Governing the Governor

Should the Governor of the Reserve Bank Be Elected, Or is the Bank Just A Tool of Parliament?
Listener: 21 September, 1996.

Keywords: Macroeconomics & Money;

Would you rather be voting for the Governor of the Reserve Bank than the parliament? A yes probably rests on the belief that the governor is more powerful than the prime minister. Irrespective of whether he is, his power comes from parliament, and he or she is but a eunuch without parliament’s command.

There are two stages of that command. The first is the Reserve Bank Act which states the purpose of monetary policy is to maintain price stability, which is not defined. The second is the Policy Targets Agreement (PTA), a contract between the Minister of Finance and the Governor, which sets down how a definition of price stability. So the governor’s discretion is very limited in the medium run. (Of course he can put off till tomorrow a change needed today, but he cannot do that for ever.)

To put the same point the other way around, suppose someone else was the governor of the Reserve Bank. Would the Bank’s monetary stance be markedly different, assuming the new governor were to pursue as vigorously the law and PTA? The answer is probably not very different. However judgements have to be made about the state and future of the economy and the effectiveness of the various measures which might be taken. So perhaps there would be some differences. And there is also the presentation. On occasions the governor sounds as bullying as Rob Muldoon use to be, and sometimes he seems to stray outside his mandate and pursue a line closer to that of the Business Roundtable than good political judgement or economic commonsense would recommend. Perhaps a different man or woman would present a different face.

The Reserve Bank Act was passed in 1989 at the height of ideological monetarist fervour, apparently without a lot of thought as to how it would operate. or whether it could be effective. The fall in the rate of inflation in the early 1990s probably had little to do with the Act, but seemed to confirm its effectiveness.

The ideologists appear to have had a vision of New Zealand without an export sector. So the Reserve Bank has had to go into the most extraordinary contortions to explain its position. Its most recent attempt has been the booklet on The Impact of Monetary Policy on Farming, in which it tries to calm farmer worries. It does this by avoiding entirely the question of the impact of monetary policy and the exchange rate on farm profitability. I am reminded of a Victorian account of procreation: “when Mummy and Daddy love each other very much, they have a baby”. Similarly the intervening steps of – if we have high interests rates and a high exchange rate, then there will be prosperity – are as a complete mystery.

The other major omission in the theory was the question of timing. Monetary interventions do not react immediately on the economy, but take months and years. Thus the current monetary stance is not simply set for the current state of the economy, but involves an assessment of the economy for some years in the future. To understand the state of the economy today, we need to recall the Reserve Bank was tightening its monetary stance a couple of years ago. One is not surprised given that (and the current fiscal stance) the economy is slowing down (and may even be contracting by the end of the year).

Undoubtedly the Bank’s management of the monetary policy is more sophisticated than the vision which set up the Reserve Bank Act. It involves some assessment of the long term sustainable growth rate of the economy, and a general strategy of managing the monetary stance to keep the economy tracking along that growth path in the medium run. If so, it involves making judgements (like what is the sustainable growth rate), and far from precise forecasts. Ultimately it is an art rather than a science. A different governor might make different decisions – but they may not be better ones.

One is curious to know how the bank’s economists think their monetary policies – high interest rates and a high exchange rate – impacted on the sustainable growth rate. Because the immediate effect is to cut back export sector profitability and investment, it seems likely that the short term monetary measures are reducing the medium term growth rate. (In my view this effect is far more powerful than the benefits of price stability). This has the makings of a vicious cycle resulting in low economic growth and stagnation.

But what is the alternative? There are a group, the most prominent of whom is Bob Jones with his book Prosperity Denied, who argue that there should be no Reserve Bank. But how do they expect the currency system to work? Others, including three of the four main parties, argue that the Reserve Bank Act and/or the PTA should be changed. No doubt they have a more sophisticated account of monetary behaviour than those who advocated the Act (it could not be more simplistic could it?). But what is their underlying theory?