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Why This Time Really Is Different For Europe


Economic Research: Why The U.K.'s Worse Recession Should Turn Into A Stronger Recovery

The U.K. economy contracted by 9.8% in 2020, its worst single-year performance in 100 years, and worse than those of almost all its peers. Why exactly was that? And how will the factors at play shape the U.K.'s recovery growth?

Among the 42 largest economies, the U.K. recorded the second-worst performance in terms of real GDP growth in 2020, only a little better than Spain, and slightly worse than Argentina and the Philippines. But is it fair to compare the pandemic growth experience of a mature economy, such as the U.K., with that of economies that typically grow much faster, such as India, which averaged 6% annual growth over 2017-2019? Absent the pandemic, India might have grown around 6% in 2020, but in fact contracted by 7%, representing an actual growth shortfall of 13%. For the U.K., by contrast, the growth shortfall was 11.3%, not much worse than the 9.8% contraction, because the economy might have grown by just 1.5% in 2020 in the absence of the pandemic.

Chart 1

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We consider this growth shortfall measure (which we calculate by removing average growth over 2017-2019 from 2020 numbers) more meaningful for comparison. When we apply it to create a new ranking (see chart 1), many economies move around significantly. Yet, the U.K. only falls to fourth position from second. So, the issue doesn't seem to be simply one of an inappropriate comparison in terms of growth.

One obvious factor could explain these differences: the stringency of lockdowns varied across countries. Indeed, our analysis shows that that this stringency played an important role in determining the growth shortfall, but, somewhat surprisingly, it only explains around 18% of the variation between countries. Sweden is a case in point: it had no official lockdown, and yet performed comparatively very well. It could be, of course, that the stringency index, although well designed, does not fully capture the severity of the restrictions on the ground. It is also very likely that the effectiveness of the same measures differed between countries. With that caveat, stringency was higher in the U.K. than on average in the rest of our sample, which we believe goes some way to explaining the U.K.'s worse performance (see chart 2).

Chart 2

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However, there are a multitude of other factors that might explain why economies responded differently during the pandemic. One key factor is, of course, the magnitude of government support regarding businesses' access to finance as well as labor market measures. Many other factors are related to the structure of the economy. For example, we think that Spain's large tourism sector explains bigger GDP losses there (and similarly for Italy and Greece). The high degree of digitalization of Sweden's economy also likely made it more resilient to social distancing (in Sweden's case, mostly voluntary). It's difficult to disentangle the impact of all these factors (for a detailed attempt, see "Initial Output Losses from the Covid-19 Pandemic: Robust Determinants," published Jan. 29, 2021, by the IMF).

U.K. Household Consumption Suffered More

Lockdowns were designed to limit face-to-face interactions because this is how the virus is transmitted. Of course, this predominantly affected household consumption, especially in discretionary and so-called social consumption sectors, such as restaurants, where restrictions were most stringent. It is therefore not surprising that among the factors that determined GDP outcomes in 2020, an economy's share of private consumption in total GDP is a major factor. This is simply because the higher the share, the more of the economy will be affected by restrictions. A chart showing this relationship would be almost identical to chart 2, above.

This is one important reason why the impact of the lockdowns on GDP was stronger in the U.K. (see chart 3). On average, private consumption makes up 62% of GDP in the U.K. versus 53% in the EU. For example, if EU consumption had fallen by 10.6% in 2020, as it did in the U.K., the direct GDP impact in the EU would have been 5.6% compared with 6.5% in the U.K.

Chart 3

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Even more important, however, is how much households usually spend specifically on social consumption, because if that sector is all but shut down, a 1% reduction there translates roughly one-to-one into a reduction in GDP. And it turns out that U.K. households typically spend around 2% more on social consumption than households do in the EU, another reason why the U.K. performed worse.

Chart 4

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While these mechanics may seem obvious, there is another side to the consumption story. With little or no activity, the services sectors that cater to face-to-face consumption, such as restaurants and shops, had to furlough disproportionately more of their employees, not only because they were worst affected, but also because they are very job-intensive. Indeed, 22% of all furloughed workers were in accommodation and food services alone (see chart 4). The prevalence of such jobs in the U.K. economy meant that, overall, many more workers were put on furlough in the U.K. than in the EU. In May 2020, one month after the peak of the crisis, around 30% of the workforce were on furlough in the U.K., compared with just 12% in the EU.

Although furlough payments prevented the worst in terms of income loss for many people, it still meant an income reduction in jobs that already earn rather low wages in normal times. Affected households had little room to substitute consumption spending into other areas, as higher-income households did, so that the high number of furloughed workers is likely to have made the impact on overall growth worse than in other economies.

Incidentally, the U.K. economy's greater reliance on consumption relative to its peers and its major trading partners was also reflected in external trade. The large import content of consumption required relatively fewer imports and, hence, net trade contributed positively to growth in 2020. This was aided by some unwinding of Brexit stockpiling after the risk of a no-deal was diffused in late December 2019.

The ONS Measures Public Consumption Differently From Peers

Lockdowns generated a highly artificial situation. By ordering businesses to close and restricting people's geographic and social mobility, they introduced both a supply and demand shock at the same time. In such a situation, the measurement of economic activity can become a challenge because this artificial situation creates distortions, and the Office for National Statistics (ONS), has repeatedly pointed out this caveat when it has published new numbers.

The challenge becomes even more difficult when trying to measure public sector output because, unlike in other areas of the economy that are mostly subject to market rules, market prices are often not available at all, while the nature of government services changes at the same time. This applies in particular to the National Health Service (NHS). The ONS estimates output in this sector by reconciling money spent and units of service provided (see "International comparisons of GDP during the coronavirus (COVID-19) pandemic," published Feb. 1, 2020, for more on the ONS approach). The variable that allows this reconciliation is the imputed price per unit. What made the reconciliation more difficult during the pandemic was that, given the overload of the NHS, services were shifted from regular activity to treating patients with the virus (see chart 5). This included some novel services, as well as some services that can be difficult to measure in units.

Chart 5

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As a result of the ONS' approach, the price of public consumption rose by 23% in 2020, while volumes actually fell by 6.5% at the same time, a pattern not seen in any otherwise similar economy. On the face of it, these numbers suggest that the NHS, by dealing with COVID-19 patients, shifted its services to much costlier ones, but to fewer of them overall. It is also a possibility that the NHS became grossly inefficient during the pandemic, but that is harder to believe. Another reason for the anomaly might be that some of the more intangible services were not properly accounted for, so that volumes were underestimated, and prices were overestimated. Because of these uncertainties, we think major revisions to government consumption data for 2020 are very likely in the future.

Chart 6

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A further reason is the ONS approach itself. It is different from the approach taken by other national statistics offices across the world, which only use spending on their health services in combination with relatively inert price assumptions. If we follow the reasonable assumption of moderate mismeasurement, then the difference in the method alone explains a considerable portion of the U.K.'s underperformance in 2020 when compared with peers. Had the ONS measured public sector output in the way it is done across the EU, the contraction in U.K. GDP would have been 1 to 3 percentage points less, according to our estimates. Looking at GDP growth in nominal terms alone, which involves no separate estimation of prices and volumes, tells a similar story: U.K. performance is much closer to that of its peers, and virtually equal to that of the EU (see chart 6).

Some Good News For the Recovery

Accounting for factors specific to the U.K. economy, but seeing through the differences in measurement, the underlying performance of the U.K. economy was much more similar to that of its peers, although probably still somewhat worse.

Chart 7

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But what do these factors at play during the downturn mean for the U.K.'s recovery? Just as the U.K.'s larger consumption share exacerbated the downturn compared with its peers, so it will boost the upswing more than elsewhere as restrictions are increasingly lifted. This has already started and is one key reason why we expect stronger growth for the U.K. over 2021-2022 than for many other European economies, at 11% cumulatively compared with 8.7% for the EU.

The NHS shift back to more regular activities as the pressure from the pandemic abates will add to this impetus, further helped by increased efforts in testing and tracing in the first half of 2021, including the ongoing rollout of the vaccination. We saw some of these effects at play already in the final quarter of 2020, when the drag on growth from the health services was greatly reduced as testing and tracing activity picked up considerably.

Conversely, net trade will likely weigh on growth, as the recovery in consumption is set to translate into higher demand for EU imports, on which the U.K. still heavily depends, while U.K. exports will continue to struggle to reach levels of the EU because of increased red tape, tariffs in some cases, and weaker demand from the EU, following the implementation of the new trade agreement.

Still, overall, the U.K. growth dynamics this year and next will be led predominantly by the recovery from the pandemic. All things going well, despite Brexit, the U.K.'s GDP growth should outpace that of most of its peers.

This report does not constitute a rating action.

Senior Economist:Boris S Glass, London + 44 20 7176 8420;
boris.glass@spglobal.com

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