That Sinking Feeling: on Track to Contraction?

Listener 9 May, 1998.

Keywords: Macroeconomics & Money;

Readers of this column will be less surprised than most at the increasingly gloomy state of the New Zealand economy. In a September 1997 column I discussed the expected deterioration in the current of account of the balance of payments. Then the external deficit was running near 5 percent of GDP. The latest figure is 7.7 percent of GDP, which traditionally would be of crisis proportions. Rather than the usual rapid collapse of the exchange rate (or the government defending the existing level by selling foreign exchange), the rate is steadily sinking. Under our floating exchange rate regime, foreign exchange transactors can take forward cover (that is purchase contracts which guarantee they can withdraw New Zealand currency at a fixed rate in the future). This smooths any precipitate descent, so the rate sinks over a long period rather than plummets over a short period.

Note that my September column was written before the Asian financial crisis was apparent, while most of the current macro-economic data refers to a time before it has impacted on the economy. Attributing the gloomy statistics to the Asian economies is misleading in two ways. First, it ignores the structural problem which existed before the Asian crisis (the topic of the September column). Second, it underestimates the impact of the collapse of our Asian export markets. Certainly there are news items now coming through (such as layoffs in export industries), but they are not yet appearing in the statistics. I am on the pessimistic side of the forecasters. After the government’s May budget others will join me.

Budget construction is a difficult task. (Harold Macmillan described it as planning a train journey using last year’s timetables.) I shall describe the post-budget debate slightly differently from what you will find in the financial pages. If the external deficit is 7.7 percent (although it will be higher by then), for every $100 the nation earns (domestically or by export), it is spending $107.70. The deficit has occasionally been higher in the past, but (except for 1975) it was then associated with an investment boom. This time it is a consumption led external deficit which is not sustainable, barring miracles. Total spending has to be cut relative to income. The issue is which spending? Or to put it more bluntly: whose spending?

The debate is unlikely to be in terms of “whose spending”. Leaving aside nutty contributions (like privatisation is the answer, whatever the question), the debate will be about increasing the government’s fiscal surplus, the “internal surplus”. (There will also be effects from rising interest rates, which will reduce spending.) The shrillest advice will be to cut government spending.

Cutting government spending is a misleading concept. Some spending, say on frigates, might be thought of as only the spending by government, but most times a cuts in government spending are a cut in individuals’ effective spending. When social security benefits are cut, it is the beneficiaries who have to cut their spending. And if, say, health spending is cut, then those on the waiting lists either have to pay private treatment fees (and so cut back on other spending) or live in continuing discomfort (sometimes to an early death).

Whatever their overt justifications, the basic covert message of almost every spending cut advocate is “we must cut everybody’s expenditure except my own” (and those who vote for me, or pay my salary). It would be so much easier for the public to understand the issues if the advocates were honest, but it may be unreasonable for advocates of self interest and pressure groups to be so candid.

As the economy deteriorates further, and so tax revenue deteriorates, there will be two enormous pressures on the Treasurer. One will be to cut government spending and/or increase taxation, to increase the surplus for reasons of fiscal prudence. The other will be to do the opposite, because we are running up to an election. I cannot tell you how Mr Peter’s will react. My guess is whatever he does it will be with a very queasy stomach.