Keywords: Macroeconomics & Money; Social Policy;
The world is facing a global financial crisis with the international system malfunctioning, as many banks – which provide the means of payment and facilitate investment – having to limit their lending because they have unsatisfactory balance sheets with insufficient equity relative to their liabilities (which are most commonly deposits). The limitations of the financial institutions means that the payments systems is not functioning properly with the consequence that it is difficult to borrow, thus seizing up the markets for trade credit, consumer credit and housing and business investment. This means there has been a reduction in demand and thereby a reduction in production and unemployment.
The global economy is so interlinked that even countries with relatively sound financial institutions – one might cite Germany – are suffering because there has been a fall-off of their
exports – in the case of Germany especially for the investment good exports they specialise in.
It would be easy to argue that is all New Zealand’s problem is. The fall in world demand is squeezing our exports and we face volume reductions last year, this year and possibly next. The fall in volumes is compounded by some weakening in export prices, which means that what we do export earns even less foreign exchange. This is what happened in the Long Depression of the 1880s and the Great Depression of the 1930s.
However the New Zealand economic situation is more complex than simply a lack of world demand for our exports as a result of the Global Financial Crisis. The great economist Alfred Marshall warned that any short statement in economics is wrong with the possible exception of this particular one. But if there was a short statement to summarise the current situation it might be that the Global Financial Crisis has exposed some fundamental weaknesses in the New Zealand economy.
That means we cannot get out of our economic difficulties unless we address those fundamental weaknesses. If we dont understand this we may pursue policies which will add to those weaknesses.
What are they? Because this conference is about ACC I am going to focus on a particular one, which is New Zealand’s indebtedness. We have a debt crisis.
I begin by insisting that as far as we know our banking system is sound, insofar as each trading bank has sufficient equity relative to its liabilities. Thus they are not like the international financial institutions which have generated the Global Financial Crisis. Our problem is that while sound, our banks have to borrow about a third of their funds offshore with the remaining two thirds are supplied by New Zealanders.
The Global Financial Crisis has made this offshore borrowing difficult. It is both relatively more expensive and it is shorter term. It is difficult to borrow for periods as long as a year, and so the banks are on a treadmill of rolling over their debt, knowing that if the global financial system seizes up again, they may not be able to. One hopes, of course, that it wont, and that the measures taken in Britain and the United States are leading to a normalisation of their financial systems. However, it would be imprudent to assume that such a crisis cannot happen again, or that the international banks will not return to business as usual as early as is hoped. Previous long recessions/depressions were characterised by false dawns – green shoots can whither.
So the macroeconomic problem that the New Zealand economy faces – aside from weaknesses in its export markets – is that it has a heavy borrowing commitment offshore. Since we are continuing to borrow from the rest of the world, we have to both roll over old debt and taken on new debt. This year to March 2010 we are expecting to borrow – one way or another – an extra 7 percent of GDP in addition to the borrowing rollovers. We need that extra $12b to pay for the imports needed to sustain the economy which we cant fund from exports; next year it may be another $10b.
The forecasts on which these estimates are based may be optimistic. Even so, they suggest that New Zealand’s net overseas liabilities will rise from about 100 percent of annual GDP in March 2008 to 120 percent in March 2011. That means remaining an outlier among the rich OECD economies, with the exception of Iceland.
So in addition to the weakness in the international economy undermining our export effort (which increases the need to borrow offshore), we face a debt crisis. The economy has too much debt, and that debt is increasing relative to the size of the economy.
You can see the policy problem we face. The orthodox response to a world economic downturn impacting on New Zealand is that the government should borrow to fund extra demand to tide the economy through the consequent internal downturn. But that exacerbates the debt crisis, making the economy more vulnerable if there is another international downturn or the weak international recovery that is expected lapses into further financial difficulties.
That is why we have had a rather strange public debate in which two parties are talking past one another. One party focusses on the weak economy which is a consequence of the international downturn. The (perfectly orthodox) response to this sort of demand weakness is that production and employment in the economy can be sustained by government spending and/or tax cuts filling the gap in demand. Ideally this demand stimulation should be temporary, unwinding as normal private sector demand refills the gap. Thus there is a merit on infrastructural investments – roads, telecommunications, house improvements – which can be ended as the economy recovers. It is a pity that the April income tax cut was not also temporary – say for just two years. I shall come back to the fiscal problem which it contributes to shortly.
The other party to the debate is concerned about the debt crisis, the excessive and unsustainable New Zealand external debt. Its prescription is that the economy is going to have to reduce the offshore debt, and that requires increasing national savings. That is exactly the opposite response to the weak economy prescription, which says we should spend our way out of the recession. For those concerned with the debt crisis that is equivalent to trying to resolving a hangover by having a hair of the dog that bit you the following morning.
There might seem to be a compromise if households save thereby reducing their debt while the government, which started off with a good balance sheet, spends. In effect that is what is happening; households are trying to rehabilitate their balance sheets by reducing their spending and increasing their savings; meanwhile the government is increasing its spending by borrowing.
But in the current circumstances, such a solution is a bit like an adolescent explaining to his father that he is broke because he has spent everything on heroin, and would his dad pony up the cash so he can keep to the smack. It’s a form of debt-shifting between domestic sectors but it does not resolve the national debt problem which is about total debt. In fact it makes it worse, because both son and father – households and government – are getting deep into debt.
The inconsistency between those who wanted to borrow more and those who said there was a debt crisis was resolved externally because the government found there was a limit as to how much it could borrow. The way the public saw it, the credit rating agencies said ‘no more borrowing’, or rather they said if we increased our borrowing interest costs would rise. The cost would not only be higher rates to the government and the taxpayers, but the costs to the banks rolling over their borrowings would rise, so that would raise the debt servicing costs to businesses and households.
Commentators demonised the agencies, but you dont think international banks who are lending tens of billions dollars rely on them? They do their own credit ratings. The government hires the credit rating agencies to tell us what those banks’ internal assessors think. So an agency’s assessments reflects what our lending sources think. We are not beholden to the credit rating agencies; we are beholden to the international banks we borrow from. That is always true for any debtor. Recall Mr Micawber’s “Annual income twenty pounds, annual expenditure nineteen nineteen six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds nought and six, result misery.”
It is instructive that the when the government agreed to revoke its future income tax cuts, at least one of the credit rating agencies took us off credit watch. Clearly they thought the promised tax cuts were imprudent. Which leads one to speculate that had the April cuts been temporary, we could have – irony of ironies – borrowed more this year and next without raising borrowing costs.
Unfortunately there is no legislative provision for their reversal, so the public borrowing is limited this year and next. Further out we face an issue which we have only been aware of since the election.
Normally a government borrows during a recession, but as the economy recovers tax revenue also recovers and some spending (such as on unemployment benefits) abates, while some of the public infrastructural spending gets wound down. The fiscal position thereby returns to the situation before the recession. Since the New Zealand government was running a fiscal surplus before the recession we might have expected a return to fiscal surplus in, say, 2011. At which point the government would get a ‘big hooray’ from the credit rating agencies – actually from the offshore banks lending to us.
However, it turns out that the fiscal position does not return to a surplus after the recession. There seem to be two problems. One is that, as I have indicated, the permanent income tax cuts have reduced revenue in the long run. But also there is the problem of public expenditure.
The aggregate public spending track set out in the 2009 budget is similar to that in the 2008 budget track. There have been very slight cuts but they are minor compared to the projected increases. So if the track was OK in 2008 what went wrong a year later?
What seems to have happened is that the long run GDP track has been lowered. While it is expected that the post-recovery economy will grow at about the same rate as it did over the last decade, the future track appears to be about 3 percent lower. In effect during the last decade the economy was running hotter than was sustainable then, fuelled by the offshore borrowing. The forecasters seem to think there not only has to be a recession to stabilise the borrowing, but the economy will not run as hot thereafter.
There are a number of issues which follow from this, although we need a bit more work on the propositions I have just set down before we can fully explore them. However I think we can say something about the consequences for the fiscal position. If the economy moves onto a track 3 percent lower than the recent past, it follows that there is a case for saying that government spending projected on the old track is 3 percentage points of GDP too high. Meanwhile there is a loss of tax revenue relative to the old track of about 4 percentage points (higher than the 3 percent because of the fiscal drag in the tax system). Combined the two effects explain the shift from a structural fiscal surplus in the past to the structural deficit which is currently projected.
How we get back to a structural surplus is something which is going to preoccupy the government for at least the next three years. In the interim the government is going to be borrowing big with the threat to fiscal sustainability and our credit rating that implies.
These issues seem far from those facing you reviewing ACC. I would think more than 90 percent of the issues which this conference is considering have to be addressed whether the economy is in recession or boom. In either case it is important that the system of accident compensation is effective, efficient and equitable.
So has this session about the economy got anything to say about the ACC review? How does ACC fit into the macroeconomy and the economic crisis we all face?
As it happens the ACC is a major saver in the economy – its revenues exceed its expenditure. The surplus is invested in the ACC fund. The next paper by Michael Littlewood and Susan St John will discuss this fund in detail. I dont want to preempt their paper, but I do want to talk a little about the macroeconomics of the fund.
The justification for the fund is that it pre-funds the future expenditure which the accidents of the past have incurred. The idea is that the funding is invested to be used to meet the expenditure in the future.
As far as macroeconomists are concerned, pre-funding by government agencies is a form of public saving, which is invested when there is a fiscal surplus. I assure you given current private saving behaviour we need a fiscal surplus in the medium term – this is an issue that I have not discussed in this paper, although I am happy to do so at question time. The prefunds are a cunning means of squirrelling away part of the surplus, hiding it from those who do not understand macroeconomics and think that surpluses should be used for tax cuts to further their consumption binges.
From the macroeconomic perspective the difficulty is how to access the nest eggs when they are needed to sustain the macroeconomy when there is a fiscal deficit. Its like having a rainy day fund, which you prudently build up in sunny times, but which you cannot get at when it rains. The temptation has to be for the government to raid the pre-funds given the borrowing challenges it faces. Yet there are political imperatives which would restrain it from doing so. At issue is how to unlock the pre-funds without destabilising macroeconomic policy in the long run.
To go a little deeper, the issue, high-lighted by the credit rating agencies, is how to reduce the amount of borrowing from the offshore banks. Every $100m we dont have to uplift potentially reduces the level of interest rates we – the government, households and business – have to pay, and so reduces the interest rate burden across the economy. It is also a win as far as the offshore banks are concerned, because the New Zealand economy looks less risky to invest in.
One way of reducing pressure on the existing financial instruments is to find a new one especially if it unlocks our rainy day reserves. What I am I am going to suggest is a simple instrument – nothing fancy – attractive to a pre-funding government agency or even for a pension funds like Kiwisaver.
What the New Zealand financial system lacks is a long bond, say for 20 years. Fixed interest long bonds tend to be unattractive because of the risk of inflation. So let us make the new long bond’s return equal to a fixed premium above the rate of inflation. That need not be more expensive for the government. What it does is to shift the inflation risk from the investor to the government. If it gets it wrong the government (that is the taxpayer) pays, although if inflation over the 20 years proves to be lower than anticipated there will be a gain to the public purse. Moreover, insofar as the long bonds are held indirectly by New Zealanders, any wins or losses from inflation will be in part picked up by the tax system.
So let us explore the idea of a long bond which will be attractive investments to long term investors such as the government agencies which are involved in prefunding future spending, such as ACC, and indeed pension funds.
You might say the government is still borrowing, but it is borrowing from a different pot, so there will be less offshore borrowing from international whole sale matrkets. Moreover the offshore bankers, who are considerably more sophisticated than the commentators in New Zealand’s public debate, will recognise that the New Zealand government is unlocking some of its nest eggs – rearranging its balance sheet – so there will be no additional threat to the economy’s medium term sustainability as far as they are concerned.
There will still be a need for medium term fiscal measures to reduce the structural deficit. If we are on the lower growth track we are going to have to restrain the public expenditure path or raise taxes – probably both. But a medium term bond, attractive to the prefunds, such as the ACC fund, would give us a little more room for manoeuver during the difficult period of high under-utilisation of economic capacity – of slow economic growth and high unemployment. It would ease the drastic adjustments needed to resolve the debt crises, but those adjustments, of households and businesses saving more and spending less, remain necessary and a priority in the medium term.
So while the ACC issues are largely independent of the current economic crisis, ACC’s prefund and some of the others can contribute to relieving the short term stress while we tackle long term problems.
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