Commentary |
19 March 2020

Vital to focus on fiscal policy as recession inevitable

It goes without saying that the medical response to the pandemic should have the highest policy priority ... On the economics of the pandemic, initial reactions have been quickly outdated. Originally published in The Australian.

Stephen Grenville
Stephen Grenville

It goes without saying that the medical response to the pandemic should have the highest policy priority. Those who warned against panic and over-reaction are quieter now, perhaps accepting that the countries that have active containment strategies (Singapore, Hong Kong, Taiwan and, belatedly but effectively, China and South Korea) are doing better than Italy and Iran (with huge question marks on the insouciance of Indonesia and India).

On the economics of the pandemic, initial reactions have been quickly outdated. Forecasters whose first response was to trim the decimal-point on their growth predictions are now shifting the “big figure”. Zero would be an optimistic guess for growth in the next few quarters. What comes after is unknown territory.

Early on, the distinction between supply and demand shocks suggested that substantial demand stimulus might not be appropriate. Now we understand that the two are intertwined; demand will be down because the supply side has been hugely disrupted. If the distinction has any relevance, it’s only to remind us that, no matter how big the demand stimulus, we can’t get tourism, travel or discretionary services such as restaurants, concerts or mass sport back to normal. Potential GDP is currently significantly lower than it was, but it will take a big stimulus to achieve even this diminished potential.

First, clear away the doctrinal baggage. The government claims two great macro-economic achievements: 28 years without recession and getting the budget back into balance. Scott Morrison has successfully extricated himself from the budget-surplus fetish, although he has not yet warned us just how far we will inevitably go into deficit.

But the Prime Minister still seems to be thinking in terms of “no recession”. If this encourages him to “go early and go hard”, that’s OK. But a recession, as measured in any commonsense way (say, significantly rising unemployment), is just about inevitable.

What, then, should be done? The key is that the social need is very great, and so support should be focused on those adversely affected. The business lobby is back on its old hobbyhorse of company tax cuts. Companies only pay tax if they make profits, so this can’t be a sensible priority. Cutting payroll tax sounds more sensible, but American analysis gives this a low priority because it doesn’t target those most affected.

Giving all social security recipients $750 is certainly more targeted than the 2008 “cash splash” and should give a good boost to demand. But many of these recipients, while deserving, haven’t been made worse off by the crisis.

The government is on the right track if it is eliminating the waiting period for Newstart. But what about raising the allowance so that it equals, or even exceeds, other social security payments? And part-time casuals who lose their jobs need help too, even if they are not eligible under current rules.

Many SMEs will be under garrotting cash-flow pressure. “Hysteresis” is the jargon economists use to describe the way workers who lose their job remain unemployed permanently. The same applies to SMEs. A bankruptcy during this downturn means some owners will never have another go at entrepreneurship. If the government tries to help them directly (as Hong Kong has done), the administration will be a nightmare — worse than the “school halls” episode.

It ought to be possible, however, to channel government money through the banks. The banks monitor SMEs’ cash flows and know the owners. They are in a better position than bureaucrats to judge which businesses have a long-term future. Grants or loans? Interest free? How to share the risk? These are the details to be worked out.

Lastly, what about the financial sector? They are the ones with the loudest and most alarmist voices. Their plight, reflected in the ASX, tops the news each night. We shouldn’t have sympathy for the “masters of the universe”, but they claim to be speaking for all those pensioners whose equity portfolios have plummeted. Equity prices will rise again and long-term holders (the true pensioners) will have their nest egg restored in time.

The banks will have higher bad debts but, thanks to tough regulation over the past decade, they are in good shape to ride out the recession. The RBA and APRA will ensure that the banks — the core of the financial system — remain solvent and able to maintain funding for creditworthy borrowers.

Some businesses have found it easier to get funding in non-bank credit markets. Some used this for profitable investment, but others took on too much risk or upped their leverage with share buybacks. Maybe that’s why the banks didn’t fund them. The cost of funding in these credit markets has gone up, reflecting an understandable reassessment of risk. Investors can’t distinguish between those who are stretched but will stay solvent, and those headed for bankruptcy.

Financial commentators are asking the authorities to support this market through purchases of commercial bonds. They demand a “put” option in times of uncertainty. But why should taxpayers take over this risk?

These uncertainties are spilling over into the safest of financial markets — government bonds. Last week the demand for these riskless assets was so great that yields fell well below 1 per cent. Now investors are wondering if they went too far, and yields have retraced, but are still abnormally low. Should the RBA provide guidance and support, assuring the market that yields won’t go back towards normality any time soon?

Monetary policy has already been pushed to the limit and should confine its attention to the short end of the yield curve. Financial markets should be left to demonstrate their much-trumpeted efficiency at price-discovery. The policy focus should turn to fiscal policy. There are times when we should worry about deficits and government debt, but this is not one of them.

Stephen Grenville is a non-resident fellow at the Lowy Institute and former deputy governor at the Reserve Bank of Australia.