An estimate of the economic impact of COVID-19 on Australia

Everything we do before a pandemic will seem alarmist.  Everything we do after will seem inadequate. Michael Leavitt

Summary

In response to widespread concern regarding the intensity and duration of economic impacts from the current COVID-19 pandemic, this article aims to inform discussion by (1) identifying the mechanism through which shocks to individual markets are transmitted to the aggregate economy (2) providing plausible upper and lower bounds for impacts drawn from actual economic data for most recent pandemics, and (3) estimating the magnitude of government intervention required to counteract the economic impact of the pandemic.  The key finding is that the impact of COVID-19 on Australia’s economy is likely to be deep - a contraction of up to 15 percent of GDP - and require government expenditure of at least $300 billion billion to offset the shocks to the labour market, consumption and investment.

Introduction

In economic theory, the output of the aggregate economy (Y) is composed by the sum of private consumption (C), government expenditure (G), business investment (I) and exports (X) minus imports (M); and is conventionally stated as Y = C+G+I+X-M. The equilibrium growth path of the aggregate economy, therefore, can be understood as the sum of the growth paths of its components. The Australian Bureau of Statistics (2020) estimates the annualised output of the Australian economy (Y) in the December 2019 quarter had a value of almost $2 trillion, composed of $1.1 trillion in private consumption (C); $700 billion in government expenditure (G); $120 billion in investment (I); $493 billion in exports (X); minus $425 billion in imports (M).

The introduction of an external shock to one or more of these sectors will require offsetting change in others to restore the equilibrium of the aggregate economy, that is, the path of output along which supply balances demand.  Otherwise, the risk of a recession is run.  This is precisely the situation unfolding in Australia as significant decline in household consumption, business investment and exports requires counterbalancing by government expenditure to restore the economy to equilibrium.

The economic transmission mechanism

The specific transmission mechanism through which economic shocks from COVID-19 to individual markets flow to the aggregate economy can be described as follows. First, a reduction in the short-run supply of labour in the market due to social isolation, illness and death leads to significant reduction in household consumption. Households reduce their consumption as they cannot travel, are concerned for their income and savings, and perceive their capital assets (primarily their home) to have declined in value. This is the well-known “wealth effect”. The most immediate detrimental economic impact is borne by the hospitality, leisure, travel and tourism sectors due to reduction in discretionary spending and the impact of social distancing rules.  Reduced household consumption reduces business confidence and its willingness to invest and employ, deteriorating the employment outlook. Reduced household consumption, combined with reduced business investment and employment, impacts government tax revenue through the collection of less GST and personal and corporate income tax. Both exports and imports can be expected to decrease as demand from household consumption and business investment decline across many countries. The solution, therefore, to short circuiting this vicious spiral is to increase government expenditure to the extent required to offset the reductions in the other sectors.

At this time, fiscal policy is preferred over monetary policy as the policy lever of choice because official interest rates around the globe are at or close to zero and there is little room left for manoeuvre to stimulate aggregate demand through further rate reductions.  In any event, cautious and debt-laden households are likely to repay debt rather than consume more. That said, the central banks’ practice of quantitative easing whereby they purchase financial instruments such as government bonds to maintain prices, liquidity and confidence will continue to assist in sustaining the economy.

Data from recent pandemics

Table 1 summarises actual economic data drawn from five relatively recent pandemics to help identify plausible upper and lower bounds for key economic impacts.  Data for the SARS pandemic of 2002 is included - despite the relatively small number of deaths - due to its similarity in geographic dispersion to COVID-19.  Data for the bubonic plague, popularly known as the Black Death, which inflicted Europe between 1347 and 1353 is provided as a historical benchmark.

Predictably, labour markets appear to have been severely impacted by pandemics.  The US Bureau of Labor Statistics’ records the rate of unemployment rising by a full third from 7.2 percent (2008) to 9.6 per cent (2010) before and after the Swine Influenza pandemic and by over half from - 3.7 percent (1968) to 5.9 percent (1971) - before and after the Avian Influenza pandemic.  China’s Ministry for Human Resources and Social Security similarly records the official unemployment rate rising by a quarter from 3.6 percent (2001) to 4.5 percent before and following the SARS pandemic.

Key findings

This section discusses the scope for government expenditure to offset the impact to the economy from shocks to private consumption, business investment and exports.  The methodology draws its data from Table 1 and applies these to the framework described in the introduction.  Trade is excluded as changes in exports and imports are likely to net out.

A plausible upper bound scenario would see  Australia’s private consumption collapse by up to 20 per cent on 2019 levels (total $1.1 trillion) which would represent a loss of $220 billion to GDP with a consequent reduction in business investment of up to 50 per cent ($60 billion); a total loss of $280 billion to the aggregate economy and a contraction of ãbout 15 percent.  Consequently, a programme of government expenditure of $300 billion plus would be required to offset these shocks.  By way of context, by 7 April the Australian Government had announced $213 billion in economic stimulus spending in response to COVID-19 (ABC 2020).

Conclusion

This study finds that the economic impact on Australia of COVID-19 is likely to be deep but is moot as to duration.  Other studies of earlier pandemics not only found their economic impacts to have been deep but also remarkably prolonged.  Economic modelling by Smith (2009) of an influenza pandemic in the United Kingdom with COVID-19’s profile (which is a clinical attack rate of 2.5 in 10,000 people globally and a case fatality rate of 6.2 per cent) estimates an impact on GDP of -6.5 percent.  Similarly, Barro (2020) estimates an impact on GDP of -10 percent from the Spanish Flu even after adjusting for World War I. 

Jorda’s (2020) study of historical pandemics focuses on the rates of return on assets (land, labour and capital) following pandemics with over 100,000 deaths as their key economic metric.  Their principal finding is startling: after pandemics the rate of return declines for decades, reaching its lowest point of -1.5 percentage points some 20 years later, and only returning to its pre-pandemic rate 40 years after the event.  They attribute this extended recovery period to the pandemic’s detrimental impact on the labour supply which increases the real wage and which, in turn, induces its substitution with capital.  In sum, all of these studies point to an unfortunately long road to recovery.