Keywords: Macroeconomics & Money;
The International Financial Crisis
By way of context the world economy faces the greatest economic crisis since the Great Depression in the early 1930s – it is possible that it will be an even greater one3. I shant go through how we got there. When the ship is leaking, headed for the rocks and not responding to the helm. analysing foolish decisions of the past is not a priority; although we should note that while some of the passengers were as irresponsible as those who sail the ship of the international economy, there are others unwillingly or unknowingly on board. And in due course we should learn from our mistakes as we set out on a fresh, and hopefully, less dangerous voyage.
The reason the rudder is not working is that the world’s monetary system is jammed. Credit is needed for trade, for business investment, for house purchase and for public works – all integral to the effective running of the economy. There is a desperate shortage of credit for periods longer than about a month. The reason is that most of the big trading banks which underpin the world’s credit system have weak balance sheets, because they contain what are known as toxic – the euphemism is ‘troubled’ – assets. Toxic assets were purchased at prices well above their current worth; we often do not know what a toxic asset is worth today. As a consequence the holders have to write down the assets in their balance sheets, although no one knows by how much.
In order to function, a trading bank has to have an adequate margin of its assets over its liabilities. If it does not, then others wont loan to it, because they fear that the bank will collapse and they will lose their investments. If enough banks are thought problematic then there cannot be the interbank lending which underpins the credit system.
The worst possibility is that the margin is negative and liabilities exceed assets. Without implicit government guarantees such institutions would be ‘bankrupt’. Some of these guarantees have been converted into partial nationalisation in order to add cash to cover the deficits in the assets of the financial institutions’ balance sheet.
Rather than call the financial institutions ‘potentially bankrupt’, some Americans describe them as ‘upside down’. Nobody knows for sure which banks are upside down, nor which other financial institutions are exposed to them and so could be upside downed if the insolvent ones go under. Potential lenders to banks thought to have toxic assets will tend to assume the worst.
Unable to borrow from other institutions, and in any case cautious and perhaps over-extended, a bank will not expose itself by new lending. So there is a credit contraction. All economic transactions which depend upon credit get cut back; businesses cut back their investment and sell out of inventory rather than production, consumers relying on credit cut back their purchases.
Firm turnover falls, there are fewer hirings, layoffs increase, some firms collapse from a loss of sales and the economy contracts. Because of global interconnectedness a fall in demand in one economy results in lower imports from others to it. They contract too, reducing their imports and the world economy goes into a downward cycle..
In recent years, such downturns were met by lower interest rates which one way or another staunched the downswing. This time, interest rates are near zero, yet there is no evidence of an economic recovery. What is different is the troubled assets. Additional or cheaper cash is not encouraging the banks to lend as long as they have substantial toxic assets on their balance sheets.
The world is facing a failure of its monetary system. Until sufficient toxic assets are purged from the financial system we are not going to get a world recovery. Therein lies the political problem. Purging toxic assets means someone has to take the loss from their face value. Everyone is keen to pass on the loss to someone else. Ultimately much will be charged to the taxpayer.
Until the credit system is working again, the economy will not start working properly. Keynes famously described the situation during the Great Depression as a failure of the ‘magneto’ – the generator and distributor of electricity to the car engine. He was not expecting capitalism to be replaced by another economic system – the car was fine except for one vital component.
Keynes, of course, advocated fiscal injections (deficits) to solve the problem. But until the magneto is fixed, fiscal injections wont jump start the economy. Its like jump starting your car with a flat battery. If there is no generator, the car will move as long as the outside current is applied. Stop that, and the engine stops.
So a fiscal stimulus will move the economy into continuous growth if the credit generator is working. When it doesnt the economy will not function under its own power. All a prolonged stimulus will do is increase the burden of public debt, to weigh on future taxpayers – including the unborn – without any long-term benefits. So the financial authorities have to fix the magneto, they have to get the gunge of the toxic debt out of it. This is proving difficult. It took the Japanese over a decade to do that in the 1990s. Hopefully this time it will be tackled faster, especially in America. They are promising to have the gunge problem resolved by the end of this year (2009). But the indications are nobody is sure how.
In the meantime the world economy depends on fiscal stimuli from various countries, to keep it moving. But fiscal deficits where spending exceeds revenue, have to be covered by borrowing. That may be easy when you are the American government issuing the world’s currency. It is much more difficult for us because the New Zealand dollar is not the world’s currency.
The Implications for New Zealand
I need to make it clear that the New Zealand trading banks seem solvent – they are the right way up. Their problem is that they are heavily borrowed offshore, have to rollover those debts and borrow more in order to cover a further net saving deficit over the next few years. But it is only ‘immediately’ their problem; they can borrow from the Reserve Bank, which makes it ‘our’ problem. And since the Reserve Bank issues only New Zealand dollars, whereas the new and rolling-over overseas loans are in American dollars, we have to borrow offshore to obtain them. I so often observe this simple proposition being ignored, I repeat it. We have to borrow well over $120 billion from overseas sources in foreign exchange – individually, corporately, the Reserve Bank, the trading banks, the government. We are all in this together.
Think of us as the dinghy attached to the ship heading for the rocks. Our fate is inextricably tied up with the international economy, but in a different way from the big economies. The dinghy is shipshape but we cant cast off the painter.
To put our troubles in context, New Zealand went into recession early last year (2008). It was a relatively mild recession. For instance, across the year there was a job loss of 14,700 jobs. In 1991 there were 34,200 jobs lost, more than double last year’s loss.
The 2008 recession was not caused by world economic conditions. It was self-induced. The New Zealand economy should have been coming out of the recession about now. However, the world downswing is impacting on us so, instead of a recovery, the local recession is being intensified by the world one. We do not know how intense the downswing will be. Forecasters keep revising their tracks down and pushing the bottom of the downswing further into the future. For instance, last December the N.Z. Institute of Economic Research predicted that the current recession would be over by the middle of this year (2009). Three months later (this March) it changed its forecast, announcing that the recession ‘may last four years’.
The usual response to an internally induced recession is to increase the fiscal deficit. That happens automatically, because tax revenues fall and some social spending increases. But it is common to increase the deficit by further tax cuts and increases in spending to moderate a recession. Last year the Labour Government both increased government spending and reduced tax levels to moderate the recession.
The flip side of a bigger fiscal deficit is additional public borrowing; that borrowing depends on the willingness of counter-parties. Even were the international markets not gummed up, there are limitations on those lenders’ willingness. If the investors think a country has too much borrowing or too much debt they will be reluctant to lend. In which case they have to be induced with a higher interest rate. We have been warned by credit rating agencies of this danger.
As I have explained, government borrowing intensifies the problem of rolling over the foreign debt. But how intense? I have made some preliminary estimates based on December 2008 forecasts – they are almost certainly too optimistic, so the actual number is going to be larger. In March 2008 net overseas liabilities (that is, what we owe to foreigners less what foreigners owe to New Zealand) amounted to 100 percent of annual GDP. That includes the $90 billion of debt owed by the trading banks, but it also includes equities owned overseas, corporate and personal debt, trade credit and host of other sorts of liabilities.
The current forecasts suggest that New Zealand will have to raise at least extra $NZ33 billion by debt and equity in a two-year period in addition to what it has to roll over. After that the net liabilities ratio would rise to 124 percent of annual GDP by March 2010, just over a year off. That is a serious deterioration. The main source of this additional borrowing is the public sector.
So while the government is dealing with the international crisis by increasing the fiscal deficit – the amount it spends above its revenue – in order to maintain demand in the economy, there is a limit to how much it can borrow. The government has opened the deficit as much as it thinks it can prudently borrow. It daren’t have a bigger deficit because it may not be able to find willing lenders at reasonable cost. Indeed there is even the possibility that if the world financial system remains gummed up, we may not be able to borrow the amount that is currently projected.
This means that unemployment is going to rise. It is forecast (perhaps optimistically) to rise to 7.5 percent of the labour force, or to over 150,000 New Zealanders. That is a little higher than it was during the recession of the Asian Crisis of the late 1990s. Sure, we can temporarily restrain the rise by increasing the size of the fiscal injection, but we may not be able to fund the rising deficit, that is, find offshore lenders who will invest in the debt the government issues. That is the dilemma the government – and all of us – faces.
The Medium Term Fiscal Prospect
There is a further problem which is also concerning the government. The best medium term forecast we currently have of the fiscal future comes from the Government’s 2009 fiscal strategy paper released in February. It is based on the Treasury forecasts released in December 2008 – three months ago, so it is probably optimistic.
The Treasury’s fiscal track shows that up to the June year 2008 government revenue was a little more than government expenses, as we built up a surplus for the stormy weather ahead. From the 2009 year – the current one – the public expenses are expected to grow broadly on trend, but the public revenue (mainly taxes) stagnates through to 2011, partly as a result of the recession but also because of the various income tax cuts.
When the economy moves out of recession from 2010, revenue remains below expenses. The small surpluses of the pre 2009 regime are replaced by an ongoing structural deficit of around $7 billion a year. (A ‘structural’ deficit persists over the business cycle.) The economic growth and revenue losses from the tax cuts are not fully reversed by the recovery. That is what the Minister of Finance is referring to by ‘decades of deficits’.
He rightly says such permanent deficits are not feasible. The government may be able to borrow$7b in a few exceptional years (especially to cover a recession) – as I have said, ‘may’ is the operative word. Borrowing that amount every year indefinitely into the future will cause the debt servicing to become unmanageable as the government debt rapidly grows and its net worth diminishes.
That is a fiscal track similar to the 1970s. The gap then was largely covered by double digit inflation, which had the effect of taxing New Zealanders who held their assets in fixed interest deposits and the like. Whether we have that option in today’s globalised world with its fluid financial markets is not obvious. But even if it were feasible, inflation is not a strategy that has much to commend it, especially as a means of resolving a fiscal crisis. As the Muldoon years show, it merely prolonged the agony of the fiscal deficit.
It is the Treasury nightmare; the sheer misery of trying to control a huge fiscal deficit and trying to fund the gap which is left, knowing the failure is inflation or increasingly excessive overseas borrowing – and usually both. The 1970s structural deficit was addressed by the Ruth Richardson measures of 1990 and 1991. Their painful memory lingers on. You may recall the summary: it converted ‘the fiscal deficit into a social deficit’.
Dealing With The Fiscal Crisis
There are those who promise economic growth higher than that built into the Treasury forecasts. The idea is that there would be a growth in tax revenue while spending could be kept on its current track and so the gap would close. However, those promising a higher productivity growth have been doing so for almost 50 years with a notable absence of success.
The borrowing crisis is reduced temporarily by sale (privatisation) of public assets, but. there is only a limited amount of family silver that can be sold, and in any case the impact on debt servicing remains much the same in the long term.
One means of reducing the revenue shortage might be to increase GST to, say, 15 percent. That would increase annual revenue by about $2.5 billion, so there would remain a large deficit of, say, $4.5 billion a year. You can now see why the Government is contemplating spending cuts.
Some question whether spending cuts should occur during a downturn. The government seems to take the view that any savings can be temporarily used for infrastructural investment. Unlike the current spending the government hopes to cut, their construction comes to an end, and the excess outlays can be turned off as the economy recovers.
The total cutting requirement, amounting to about 10 percent of total expenses (or 6 percent with the GST hike) , is daunting. Do not confuse it with the usual re-prioritisation program in which an incoming government cuts some of the previous government’s spending, and puts in its own favourites instead. Such cuts are marginal, although I fear that law and order spending may get out of hand.
Whatever the marginal spending cuts in minor expenditure portfolios such as culture, the environment and foreign affairs, and the effect of increases in user charges – which are indirect taxes by another name – any large government expenses cut almost certainly has to target the big ticket items of education, health and welfare. That will involve cost shifting from the taxpayer to the general public. They are the same of course, except different people will be affected differently. Making us pay for our own health is a tax on the sick. Requiring us to take out private health insurance is a tax by another name.
The Politics of the Medium Term Fiscal Crisis
The government appeared to have had no inkling of this fiscal and macroeconomic challenge when it was campaigning last year. Its economic policies were largely framed around the situation in early 2007 with the assumption that the world economy would continue to flourish. Thus its election campaign seems to have not been influenced by the events of August 2007 which signalled the boom had ended, or by September 2008 which repeated the signal so powerfully that it was even understood by the ideologically committed who had expected the system to correct itself after August 2007. However the new government has got the message of the underlying fiscal realities. But you have to read their statements very closely to see this.
It was instructive that over three-quarters of the proposals at the Employment Summit were things that should be done anyway, boom or bust (including those that were impotently platitudinous). I am not sure the remaining quarter will be much help either, since they were not sensitive to the fiscal realities we operate under. It would be helpful if the government were clearer.
Other than the unwillingness to contemplate the income tax hikes in the medium term, the current vigorous scrutiny of government spending does not reflect an ideological drive. Were there today a government of the left, it would probably have just as large a fiscal deficit, just as constrained by the nation’s ability to borrow offshore. And it would be as acutely aware of the problem of the fiscal deficit not closing after the economy recovered and be looking at how to address the ongoing gap.
Where right and left governments would will disagree is who should bear the burden of the fiscal cuts. It is easier to put the left’s perspective:
– The poor did not cause the crisis, nor were they beneficiaries from the prosperity which led up to it;
– The environment did not cause the crisis, nor has it greatly benefited from the prosperity which led up to it.
– Children did not cause the crisis; some who will service the debt burden are not even born;
– Social security beneficiaries did not cause the crisis; they have not had an increase in the basic benefit level in real terms since 1991.
Those of the centre-left would go on, I imagine, to say that while they accepted there was a need for sacrifice, those groups should bear little of the burden. Rather it should be shared in proportion to income above some threshold, although they might argue that those who particularly benefited from the financial bubble should make a greater contribution to its resolution (although, of course, the greatest beneficiaries were offshore). That suggests the left would favour a rise in income tax rates in due course. However I would hope they would be willing to pursue rationalisation of government services and user charges where this made economic sense. Mind you, the left will not be in government before 2011 so this is all very theoretical (although I shant be surprised if the Maori Party struggles over such issues).
The extreme right will argue – as they do boom or bust – that government assistance and funding should be stripped away, even if the weakest suffer. I doubt that they will be very influential in the Key-led National Government, although many will interpret every response it makes that way.
What will be the current government’s priorities? I cannot tell you, and it has not told us. It probably has not reached the stage of a clear listing; it may never do, but instead make various practical decisions, which may reveal its priorities later to historians .
An Economic Strategy
What might the government do to moderate the impact of the downswing? Since the immediate threat is being towed along by the world economy drifting onto rocks, the focus has to be on the short-term measures. Most of the short term measures are going to be taken – or not taken – off shore. We just have to pray that the key overseas players – the US, the EU, Japan and China – get it right enough. It is not simply a matter of fiscal injections to increase activity. They have to resolve the toxic assets problem to get the financial system working properly again. We havnt that problem. Ours is the overseas debt which has tied us to the ship, and our demand for imports which the world supplies.
In the longer term there are likely to be dramatic changes to the way we think about economies and how we regulate them. If the downturn does not last too long, I expect that we shall retain a market economy with widespread private ownership; one where the production and distribution of products will be regulated largely by the market, as they are now. However in the future financial markets will be much more closely regulated by public interventions.
This is not only because of the obvious failure of the unregulated markets – acknowledged by Mr Anti-regulator, Alan Greenspan. There is a long history of thoughtful economists criticising the unconstrained financial system. You did not hear them because of the noise coming from the financial sector saying that the system would work well enough if it was left to their greed. But considered analyses were there. For instance my Globalisation on the Wealth of Nations devotes some pages to the professional critique; I would have devoted more had I realised how close the crisis was and how big it was going to be.
With less noise coming from the empty barrels of the financial sector (or are the barrels jammed full of toxic assets which are empty?) we may well end up with aspirations for a kinder gentler society, although that requires that global strife is not too serious. The US economy will come out of the financial turbulence relatively weaker. Its days as the international hegemon are coming to an end, although it will not be replaced by another hegemon. Instead there will be a quartet, or quintet, of economies – America, the European Union, Japan, China, possibly India – none of which will be powerful enough to dominate the rest of the world. The international regime may not be particularly stable.
Returning to the short term, I think the government right to give employment a high priority. The justification for it being top of the list is not so much an economic but a social A society functions better when every worker has a job.
To minimise unemployment there may have to be job sharing, shorter working weeks, and even lower pay. However, it is not effective to protect jobs which in the long run are not viable. We need to ensure aggregate production is expanding especially in exporting, investment and training.
Nor, would a strategy of increasing productivity be helpful. Productivity is the ratio of output to employment. Since we are trying to increase output as much as possible, higher productivity means lower employment. Certainly we should not inhibit the growth of productivity, but finding ways to accelerate it in the short term should not be a priority. I found the calls for a greater focus on productivity at the Jobs Summit worrying; either those who were making the call did not understand what they were saying, or they had another agenda in which jobs and welfare were marginal, or – of course – both.
A secondary social goal might be to maintain people in their own homes. Increased mortgagee sales are going to be inevitable, but too much distressed selling is bad for an orderly housing market and disastrous for the families involved. Particularly where the sale is a consequence of losing a job, there may be a case for supplementary mortgage support.
Having set social goals, how do we go about pursuing them? Undoubtedly that involves increasing the fiscal deficit, the governments spending relative to its revenue. However, as already explained, the deficit cannot be of unlimited size because the government cannot borrow offshore to an unlimited extent. It may even be imprudent to borrow up to our expectation of our borrowing limit. The world recession may go on for much longer.
That there is a borrowing limit means there is going to be some increase in unemployment. We should aim to minimise the time anyone is unemployed in order to soften the social impacts. But a higher rate of turnover among the unemployed also means a higher proportion of the labour force will be unemployed in any year. Not a pleasant outcome, but better than people rotting in the limbo of long-term unemployment. Training is a form of unemployment which has long term benefits in upgrading the skills of the workforce.
We can increase the number of jobs by choosing job-intensive government spending. As far as the fiscal deficit and borrowing is concerned, purchasing Cadillacs for cabinet ministers is the same as hiring workers to improve the quality of housing. But the second option generates many more jobs for New Zealanders, the first more imports. Even so, we need to avoid make-work programs whose only value is that they disguise unemployment.
A way to think about this is to focus on the nation’s balance sheet – its assets and its liabilities. The fiscal projections already show the government balance sheet is deteriorating as it ends up with more debt relative to its assets – that is the effect of running fiscal deficits.
However we can improve the non-government balance sheet with more export capacity, more infrastructure, better housing, better skills, a better quality of the environment. That gives a second test on any government spending proposal (or tax cut). The first was does it protect us from the worst rigours of unemployment? The second is whether it contributes to the long term prosperity of the New Zealand economy.
Since the long term challenge includes reducing the structural fiscal deficit, any tax cuts or spending should be temporary or reversible. I favour a rigorous review of long term spending commitments now. Serious ones require time to implement. Savings in the short term need to be recycled into reversible injections – especially infrastructure training and other spending which will improve our long term production capacity and social health, but which will not continue indefinitely.
Time has limited the list of what we can do. But whatever we do there is going to be hardship. We have tied ourselves to the international economy through our desire for imports, especially those paid from borrowings rather than earnings. Even when the world economy gets back to some sort of normality – which requires normality in its financial system – there will still be much that has to be done here in New Zealand – including not repeating our mistakes of the past; no doubt we will make other ones. In the interim let’s do our best to moderate and share the hardship fairly, but let’s not damage the long term prospects while we do it.