Demand and supply, the coronavirus and the economy – what the crisis means

The last few weeks have seen an unprecedented change in the way the UK economy works. Supply of many goods and services has essentially dried up as workers stay at home and businesses furlough staff. Demand has also fallen off a cliff for all but the basic essentials.

This combination of issues and the fact that consumers can’t spend what they have is, according to Peter Toogood, chief investment officer at Embark Group, is what makes this crisis particularly acute. Indeed, he goes as far as saying that: “GDP has effectively stopped, which is something that no one who is alive today has ever seen”.

The pandemic is proving to be such a crisis because the economy is experiencing both a demand side shock and a supply side shock simultaneously.

Why this is different to Brexit

The coronavirus pandemic has come at the end of an already uncertain period for the economy, largely caused by the UK’s decision to leave the European Union.

However, Andy Haldane, chief economist of the Bank of England, described Brexit as a supply side economic shock. This is because introducing restrictions on the movement of people, goods and services has the effect of reducing supply, which pushes costs up and growth rates down.

A demand side shock didn’t happen in the UK after the referendum in 2016 as consumers continued to spend. This is why, he says, that the UK economy performed better in the aftermath of the referendum than the Bank had predicted.

First came the supply side shock…

A supply side shock occurs in an economy when it becomes harder for goods to get to market, either because:

• Companies can’t finance their operations as banks are not lending
• Consumers can’t access credit, even if they can afford it.

The current coronavirus crisis first led to a supply side shock in the UK when Chinese factories began to shut down. Goods manufactured in Wuhan and the surrounding region could not be manufactured and exported to the UK, creating immediate shortages. We saw this through early warnings from car manufacturers that they could not obtain parts.

A shock such as this would normally lead to a sharp rise in inflation, as fewer available goods cause prices to rise.

…and then the demand side shock

A demand side shock in an economy happens when individuals and companies reduce their consumption, either because:

• Their income drops
• They fear their income will drop in the future and so begin saving now.

After the initial supply side shock happened, the virus then spread to the rest of the world. The fear of a reduction in supply of goods and services became all but irrelevant as the demand for goods collapsed, in Europe, then in the UK and then in the US. Fewer shops were open, and individuals were restricted in getting out to buy.

Finding a solution to the current crisis is difficult

Trying to find both supply and demand side solutions to the current crisis is difficult for a number of reasons. Supply side solutions are ineffective as:

• Increasing the ability of banks to lend won’t work if businesses can’t actually supply goods and services (because they have been instructed to close)
• Increasing the availability of credit to consumers won’t work as they can’t get to the shops to use this additional purchasing power

The extent of the current crisis means a demand side solution is also difficult. The economist John Maynard Keynes argued that the answer to a demand side shock in the economy was for the government to spend money, and consequently to increase the demand for goods and services.

However, it’s impossible for the government to inject demand into the economy if the shops cannot get goods to sell, or consumers can’t leave their homes to do any of the jobs that might be created!

Even the measures taken won’t necessarily solve the problem

Richard Flax, chief investment officer at Moneyfarm says that while supply side measures can have an effect quite quickly, measures to tackle the demand side of the economy take time.

Edward Park, deputy chief investment officer at discretionary fund management firm Brooks Macdonald, says that even if the emergency measures that the government have announced do work, and the UK economy comes out of recession when the pandemic is over, it is unlikely that the economy will bounce back immediately.

This is because the debt created now will have to be repaid, both by the government and by any company that has accessed emergency borrowing (such as a Business Interruption Loan).

He adds: “The UK government has announced fiscal stimulus targeting the economic impacts of the Coronavirus outbreak. The highest profile part of this is the promise of £330 billion of government guarantees to finance bridging loans for UK businesses struggling with cash flow pressures.

“While this headline grabbing number, equivalent to 15% of GDP, will help it will still need to be repaid which will be easier said than done for businesses that need to provide financial support to staff, pay rent and honour contracts with suppliers.”

The use of ‘helicopter money’

Initially, the UK government’s response to the crisis was to use orthodox policies, both on the demand and supply side (albeit on a much larger scale than ever before).

With millions of jobs and businesses at risk, the Chancellor has now been forced to deploy a much more revolutionary approach known as ‘helicopter money’. This is where the government hands out money directly to its citizens.

We’ve seen three main announcements in this regard:

• Direct grants to small business, most notably in the retail, hospitality and leisure sectors of up to £25,000
• A scheme to pay self-employed workers 80% of the average of their last 36 months’ earnings (up to £2,500 a month) as a lump sum in June
• A scheme to pay up to 80% of the wages of ‘furloughed’ workers to enable businesses to keep staff on for when they reopen

Helicopter money is both a supply side and a demand side policy. It increases the amount of cash in the economy and ensures money is paid directly to individuals, rather than being stuck within the banking system.

As Nouriel Roubini writes in The Guardian: “Only central governments have balance sheets large and strong enough to prevent the private sector’s collapse.”

Get in touch

If you have any questions about the current economic situation and its impact on you or your business, please get in touch.  Email info@depledgeswm.com or call (0161) 8080200.