A significant shock, policy response, and long-run challenges
The COVID-19 shock is truly a ‘once in a generation’ event (touch wood). And the macro policy response (ie the response from both the Government and the Reserve Bank) has been appropriately swift and substantial. It has cushioned the blow, even if it is unable to offset and even out the impacts entirely.
But what about the longer-run implications? While necessary, this policy response, in the context of tight housing supply, is leaving in its wake a housing market that is even more difficult to enter for first-home buyers, along with a growing public sector debt burden that will need to be at least partially consolidated through some combination of higher taxes and less government services than otherwise at some point in the future.
Politicians certainly have their work cut out, but they are the only ones who have the tools available to address these issues over the long run. These are structural issues that cyclical policy tools (chiefly monetary policy) are not equipped to address. The trajectory we’re on, as well as New Zealand’s demographic profile, suggests policy makers are going to become more and more attuned to these issues over time as voter concerns evolve.
‘Damage control’ policies have limited the economic fallout…
Although the data is impacted by volatility, the economy has been a lot more resilient to the current crisis than economists initially expected. It remains unclear how much of the positive vibe in the recent data will translate into real, on-theground economic activity in a sustained way, but it’s clear that the monetary and fiscal policy response has been very effective at limiting the initial hit to economic activity.
That’s great news because it means the transition through the recovery (ie once virus risks are contained, and borders reopened) will be a lot easier than otherwise.
The initial macro-policy response has been trying to lean against the turn in the business cycle by limiting the hit to incomes, expenditure and production. For monetary policy, this means making sure credit is flowing smoothly, debt-servicing costs are kept low, and businesses and households have confidence to spend and invest. And the RBNZ has done just that! However, the vigorous response of the housing market has also exposed decades of inadequate policy action from the Government in addressing New Zealand housing supply problems.
For fiscal policy, damage control has meant ensuring that policies limit the income hit, keep people connected to the labour market as far as possible, boost confidence, and stimulate the economy through the recovery – all the while keeping COVID-19 at bay. And to date, the fiscal response has been powerful, essentially paying, through the wage subsidy, for a significant portion of the lost production brought about by lockdowns – at the cost of a lot of government debt.
In addition to the above, fiscal policy has a longer-run role to play by focusing stimulus on bolstering the productive capacity of the economy through investment in key infrastructure and training, addressing regulatory bottlenecks (such as RMA reform), and incentivising businesses to invest. If successful, this part of the policy response could really limit the burden the policy response is currently putting on the younger generation.
…but there will be longer-term scars
Although policy has provided a cushion, that’s not to say there won’t be some permanent scarring brought about by this crisis. A significant amount of damage for some sectors of the economy is unavoidable. Challenges lie ahead, and some colossal forces are pushing and pulling at the economy right now as the lost summer of tourism goes up against strong housing momentum. It’s still not clear where the dust will settle, let alone exactly how virus and vaccine developments will evolve from here, although recent news flow is encouraging.
Unfortunately, we think some of the lost GDP is gone for good – the question is how much. Lockdowns, a closed border, the very sharp and synchronised shock among our trading partners, and the turn in the business cycle more broadly will do that. Here’s how:
- International tourism will never completely make up for lost ground. Once borders eventually reopen, New Zealand is unlikely to play host to twice as many tourists as before. There simply isn’t capacity for that! Further, while there will certainly be some pent-up demand, foreign incomes are likely to be weaker and that’s likely to weigh on highly discretionary spending (such as international holidays). And that’s before we consider the possibility of lingering health concerns associated with travel, and possible barriers to travel, such as testing and proof of inoculation, and potentially long delays in rebuilding air capacity. Indeed, it’s possible that New Zealand may never be as well serviced by international airlines again. Many other services industries face similar issues – it’s hard to make up for lost time when many foregone services (eg haircuts) don’t get consumed at an increased rate on the other side.
- Reduced business investment (typically a significant underperformer during a crisis and very weak currently) has put New Zealand’s capital stock on a lower-than-otherwise path. That means, in short, that we can’t make as much stuff. Sure, it’s possible that investment comes back with a vengeance. But not while the outlook is still uncertain, as it is expected to be for a while, and it’s hard to see it making up for lost ground. All else equal, a smaller capital stock implies a lower productive capacity, weaker economic activity, and lower incomes than otherwise.
- Further, this shock has hit different sectors of the economy very unevenly. That’s exacerbating skill shortages to which the closed border is also contributing, creating a real growth constraint for those firms that are seeing stronger demand and looking to expand. This, plus New Zealand’s relatively highly regulated labour market, could see the unemployment rate come down only slowly, also leading to a more sluggish recovery than otherwise.
All up, once we’ve navigated the lockdown noise in the data, we expect trend GDP is likely to settle below its pre-COVID trajectory, just as it did following the Global Financial Crisis (figure 1), with it taking even longer for the labour market to return to normal.