In its Green Paper, the Actuaries Institute has identified plausible “alternative futures” that would result in the Australian economy diverging significantly from current expectations and perhaps involve a severe recession.
Actuary Dr Hugh Miller, who collaborated on the Green Paper with independent economist, Michael Blythe, states, “Scenario analysis delivers large benefits by investigating potential futures that may be low probability but high impact.”
Dr Miller adds, “These are the types of shocks that cause the greatest disruption and require the greatest adjustments. Understanding the implications and having a game plan in place are powerful supports for decision-makers.”
The paper notes that many of these unexpected shocks can produce lasting change. It references how the 9/11 attacks transformed the geopolitical backdrop dramatically, and how the Global Financial Crisis changed much of the way organisations are managed and regulated. It also highlights how the impact of the COVID pandemic is still playing out.
Dr Miller suggests the Baseline Scenario, which is the benchmark for the three “alternative futures”, is the only one that avoids a recession with positive although modest GDP growth rates. It is important to note that this is the expected path for the Australian economy and financial markets.
Assessing the chance of Stagflation (high inflation and high unemployment), the Green Paper said this is a plausible scenario in the current environment (high energy and food prices, supply chain pressures, strong demand, earlier reflationary policy settings) and clearly the current direction of global risk.
The Institute’s stagflation scenario has expansionary fiscal policy, too loose monetary policy and supply side constraints combining to drive a wage-price spiral, while inflation peaks at around 9%.
The resolution of the is scenario is ultimately a a severe recession, explains the Green Paper, including high unemployment and high long-term government bond yields.
The Institute writes, “While long-term parameters eventually settle around the same baseline growth rates, the economy is 5% smaller than in the baseline by the end.”
A Major Correction in House Prices is the next alternative future the Green Paper highlights.
This scenario is based on a 30% drop in dwelling prices which is beyond all current mainstream projections. The Institute states that the price decline is triggered by an overly aggressive Reserve Bank tightening cycle that would effect the economy and financial system.
Interest in this scenario has been refreshed given the current slowdown in the housing market, high levels of household debt, budget pressures, stagnant wages growth, bank exposures to housing and rising interest rates, explains the Institute.
It writes, “while most key economic variables converge back to the baseline projections towards the end of the scenario, the economy is smaller than in the baseline by the end, this time by 2%. The unemployment rate and debt servicing ratio are crucial variables to watch for this scenario.”
The final alternative scenario, Adoption of Modern Monetary Theory, focuses on achieving full employment by funding government expenditure through creating money rather than issuing debt.
The Institute explains this as a “new paradigm” scenario and though unlikely, it suggests that policymakers have moved some way in that direction. In this scenario, the activity benefits of the MMT-driven boom largely evaporate during the subsequent recession.
Should any of these three plausible, yet improbable scenarios occur, it is likely that all major economies around the world face similar risks.
Closing, Annette King, Actuaries Institute President, suggests the scenarios outlined in the Green Paper highlight the need for policymakers, advisers and industry to be on alert at all times.
She states, “If under plausible scenarios a business model is found unsustainable, clearly change is required – to the service or product offered, the public policy or regulatory settings in the market, or both.”
King adds, “Scenario analysis is widely used by government, regulators and businesses. It has wide application across all sectors of the economy and allows the impact of myriad factors to be assessed, such as climate change, cyber and pandemic risks – key challenges all organisations are currently facing.”
