Economic and Financial Market Update: Do Big Changes Lead To Big Changes?

Summary: 

• There will be more working from home, but the Office will remain important; 
• The crisis has highlighted the vulnerability of supply chains to a global economic slowdown; 
• Governments will be a bigger part of the economy; 
• How we pay for the rise in government debt will determine how the economy performs over the next decade. 

The enforced social distancing policies over recent weeks has led to a big change in economic growth. But it has also led to broader changes to the wider economy and society more generally. Some of those changes have been for the good. There are less traffic accidents. Pollution is lower. People seem to be exercising more. Older people are becoming more accustomed to using technology to stay in contact. 

There has been an increasing amount of discussion as to whether some of the changes caused by the Coronavirus might have permanent implications. Below are comments on four of the changes that have been widely discussed.

Working from home

According to the ABS at the end of last year around one-third of all employees usually worked from home (including owner-managers). Another survey by Indeed indicated that around two-thirds of employers allowed remote working. So having employees work while not in the office is not a new concept. What is new is the numbers of people working remotely and the length of time that many people are doing it. 

Initially there were concerns as to whether Australia had the internet bandwidth to cope with so many people working remotely at one time. It (mainly) has. But if this is to become a permanent feature of the way we work some changes are likely needed. While Australia has a high proportion of people with internet access by global standards, we pay relatively more for the privilege of having an internet with relatively slow speeds.

A benefit of this crisis is that working from home has got easier. More people are getting used to understanding the benefits of remote working tools such as Zoom, Skype and Webex. Managers who might have had suspicions about people not being in the Office now have found efficient methods to deal with widely dispersed teams. And recent experiences will reinforce that working from home is very useful when you need to concentrate on getting something done.

But for many people there will remain good reasons to go into the Office. For office workers the technology setup will usually be superior at work. Video chats between individuals work well enough but it is a lot harder to have group discussions. Research indicates that people find video conferencing more exhausting (we are not used to talking to a big head). And for those with families it is hard to be full-on at work when there are kids playing around your feet.

Ongoing innovation and customs will solve some of these problems. ‘Zoom etiquette’ will evolve (as will the security). The likelihood is that technology will continue to get cheaper making it easier for the home to be setup like the Office.

But more importantly a key part of a job for many employees is the people you work with. At its core that is what the WeWork business model was all about. It brought together people that could have chosen to work from home but craved the energy and stimulation that can only come from working with others. 

Being with people is also why going to see live sport/music remains popular. People go to the cinema less often these days. But the proportion of people that go to see a ‘flick’ has not significantly changed over the past twenty five years despite the massive improvements in home entertainment systems. 

And it is the reason why despite the increasing ability to work from home the biggest driver of office vacancy rates remains the strength of the economy (which also suggests that vacancy rates are likely to rise over the course of this year).

The bottom line is that recent experiences is likely to lead to both an increase in remote working and in the productivity in doing so. But this will never fully replace the need (or desire) to go into the office. The COVID experience though has highlighted the benefits of being flexible in how we work. 

Increase in precautionary behaviour

There is a growing thought that the economy has been structured for maximum efficiency but at the cost of minimising safety buffers. The thinking is that while this approach ‘brings home the bacon’ in the ‘good’ times it gets exposed when the economy abruptly slows. Three issues have been highlighted.

One is that households and businesses will feel the need to raise their level of saving following the downturn. Since the GFC most Australian firms have increased their cash holdings (and reduced leverage) although the ratio of cash to liabilities has fallen a little since the end of the mining boom (reflecting slowing profit growth). Cash holdings are substantially higher in Japan. Partly this is because of weak growth in their domestic market (reducing Capex needs) and partly because shareholders have been less demanding. In the US where shareholders are used to getting their way cash holdings are substantially lower (also a result of a tax system that encourages share buybacks).  

Certainly a number of firms that have done best this year are those with strong balance sheets with large cash holdings. But firms in the most affected parts of the economy (transport, recreation, accommodation) would have to hold such a large cash buffer to guard against the extent of the shutdown that it would have severely limited their ability to invest in their business. And holding large cash buffers is difficult for small firms.

History does indicate that in a slowdown Australian households are likely to save more. In the past three economic slowdowns (1980’s, 1990’s and the GFC) the household saving rate jumped by 3-5 percentage points around the time the unemployment rate rose. Most saving is done by higher-income households. In downturns they are less likely to lose their job but they turn risk averse in the worry they might. The rise of the saving ratio might be less this time as the Government has been more pro-active in providing a higher income safety net than in preceding recessions (although the focus has been on lower-income earners that are less likely to save).

The second issue is whether firms will make changes to their supply chains following the problems caused by the shutdown. This is not the only time over recent years that global supply chains have been impacted by left-field events. Natural disasters such as the earthquake that hit Japan, the tsunami that hit Thailand and the local bushfires all created problems for particular sectors. The US-China Trade War had a more widespread impact, and highlighted the problem about over dependence upon China. Firms responded by diversifying their supply sources (for example, Japanese firms implemented a China-plus-one supplier policy). 

The problem though is that the pandemic has created global problems, reducing the ability to diversify. Sure firms could look to buy more products and services locally. But state borders in Australia have also been closed which would make local supply chains also clunky. In any event, as Europe and the US went into shutdown many of the Asian economies (particularly the industrial sector) were largely back-up-and-running. Perhaps a bigger issue is less how much is sourced from offshore but the complexity of supply chains. Having long supply chains creating specialisation across countries can increase efficiency and innovation. But it can also come at the cost of making supply chains more vulnerable.

Of course firms always have the option of holding a higher level of stocks as protection against supply chain problems. But holding stock is costly and (depending upon the good) can easily become obsolete because of deterioration or changes in consumer/business taste. And inevitably during the good times management will be questioned about their high level of stocks.  

The crisis has also shown up the vulnerability of Australia having a low domestic manufacturing capacity. The issue most widely highlighted has been that the vast bulk of Australia’s (but also many countries) medical equipment and medicines are imported. This has led to talk about the importance of self-sufficiency in sectors of national importance. But that raises the question of which industries are truly of national importance. Many might agree that being able to manufacture most of your medical needs is one. But is being able to manufacture tin cans for fruit? 

The big picture question is what price are we prepared to pay to be self-sufficient? The reason why Australia has a low manufacturing base is that mostly it can be done more efficiently elsewhere. This has left Australia to focus on sectors where we have historically been more productive (such as mining). This approach has led to Australia having one of the highest standards of living in the world. Doing more manufacturing in Australia will provide protection against infrequent but major events (such as pandemics or wars). If we think those events might become more regular then there might be benefit in making more stuff at home. But it may also come at the cost of less employment and activity in other (more efficient) sectors.

Structurally higher Government spending

An important economic outcome of the Coronavirus has been the significant and aggressive fiscal response of global governments (including Australia). Governments have provided income support to households and firms (mainly SME’s), investment incentives, industry support and debt guarantees. In the developed markets of North America, Europe and Australia/NZ the average size of these packages is around 10% of GDP (and could head higher). Asian countries were initially less generous given their stronger initial handling of the pandemic. But the arrival of a second wave of infections (such as is happening in Singapore) and the gloomy backdrop of the global economy is leading them to spend more money. 

Some of this increased spending will be easily unwound. As workers return to jobs the need for widespread wage subsidies will fall. More firms will earn profits leaving less need for industry support or loan guarantees. More income in the economy means more tax should be paid. But other programs might be harder to unwind. For example, the generosity of the income support programs will likely reopen the debate for higher unemployment benefits. Increased health spending is almost certain, particularly on greater preparation for future pandemics.

Historically major events have resulted in higher levels of government spending. Although Australian Government spending (as a proportion of GDP) declined after the end of both World War I and II, it ended up at a higher level than before the start of both World Wars. To a lesser extent the same happened after the GFC. That said the biggest rise in government spending happened over the 1960s and 70s (only partly related to the Vietnam War). 

Over time there has been a structural rise in Government spending in Australia (and most developed countries). Wealthier populations have demanded that Governments can (and should) do more. This may well happen again on this occasion. At a minimum, increased level of government spending will be needed in the short term to support the economic recovery. Higher levels of spending might also be required to help implement any productivity

Higher Government debt

The combination of a big rise in government spending and low taxation (because of the weak economy) will mean big budget deficits and a significant rise of debt of Australian Governments to its highest level (as a proportion of GDP) since the Second World War. That debt ratio will be a lot higher in most other developed countries.

The question of how the governments’ finance their big debt levels will have important implications for how the economy develops over the next decade. The high debt in Australia resulting from the Second World War was repaid via very strong economic growth, relatively high taxes (the top marginal income tax rate in the early 1950s was 75%) and capital controls (firms and banks could not borrow overseas, there were limits on how much households and firms could borrow, regulations meant that a higher proportion of bank assets had to be held in government debt). 

The ideal answer is that very strong economic growth creates enough income to repay debt. Hence the renewed talk of improving productivity growth. While stronger productivity growth would clearly be a good thing it is unlikely to lead to the sort of growth rates caused by post Second World War restructuring and a population boom. The impost of capital controls would be a major shock to the current structure of the financial system. 

Higher taxes are possible. In Australia, government revenue as a proportion of the economy remains relatively low by global standards. But increasing tax to pay-off debt (as opposed to economic-boosting measures such as increasing infrastructure spending) could lead to slowing economic growth. And it likely will require changes to our current tax structure given the over-reliance on income-based taxes (over spending or wealth).

The other key question is who will buy the debt? Banks will be one buyer, a result of liquidity regulations. It is also possible that in a scenario of sustained high deposit growth and weak credit growth we could naturally see more funds flow into government debt. Pension and bonds funds may also hold more debt as this crisis has highlighted the benefit of holding high-quality assets that can be easily sold. Overseas investors are still likely to be buyers reflecting Australian Governments’ relatively high credit rating and relatively higher return (compared with Europe and Japan).

The RBA will also be a major buyer. Although Governor Lowe has made it clear that the RBA is not directly financing the Government, they have indicated that they will buy whatever amount of debt is necessary to ensure that there is plentiful cheap financing available for the economy. It is difficult to know how much buying this might require. But if the economy is weak for an extended period it could be quite a bit. Already the Bank of Japan holds nearly half of all the Japanese Government bond market.

Any big economic shock does cause lasting changes. How big those changes end up being is dependent upon how large and for how long the economic shock lasts. Some of the changes are from trends that were already in place (such as working from home). The most likely change is that Governments’ will play a bigger role in the economy.

We live in interesting times!

Regards,

Peter Munckton - Chief Economist