Should the Economic Reforms be Intensified or are New Policies in Order?
Listener 14 October, 2000

Keywords: Growth & Innovation; Macroeconomics & Money;

There is a debate going on about what to do about the economy. The loudest view is that it is the fault of the new government, and that we only have to return to the policies of the last fifteen years and everything will come right. There are three reasons why this is not very compelling. First, the Labour-Alliance government does not seem to have changed policy that much. Second, the ‘collapse’ began in early 1999 or even 1998, well before the new government took power. And third, over the fifteen years the performance of the New Zealand economy has been the worse in the rich OECD, inflation excepted. So the past policies have failed, and are unlikely to succeed in the future.

The alternative view is that the current economic difficulties were broadly predictable (although when they would happen was not). The policies were fundamentally flawed, and the inflation and external imbalance are their consequences.

At issue, then, is whether the reforms should be intensified or whether they have generated the crisis and a different macro-economic policy needs to be pursued. How might it evolve? Typically new policy develops, as it is confronts practical difficulties. That may well be happening in regard to the Reserve Bank’s next monetary policy announcement.

The ideological 1989 Reserve Bank Act was predicated on the belief that monetary policy can control inflation, but there is not a single paper from the officials which discussed whether this is possible or how it is possible. Over the decade the Reserve Bank has tried to develop a theory of the economy to justify their legislation. Inflation has been low, largely through running an over-valued exchange rate, which influences directly about 40 percent of the consumer price index. It has been a bit like a student who is allowed to mark 40 percent of his own exam papers. He gives himself an A+ which, with a modest C for the remaining papers, gives an overall grade of B+.

However, in the long run the Reserve Bank cannot deny the underlying logic of its policies. An over-valued exchange rate means too many imports and too few exports, so the current account deficit opened up. Eventually the foreign lenders notice the poor economic performance, and stop advancing as much foreign funding. The exchange rate falls. This is exactly what has been happening.

The Reserve Bank seems to focus its theory of inflation on demand management. It argues that if there is too little slack in the economy, businesses and workers push up their prices too fast. Higher interest rates discourages investment and consumer spending booms creating slack in the aggregate demand, and so eliminating the inflationary pressures. As it happens the high interest rate also pushes up the exchange rate. Hence the B+.

This time the foreign lenders are very grumpy. Higher interest rates are not going to attract new foreign funds, nor raise the exchange rate much. Meanwhile, oil prices are high adding to the cost pressures. The Reserve Bank could try demand suppression to keep the inflation rate within the target, but that would mean some domestic prices might have to fall. The most likely price to do this, is that of labour – the wage rate. Depressing nominal wages would require a rip-roaring depression.

Fortunately there was a little commonsense when they settled the Policy Targets Agreement which sets the Reserve Bank’s operating objectives. It allows for unusual cost pressures. The Reserve Bank could discount its inflation target for the collapsed exchange rate and the price of oil, and thus would not have to screw down the economy to the extent an strict reading of the 3 percent annual inflation target implies. ‘Great,’ you say if you are a worker or a borrower (or both). But true inflation would be higher.

The government is only forming a policy view as I write. My guess is that its package may require coordination between the Reserve Bank and Treasury, some public understanding, and possibly (probably?) some involvement by the major private sector players (including the unions). If so it could be a shift from the failed policies of the last fifteen years.