A year on

24 January last year was the date of my first post on the coronavirus, specifically the potential for significant economic damage and disruption if it turned into something significant beyond China. At the time, there was no great prescience involved; it was simply that I follow China news reasonably closely, combined with the fact that I’d been fascinated by the economics of pandemics since I’d spent a lot of time on an earlier whole-of-government planning and preparedness exercise in the 2000s, when health authorities worried that an avian influenza would mutate into easy human-to-human transmission. For some time I’d had in the back of my mind to write a post about some of that work, about the potential scale of the near-term economic losses, and the sorts of economic interventions that might be called for.

A year on, I’m not really that interested in looking at how, for example, unconditional forecasts compared with outcomes (although as it happens I filled in my responses to the Reserve Bank’s Survey of Expectations the following day, and looking through those numbers now I must still have regarded widespread economic disruption affecting New Zealand as still being a very low probability). Rather I’m more interested in reflecting on what I’ve learned and what has surprised me, about economic behaviour and economic policy, given the way the virus itself has unfolded (the latter not being something economists had anything particular to offer on).

The thing I’ve found most surprising, given the severity of the virus, is the apparent resilience of private demand. My mental model 10 months ago was that private demand – consumption and investment – would fall quite sharply and stay quite low for a prolonged period (you can no doubt find me running that line in numerous posts through much of last year), and that that would be so whether or not a particular country was successful at keeping the virus out altogether, mostly stamping it out (eg NZ), or not. There were several reasons why that seemed plausible to me:

  • there were lost income-earning opportunities, which couldn’t be directly replaced while the pandemic persisted because –  for example –  people couldn’t travel internationally, or faced higher costs, more restrictions, and/or more uncertainty in doing so (eg I was supposed to be doing an overseas consulting trip in late Feb/early March 2020, and we cancelled not so much for fear of the virus in the other country, but from fear of having unknowable trouble/expense/disruption getting home again),
  • specifically, and for example, foreign students couldn’t come here, and although many were already here the longer the pandemic (and associated uncertainty) lasted the fewer were likely to be here (more go home, hardly any come).  Even if people were happy to study online from abroad, they wouldn’t be adding as much to demand here (food, travel, accommodation etc),
  • cross-border tourism was going to become all-but impossible, and if not impossible then that much more costly and uncertain,
  • inward immigration –  a key factor in New Zealand demand cycles –  was likely to be materially dampened for some time to come,
  • since no one knew how long the virus, and associated disruptions, would persist, private investment – the most cyclically variable part of GDP –  was likely to be particularly hard-hit.  Even allowing for some new spending on capital equipment directly associated with responding to the virus, it seemed likely that both from the demand-side and the financing side investment activity would fall away quite sharply –  perhaps especially in the sectors directly adversely affected, but more generally too.   Any disruptions to cross-border supply chains would only reinforce that
  • And even if New Zealand got more or less on top of things behind largely-closed borders, the economic losses in other countries that didn’t seemed likely to be severe.  The state of world economic activity typically matters a lot for New Zealand, including through commodity price channels. Investment, in particular, seemed likely to be hard hit.
  • more generally, uncertainty seemed likely to be a huge consideration, affecting households, firms, banks.  Pretty much everyone in fact, here or abroad.  At a household level, for example, even if a wage subsidy or similar protected your job in the narrow lockdown period, the economic environment had turned much more hostile and uncertain.  Losing a job, and finding it harder than usual to get another, was likely to affect spending and activity now.
  • (I also expected house prices to fall temporarily, perhaps by 10-20 per cent in real terms, as had happened in the previous recession, but unlike the Reserve Bank I’ve never believed that overall house price developments have much impact, one way or the other, on private consumption spending.)

And all this was reinforced by a recognition that in typical recessions we see these sorts of demand contractions, increases in unemployment, increased caution by lenders (and by investors) even when –  as usually –  interest rates are cut a long way.  And this time, interest rates hadn’t really been cut by that much at all –  in some countries almost not at all, but even in New Zealand by some fairly-modest fraction of what we normally see (75 basis points vs, for example, the 575 basis points of cuts in 2008/09).  So monetary policy would be doing something but not very much….and I thought those effects would be mutually reinforcing as the private sector recognised how little monetary policy was doing.    As just another example, serious downturns here usually see the exchange rate fall a lot, which is helpful in buffering the downturn.

There was, of course, fiscal policy. Fiscal policy also typically turns somewhat stimulatory during the worst of recessions, and we could expect more this time round – as indeed we saw, whether in countries (like NZ) with no much initial government debt, or in others with historically high debt to GDP ratios.

And yet, and yet…..if one is to believe a variety of economic indicators, the level of economic activity now doesn’t seem far from what it was a year ago. GDP is a badly lagging indicator, but on both measures real GDP in the September quarter was a bit above where it had been at the end of last year. Treasury’s activity index is partial, but more timely, and for what it is worth suggests that in December activity was about 1.5 per cent higher than a year earlier, and this in a country where there are now fewer people actually physically here (people who need to eat, need accommodation, take holidays etc) than were here last year. (Of course, there was still a lot of lost output back in March/April 2020, and most of that will never be recovered, but that isn’t my point here).

Of course, the unemployment rate has risen – although we won’t know the Dec quarter outcome for another week or so. But even if the December number is a bit higher, no one seems to expect anything dreadfully bad now – I don’t think any projections for the unemployment rate are now as bad as those in any of the past three New Zealand recessions.

It is all a bit surprising, on a number of counts.

One thing I clearly got wrong was in assuming that when New Zealanders couldn’t travel abroad – a non-trivial chunk of total spending by New Zealanders – they would mostly save, at least for a time, what they couldn’t spend abroad. As I noted last autumn, it didn’t seem that likely that a week in Whangamata in July was going to seem that attractive if you’d been hoping to holiday in Fiji, the Sunshine Coast, or more far-flung northern hemisphere places. And no one seemed likely to take up skiing when they previously holidayed in the sun in midwinter. Add in the economic uncertainty – see above – and it seemed not very likely there would be a lot of expenditure-switching towards the local economy. And yet there clearly has been. Whether people have been taking more holidays at home – especially over the summer – buying a car or a boat, eating out more, or committing to house alterations etc, the expenditure switching seems to have occurred, on a quite large scale. So much so that despite the really dramatic loss of overseas tourist spending – and some dip in foreign student spend – and the weakness in the wider world economy, overall economic activity seems to have recovered surprisingly well.

Perhaps it won’t last. Perhaps it isn’t well-measured. But for now at least it is hard to dispute the overall story. There are still, clearly, sectoral holes – pictures of near-empty carparks/bus parks in former overseas tourist hotspots – but the overall story seems surprisingly strong. Not boom times of course: unemployment is up fairly materially, but right now it has the feel of a quite-mild downturn overall. Consistent with that, and even though inflation expectations themselves have fallen, core inflation in the year to December was right where it had been in the year to December 2019 – a bit below target, still, but not falling as one might have expected (as the Reserve Bank did expect).

What explains it? Well, clearly there was more scope for expenditure-switching than I’d supposed. And that is good to know. But it can’t be anything like the whole story. After all, the wider world economy continues to materially underperform (relative to, say, expectations at the end of 2019), and uncertainty remains high (recall all those optimists about trans-Tasman bubbles back in the middle of last year, and compare that with the current situation – where even when/if Australia unilaterally reopens again to us, you’d surely be hesitant about booking when you don’t know the regulatory climate at the time you travel out, let alone what you might face coming home. No one has a good sense of when major industries – foreign tourism or export education – will return to normal, no one knows when population growth will resume, no one knows when the world economy will again be firing on all cylinders.

Of course, some will credit monetary policy. All those people talking up the “money printing” theme, and tying that into the unexpected surge in house prices. I don’t buy that story because – like the Reserve Bank – I think quantitative easing works mostly by changing interest rates and – see above – interest rates just haven’t changed by unusually large amounts. Perhaps there are some headline effects that neither the Bank nor I have paid enough heed to, but even if so such effects are unlikely to last for long. Oh, and of course the exchange rate – usually a key part of the monetary transmission mechanism – is no lower now than it was a year ago.

What about fiscal policy? There was, of course, a lot of fiscal support provided in the middle of last year, mostly in direct income support. A small amount of that is permanent (boost to household demand), notably the increases in welfare benefit levels, but by far the largest chunk was the wage subsidy. And large as that was (a) it has long since ended, and (b) it wasn’t large enough to replace all the private sector income loss (see how much GDP fell in the June quarter, even as jobs and basic household demand were supported by the wage subsidy payments. And as far I can tell there isn’t a lot of fiscal stimulus happening now (beyond what was already in the works and forecasts a year ago) – I’m sure there are some specific projects getting underway, but since little is ever really “shovel-ready” it just can’t be much relative to the scale of the wider economic challenges.

I don’t have strong conclusions, just puzzles. Why are people spending as strongly as they are, especially when we are reminded every day of our own vulnerability to new Covid outbreaks, lockdowns etc etc? It isn’t obvious that people have adequately factored in the real level of uncertainty.

Among the puzzles is that if unemployment is up and yet GDP is also flat or a bit up on a year ago, and the number of people here is a bit less than it was – that seems to suggest a boost to productivity that doesn’t make a lot of sense. When there was talk of really big job losses, people recognised that a lot of lowly-skilled people might lose their job, averaging up productivity even if no actual person was more productive, but now we are dealing with quite modest job losses. Even if GDP hasn’t fallen we’ve had material dislocations in individual sectors and those usually take time to work through. And – even with all the advances of technology – if we’d been told people couldn’t travel for a year – work and leisure travel – most would have assumed that would be a drag on productivity. Perhaps not instantly, but over time. And certainly not a boost. Business travel took place for a reason – and not the “joy” of long haul flying.

So some things don’t seem quite right. And in some cases not that sustainable. But quite what gives and when, who knows.

As for policy, my own position is that more macroeconomic policy support remains warranted. The case is simple: inflation and inflation expectations are below target and the unemployment rate is above any sort of NAIRU. I’d focus on monetary policy, which is the tool best-suited to short-term demand stimulus (as distinct from the income replacement imperative in March/April). If anything, over the last year I’ve become more wary of fiscal policy for countercyclical purposes. It gets presented as some sort of free lunch when it isn’t, and involves whichever lot holds power at the time making real resource commitments – to their own ideological biases – that are difficult to change later and which often don’t stand close scrutiny re the quality of the spending. By contrast, monetary policy attempts to mimic what real economic forces (savings, investment) would be doing to market interest rates, and involves no politician or public servant committing any real resources, or controlling anyone’s spending. Those best placed to spend more do, those more hesitant don’t, and interest rates can – or should be able to – be adjusted without limit (if central banks had done their jobs) to provide what support is needed, including drawing demand towards New Zealand (whereas fiscal policy focused on government spending) only tends to further increase the real exchange rate, and the excessively inward orientations of the New Zealand economy.