What shape will Australia's recovery be?

Will Australia’s economic recovery be short and sharp? Or will it be protracted, with economic growth remaining sluggish for sometime following COVID-19?

Depends on who you ask.

The source for this discussion is a great article by the economist Jason Murphy titled Coronavirus Australia: What if the economic recovery is not V-shaped?

Let’s start with the optimistic view: the V-shaped recovery. This looks like it sounds: a plunge down, small time at the bottom, and then a quick escalation up. According to the International Monetary Fund (IMF), this is how Australia’s economic recovery will proceed.

V-shaped economic recovery. Source: news.com.au (click through for article)

As Murphy writes: “This is a very bad recession. But at least it is quite short. The assumption the IMF makes is that the economy bounces back when the virus is defeated.”

Okay, but what if the IMF is wrong? 

The pessimistic alternative is an L-shaped recovery. Basically, growth drops (the vertical line of the L), and then we spend a long time along the bottom of the L until growth speeds up. This is a more painful economic recovery as it takes much longer to see a rebound in economic growth rates and employment.

Source: The Conversation (click through for article)

This is how Greg Jericho, The Guardian’s economics writer, describes the L-shaped scenario: “Finally there is the dreaded “L” shape, in which the economy stays weak for even longer – five to 10 years of barely enough growth to keep unemployment flat, but not enough to improve things all that much.”

So what happens next? It’s going to be a wait and see. In terms of Australia, it will depend on the success of re-opening the economy and getting life and business back to normal.

How bad is COVID-19 for the Australian Economy?

What will be the impact of COVID-19 on the Australian economy? 

The Australian Financial Review asked this very question of a number of economists.

The answer? No-one knows for sure. But economists generally believe it will be very negative for employment and economic growth in Australia.

The AFR article found that economists forecast Australia’s unemployment rate could rise from its current rate of 5.1 per cent (as of February 2020) to 9.4 per cent. This would represent 1.22 million people out of work.

In addition, economists stated that the economy could shrink by 3 per cent. Not to 3 per cent, but by 3 per cent. This would take the Australian economy into negative economic growth and a recession. According to journalist Aaron Patrick, this would create “the worst recession most living Australians have experienced”. 

The AFR article. Click through to read it.

Let’s take a look at some of the individual economists’ views. The article spoke to UBS (an investment bank) economist George Tharenou who said that unemployment could reach 10 per cent if businesses weren’t quickly able to operate as normal. 

As of late March, restaurants and cafes around me are restricted to take-away only which has significantly reduced their daily revenues and led to them standing down or letting go of staff. My local cafe has gone from 80 seats and maybe 10 staff to no seats and four staff.

Independent economist Saul Eslake, who was chief economist at ANZ Bank, said that unemployment would peak at 7.5 per cent as the Federal Government’s stimulus packages helped business keep on staff.

As of late March 2020, the Morrison Government had announced two stimulus packages worth around $84 billion with a range of measures targeting businesses to help them retain staff during this challenging time.

Employment is rightly regarded as a major issue right now. Just think about the flow on effects of a significant rise in unemployment. Consumers lose confidence and incomes, which reduces demand for goods and services, which could drive unemployment even higher. Derived demand (the fact that demand for labour is derived from the demand for goods and services) would work in a negative sense. 

This is why government intervention to keep employment as robust as possible is so important right now.

The Australian economy in 2020 (maybe)

What should we expect from the Australian economy in 2020?

Forecasting the future is a tough game, but economist Stephen Koukoulas has given it a go. In an article for Yahoo Finance, Koukoulas has taken a look ahead into the future for the Australian economy. I’ve focused on four of his predictions and you can read his full article for more.

Australia’s Economic Growth

In 2019, Australia’s annual growth in gross domestic product (GDP) was relatively weak. GDP averaged around 1.7 per cent in annual terms. Compare that with the government’s goal for economic growth of around 3-4 per cent in annual terms.

In his article, Koukoulas presents an optimistic case for Australia’s GDP. He suggests it could reach 2.5 per cent by mid-2020 and perhaps as high as 3 per cent by the end of this year.

His relative optimism is based on three factors:

• A rise in public sector spending, particularly in infrastructure (this represents government spending, or G, in the aggregate demand equation)

• Increased business investment, potentially helped by record low interest rates in Australia

• Increased consumption, boosted by a recovery in consumer confidence and the wealth effect (where rising asset prices, house prices in Australia’s case, encourage consumers to boost spending).

Australia’s Unemployment

In 2019, Australia’s labour market was relatively weak and unemployment did not budge far from the 5 to 5.2 per cent range. Koukoulas believes UE could rise even further to around 5.5 per cent in 2020.

But! If the predictions around higher economic growth come true, unemployment will likely fall. Koukoulas states that if GDP growth hits 3 per cent, then we will see noticeable falls in unemployment and underemployment.

Why is this the case? Well, if economic growth rises, this means there is greater production of goods and services in the Australian economy. To achieve this, local firms will need additional factors of production (or resources) — particularly labour. They will demand more labour, which will push down UE. (This is known as derived demand, where the demand for labour is derived from the demand for goods and services).

Inflation in Australia

The Reserve Bank of Australia’s goal is to keep inflation between 2 to 3 per cent over the course of the business cycle. This is known as the target band. For the duration of 2019, Australia’s inflation rate was below the target band.

Koukoulas says if the economic growth mentioned above takes place, inflation will likely rise to 2 per cent or to sit inside the target band. This demonstrates the link between economic growth and inflation: as economic growth rises, the demand for goods and services will also rise, leading to higher prices and inflation.

The Australian Dollar

In late 2019, the $A traded around the US$0.66-US$0.68 mark. However, Koukoulas believes the $A could be trading as high as US$0.77 in 2020.

He presents two potential reasons for this appreciation:

• Improving global economic growth will lead to higher demand for Australia’s commodity exports. This will increase demand for the $A as buyers need local currency to purchase Australian exports.

• Improving domestic conditions could lead to greater investment in the Australian economy. To participate in this, foreign investors will need $A, which will also cause the currency to appreciate.

One point I would add here is that a stronger $A will make exports more expensive and less internationally competitive. This could result in Australia actually selling fewer exports, which may have negative consequences for the trade balance and the Balance of Payments.

We’ll be watching this year to see how these forecasts unfold.

What next for the world economy?

Quick question: over the last 50 years, how many times has the global economy experienced negative economic growth?

So, over the last half century, how many times has the global economy contracted?

Just once. During the Global Financial Crisis of 2008/09. Just check out this graph from the Financial Times.

This is an extraordinary development. Despite oil shocks, debt crises (Latin America and Greece), the Asian Financial Crisis and various wars, the global economy has kept growing.

But in late 2019, economists have been vocal about potential risks to global economic growth.

A synchronised slowdown

In mid-October 2019, the International Monetary Fund (IMF) downgraded (reduced) its forecasts for global growth. The IMF forecasts that global growth to fall to its weakest pace since the GFC.  

Just look at the language the IMF used:

“The global economy is in a synchronised slowdown and we are, once again, downgrading growth for 2019 to 3 per cent, its slowest pace since the global financial crisis. Growth continues to be weakened by rising trade barriers and increasing geopolitical tensions.”

In terms of figures, the IMF forecasts that the world’s advanced economies will grow by 1.7 per cent in 2019 (compared to 2.3 per cent in 2018). Growth in emerging and developing markets has also been downgraded to 3.9 per cent in 2019 (from 4.5 per cent in 2018). 

Monetary policy might be working

There has been some debate about the effectiveness of monetary policy (central banks’ use of official interest rates to boost economic growth) in economies around the world. But the IMF says the use of MP has been very helpful.

According to the IMF, if governments around the world had not loosened monetary policy (reduced official interest rates), global growth would currently be 0.5 percentage points lower in 2019 and 2020.

So, what happens next?

The IMF would like to see governments to do more to improve the state of the global economy. This includes removing trade barriers and ending the trade war, and implementing expansionary fiscal policy, particularly involving additional investment in infrastructure. In Australia, the Reserve Bank of Australia has been arguing for the latter. 

The IMF is clear: now is the time to act. “The global outlook remains precarious with a synchronized slowdown and uncertain recovery. At 3 per cent growth, there is no room for policy mistakes and an urgent need for policymakers to support growth,” the organisation says.

We’ll have to see how the governments respond.