Kiwiblog

The Dom Post has a guest column by Stephen Kirchner from the CIS:

The idea that New Zealand can ignore inflation and grow faster through easy money and a lower exchange rate is a tempting, but short-sighted view. It ignores the fact that higher domestic prices would ultimately undermine rather than promote international competitiveness. Economic growth and export success must ultimately be built on real factors such as productivity growth, not easy money and exchange rate depreciation.

It is like cheating on an exam – only works for a while

The Reserve Bank’s primary focus on inflation recognises that monetary policy needs to be based on a single instrument and policy objective. Pursuing multiple objectives with multiple instruments, as Labour now suggests, is a recipe for incoherent policy and poor economic performance such as New Zealand experienced before its path-breaking reforms of the 1980s.

TVNZ is a good example of having multiple conflicting objectives. Either none of the objectives are achieved particularly well, or some of them are just ignored.

It would also undermine the transparency and accountability that were important objectives of the Reserve Bank of New Zealand Act. Under the current framework, the governor of the Reserve Bank is personally accountable for realising the inflation target under a policy targets agreement with the finance minister. Sustained breaches of the inflation target can result in the non-executive members of the Reserve Bank board recommending dismissal of the governor to the minister. This is no idle threat, but it would be difficult, if not impossible, to hold the governor accountable for achieving multiple objectives instead of a clearly defined inflation target.

An excellent point. More objectives will mean less accountability. The Governor will always have a get out of jail card.

Since the first PTA was entered into in 1990, the inflation target has been progressively watered down. Most notably, the inflation target has been relaxed from 0-2 per cent to 1-3 per cent and given a medium-term focus, so there is now greater tolerance of short-term breaches.

I actually believe it should go back to a 0% to 2% range. Over time even 3% inflation is too much.

Matt Nolan blogs:

Monetary policy at heart isn’t about “unemployment” or “output” or “the exchange rate” (which is a relative price).  Monetary policy is about money, it is about the supply of money, it is about the price level and inflation.  The “interest rate” is merely an instrument central banks use to control the money supply and keep “inflation stable”.  By keeping inflation stable we increase certainty and we help make sure that money remains a good indicator of the relative value of REAL goods and services.

The idea that we should mess around with this to tinker with other things misses the point – if our exchange rate is funny, unemployment is high, or output is below potential we have to ask “what issues in REAL economy are causing this”.  Monetary policy in itself is irrelevant – monetary policy IS about money, it IS about inflation, it IS about expectations regarding these nominal variables, it IS NOT about real economic variables.

I am not saying that monetary policy hasn’t moved real variables – but in a world where monetary policy IS solely focused on inflation and consistent expectations is a world where monetary policies impact on the real economy is at its best.

It worries me greatly that Labour have abandoned support for a bipartisan monetary policy consensus.

Just as Scrubone has become the dedicated fisker of No Right Turn, B K Drinkwater has appointed himself as the fisker for Marty G at The Standard. His latest response to the suggestion that monetary policy should target inflation, unemployment and the exchange rate is:

Genius! What the RBNZ should do is this: pick a point on the Philips Curve and manage New Zealand’s economy towards it! If only some genius thought of this before.

Oh, wait. Someone did, and it didn’t work. Apparently, some guy called Friedman accurately predicted its failure …

Stagflation in the 70s proved Friedman correct, but this is where Phil Goff wants us to go back to.

I actually can’t figure out whether Marty wants the interest rates to be low or high. He thinks that if they’re too high, then the currency carry trade will create a “flood of credit”, making mortgage rates too low. His preferred solution—abandoning inflation-targeting—clearly implies that he wants the OCR lower than it is, and that by doing this, somehow mortgage rates will go up.

He’s very confused.

And then Blaise sums up:

So Marty wants the following:

• A lower OCR
• Higher mortgage rates
• Jobs, or in other words, investment in New Zealand
• Reduction in the currency carry trade, a big chunk of such investment

My head hurts.

Need more be said.

Matt Nolan translates what Labour is proposing:

Labour goals were:

1. a stable and competitive exchange rate;
2. reduced interest rates for businesses and home owners;
3. continued priorities of price stability and low inflation;
4. to guard against expectations of price rises.

So, with goal 1 they want to reduce the flexibility of NZ$ prices, which will lead to higher unemployment and a worse allocation of resources.  Furthermore, they want to keep the dollar low which implies subsidising exporters to the cost of households in the short-term.

With 2 they want to punish savers.

And with 3 and 4 they want to contradict themselves – as by limiting price flexibility and holding the exchange rate and interest rates down they WILL drive an increase in inflation expectations, dump price stability, and remove any chance of a low inflation environment.

Tracy Watkins reports:

Labour leader Phil Goff is calling an end to the 20-year consensus on monetary policy.

Mr Goff is expected to use a hard-hitting speech to Federated Farmers in Wellington today to declare that the Reserve Bank’s policy targets – which influence interest rates and the dollar – are no longer working.

Labour came under pressure while in office to change monetary policy and signalled a rethink toward the end of its term but did not indicate what might replace the current regime. Mr Goff is not expected to spell out the alternatives in his speech today but will call for more work on the options.

This looks rather desperate.

First of all, it is of course correct that monetary policy is not perfect.

But I am reminded of the words of Winston Churchill about democracy – how it was the worst form of Government – apart from all the others that have been tried.

While there are some enhancements that can be made (and Dr Bollard has been doing some work on these), you can’t really make significant changes without allowing inflation to get out of control – and that just lowers the country’s standard of living – everyone gets poorer.

So to some degree Goff is just posturing to, unless he starts specifying what changes he would make. But declaring monetary policy is no longer working is silly, because of course it is. You can’t blame the high NZ dollar on monetary policy considering we have the official cash rate at a very low 2.5%.

Don Brash does an excellent rebuttal in the NZ Herald to a call by Bryan Gould for more regulation. Some extracts:

But Gould implies that the crisis was caused by “free” and unregulated markets, especially in the financial sector. This is quite simply nonsense. Banks may be relatively lightly regulated in New Zealand (where there is no banking crisis), but they have been highly regulated in the United States and Europe for many years.

Worth thinking about. And then talking about the US regulations:

In many ways, this intensive supervision by official agencies made matters worse by leading bank customers to assume that banks were effectively “guaranteed” by Government, thereby enabling banks to operate with levels of capital well below those regarded as prudent in earlier decades. Perhaps even more serious, intensive supervision led some bank directors to suspend their own judgment, and believe that they were behaving prudently provided they were observing all the rules.

Often a problem – a minimum standard becomes a target.

Gould seems not to have noticed that the crisis emerged not in the essentially unregulated hedge fund industry, or even among private equity funds, but in the most highly regulated part of the financial sector, namely banking.

Yep.

Gould argues that “Government involvement in the management of the economy is essential”, implying that that has not been the case in recent decades. Again, that could hardly be further from the truth.

Government taxation and spending make up some 40 per cent of total economic activity in most developed countries, and in all developed countries regulations of one kind or another tightly control what businesses can do.

It’s not exactly libertarian heaven with the status quo.

Gould in any case asserts that fiscal policy is more important than monetary policy. I would not want to get into a debate about which is more important – both are important. At its most basic, monetary policy is essentially about preserving the purchasing power of money.

Unless that is achieved within some tolerable limits, money can’t fulfil its important roles as a unit of account, a basis for transactions, and a store of value – just ask the Zimbabweans!

When people argue for a bit more inflation they are arguing for a bit less purchasing power.

With the benefit of hindsight, monetary policy was probably too loose in recent years, in some countries at least.

This is the irony – interest rates were probably too low, causing too many people to borrow.

We also know that, in the nineties, the United States Government started putting pressure on American banks to lend to borrowers of quite marginal creditworthiness to prove that they were not discriminating on the basis of race.

It is often the best intended policies that have the worst results.

Don Brash writes an op-ed in response to Finlay MacDonald’s call for politicians, not the Reserve Bank, to be in charge of determining interest rates. Brash responds:

He then goes on to argue that “plenty of people” see this act “as a relic of failed economic dogma, well past its due date for reform”, although he mentions only two people by name – Jim Anderton and that well-known economist Winston Peters.

Need more be said.

He links the Reserve Bank Act and similar legislation elsewhere to the current financial crisis.

Whatever the cause of the current crisis, nobody that I know of seriously suggests it was caused by our Reserve Bank, or other central banks, focusing monetary policy on keeping inflation under control by keeping interest rates too high. Indeed, there are many observers who believe that the trigger for the current crisis was interest rates in the US being kept too low for too long, with the result that banks were encouraged to lend to a large number of borrowers of very marginal creditworthiness.

Excellent point.

First, the central banks of virtually all developed countries – certainly the United States, the United Kingdom, Canada, Australia, and the countries of the European Monetary Union – have removed monetary policy from the day-to-day influence of politicians. Why? Because experience over decades has shown that politicians have a tendency to manipulate monetary policy for their own political advantage, to the economic cost of their countries.

I can’t comprehend why anyone would want Rob Muldoon setting interest rates again.

Fourth, nothing about New Zealand’s experience since we reached price stability in 1991 suggests that focusing monetary policy on keeping average prices stable damages growth or employment. We’ve had some of the best growth in our history over the past 16 years, and, until recently, we had the lowest level of unemployment in the developed world.

Exactly. Emperical evidence is overwhelming that you can have low unemployment with monetarist policies. Likewise overwhelming evidence that you can eliminate protectionist trade barriers and have low unemployment.

Fifth, while dropping interest rates can stimulate economic activity in the short-term, all countries have learnt from bitter experience that, in the longer-term, using interest rates to try to get faster economic growth results only in damage to economic growth, as inflation makes it harder to interpret the price signals coming from the market. Sustainable economic growth ultimately depends on increasing output per person employed in other words, on productivity and tolerating higher inflation does nothing to achieve that goal. If it did, Zimbabwe (with high inflation) would be enjoying fantastic economic growth and high living standards, and the United States (with low inflation) would have poor growth and low living standards.

Whatever the problem is, high inflation is never the answer.

It is a sign of the desperation in Labour’s ranks that both Mallard and Cullen are now hinting at abandoning the 20 year consensus on monetary policy being used to keep inflation low.

Using the cash rate to keep inflation low is not perfect. People accept that. In fact one of the best criticisms I have seen of the model came at the Business Roundtable Retreat of all place.

But just as Winston Churchill said democracy is the worst way to choose a Government, except all the other way – the same tends to apply to monetary policy.

Despite what WInson Peters says, there is no evidence at all that having higher inflation will lead to lower unemployment. We have emperical evidence for this in NZ, where we have had one of the lowest unemployment rates and low inflation.

If you go easy on inflation, you may get a short-term economic boost, but in the medium to long-term you are worse off. This is why almost evert OECD country has a similiar monetary policy to New Zealand. Only fringe dwellers seriously disagree with the basics.

Now as I said the status quo is not perfect. The question is whether one can find a better solution. The Visible Hand in Economics is canvassing that issue.

The most appealing proposal I have seen is from Don Brash who has an unorthdox solution that the Reserve Bank be given an additional weapon or lever – the rate of petrol tax. Brash advocates that as petrol consumption is fairly price inelastic, an increase or decrease in petrol tax could warm up or dampen the economy in a similiar way to changing the cash rate. But with the benefit that exporters are not so badly affected by the exchange rate going up due to higher interest rates.

There are constitutional issues around such a move (Brash suggests over the long term it would have to be revenue neutral so the RBNZ is not making profits from it).

I certainly think it is an idea worthy of study. My initial question (and I would love it if an economist could crunch some numbers) is how much would one have to increase or decrease the rate of petrol tax to be equal to say a 25 point change in the cash rate?

A leading economist did a presentation to the Business Roundtable Retreat on Friday. It was Chatham House Rules so I can report some of the detail – but not who said what. It was an analysis of the trends and issues in the economy, and then some possible solutions.

• The 90 day bill rate predicted to drop in 2009 to 6% but then to increase and stabilise at 7%
• A small increase in the unemployment rate reaching 4% in 2010
• The equilibrium level of inflation may have increased from 2% to 2 1/4 to 2 1/2 per cent.
• Migration to Australia would continue and this would be of the relatively “more productive” New Zealanders. This isn’t a judgement on education levels or intelligence as much as recognising they are people with “skills established in this economy” so generally more productive here than any replacements.
• Mining in Australia is only 7% of GDP and 2% of their workforce so incorrect to credit the minerals boom for their economic growth.
• The big challenge for NZ is to increase our productivity, and it is hard to do this with a declining talent pool. Hence we have a vicious circle – the more people who leave, the harder it is to increase productivity so incomes can increase to keep people here.
• Agricultural Protectionism is a real issue and hurting the agricultural sector
• Multilateral trade deals and plurilateral trade deals are better than bilateral deals
• NZ needs to shift focus in trade deals from purely agricultural access to also have investment rights in agricultural processes and storage facilities.

He also did a very nice summary of one of the problems with the current macroeconomic model. Basically, if I recorded it correctly, it is:

1. Increasing Inflation –> Increasing Cash Rate
2. Increasing Cash Rate –> Increasing Interest Rates
3. Increasing Interest Rates –> Increased NZ$
4. Increased NZ$ –> Decreasing Exports
5. Decreasing Exports –> Decreasing Economic Growth
6. Decreasing Economic Growth –> Decreasing Investment
7. Decreasing Investment –> Decreasing Productivity Growth
8. Decreasing Productivity Growth –> Decreasing Aggregate Supply
9. Decreasing Aggregate Supply –> Increasing Inflation

In one sense it is an argument why it is important to keep inflation under control from the beginning, but it does highlight a weakness in the current monetary policy cycle. Whether there is a better solution though is the real question.

It was suggested that the RBNZ targets should have the emphasis on targeting inflation over the medium term removed, as it has led to timidity with the RBNZ late to act, with the consequence being inflation and interest rates stay higher for longer than they otherwise would have been.

He also highlighted some ways to increase productivity:

1. Encourage people to stay in NZ
2. Increase the returns for effort
3. Reform and reduce tax levels
4. Get rid of redistribution policies which just redistribute money back to those who pay it, and adds a deadweight cost to the economy
5. Reduce the rate of growth in the public sector relative to the private sector
6. Make it easier for employers to release lower productivity staff

Now people can make arguments against each and every one of these on grounds of social justice or fairness etc. I mean for example I wouldn’t advocate being able to get rid of staff at whim. But the point the economist was making is that if you don’t do these things, you will find it harder to increase productivity growth. So it is all a trade off – if you do not do any of the above you’ll watch the gap with Aussie grow even faster.

There is also a list of what not to do:

1. Don’t discourage the able from staying
2. Don’t discourage more effort
3. Don’t discourage investment
   1. Don’t ignore property rights
   2. Don’t have costly planning requirements
   3. Don’t increase the regulatory burden
   4. Don’t impose climate change policies which have large risks for investors

It was clarified this wasn’t an argument for having no policies to mitigate climate change. It was for uncertainty and risks to be minimised.

And again people can argue for or against each of the above – it was just a reminder that there is a cost to productivity growth if you do discourage effort and investment etc.

To some degree it was a bit gloomy.  The vicious cycle with migration and the impact of monetary policy on productivity growth make it very clear that closing the gap with Australia will not at all be easy.  It won’t just happen by chance without a change in policies.  And there will be no one or two simple things to do – it will only happen as a result of taking action in a dozen different ways, each incrementally helping increase productivity growth.