Keywords: Macroeconomics & Money;
I was recently involved in a non-government discussion about policy responses to the current recession which gave no attention to what was causing the downswing. I belong to another methodology – the one this seminar has honoured – to first define a problem before one tries to solve it. Most of this paper is concerned with the analytics of the recession, with a particular focus on the possibility of a future banking crisis.
I dont think New Zealand has ever had a banking crisis. Not a proper one involving serious problems in lots of banks. Chris Hunt reminds us there have been occasions where we have had bank crises, with a particular bank in difficulties, but that is an order of magnitude smaller. Our bank crises have involved banks being overwhelmed by their bad debts, following poor governance. That could happen again, and the Reserve Bank has measures to address the possibility.
Today I want to talk about a different sort of banking crisis – a systemic one involving a number of banks – which we have yet to experience, although we came close to one recently. The best parallel is what happened to Northern Rock, the British building society, although this involved only one bank. Like most of New Zealand’s banks, Northern Rock was heavily dependent on the wholesale credit market for its funds. When they dried up in late 2007, there was a run on the bank from its depositors; Northern Rock is now in public ownership.
New Zealand’s banks escaped that fate for at least three reasons. First, they raise only about a third of their funds in the international wholesale market, whereas Northern Rock was raising three-quarters. Second, the New Zealand banks are better managed; their borrowings were ‘plain vanilla, rather than fancy securitisation. And third, the Reserve Bank of New Zealand successfully handled the difficulties as the lender of last resort, and in its financial surveillance role.
But as long as our banking system is heavily exposed to the international wholesale credit markets, we could experience a Northen Rock type meltdown if those markets dry up again; the larger their exposure, the higher the probability of a meltdown.
Any analysis of a potential future banking crisis is complicated by four separate but interlinked sources of the downturn that New Zealand is currently facing.
The first is that, as a result of the macroeconomic policy regime, the exchange rate cycles to the detriment of the export sector. The TWI was at the top of the cycle in 2007, and that probably induced the New Zealand’s recession which began in early 2008. We are unwise to see the 2009 as a continuation of the 2008 recession. I wont say much more about this problem – not here anyway – but the 2008 downswing was of our own making. It looks as though the cycle bottomed out in early 2009, and is in an upswing phase again. If so, a lot of forecasts of the economy are compromised. In terms of banking crises the top of the exchange rater cycle is a potential source of bad debts from export ventures, especially those dependent upon debt on land.
I have more to say about the second source of the fiscal crisis that the economy faces. The problem of a large structural fiscal deficit is evident in the Treasury projections. Unless the medium revenue and spending streams are addressed, we shall see, among other things, either the trading banks increasing their recourse to international wholesale credit markets, or the New Zealand government doing so. A given is the greater the recourse, the higher the cost of borrowing.
The third source is the international economic recession, which is reducing our export sales thereby depressing the economy. In the past such downswings are often associated with a fall in the terms of trade. A fall has not happened yet, but it will add to the nightmare if it does. It will be source of bad debts, as it was during the Long Depression.
I call the fourth source a ‘debt crisis’; it could lead directly to a banking crisis. I am not concerned here about overseas liabilities which arise from foreign direct investment.– that is another policy issue. The debt crisis is about the degree to which our financial system is exposed to the international wholesale credit markets. Many would argue that it is already over-exposed; yet on current forecasts the exposure is likely to increase.
I have highlighted the last two sources – the fall in demand for exports from the international downturn and the debt crisis – because the orthodox policy responses to each are in conflict. An economy in recession from a temporary international downturn can maintain production by measures which increase domestic demand, but that reduces domestic savings. However an economy with a debt crisis should increase its domestic savings in order to reduce offshore debt.
Where there is also a medium term fiscal crisis and an exchange rate upswing, the case for increasing domestic savings is reinforced. Yet if we increase the savings the economy will initially contract further, and unemployment and poverty will rise.
The lesson I draw from this analysis is that fiscal policy and monetary policy cannot be independent. In the medium run the real and monetary parts of the economy are not orthogonal. (I am not even sure they are in the long run, because long run behaviour is path dependent, but that is for another discussion.)
The nonsensical notion of policy independence arose from the peculiarities of the US constitution where fiscal policy is the responsibility of Congress and monetary policy of the Fed, with no institutional mechanism to coordinate them. There is a famous statement by Carl Christ at an economists’ conference in the 1950s, which said that since monetary policy was slow to take effect and fiscal policy was quick, while Congress was slow to move and the Fed quick, then the Fed should be responsible for fiscal policy and Congress for monetary policy.
Our constitution – which comes from the British tradition – allows much better institutional coordination between monetary and fiscal policies. I am glad we have abandoned the practice of the 1990s whereby the Treasury and the Reserve Bank were divided by The Terrace. The two institutions have been joined at the hip dealing with the current crisis. That is what one would hope.
What is especially pertinent here is that the Reserve Bank has only limited abilities to reduce further the threat of a banking crisis. Certainly it can do more about the surveillance of non-bank financial institutions, and it needs to remain alert to rising bad debts and poor quality governance. But as long as our banks have to raise funds from international wholesale credit markets they are vulnerable if it seizes up. If that happens then the Reserve Bank can do a number of things, as it did in 2007/8, or would have done if things had got worse.
But while there may be little more the Reserve Bank can do to prevent a banking crisis than it is already doing, there are areas which are in the responsibility of the Treasury whose management can lessen the probability of banking crisis.
The fiscal track will have a major influence on the monetary situation. As the government borrows more, either the banks will borrow more offshore or the government will have to raise offshore denominated debt itself.
Retrospectively, it is a pity that Kiwisaver was not introduced years earlier, so we had more domestic savings. (It is also a pity that the April 2009 tax cuts were not temporary. Had they been the government could have borrowed more this year without being put on credit watch.)
I have used almost all my time to define the problem. What the analysis suggests is that government borrowing policies can affect the probability of a banking crisis. And yet we need to borrow to protect New Zealanders from the worst effects of a world economic downturn. As an analytical economist I like the tradeoff, but it is little comfort to New Zealanders. So let me, in the little time left, make one suggestion of how we can ease the pressure on borrowing offshore.
Next week I elaborate a proposal that the government issue a long bond – say 20 years out – which will be attractive to Kiwisaver and other pension funds, and to those government agencies which have prefunding arrangements for future expenses including the ACC fund, the Government Superannuation Fund and the NZ Superannuation Fund. In order to make it attractive, I expect that the interest rate will be inflation plus a real margin.
Insofar as the long term investor funds change the balance of their portfolios towards the New Zealand government long bonds and away from overseas denominated assets, that will reduce the amount of overseas borrowing. In effect the economy as a whole will sell some of its overseas assets thereby reducing the borrowing from international wholesale markets.
(In parenthesis, I add, a long bond is not an emergency measure. It makes sense to have one anyway. Its lack has exacerbated New Zealand’s macroeconomic difficulties. Any time is a good time to introduce one, but especially now.)
However it must be emphasised that while a long bond will give a little respite, it will not resolve the debt crisis as long as we – households and the government – fail to save. As long as we have a debt crisis we have the threat of a banking crisis. We just avoided one in 2007 and 2008; we need to act now to reduce the probability of a next one.
Footnote. There was not time to address an interesting paper by Luci Ellis on housing booms. I have put some thoughts here. .