Are we going from a terrible year to a great 2021?

The year 2021 will be better economically than generally expected. For the time being, the economy differs between regions, but this recession is different from previous recessions. The year 2020 is admittedly without the Olympic Games, but with many world records. In which investors have been asked new pressing questions. Han de Jong looks back and forward.

2020 has turned out to be a terrible year, an 'annus horribilis'. First of all, of course, there are the consequences of the coronavirus for public health. Bovendein, the economy has taken an unprecedented hit as consumer and business behavior changed amid fears of the deadly virus that is looming. The restrictions on public life have also taken their toll.

Vaccines are now becoming available and we see light at the end of the tunnel. It's hard to say how far that is. It's getting closer every day. 2021 promises to be a better year than 2020, although it could hardly be otherwise.

The opposite of an Annus Horribilis is a great year, an 'Annus Mirabilis'. In my final macro commentary of 2020, I try to formulate an answer to the question of whether 2021 might go down in the books as such an Annus Mirabilis. I am optimistic, although the year has got off to a false start due to the new new lockdown in the Netherlands and other European countries.

The differences between the 2020 recession and past recessions are significant and remarkable. This has consequences for the recovery capacity of the economy. More than usual, this consideration takes the form of a comic book. That is, many images with a limited, but still considerable amount of explanatory text.

'World records'
The economy has set a significant number of world records this year. The first picture shows that more countries were simultaneously in recession in 2020 than in any other year in the last 150 years.

1. Percentage of countries with negative economic growth

The contraction of the economy in the second quarter was unprecedented. Picture 2 shows the growth per quarter in the US. In the second quarter, the economy shrank by almost 9%. Over the past 70 years, the most severe contraction in a quarter was just over 2%. Our economy did fractionally less badly. Growth in the third quarter was also a record, never before did the US economy - but also ours - grow as fast as in the third quarter.

2. US: GDP growth, % quarter-on-quarter

Unemployment also rose spectacularly in the US.

3. US: 2 month unemployment rate change, percentage points

Unemployment in the Netherlands rose only slightly, as a result of which the difference between the unemployment percentage in the two countries also reached a record. The following graph shows this. The divergent development is the result of the differences in approach to support measures. For us, the emphasis on job retention in the US was much more on income support. Our relatively low unemployment rate undoubtedly masks a strong hidden unemployment.

4. US unemployment minus Netherlands unemployment, percentage points

Governments and central banks responded in an unprecedented manner. Very strong stimulus measures to protect incomes, jobs and businesses, together of course with the cyclical effects of the recession itself, led to a sharp deterioration in public finances. In the Netherlands, a budget surplus of 1,7% of GDP turned into a deficit of more than 2019% of GDP in 6. In the US, the deficit tripled to about 15% of GDP. Picture 5 shows the US budget deficit in dollars.

5. US: Federal Budget Deficit, 12-Month Rolling Sum ($bn)

Central banks were also not indifferent. Threatening liquidity problems in the US government bond market forced the Fed to intervene on a large scale in the spring. Soon, most major central banks resorted to massive asset-buying programs to maintain liquidity in financial markets and keep the flow of credit in the economy going. This policy was successful, but it did lead to strong growth in the balance sheet totals of central banks. See pictures 6 and 7.

6 and 7. Change in balance sheet total for 8-month periods in billion $ (6) and € (7)

The spectacular deterioration of public finances and the equally spectacular growth of central bank balance sheets have had corresponding effects on the money supply. In Europe this is still the case. The year-over-year growth of social money M1, for example, accelerated in the eurozone from about 8,5% in February to more than 13% in October. In the US things went even faster, as Picture 8 shows.

8. US: M1 Growth % Year Over Year

A very strange, actually perverse, record was set in our own country in the field of bankruptcies. In a recession, the number of bankruptcies generally increases, albeit with some delay. During the recovery, the number of bankruptcies decreases again, also with some delay. This time, the number of bankruptcies fell sharply during the recession.

In fact, Picture 9 shows that the number of bankruptcies in our country during the last 38 years did not decrease as quickly as it does now. This is undoubtedly due to the government's support measures and the way in which banks approach their business customers who have run into problems (for the time being). To what extent this is the calm before the storm remains to be seen.

9. Bankruptcies in the Netherlands, companies and institutions % year-on-year

What's different in this recession?
The 2020 recession is quite different from previous recessions in a number of ways. These differences affect the recovery process and especially the recovery power.

• First, this recession was caused by an external shock, not a problem inherent in the economy itself.
• Second, differences are reflected in the 'world records' just presented. Against this background, I caution against placing a high value on quantitative economic forecasting. The models with which they are made are fed with historical data to establish connections. Since we haven't experienced what we're going through this year before, those models actually have no idea either. Economic relations are certainly not all linear.
• The developments surrounding the virus and vaccines continue to be very decisive, both for economic behavior and for government measures.
• Some sectors remain remarkably strong. For example, the housing market in many countries is much stronger than you might expect in the current state of the economy. Also the investment propensity of companies, at least in the US, seems to deviate from what you can normally expect in a deep recession.
• Perhaps the most important thing in this list is that the revenue model of many companies has suddenly received a boost. At many companies the revenue model has been damaged, at others previously unrealistic revenue models have suddenly become viable. Now revenue models are always under pressure. Normally, however, this is a gradual process, now the disruption is extreme. If companies respond attentively to this - and there is no reason to assume that they do not - the growth potential of the economy in the coming years could actually be somewhat higher than in recent years.
• As shown, the number of bankruptcies in our country is falling. This is also happening in other countries. Due to the deferred taxes, withdrawn credits and the temporary relief of debt payments that banks apply, many companies are carrying an increasing debt burden into the future. This bill for this will inevitably present itself at some point.

Consequences of policy for sustainability of public finances and inflation
The deterioration of the government budget is leading to a sharp rise in government debt. The question arises to what extent this undermines the sustainability of public finances. In our country this is not so bad, because we started this pandemic with very healthy public finances.

Suppose that, due to the pandemic and the policy, our government debt will eventually be 20% points higher in GDP than without all the trouble. The next picture shows how much that will cost us in interest payments at various interest rates. The Dutch government now borrows for most maturities at a negative interest rate. So borrowing more does not lead to more interest charges at all, but rather to less interest charges.

At some point, the outstanding debt naturally needs to be refinanced and then the interest rate may be higher. The table (10) shows that even at an interest rate of 4%, the additional interest payments on the government debt 'only' increase by 0,8% of GDP per year.

10. Hypothetical interest rate and additional interest charges

It is of course a matter of taste whether 0,8% of GDP extra interest charges at an interest rate of 4% is a lot or not. Picture 11 provides some perspective. That picture gives an overview of the interest charges on the national debt during the last 50 years. The combination of the falling debt ratio and falling interest rates has brought total interest payments on the government debt in 2020 to a level that is lower than any other time in the last 50 years. If we assume that the national debt as a whole has to be refinanced at 4%, then interest charges will be low in historical perspective at around 2,5 to 3% of GDP.

11. Interest burden on government debt as a percentage of GDP

I often hear people say that we have to 'pay back the borrowed money once'. That's a misunderstanding. Governments rarely repay debt. And that is only possible if they have budget surpluses. That doesn't happen often. What really matters is keeping the debt ratio under control.

Our current debt ratio is certainly not a problem. That ratio remains constant, at least as long as the budget deficit does not exceed the growth of our nominal GDP. Our nominal GDP is growing at a rate of approximately 3%. Due to the expected economic growth in the coming year, the budget deficit will fall to approximately 2021 to 4,5% of GDP in 5, according to the CPB and DNB. A great deal of further action to bring the deficit below 3% is then no longer necessary.

My conclusion is that our public finances are robust and that government support measures do not unduly affect the future. It should be noted, however, that the story is more problematic in most other countries.

Is inflation going to rise?
Inflation has fallen this year. Headline inflation in the eurozone is now negative, while core inflation has also fallen markedly. (see Picture 12)

12. Eurozone inflation (HICP)

Given the very special economic developments and the policy responses of governments and central banks, the inflation outlook is more uncertain than it has been in recent years.

The unprecedented monetary expansion suggests that there is more than enough fuel for a possible rebound in inflation. Undoubtedly, there is now also a lot of catch-up demand in the economy due to delayed consumption. When life normalizes and that catch-up demand - financed from that increased money supply - comes to the market, bottlenecks will undoubtedly arise.

Making up part of the damage
Companies that have been hit hard this year want to take the opportunity to make up for some of the damage through price increases. Travel organization TUI recently announced that the bookings for the coming summer are going through a storm and that they are using higher prices. The question is, however, whether this leads to an inflationary process or whether it concerns one-off shocks. I actually think the latter.

Another argument to foresee higher inflation stems from the expectation that the process of off shoring that has taken place in recent decades will turn around to reshoring.,after showing how dependent we are on supplies of essential products. When large-scale production moves from low-wage countries here, the costs increase. I suspect there is not enough restoring will take place to materially raise inflation. Ultimately, in my view, higher prices actually slow down this process.

A third possible source of inflation is commodity prices. They initially fell sharply this year, but are now on the rise again. I think this will certainly push headline inflation up a bit, but I doubt it will start a real inflationary process.

Confluence of demographic trends
Finally, I would like to report that some economists believe that demographic factors will push inflation up in the coming years, perhaps decades. Read for example: The Great Demographic Reversal; aging societies, waning inequality and an inflation revival by Charles Goodhart and Manoj Pradhan. They argue that the remarkably low inflation of the last 20 years has been caused by a convergence of some demographic trends that are now reversing. However, timing is very difficult with these kinds of predictions. The fact that inflation may rise in the next 20 years does not mean that it will already happen in 2021.

In our own country, the pandemic and its economic consequences have had a remarkably rapid impact on the negotiated wage increase agreed in collective agreements. Figures from the AWVN show that wage increases have fallen sharply this year. At the start of the year, the increase in the negotiated wage increase on a 12-month basis agreed in new collective labor agreements was still almost 3%. That fell to 1,7% in November.

Labor costs are a major driver of inflation. Increased unemployment, including hidden unemployment, will keep wage developments under pressure in the coming period. In addition, companies have cut other costs on a large scale to survive, so they can now operate from a lower cost base. This will also keep inflation under pressure for the foreseeable future.

On balance, I expect inflation to rise from its current level. The end of the temporary VAT reduction in Germany alone contributes to this. Rising oil prices also raise inflation somewhat. In addition, inflation shocks can be expected in the next 12 to 24 months due to bottlenecks in the economy, when catch-up demand suddenly comes to the market. However, I do not expect inflation to be materially higher than before the pandemic.

Look at recent economic developments
There is now a remarkable divergence in the world economy. In Asia, where the virus is well under control, the recovery is continuing strongly. Until recently, this was also the case in the US. Meanwhile, the rise in the number of infections in the US is leading to a loss of momentum, while this has been going on for a while in Europe.

Picture 14 shows that production in China has regained its old growth rate and is even slightly surpassing it, although consumption in China is recovering somewhat more slowly.

14. China: % Year-on-Year Growth

The difference in momentum between Asia and Europe is also nicely reflected in Picture 15. The improvement in producer confidence in Korea is continuing strongly, while it is stalling in the Netherlands.

15. Producer Confidence

If you measure the pulse of the international economy, it would be a good idea to follow figures about the transhipment of containers in ports. Picture 16 shows that the world trade in goods is on the rise. This is also the case in Northwestern Europe, but our region is certainly not leading the way.

16. Index of container throughput in ports

It is therefore not surprising that Dutch goods exports are recovering, as picture 17 shows. The lockdown that we are now experiencing will therefore cause considerably less damage to the economy than the first one in March-May.

17. Dutch goods export % year-on-year

Aviation is being hit very hard. Commercial flights have only partially recovered from the thump taken earlier this year, as picture 18 shows.

18. Number of commercial flights (global *1.000)

Resiliency of the economy
There is great uncertainty about the recovery capacity of the economy. DNB, the CPB and the IMF have recently published forecasts for the Netherlands. They are close to each other. After a contraction of about 4% this year, our economy will grow by just under 2% per year over the next 3 years, according to forecasters. It will therefore take until sometime in 2022 before our economy has reached the size of the end of 2019 again. The picture they paint for the Netherlands can be adopted for other countries in terms of direction.

I do not venture into numerical predictions and stick to qualitative appraisals. In my view, economic development will surprise positively rather than negatively in the coming year. Of course, all of this is subject to the proviso that we will get the pandemic under control in the not too distant future.

My first consideration for taking a more positive view of the future than the economists at DNB, the CPB and the IMF, is that I have learned from experience that macroeconomists are often somewhat cautious in forecasting economic recovery. More importantly, a significant part of the economic damage caused by the pandemic has been absorbed by the government budget. That should benefit the recovery power.

Swollen private bank balances
Furthermore, there is no doubt a large amount of 'catch-up demand' has arisen. Of course, consumers do not end up with all unfinished consumption, but some of it certainly does. In total, the consumer also has the means to do so, as evidenced by the money growth figures. Also think of the swollen bank balances of private individuals, which are part of that money supply.

Unlike during previous recessions, governments and central banks are making it clear that accommodative policies will not be rolled back too early. So there will be no sooner put a brake on the recovery. Rather, the recovery will initially continue to receive support from policymakers.

But for me the main reason to be a bit more optimistic than many others is that companies have reacted vigilantly to the problems. Earning models have come under sudden pressure. It is not easy to get a good picture of what exactly is happening at companies. But Picture 19 shows what has happened to corporate profits in the US.

They took a hit in the second quarter. In the third quarter, however, that damage was fully recovered and corporate profits together were more than 3% higher than a year earlier. In my view, the development of corporate profits is an often underestimated driver of the economy. Reliable up-to-date figures for Europe are lacking, although it was noticeable that listed companies significantly exceeded analysts' expectations in the third quarter.

19. US: Corporate profits (national accounts, entire economy) in $bn

Not only corporate profits recovered remarkably well in the third quarter. Digitization in companies also seems to be accelerating, as suggested by Plaatje 20. Also note how the recent development differs from that around the recession of 2008/09.

20. US: Business investment in information processing equipment
(in constant $bn)

It should be emphasized again that we have less insight into developments in Europe in this area. In a recent survey by Statistics Netherlands, many Dutch companies said they would actually cut investment in 2021. Ultimately, I think that international competitive pressure will lead to the tightening of revenue models contributing to the still underestimated growth dynamics.

Hans de Jong

Han de Jong is a former chief economist at ABN Amro and now a resident economist at BNR Nieuwsradio, among others. His comments can also be found on Crystalcleareconomics.nl

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