UK economy contracts as expected – depth of recession depends on government response

While a painful drop in output is expected, the ultimate length and depth of the recession depends on the decisions taken by politicians.

The UK economy contracted by 2% in the first three months of 2020, marking the worst quarterly result for the economy since the financial crisis.

That period only covered a few days during which the UK was placed under “lockdown” in a bid to contain the spread of coronavirus. As Richard Hunter, head of markets at interactive investor notes: “The figure is, of course, for the first three months of the year and as such is equivalent to driving with the rear-view mirror.”

March specifically saw a significant fall in output, with GDP contracting by 5.8% compared to February. According to Helal Miah, investment research analyst at The Share Centre: “The monthly figure for March doesn’t tell the whole story, but the economy falling by 5.8% is somewhat closer to reality.”

The full extent of the damage to the economy will become clearer in the second quarter, in which the full impact of the lockdown will be felt.

As Hunter notes: “The second quarter is likely to bear the economic brunt of the pandemic while also confirming the inevitable recession which is almost certainly already in play in the UK.” Estimates place the contraction in GDP as being somewhere between 20% and 30%.

However, while a painful drop in output is expected, the ultimate length and depth of the recession depends on the decisions taken by politicians, says Nick Wall, co-manager of Merian Strategic Absolute Return Bond fund at Merian Global Investors.

To mitigate the economic impact of the virus and lockdown, the government has ramped up government spending and borrowing to historically high levels.

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To deal with this once the pandemic is over, the government will have to engage in a form of “financial repression,” says Wall. The sort of financial repression it chooses, he says, will determine whether we see a short and sharp recovery or a long, arduous grind back to pre-virus prosperity.

Wall offers some historical perspective. He notes that after the economic shock of the First World War, “the UK sought to pay off her debts via a period of internal devaluation (aka austerity) after re-joining the gold standard at its pre-war level.”

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This was deflationary, harming economic activity and the prospects of workers while benefiting savers.

An alternative example, says Wall, is that of France after the Second World War. The country “opted to pay off her debts by holding down real rates far below the rate of nominal growth.”

This punished savers with negative real returns, but was much less of a burden to the wider economy.

Wall says he expects and hopes to see something close to the second example. He argues: “Given the outsized economic impact on younger cohorts and the rejection of austerity as a policy tool, coupled with low inflation, we expect the government to follow the French example.

“And, in our view, the Bank of England will help the government implement this policy course by increasing bond purchases next month – the last thing HM Treasury needs now is an episode of bond vigilantism.”