Pandemic would batter confidence
Email Print Normal font Large font By Ross Gittins
February 25, 2006
WHEN people try to envisage the effect of a bird flu pandemic they say that, along with the terrible loss of life, there'd also be dire effects on the economy.
The deaths would matter most, obviously. But what economic effects could we expect? How dire might they be? And what could the managers of the economy do to reduce them?
These questions are worth thinking through, just in case the worst comes to the worst. And three Treasury officers - Steven Kennedy, Jim Thomson and Petar Vujanovic - have done so in a Treasury working paper.
Just how many people died would depend on how contagious the virus was, its virulence (strength) and the success of measures to
limit its spread. The authors assume - purely for illustration - that it spreads extremely rapidly, has a uniform impact across the country, and leads to 40,000 deaths.
This would be a smaller outbreak than the pandemics of 1957 and 1968, and a fraction the size of the Spanish influenza pandemic of 1918. But, as we shall see, it's not the number of deaths that does most to determine the size of the economic fallout.
The authors identify the six main "pathways" by which they imagine the pandemic would affect the economy. They then run them through Treasury's TRYM model of the economy one by one, building up a cumulative effect.
They start from the assumption that, had it not been for the pandemic, gross domestic product would have grown at its trend rate of 3.6 per cent, with consumption, housing investment and business investment each growing at that rate. The unemployment rate would have been 5 per cent, the inflation rate 2.5 per cent and the budget in balance.
The six effects are six shocks to the economy, some hitting the demand side and some the supply side. Note that successive shocks can have opposite effects on variables such as unemployment.
Obviously, the pandemic is likely to start overseas and spread to various countries. This would have an effect on the world's demand for our exports, even if the virus didn't make it to Australia.
In particular, there'd be an immediate collapse in the number of tourists visiting Australia. Any slump in our trading partners' economies - plus any disruption to transportation - would lead to a further decline in our exports.
The modellers estimate that, rather than growing by 3.6 per cent over the first year of the shock, the volume of our exports would fall by 5.3 per cent.
The resulting slower growth in production worsens employment and household income, which in turn reduces consumer spending. GDP growth slows from 3.6 per cent to 2 per cent and the unemployment rate rises by 0.5 percentage points.
The second respect in which the economy is affected is the 40,000 deaths in the first quarter of the first year. Although this represents 40,000 people who cease all production and consumption, that's not enough in an economy of 20 million people to have a noticeable effect on GDP.
The third pathway by which the economy is affected concerns the labour force. There's huge absenteeism, as workers seek to avoid infection by staying away from their workplaces.
This is particularly likely to happen in the services sector, where contact with the public is required. Assuming about 20 per cent of the labour force is absent from work over the first quarter (but straggles back to work over the following three quarters), we get a decline in employment.
This means lower household income and therefore lower consumer spending. The growth in GDP slows further to 0.5 per cent.
The fourth pathway through which the economy is affected is the blow to consumer confidence. People become frightened of what the future may hold and so they pull in their horns, stop spending and start saving.
"Even with only a small number of deaths, the confidence effects on consumption are likely to be large and immediate and are likely to overshadow all other factors in the short run," the authors say.
The sectors likely to be most affected are services such as hotels, restaurants and cultural and sporting events. It's assumed household consumption falls by 10 per cent in the first quarter, before recovering over the subsequent quarters. This means that, instead of growing by 0.6 per cent, consumer spending declines by 6.3 per cent.
That produces a recession (remember consumer spending accounts for about
60 per cent of GDP), which increases the unemployment rate a bit and thus adds to the fall in consumption (you get a negative multiplier effect, in other words). GDP contracts by 2.5 per cent over the year.
The fifth pathway is the effect of the loss of confidence on investment in business and new housing. We know that, during recessions, these things are hit much harder and for longer than consumer spending.
It's assumed that business investment declines by 7.4 per cent and housing investment by 12.6 per cent. Even though such downturns are moderate by historical standards, this increases the contraction in GDP to a huge 5 per cent.
The final pathway is a big negative shock to the demand for labour because of a large number of temporary business shutdowns and because, in the uncertainty, a lot of businesses just stop hiring.
As a result of the consequent decline in household income, the fall in consumer spending increases to 8.6 per cent, the contraction in GDP increases to 5.7 per cent over the first year and the unemployment rate shoots back up to 5.9 per cent. The budget blows out to a deficit of 3.5 per cent of GDP.
So here's the bottom line: a seriously frightening outbreak of bird flu could plunge us into a recession that was about half the size of the Great Depression. And while consumption and GDP would have recovered by the end of the second year, unemployment doesn't start to fall until the third year. (If we were lucky.)
The conclusions for the economic managers are that their focus should be on re-establishing consumer and business confidence as quickly as possible. And financial relief to those viable businesses that were hardest hit by the crisis, such as restaurants, would stop a temporary setback to them becoming a permanent collapse.
The budget deficit would blow out automatically. But the key to re-establishing confidence would be to swing immediately to expansionary policy settings (which wouldn't be a risk because the episode would be deflationary, not inflationary).
The Reserve Bank should (and would) slash the official interest rate, while Treasury was urging Peter Costello to make himself the biggest deficit spender since Jim Cairns.
Email Print Normal font Large font By Ross Gittins
February 25, 2006
WHEN people try to envisage the effect of a bird flu pandemic they say that, along with the terrible loss of life, there'd also be dire effects on the economy.
The deaths would matter most, obviously. But what economic effects could we expect? How dire might they be? And what could the managers of the economy do to reduce them?
These questions are worth thinking through, just in case the worst comes to the worst. And three Treasury officers - Steven Kennedy, Jim Thomson and Petar Vujanovic - have done so in a Treasury working paper.
Just how many people died would depend on how contagious the virus was, its virulence (strength) and the success of measures to
limit its spread. The authors assume - purely for illustration - that it spreads extremely rapidly, has a uniform impact across the country, and leads to 40,000 deaths.
This would be a smaller outbreak than the pandemics of 1957 and 1968, and a fraction the size of the Spanish influenza pandemic of 1918. But, as we shall see, it's not the number of deaths that does most to determine the size of the economic fallout.
The authors identify the six main "pathways" by which they imagine the pandemic would affect the economy. They then run them through Treasury's TRYM model of the economy one by one, building up a cumulative effect.
They start from the assumption that, had it not been for the pandemic, gross domestic product would have grown at its trend rate of 3.6 per cent, with consumption, housing investment and business investment each growing at that rate. The unemployment rate would have been 5 per cent, the inflation rate 2.5 per cent and the budget in balance.
The six effects are six shocks to the economy, some hitting the demand side and some the supply side. Note that successive shocks can have opposite effects on variables such as unemployment.
Obviously, the pandemic is likely to start overseas and spread to various countries. This would have an effect on the world's demand for our exports, even if the virus didn't make it to Australia.
In particular, there'd be an immediate collapse in the number of tourists visiting Australia. Any slump in our trading partners' economies - plus any disruption to transportation - would lead to a further decline in our exports.
The modellers estimate that, rather than growing by 3.6 per cent over the first year of the shock, the volume of our exports would fall by 5.3 per cent.
The resulting slower growth in production worsens employment and household income, which in turn reduces consumer spending. GDP growth slows from 3.6 per cent to 2 per cent and the unemployment rate rises by 0.5 percentage points.
The second respect in which the economy is affected is the 40,000 deaths in the first quarter of the first year. Although this represents 40,000 people who cease all production and consumption, that's not enough in an economy of 20 million people to have a noticeable effect on GDP.
The third pathway by which the economy is affected concerns the labour force. There's huge absenteeism, as workers seek to avoid infection by staying away from their workplaces.
This is particularly likely to happen in the services sector, where contact with the public is required. Assuming about 20 per cent of the labour force is absent from work over the first quarter (but straggles back to work over the following three quarters), we get a decline in employment.
This means lower household income and therefore lower consumer spending. The growth in GDP slows further to 0.5 per cent.
The fourth pathway through which the economy is affected is the blow to consumer confidence. People become frightened of what the future may hold and so they pull in their horns, stop spending and start saving.
"Even with only a small number of deaths, the confidence effects on consumption are likely to be large and immediate and are likely to overshadow all other factors in the short run," the authors say.
The sectors likely to be most affected are services such as hotels, restaurants and cultural and sporting events. It's assumed household consumption falls by 10 per cent in the first quarter, before recovering over the subsequent quarters. This means that, instead of growing by 0.6 per cent, consumer spending declines by 6.3 per cent.
That produces a recession (remember consumer spending accounts for about
60 per cent of GDP), which increases the unemployment rate a bit and thus adds to the fall in consumption (you get a negative multiplier effect, in other words). GDP contracts by 2.5 per cent over the year.
The fifth pathway is the effect of the loss of confidence on investment in business and new housing. We know that, during recessions, these things are hit much harder and for longer than consumer spending.
It's assumed that business investment declines by 7.4 per cent and housing investment by 12.6 per cent. Even though such downturns are moderate by historical standards, this increases the contraction in GDP to a huge 5 per cent.
The final pathway is a big negative shock to the demand for labour because of a large number of temporary business shutdowns and because, in the uncertainty, a lot of businesses just stop hiring.
As a result of the consequent decline in household income, the fall in consumer spending increases to 8.6 per cent, the contraction in GDP increases to 5.7 per cent over the first year and the unemployment rate shoots back up to 5.9 per cent. The budget blows out to a deficit of 3.5 per cent of GDP.
So here's the bottom line: a seriously frightening outbreak of bird flu could plunge us into a recession that was about half the size of the Great Depression. And while consumption and GDP would have recovered by the end of the second year, unemployment doesn't start to fall until the third year. (If we were lucky.)
The conclusions for the economic managers are that their focus should be on re-establishing consumer and business confidence as quickly as possible. And financial relief to those viable businesses that were hardest hit by the crisis, such as restaurants, would stop a temporary setback to them becoming a permanent collapse.
The budget deficit would blow out automatically. But the key to re-establishing confidence would be to swing immediately to expansionary policy settings (which wouldn't be a risk because the episode would be deflationary, not inflationary).
The Reserve Bank should (and would) slash the official interest rate, while Treasury was urging Peter Costello to make himself the biggest deficit spender since Jim Cairns.