Punishing Exports: How Our Monetary Policy Inhibits Growth.

Listener: 20 September, 2003.

Keywords: Growth & Innovation; Macroeconomics & Money;

Remember the teacher who put the whole class into detention because of the misbehaviour of some rowdies at the back? Exporters have a similarly bitter view of the Reserve Bank (RBNZ). It has maintained a high base interest rate (coming down slowly) because the domestic rowdies have been putting inflationary pressure on the economy. Relatively high interest rates affect the rowdy businesses, but also the rest of the economy, especially exporters, because high interest rates tend to push up the exchange rate and reduce the profitability of exporting.

Does it matter? After all, the inflationary pressures across the economy are being slowed down. If the only concern is the level of prices, it may not. But the export sector is central for economic growth. Putting it into detention compromises the long-run prosperity of the economy.

Export businesses are crucial because they can grow faster than the economy as a whole, by selling into rapidly increasing foreign markets, or increasing their market share. By doing so, they drag the domestic sectors along, accelerating their growth and the economy as a whole. In contrast, a domestic business can grow rapidly only at the expense of other domestic businesses. (The exception is import substitution where the growth is at the expense of foreign exporters. But their profitability is as influenced by the exchange rate as much as exporters’.) When the exchange rate rises, businesses find it harder to compete overseas and cover their domestic costs, their profits go down, so exporting and export investment slow down, undermining the long-run growth of exporters and their ability to drag the economy along a high growth path.

Why then does the RBNZ hold up interest rates at the expense of exporting and growth? One reason is that the Reserve Bank Act says the RBNZ’s sole concern is price stability. More fundamentally, it really has only one policy instrument –– setting the base interest rate. It is like the teacher whose only available punishment is detention of the whole class, and who has no way of punishing only the rowdies. Note how the best use of detention is dealing with uproar, rather than trying to improve academic performance. Similarly, monetary policy may be better directed towards price stability than economic growth, even though pursuing the former may damage the latter.

It is a mathematical truism that a single policy instrument can target only one policy objective. Yet it is unclear from the official papers that led up to the Reserve Bank Act what the advisers were thinking. My suspicion is they were relying on something like the “Mundell-Fleming” model that says only monetary policy works when the exchange rate is floating (as it is today) and that only fiscal policy works when the exchange rate is fixed (as it was before 1985).

Unfortunately, the model makes a whopping great assumption that is practically wrong when it postulates that the economy can be characterised by a single product. Some modelling simplifications are inevitable, but the central feature of any small open economy, such as New Zealand’s, is that there are at least two major sectors producing different products: tradeables (mainly exports) and non-tradeables (for domestic markets). Assuming only one sector is a bit like assuming your class was only rowdies or goodies, but not both. The outcome will be poor performance (educational or economic).

The implication is that if we are to avoid collateral damage in the external sector while suppressing inflation in the domestic sector, we need more policy instruments. James Meade, awarded an economics prize in honour of Alfred Nobel in 1977, suggested four such instruments, assigning money for regulating nominal demand, the wage path set by unions and employers to determining the price level, using interest rates to affect investment, and fiscal policy to influence the balance of payments.

Unfortunately, it has not proven possible to control the stock of money sufficiently for such policy target purposes, while our union structure is too weak for them to lead a wage path. But it makes sense for the fiscal stance (the government’s deficit or surplus) to contribute to controlling the macroeconomy. Like Meade, I see its role as especially important in influencing the balance of payments, which determines the size of the tradeable sector and long-run growth prospects.

Even though they may be unworkable, Meade’s proposals indicate that there are options outside of the current constrictive interpretations of the Reserve Bank and the Fiscal Responsibility Acts and first-year economic models. It requires just a bit of creative imagination and disciplined thought. Like the teacher who gave us detention in the library. The goodies got on with their study, while the rowdies suffered misery (except for the one who began reading some books and joined the goodies).