Listener: 9 September, 2006.
Keywords: Macroeconomics & Money;
The external deficit (of the current account of New Zealand’s balance of payments) is currently around 10 percent of GDP. Once, a deficit of three percent of GDP was thought about right; we got edgy when it rose above five percent. Should we, then, be panicking now?
Things are very different today. The value of exports of goods and services is still close to the value of the import of goods and services. What differs is the international investment income received by foreigners. Nowadays we owe so much overseas that the interest and profit on the debt and foreign investment amount to almost eight percent of GDP. That is more than is earned by our single largest exporter, the tourist industry.
The economy is borrowing not so much to spend more on goods and services as to cover its debt servicing. It’s a bit like using a credit card to pay for the interest on your other debt. You avoid having to cut back on spending, but eventually the amount of debt servicing overwhelms you.
Is that what New Zealand faces? In the old days, the gap was covered by government borrowing. Today the government’s spending roughly balances its revenue, and its net borrowing is negligible. New Zealand’s borrowing now is mainly private.
Do private borrowers make good decisions? Many do not, and they don’t always get away with their bad decisions. (Nor do their lenders, a lesson learnt by those who invested in the finance companies that recently failed.) But it is not obvious who would make better decisions.
Even so, in aggregate it’s hard not to conclude that we owe too much. I don’t know who are the more asinine: those who borrow for private consumption by mortgaging the house or those who say the borrowing is responsible because house prices are rising. Your house price is only meaningful if you are one of a handful selling. If everyone has to sell – during, say, a debt crisis – the price will fall and those capital gains you have borrowed against will become losses.
You can’t juggle credit cards forever – and the same applies to the economy. Stein’s law says, “If it can’t last, it won’t.” Yet the immediate prospect is that debt servicing will continue to rise; and eventually spending will have to be cut to achieve a prudent level of debt.
There are three broad ways in which the binge could be brought to an end: a voluntary reduction in spending; a shock peculiar to New Zealand, with overseas investors taking fright; or a major global financial shock. The second possibility is the least likely, so the outlook lies probably between the first and the third.
Have we time to make the adjustment before that financial shock? Who knows? Any such shock – I can’t tell you the details, because it could happen in so many different ways – will impact heavily on those deep in debt. (Some creditors will also find their investments of little value.) Workers – even those with good credit records – will suffer, too, if they lose their jobs as spending and production shrink (though their savings will cushion them to some extent).
The government, with a prudent balance sheet and low debt, will be able to ameliorate these impacts a little. But it won’t be able to do as much as the over-borrowed will expect. (Yes, despite the debt being the result of private decisions, we expect a public-sector bailout when we get into a private mess, as happened with the financial sector after the 1987 crash.) It would be very irresponsible for the government to increase its debt levels by, say, giving tax cuts (without public spending cuts) before the private debt mountain had been reduced.
A cut in spending will cause a fall in imports relative to GDP. Provided export returns don’t fall, too – they could, under certain shock scenarios – the external deficit should fall. At which point an important lesson should become evident: a high external deficit is not in itself a bad thing but an indicator of severe internal imbalances.<>It is unusually high now.