexit (approximately €1.2 billion) are now fully spent on virus-related measures as well as additional revenues publicly pledged. Also, the sharp increase in unemployment will result in a sizeable increase in transfer payments. Based on our results for the labour market, upwards of €2 billion in such payments are now required in 2020. 6 6 We are particularly grateful to our colleagues Karina Doorley and Barra Roantree for providing us with this estimate based on the SWITCH model. 12 | Quarterly Economic Commentary – Spring 2020 We also include the cost of an income protection scheme similar to that proposed in the United Kingdom. Under such a scheme 80 per cent of the salary of workers made redundant during the virus crisis would be paid by the national Exchequer. On top of the regular transfer payment, we estimate this would result in an additional €2.8 billion expenditure over the period in question. When we combine this with the lower revenues on the taxation side, it results in a deficit for 2020 of over 4 per cent for the year. It may be necessary to increase the deficit beyond this amount if additional health expenditure and/or social welfare payments are required. Additional expenditure may also be required to fund a broadly-based stimulus when economic activity recommences in Q3 and Q4. Obviously, if there is a significant delay in the economic recovery both globally and domestically, then the size of this deficit would also increase as the year progresses. Quarterly Economic Commentary – Spring 2020 | 13 General Assessment ECONOMIC IMPACT OF COVID-19: Ultimately, in order to contain the spread of the COVID-19 virus, the public authorities have had to implement measures which will have a drastic impact on certain aspects of economic activity. In that regard it is important also to note that, for once, Government policy is actively seeking to limit certain aspects of economic activity. Part of the necessary action taken by the authorities involves closing schools, pubs, restaurants, hotels and limiting the use of airports. All of this significantly curtails what Wren-Lewis 7 calls ‘social consumption’. This will inevitably result in a significant decline in output in key sectors of the economy with a significant increase in unemployment. The likely increase in Irish unemployment will be substantial in size and rapid in nature. To provide some perspective, at the height of the financial crisis Irish unemployment went from 5.3 per cent in February 2008 to almost 14 per cent in September 2009. This time around, the unemployment rate could increase to 18 per cent in Q2 of this year from its rate in February of 4.8 per cent. If economic activity does begin to return to normal in Q3 and Q4, the unemployment rate declines through the rest of the year from 16.5 per cent in Q3 to 10.7 per cent in Q4. Given the uncertainty around the duration of the virus it is not possible to produce accurate forecasts at a time like this. In estimating the economic effect of the virus, our approach is to conduct scenario analysis as opposed to a traditional forecast. Also, given the rapidly changing nature of the pandemic, it is likely that even well thought out scenarios can quickly become out of date. Therefore, we will produce a range of scenarios and economic updates over the coming months as more information becomes available concerning the scale and impact of the pandemic. We begin by providing a specific scenario which considers the impact on the Irish economy of a continuation of the current restrictions and controls on economic and social life for a 12-week period. On an annualised basis, we believe consumption could decline by almost 4 per cent relative to 2019 levels under such a 12-week pandemic period. We combine these impacts on consumption along with impacts on trade and on investment. These results indicate that the Irish economy is almost certainly heading for a significant contraction in 2020. 7 Wren-Lewis defines consumption as social if it helps bring people into contact with other people. See https://mainlymacro.blogspot.com/2020/03/the-economic-effects-of-pandemic.html for more on this. 14 | Quarterly Economic Commentary – Spring 2020 It is important to acknowledge the assumptions made in this exercise. These include the expectation that most major economies will have managed to contain the virus by July, and that normal economic activity will recommence during the latter two quarters of the year. If this does not happen then the impact on the Irish economy will be even more severe. Under our scenario, key fiscal metrics for the economy will be adversely impacted. While a surplus had looked likely at the onset of the year, the knock-on impact of lower taxation revenues coupled with greater than expected public expenditure on health and social welfare means that a deficit of at least 4.3 per cent is now likely in the public finances. THE POLICY RESPONSE TO COVID-19: While the most pressing policy concern at present is to introduce whatever measures are required to stem the spread of the virus, policies to stabilise the economic fallout are also critical from an economic and human perspective. The overarching policy concern should be twofold: protecting household incomes and ensuring businesses can survive the pandemic period and remain viable in the aftermath. While the financial crisis and the current situation are very different, one lesson from the previous period should guide policy choices now. It is clear that households and firms with high debt levels cut back on consumption, investment and employment. If businesses, in particular, are to maintain employment and return to growth when the acute medical phase of the current crisis has abated, policies should be focused on helping these enterprises to manage their payments and cash flow without running up significant debt levels. Supports to protect workers’ incomes can have a double boost of ensuring households have sufficient resources while lowering cash flow issues for employers. Policies by the financial sector to provide loan repayment holidays are welcome and should give households and firms breathing space, but more is required across a range of fixed payment items (such as rent, utilities, taxes and other charges). On the fiscal front, the Government is already taking stimulatory action. While a further stimulus will be required at some stage, in the immediate future fiscal policy support should be specifically targeted towards income supports and measures to help firms remain viable. At present, with Government policy actively seeking to discourage people from engaging in unnecessary human contact, households are effectively being constrained only to consume bare essentials such as basic groceries. This would lower the impact of a broad stimulus now as households would have few avenues to spend. However, when the public health Quarterly Economic Commentary – Spring 2020 | 15 phase of the crisis is over, more traditional fiscal policy levers should be engaged in an extensive and globally coordinated manner. During this phase, huge responsibility lies with the European Central Bank (and European Banking Authority) as both lender of last resort and financial regulator. The ECB has outlined a series of measures which aims to support the supply of credit provided by banks to firms and households within the Euro Area. However, much more will be needed from the ECB in the weeks and months ahead and it will have to act in a ‘whatever it takes’ fashion. It is clear that sovereign governments across the Euro Area are set to substantially increase their levels of debt over the coming months and years in response to this crisis. In the domestic context for example, it may be necessary to increase the deficit beyond the 4.3 per cent estimated under the present scenario; governments must do all that is required to meet the healthcare demands of this crisis. It is imperative, therefore, that the ECB does all that it can to prevent this development from becoming a full-blown sovereign debt crisis. It must also ensure that subsequent debt levels do not impede economic activity across the Euro Area in the years to come. While the ECB is explicitly forbidden from engaging in monetary financing of government debt, there are more imaginative ways it can alleviate the fiscal burden on member states. For example, Whelan (2020) 8 has suggested that the ECB could issue very long dated Eurobonds. An announcement could be made where it would state that the ECB would purchase substantial quantities of these in the secondary market. This would enable governments to fund large deficits. These ECB purchases could then be calibrated to keep the yields on newly issued Eurobonds low for long periods of time. Alternatively, the ECB could loan money to the European Investment Bank which would provide funding to firms in distress. Honohan (2020) called for a ‘massive’ expansion of this type of funding. 9 From a regulatory perspective, reductions in capital requirements for banks will be needed as the Central Bank of Ireland recently announced with its Countercyclical Capital Buffer. Creative ways to ensure loan modifications can occur without being classed as non-performing in the long run are going to be needed to ensure bank lending continues in the recovery phase and a credit crunch does not ensue. 8 https://twitter.com/WhelanKarl/ 9 https://www.piie.com/commentary/op-eds/coronavirus-no-excuse-repeating-errors-financial-crisis 16 | Quarterly Economic Commentary – Spring 2020 Overall, it is evident that European institutions must learn from some of the significant policy mistakes 10 which were made in dealing with the financial crisis of 2007/2008. Coordination and coherence are required across institutions such as the European Council (EC), the European Central Bank (ECB), the European Stability Mechanism (ESM) and the European Banking Authority (EBA). 10 See McQuinn, K. (2015) for more on this. ‘European fiscal policy during the crisis: An Irish perspective’, Research Note, Quarterly Economic Commentary, Autumn: The Economic and Social Research Institute, Dublin. Whitaker Square, Sir John Rogerson’s Quay, Dublin 2 Telephone +353 1 863 2000 Email [email protected] Web www.esri.ie Twitter @ESRIDublin ISSN: 0376-7191 ISBN: 978-0-7070-0518-8