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>Alan Bollard’s not a Grinch, he’s just doing his job.

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>Listener: 5 April, 2008.

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>Keywords: Macroeconomics & Money;

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>Last October, Alan Bollard, Governor of the Reserve Bank, broke an implicit constitutional convention when he said that if this year’s tax cuts were too generous, he would have to tighten monetary policy. Governors have long muttered in private about irresponsible fiscal stances (to do with the balance between taxation, public spending and government borrowing), but reservations weren’t aired publicly. You can find the odd remark during the Don Brash years, but the threat was never so explicit.

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>Bollard has clearly stated that too permissive a fiscal stance would mean higher interest rates. Before him is the example of his Australian equivalent, Glen Stevens, who raised interest rates just before last year’s election, because he judged the Australian Government’s fiscal position was too expansive. Bollard would not do that lightly, but like his transtasman equivalent, he might have no choice.

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>The public rhetoric misrepresents Bollard. It is easy for lazy journalists to present him as the Grinch who stole Christmas; in fact, he has statutory and contractual obligations requiring the Reserve Bank to restrict the economy when inflation is increasing, by maintaining and increasing high interest rates. Those who complained about the Grinch months ago are now complaining about inflationary pressures.

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>Almost certainly, Bollard is not opposed to tax cuts per se. His concern is that they inject extra demand pressure into the economy – which, above a certain level, can be inflationary. If tax cuts are accompanied by lower public expenditure – which reduces demand pressures – there might be no need for additional monetary restraint. The Reserve Bank’s concern is the degree to which the Government budget is stimulating the economy, measured by the overall fiscal deficit.

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>While the breaking of the constitutional convention is to be welcomed !– although one hopes it is necessary only rarely !– the underlying economics analysis has also shifted. It was commonly accepted 40 and more years ago that fiscal and monetary policy could not be set independently. That insight got lost in the late 1980s when Rogernomics dictated that the Reserve Bank should run monetary policy independently of fiscal policy (and the Rogernomes ran some of the most permissive fiscal stances of the post-war period). In the mid-1990s, the Reserve Bank and Treasury hardly talked, but when Bollard became Secretary of the Treasury relations began to thaw.

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>Our monetary policy is not out of line with conventional wisdom. US Federal Reserve chairman Ben Bernanke recently said of the interaction between fiscal and monetary policy that the Fed couldn’t regulate the economy by itself, but needed co-ordinated fiscal assistance.

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>This return to Keynesianism is becoming increasingly necessary, given the challenges the world economy faces. The monetarism that so influenced the Rogernomes is a very simplistic theory (even some journalists can understand it). But it is not particularly useful during periods of economic and financial turmoil. That doesn’t stop monetarists from obsessively repeating their ideology, but the cold reality is that it is their nostrums that created the current mess.

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>The Minister of Finance, Michael Cullen, is a Keynesian who flagged when he took office that, if necessary, he would run a financial deficit. Fortunately it was not appropriate to do so in the first eight years of his tenure, but it may be necessary this year. Cullen has announced a set of criteria that, if met, would enable him to cut income taxes. Bollard is probably comfortable with the criteria, but will scrutinise their application closely.

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>An even bigger worry is that the Opposition will overbid with even more extravagant tax cuts, as it did in 2005. It would be constitutionally very innovative if the Governor of the Reserve Bank were to comment on the Opposition’s policies. Let’s hope he won’t need to.