Talk to virtual Comview conference
I want to talk to you about how the Australian economy has changed as a result of the pandemic, including a once-in-30-year change in the macro-economic policy mix, and consider how the economy can recover from this unique recession.
You don’t need me to tell you that the coronavirus is the greatest threat to the health of Australians and the entire world since the “Spanish” flu pandemic a century ago. Nor that the recession this pandemic has precipitated is the greatest blow to our economy, and the world economy, since the Great Depression of the 1930s. What I may need me to remind you of is that, despite Victoria’s second wave, Australia has so far had more success in suppressing the virus than almost all the other advanced economies, and this should mean we suffer less economic damage than they do. It’s also true that our major trading partners – China, Japan and South Korea – have also done well in controlling the virus, which is another good sign for our recovery relative to the other rich countries. However, the pandemic is far from over and we don’t know when that will be. We could still suffer setbacks, and it’s hard to see a full return to business and consumer confidence until it’s clear the pandemic is over. With the rich countries likely to grab the vaccine before the poor countries get it, it seems likely that international travel will be the last thing to return to something like we were used to.
Why this recession is unlike previous recessions
Usually, recessions occur not simply because the economy runs out of puff, but because an inflationary boom prompts the macro authorities to apply the interest-rate brakes, but they hit it too hard and the boom turns to bust. The mood of optimism flips to pessimism, and greed turns to fear. This time, however, there was no boom and no inflation. The economy had not properly recovered from the global financial crisis more than a decade earlier, it was growing slowly and the mood was already sombre.
This time, the recession was driven by governments’ attempts to limit the spread of the virus by closing our borders, shutting down a large part of the economy and requiring people to leave their homes as little as possible. This means the contraction in demand came suddenly and completely, rather taking months to decline, as it usually does. Note, however, that had the government not ordered a lock down, economic activity would have fallen anyway as people tried to avoid being infected.
But the fact that it was the government’s own actions in ordering the lockdown meant that its fiscal policy and monetary policy response to the recession was faster and larger, particularly its two big measures, the JobKeeper wage subsidy scheme and the temporary supplement to JobSeeker unemployment benefits. JobKeeper’s objective was to maintain the link between employers and their workers even if the lockdown left them with little work to do, so that once the lockdown ended, normal trading could resume. Together with other measures, another goal was to help protect the cash flow of firms during the lockdown. At one point 3.5 million workers were benefiting from JobKeeper, who otherwise would have been unemployed. With the lockdown having soon been lifted in all states bar Victoria, it’s now clear that much of the collapse in employment and hours worked in April has now been reversed, with Victoria now following. So there has been a significant bounce-back, with much of the 7 per cent decline in real GDP during the June quarter reversed in the two following quarters. Even so, the bounce-back has been far from complete. And although the collapse of many businesses has been avoided, many failures haven’t been.
How the coronacession has changed the economy
In a recent speech, Reserve Bank governor Dr Philip Lowe listed five respects in which the pandemic is leaving its mark on the economy. The first is on the labour market. The rate of unemployment is expected to peak at about 8 per cent by the end of the year, with the rate of under-employment even higher. Unemployment will then decline only slowly and still be above 6 per cent by the end of 2022, the year after next. This suggests wage growth will continue weak.
Second, weak population growth. Restriction of international travel and migration, and a lower birth rate, mean the population is expected to grow by just 0.2 per cent in the present financial year, the lowest since 1916, and be weak the following year. This compares with growth averaging 1.5 per cent a year over the past two decades. Even when eventually international travel resumes, it’s not clear that our rate of immigration will return to what it was. And, even if it does, it seems unlikely that the two or three years of lost population growth will be made up. Australia has had one of the fastest rates of population growth among the advanced economies, with higher rates of economic growth to match. This may not continue, although it may not mean lower rates of economic growth per person. If so, we’ll have a smaller housing industry and less need for investment in new infrastructure.
Third, a changed property market. The market is being hit by a range of conflicting factors: a recession; lower population growth; record low interest rates; government incentives to support residential construction; and changes to the way that people work, shop and live. Rents for CBD retail properties have fallen, as have vacancy rates for office blocks. Residential property prices have fallen in Sydney and Melbourne, particularly for apartments.
Fourth, attitudes to risk. Businesses and households seem to have become more averse to the risks involved in decisions to borrow and spend, despite the fall in interest rates. This is understandable when there is so much uncertainty about what the future holds but, as Lowe reminds us, economic growth depends on business people and consumers being willing to take calculated risks to advance their prosperity. Lowe worries greater risk aversion may add to the signs that the economy has become less “dynamic” – slower to change over time. These signs include low numbers of new firms, less switching between jobs, slower adoption of new technology, and fewer workers moving from low to high productivity firms.
Fifth, digitisation. It seems clear that the pandemic and the lockdown has hastened the adoption of digital technology. Doctors’ longstanding resistance to telehealth and electronic prescriptions has broken down. Many firms have used technology to allow their staff to work from home, and much of this may continue after the pandemic is past, with big implications for time spent commuting, CBD retailing and transport infrastructure needs. Online meeting technology has reduced the need for travel. There has been huge growth in online retailing, which is unlikely to be reversed. Electronic transactions have greatly reduced cash transactions.
The changed macro management policy mix
For the first 30 years following World War II, the main policy instrument used to stabilise demand as the economy moved through the business cycle was fiscal policy, with monetary policy playing a subsidiary, supporting role. That changed in the late 1970s when the advanced economies acquired a serious problem with high and rising inflation, and “stagflation” destroyed confidence in the simple Phillips curve trade-off between inflation and unemployment. The conventional wisdom became that monetary policy, conducted by an independent central bank, should be the main instrument used for stabilising demand, with fiscal policy playing the subsidiary role.
But roughly 30 years later, the coronacession has a seen a reversion to fiscal policy playing the dominant role in short-term stabilisation, leaving monetary policy as a back-up. Ostensibly, this is because the need for stimulus was so great and because, with interest rates already so low, monetary policy was left with little room to move. In the recession of the early 1990s, for instance, the official interest rate was cut by more than 10 percentage points. In the response to the global financial crisis of 2008-09, the rate was cut by more than 4 percentage points. In the response to the coronacession, the RBA has been able to cut by less than 1 percentage point before taking the cash rate virtually to zero, at 0.1 per cent. Since March the RBA has also resorted to “quantitative easing” – buying second-hard government bonds from the banks and paying for them merely by crediting amounts to the banks’ exchange-settlement accounts with the RBA – but how much this does to stimulate demand for goods and services (as opposed to demand for assets such has houses and shares) is open to doubt. By contrast, the federal budget has provided a total of $257 billion in direct stimulus over serval years, equivalent to 13 per cent of nominal GDP in 2019-20. (This compares with stimulus in response to the GFC of 6 per cent of GDP in 2008-09.)
Behind these immediate reasons for fiscal policy resuming the leading role, however, are deeper, structural factors. As Treasury Secretary Dr Steven Kennedy has observed, there has been “a fundamental shift in the macroeconomic underpinnings of the global and domestic economies, the cause of which is still not fully understood”. This is a reference to the “secular stagnation” or “low-growth trap” I discussed at last year’s Comview. Your modern, independent central bank – and the policy mix that gave top billing to monetary policy – was designed to cope with the problem of high and rising inflation. But, as former Reserve governor Ian Macfarlane has explained, inflation in the advanced economies has been falling for the past 30 years and is now below central bank targets. Low inflation means low nominal interest rates, of course. And, as Treasury’s Kennedy has reminded us, the global real interest rate, similar to the neutral interest rate – the real official rate that’s neither expansionary nor contractionary – has been falling steadily for the past 40 years. This has been due to structural developments that drive up savings (the supply of “loanable funds”) relative to the willingness of households and firms to borrow and invest (the demand for loanable funds), he says. This “is likely due to some combination of population ageing, the productivity slowdown and lower preferences for risk among investors,” he says.
All this says that fiscal policy’s return to primacy over monetary policy is not just a temporary development, but the culmination of structural forces building up over decades, suggesting this will be a lasting change. It may be many years before inflation returns as a problem.
Fiscal policy and monetary policy: pros and cons
Monetary policy’s great advantage is that it can be changed so quickly and easily, by a decision of the RBA board (this covers the decision lag and implementation lag), whereas fiscal policy changes involve possibly protracted development of measures and consideration by cabinet (the decision lag), and then often delays before the measures can be put into effect (the implementation lag). But, once implemented, monetary policy changes probably take longer to have their full effect on the economy (the impact lag) than does fiscal policy.
But fiscal policy measures – whether on the tax or spending sides of the budget - can be targeted to fixing particular problems, whereas monetary policy is a “blunt instrument” or one-trick pony: it uses interest rates to encourage or discourage borrowing and spending. Fiscal policy includes the budget’s automatic stabilisers (to which, Kennedy has argued, JobKeeper and the JobSeeker supplement, being open-ended, were temporary additions).
Economists at the IMF and elsewhere argue that fiscal policy multipliers are higher than earlier believed. This is partly because leakages to imports are less significant when all major governments are stimulating simultaneously in response to the same global shock (such as the GFC or a pandemic). But it’s also because the effect of fiscal stimulus isn’t reduced by the “monetary policy reaction function” – the decisions of independent central banks to raise interest rates because they fear the fiscal stimulus will add to inflation pressure.
Finally, and as I said in last year’s talk, monetary policy’s “comparative advantage relative to fiscal policy is controlling inflation, not stimulating demand when the economy is again caught in a liquidity trap”. Because we are likely still to be caught in a low-growth trap even when the pandemic is a receding memory, l have no trouble believing the econocrats’ repeated warnings that the road to recovery will be long and bumpy.
