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The post-Covid boom and the road beyond

boomboom
What we can expect as we emerge from the pandemic.

By Ioannis Tirkides

Optimism is rising high in the global economy for the recovery in 2021-22, and growth forecasts are being revised higher. The European Commission now expects real GDP growth of 4.2 per cent in the EU in 2021 and 4.4 per cent in 2022, compared with 3.7 per cent it was predicting earlier.

For Cyprus, growth forecasts for 2021-22 range between 3 per cent and 4 per cent. The global economic outlook is better now than earlier thought, and for good reasons, but downside risks, are perhaps downplayed. Some for good reason, some not. In this article, we are going to look at the present and the future, the fundamentals that lie behind the trends, the risks, and the challenges. We conclude that the recovery is a little overstated, and that policy makers should be thinking longer than a year or two.

Caution, forward thinking, and the political will to get through the reforms and required restructuring is what is going to propel us forward sustainably, even if the ride is a  little bumpy in the beginning. Changing the growth model as we all believe we should, will come neither cheaply nor easily!

Let’s start at the beginning. The better economic outlook in Europe and elsewhere for 2021, is justified.  The policy stimulus will be exceedingly large for yet another year. Budget deficits, that had exploded in 2020 for  good reason, will remain just as bloated in 2021.

In the United States, the budget deficit rose from 6.6 per cent of GDP in 2019 to 16.1 per cent in 2020 and it is expected at 16 per cent also in 2021, according to the spring economic forecasts of the European Commission. In the Euro area as a whole. The budget deteriorated from near balance in 2019 to a deficit of 7 per cent of GDP in 2020 and expected at 8 per cent of GDP in 2021. A huge fiscal expansion in 2021 coupled with complete monetary accommodation will go a long way pushing GDP higher.

The other factor  propelling GDP higher is  described as endogenous, which means that in part, the recovery will happen by itself.   The lockdown measures that were on and off all year in 2020, meant that people consumed less and saved more. As we now normalise, part of that extra saving will be spent on top of the usual rate, causing private consumption to rise much faster.  With consumption about two thirds of the economy, this will produce a lot of growth for the year.

Data on household savings tell the story. though there are differences from country to country. The household savings rate jumped from 12.2 per cent to 18.6 per cent between 2019 and 2020 in the European Union as a whole. It jumped from 18.4 per cent to 23.5 per cent in Germany and from 10 per cent to 17.5 per cent in Italy, respectively. Cyprus in comparison, is the poor cousin of the group, with  the lowest household savings rate in the EU after Greece. Our household savings have been chronically low, having gone negative in the previous recession, then recovered very modestly in 2016-19, rising marginally from 3.1 per cent in 2019 to 3.8 per cent in 2020. which reflects badly on the current account.

In the end, the recovery in 2021 will be partial, and uneven. The EU as a whole contracted by 6.1 per cent in 2020, more sharply in some member states than in others, and a rebound of 4.2 per cent will not recover the output losses entirely. Some northern countries will likely return to pre-crisis levels in 2021 but the southern countries will not, which highlights the long-standing divergences in Europe.

Economic policy and future economic risks

The fiscal stimulus of 2020 led to the sharp deterioration of public finances. A number of issues thus arise. When should the stimulus be withdrawn? How sustainable are current debt ratios? And is inflation creeping back?

There is a consensus view that for 2021 at least, we should keep our foot firmly on the accelerator. Fiscal and monetary policies will be adapting to changing conditions as we go along, but they should retain an expansionary bias until full recovery is attained. The stakes from reversing policy too early are too great, and polices will remain expansive for longer than the pandemic lasts.

But fiscal policy should become better targeted, to support the most vulnerable sectors of the economy, and segments of the population. Fiscal policy should also become more flexible to facilitate the reallocation of resources as economies undergo their digital and green transitions. This will almost certainly require a change in the composition of both revenues and expenditures, not an easy feat a-priori.

Expansionary fiscal policies and their monetary accommodation can be inflationary. But monetary policy has been excessively accommodative for the most part after the global financial crisis of 2008, while inflation remained muted. That was because structural factors like globalisation, rising income inequalities and credit deleveraging were long pushing aggregate demand lower. Globalisation in the past twenty years or so, has expanded our production possibilities globe-wide, immensely.

Globalisation also helped cut production costs as labour-intensive activities were shifted to low wage jurisdictions. Then rising income inequality in the advanced economies, a phenomenon that has been shaping up for about as long as globalisation, also works to reduce aggregate demand by shifting more money and wealth to the rich who will not spend it, and less to the poorer segments who would spend it if they had it. And then there is the old classic, the ongoing loan deleveraging is also destroying credit as you go along, that process is by its very nature deflationary.

Yet, supply scarcities are all over, from basic commodities, to microchips to food. These shortages amidst sudden bursts in demand as we return to normality, lead to inflation spikes. These should be temporary. But if shortages do not go away as quickly as we may like to think, then the inflation spikes we now anticipate may not be so temporary.

Public debt has been rising in Europe and elsewhere, ever since the global financial crisis. Between 2007 and 2019 the average debt ratio in the EU as a whole, had risen by 15 percentage points of GDP, and then by another 13 percentage points in 2020 alone. It will rise further in 2021. But remarkably, the higher debt ratios are more affordable today than fifteen years ago, because of the sharp declines in debt service. In the EU as a whole, debt service dropped from 2.7 per cent of GDP in 2007 to 1.4 per cent of GDP in 2020. Debt sustainability is relative and depends in large part on interest rates remaining low for longer. That may not be entirely in the hands of central banks for much longer!

Afterthought

The post-Covid boom will come and will go, and at the end we will find ourselves where we started. We will have to deal with what preceded Covid, the legacy it brought in its sway, and prepare the future. Prior to Covid, the global economy was slowing, the pace of productivity growth was dropping, and income inequality was rising.

This combination of events were impacting labour markets most severely, creating what is called jobs polarisation, where jobs growth is concentrated at the low end of the market, bringing social discontent with it. We will also have to deal with the legacy of the pandemic, as we already discussed extensively, the much higher debt ratios, and the much-bloated central bank balance sheets. Turning to the future, we are at the beginning of a major structural transformation, driven by the digital and green transitions. This will be a long process, and very transformative for all sectors of the economy, governments, labour markets, and private enterprises. To succeed, we will need to deal with the underlying many challenges, prudently and effectively, and in an inclusive manner foremost. This is as much true for the global economy at large, as it is for all countries, large and small!

Ioannis Tirkides is the Chief Economist of Bank of Cyprus. Views expressed are personal and may not necessarily reflect those of the employer.

The article is published in the Blog column of the Cyprus Economic Society and  in the Cyprus Mail under a media partnership agreement.

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