The Economics of an Epidemic Explained

Australia Institute Senior Economist Matt Grudnoff explains the economics of an epidemic

Will coronavirus have a big effect on the economy?

Yes, it will have a big impact on the economy, but the size of the impact will depend on the government’s reaction to the crisis.

Part of the reason that the share markets around the world are so volatile is that we really don’t know what is going to happen or how long the crisis will last.

Given the increasing measures to lock down people’s movements, the closing of countries' borders and measures to reduce the number of people we interact with, it is likely that this will have a large effect on the economy. The final impact on the economy will depend on how long it goes for and most importantly of all, how effective the government’s stimulus policies are.

How will coronavirus impact the economy?

The biggest impacts will be on how the coronavirus disrupts the production of goods and services and how much demand is lost as people spend less.

While countries are restricting the movement of people, the movement of goods has not been as restricted.

The problem is when a country goes into lockdown there is less production.

We saw this at the beginning of the crisis in China. In January, the government in China extended the Chinese New Year holiday in order to slow the spread of the virus. But this also shut down production and this flowed on to business supply chains and impacted businesses and consumers in Australia and around the world. As other countries lock themselves down, it will have a similar effect.

Immediate impacts are being felt by airlines like Qantas and Virgin, which are canceling international flights; the arts sector, as theatre, music gigs and dance company productions shut down; restaurants and bars will see a slump as people are advised to avoid crowds of more than 100 people indoors. However, companies like Woolworths and Coles are doing better than expected, largely due to panic buying.

The coronavirus will also slow people’s spending.

Apart from buying essentials, as people become more worried, they will spend less. If workers begin to lose their jobs or lose shifts this will add to the lack of demand in the economy. Less demand means less things have to be made and less workers are required to make them.

What is a recession?

A ‘technical recession’ is two consecutive quarters of negative economic growth.

The problem with this definition is that people don’t experience recessions through something as abstract as negative economic growth. They experience recessions through rising unemployment and a fear of losing their job.

During the 1990s recession unemployment increased by about five percent. This not only reduced people’s spending power, since when you go from employed to unemployed you lose a lot of income, but it also made people who were employed very worried about losing their jobs. Because people could see unemployment continuously rising people realised if they lost their job, they had little chance of getting another one.

This meant that even those that had jobs spent less as they tried to build a financial buffer against unemployment. All this added to the lack of demand in the economy and made the recession worse.

Is a recession inevitable?

No, a recession isn’t inevitable but its highly likely, as is rising unemployment, especially in the absence of a much bigger stimulus than stage 1.

When the GFC hit in 2008 people were convinced that a recession was inevitable. But an effective stimulus package prevented a recession and the same can happen again.

For Australia to avoid a recession requires the government to be quick and smart in where they target their stimulus and how much they will spend.

The government must convince people that they will do whatever it takes and spend as much as is needed to prevent a recession. If they do this then they can maintain confidence in the economy and avoid a large fall in demand.

What should the government do?

The economy needs stimulus and lots of it. The government has already announced $17.6 billion but much more is needed.

The government’s stimulus spending is designed to create more demand in the economy and help fill the hole in demand created by the crisis. Stimulus spending should slow the increase in unemployment which means more people keep their jobs and have more income to spend. It also means people are less worried about losing their job and are less likely to stop discretionary spending.

When should the stimulus happen?

The stimulus needs to be happening when the crisis is impacting the economy. For the coronavirus the economy is being impacted now, so the stimulus needs to be now.

The whole point of stimulus is to slow the increase in unemployment by creating demand in the economy.

If the government waits too long, then the fall in demand will increase unemployment, confidence will fall, and household spending and investment will fall. This can lead to a vicious circle and make in much more difficult for the government to pull the economy out of.

But that doesn’t mean that all the stimulus needs to be immediate. The impact of the coronavirus is likely to last for at least several months. The economic impact will be even longer. Some of the government’s stimulus should be targeting to maintaining demand and employment in the medium and longer-term. With medium- and longer-term stimulus the government has more time to develop projects. These still need to be urgently undertaken but they can be projects that have longer completion times and can target the kinds of things that employ more people.

Who should the government target their stimulus to?

Government stimulus can be broadly split into two forms. The first is giving money to individuals or groups. The second is direct government spending. In the first stimulus package that the government announced in early March, it was mostly about giving money to individuals and groups. Giving $750 to welfare recipients or $25,000 grants to businesses are examples of this. The government doesn’t have to hand out money directly, it could also come in the form of tax cuts, which have the effect of increasing people’s after-tax incomes.

The size of the stimulatory effect that handing out money to people has depends on who you hand it to. The more the money is spent in the domestic economy the bigger the stimulatory effect. The more that the money is saved or spent on imports the less it will stimulate the economy. The money for welfare recipients will be very stimulatory as welfare recipients tend to spend most of their income on essentials in their local communities. Money for high income people tends to be less stimulatory because they tend to save a larger part of their income.

Money for business is also less stimulatory. This is because during a crisis business are worried about future cash flow and are potentially facing a fall in sales. In this situation they’re not likely to spend. An example of this in the government’s first stimulus package is the expansion of the instant asset write off that allows businesses to get back a proportion of an investment when they lodge their tax return. But if businesses are worried about future sales, they’re unlikely to spend on plant and equipment.

Government spending can be the most stimulatory when the government is purchasing goods and services from the private sector since 100% of the money allocated is spent. The government is not giving the money to someone else who then decides if they’re going to spend it.

Can’t the government wait and see where it needs to stimulate and how much is needed?

No. The longer the government waits, the more people become unemployed, the more businesses close and the more worried people become. Stimulus is about slowing the fall in demand. Waiting just makes the fall in demand larger. Stimulus is most effective when it happens early. Waiting to see how big the problem is will only make the problem bigger.

Isn’t it just a waste of money?

This is one of the biggest misunderstandings about stimulus spending. Stimulus is about the government buying more employment at a time when unemployment is rising. Stimulus is about the government keeping the economy strong at a time when economy is stagnating. Anything else the stimulus does is a bonus. This doesn’t mean that the government shouldn’t try and get other benefits form the spending, but these other benefits are secondary.

When considering these secondary benefits, we can think of stimulus as an opportunity to help shape the country we want. It is an opportunity to do things that we were told, or we convinced ourselves we couldn’t afford. But stimulus spending should ultimately be judged on how effective it is in stopping a recession and mass unemployment.

Stimulus spending needs to happen quickly. If spending quickly means we don’t get ‘value for money’ then that is perfectly acceptable if the spending saves us from a recession. Spending quickly often means less planning and an increased likelihood of not getting the best deal. But if the objective is to get money into the economy then paying more doesn’t reduce the effectiveness of the stimulus.

What is so bad about a recession anyway?

It has been almost 30 years since the last recession, which means that most of the people working today have never experienced one in their working lives. Recessions are simply awful. They’re awful economically and they’re awful socially. The unemployment they cause for many will be permanent. There was a large group of people, mainly older men, who never worked again after the 1990s recession. They previously worked in manufacturing type roles and the growing services sector simply didn’t absorb them.

Recessions are particularly bad for those on the margins of the labour market and the poor. In short, recessions are something we should do all we can to avoid. If budget deficits are the cost of avoiding a recession, then most economists agree that it is a small price to pay.