Australia is in for a long and damaging economic slump, unless governments inject substantially more fiscal stimulus.
The July budget update forecast that unemployment would hit 9.25 per cent in coming months. The Reserve Bank is forecasting unemployment to hit 10 per cent by Christmas. Treasury apparently expects unemployment to remain above 6 per cent for the next half-decade.
That would be a disastrously sluggish recovery – as slow as the recovery after the 1990s recession – widely seen now as a failure of macroeconomic policy.
It would be a slower recovery in unemployment than Australia experienced after the 1980s recession. It would also be substantially slower than the US experienced after the Global Financial Crisis, when unemployment fell from a peak of 10 per cent in 2009 to 5.7 per cent five years later.
The US after the GFC should be no one’s idea of a rapid labour market recovery. Yet that’s the scenario Australia is drifting towards.
The recovery is expected to take years
The Parliamentary Budget Office recently published new projections of the Australian economy’s potential – the level of economic activity we could achieve with full employment and no idle equipment.[note]The PBO published scenarios for how COVID would impact on the government’s fiscal position. For this financial year, the PBO used the government’s pre-COVID estimate of potential, adjusted for the reduced overseas migration owing to international travel restrictions.[/note] The figures published by the PBO suggest our potential output this financial year is around $1.96 trillion. The Reserve Bank’s latest forecasts anticipate us producing goods and services worth only around $1.82 trillion. The gap between our actual and potential output – the ‘output gap’ – is expected to be around $140 billion or 7.5 per cent.
It’s inevitable that we’ll have a large output gap this year – the second-largest state in the country has been in some form of lockdown for most of the financial year so far. But the really scary part is that the output gap could persist for more than half a decade. The PBO has followed the standard budget assumption that it will take seven years to return to potential — which would mean we won’t close the gap between actual and potential output until 2027-28. In total, the output gap over the period between now and mid-2027 is projected to be around $620 billion in inflation-adjusted terms.
This projection should shock. If it comes to pass, we’re in for the better part of a decade with the economy operating well below potential, with unemployment higher than it could be and living standards below where they could be.
Deep recessions leave ugly scars, but the worst can be avoided
A recession this long and deep would leave ugly scars. Recent work by officials at the Treasury found that when youth unemployment goes up by 5 percentage points – as it has in recent months — the wage that new graduates can expect to receive goes down by 8 percentage points, and they’re less likely to be employed in the first place. The effect on graduates’ wages lasts for years: over a decade they lose the equivalent of half a year’s salary compared to otherwise-equivalent young people who graduated into more benign economic conditions. A recent staff working paper from the Productivity Commission came to a similar conclusion – economic downturns have big and long-lasting effects, particularly on young people.
But the Treasury authors show that the worst effects can be avoided if unemployment falls quickly. For instance, if unemployment returned to pre-recession levels within three years, the hit to young workers’ wages over the decade would be halved.
Governments need to act
Faced with this scenario – a long and deep recession with sluggish recovery – policy makers should do everything in their power to stimulate the economy.
In normal times, Australians would look to Martin Place in Sydney, with the expectation that the Reserve Bank would deliver enough of a boost through monetary policy to get us out of the slump. But the Bank has cut its cash rate 0.5 percentage points and now finds itself at, or least close to, the lowest it can go. This is unlike past downturns – in the wake of the GFC, the RBA cut the cash rate by 4.25 percentage points. It cut by 2-2.5 per cent during earlier, much smaller, shocks – the Asian financial crisis and 2001 financial bubble. The RBA just hasn’t had the same room to move this time.
The RBA can and should do more, but it cannot do enough by itself. The Federal Government must step up.
The Government acted quickly and commendably to support households and businesses through the acute crisis period. The actions weren’t perfect, but they’ve helped turn what looked likely to be an unprecedented economic catastrophe into something more like a conventional terrible recession.
But the fiscal taps look set to be turned off in the coming months, as the emergency support is withdrawn. The fall off the ‘fiscal cliff’ might be cushioned a bit by the boost from households that have saved more during shutdown, and households that have withdrawn their super savings, but fiscal policy looks set to be a drag on growth.
More – much more – fiscal support is going to be needed over the months and years ahead.
In June, Grattan Institute called for additional fiscal stimulus of about $70-to-$90 billion over the next two years. Those numbers now look too small.
Based on the updated RBA forecasts, we now estimate additional stimulus of about $100-to-$120 billion is needed. This would be enough to cut the unemployment rate by about 2 percentage points relative to where it would otherwise be by the end of 2022. It would bring unemployment back down to around 5 per cent – around the level the RBA expects is needed to get wages growing again. And governments will need to spend more in the years beyond to keep it there.
Extra stimulus will mean extra government debt. But the Australian government can now borrow for 10 years at a fixed interest rate below 1 per cent. Adjusted for inflation, that’s a negative real interest rate, making debt more affordable than it has been in living memory.
There will naturally be concerns that further debt will place a burden on younger generations. But they are the generations that will wear the cost of high unemployment unless we act.
Australians should not settle for a prolonged slump, with all the scarring and misery it brings. Our leaders should prepare a plan now to get unemployment down as quickly as possible. The Reserve Bank and Treasury are forecasting economic policy failure. Australian governments should be prepared to spend, and spend big, to avoid it.
Note: this post was amended on 11 September to clarify the nature of the potential output figures published by the PBO. The PBO does not engage in economic forecasting. The potential output estimates published by the PBO used the government’s pre-COVID estimate of potential, adjusted for reduced migration.