Policymakers have faced extraordinarily tough choices over the past few months. But, as tough as they have been, the hardest choices are yet to come.
Public policy played a crucial role in protecting households and businesses from the impact of the COVID-19 crisis, particularly the effects of government-mandated social distancing measures. But it is clear that the public balance sheet should not be used to insure all businesses and households against the structural change that will stem from the outbreak of the coronavirus.
If this were to happen, not only would it be costly in terms of rising government debt, but much of the dynamism that comes from the market allocating capital would be lost.
As is well understood, in the face of the threat of an exponential increase in infection rates, rapidly rising fatalities and health systems being overwhelmed, policymakers delivered stringent social distancing measures. This in turn closed large swathes of the economy and caused an economic recession. To support the economy, massive monetary and fiscal policy easing was delivered.
Interest rates were slashed to near zero all the way out to the 3-year government yield and banks can directly access the RBA's balance sheet, lowering their cost of funding further. This has allowed banks to offer repayment holidays to households and businesses.
The government delivered massive cash support to households, through direct cheque payments, a boost to the unemployment benefit and a business wage subsidy scheme. Renters have been given temporary protection through a moratorium on evictions, and companies have access to short-term safe harbour arrangements to prevent insolvencies. All in, fiscal support has totalled around $A160 billion, or 8% of GDP.
In short, policymakers delivered broad-based forbearance. In normal times, the market allocates capital and prices risk, but with this large dose of forbearance the risk spectrum has been flattened. Almost all high and low risk businesses and households were able to get access to some form of support. This made sense during the crisis.
But now that the health crisis is almost over and the economic recovery is beginning, many of these public policy support mechanisms will need to come to an end. Australia was fortunate to have a low level of government debt prior to the crisis so it could deliver support when needed. The new debt will now need to be serviced and the larger that debt is, the more costly it will be.
Australia now also needs the market system of allocating risk to be allowed to work. Weak productivity growth over recent years is due to a lack of economic dynamism. The longer the public sector supports are in place, the more the potential dynamism of the economy is likely to be eroded.
This will be an enormous political challenge. Indeed, politically it may prove to have been easier to deliver the massive fiscal support than to remove it.
Part of the challenge is that the economy has inevitably been weakened by the COVID-19 crisis. Many businesses will not be able to return to operating as they did before.
With borders closed, and travel likely to be heavily constrained for some time, businesses that benefited from visitors and permanent arrivals are likely to struggle. This includes the tourism sector and education exports and, through curtailed migration, other industries are likely to suffer as well.
Even if social distancing measures are gradually wound back, people may not return to the same degree of social activity as prior to COVID-19. An extended period of working from home may mean workers and employers need less office space. Businesses that feed off these offices, such as cafes and restaurants, may struggle.
A move to virtual communications may see less business travel. Bricks and mortar retail may suffer as COVID-19 accelerated the use of online purchases. Many businesses and households will correctly argue that the COVID-19 event permanently changed their economic situation. Business insolvencies are likely to rise once the moratorium comes to its end. Mortgage defaults are likely to increase once bank repayment holidays are over.
These challenges mean that we expect GDP to be below the previous trend running through 2021. Even with an expected bounce back in growth, we still forecast the unemployment rate to be 6.25% at the end of 2021, well above the 5.25% before the COVID-19 crisis.
Finding the right balance between public forbearance and allowing the market to, once again, be the key arbiter of capital allocation, will be a significant economic and political challenge.
We think policymakers should use this crisis to deliver comprehensive economic reform. Although there will be some winners and losers from both the COVID-19 shock and any reform agenda, the overall national interest would benefit from a more dynamic economy that lifts productivity growth. The October budget presents a rare opportunity for policymakers to set out a comprehensive vision for the economy.
This article first appeared in The Australian newspaper