An L-ish Future?

Our economy is suffering from some severe imbalances that are hindering an upswing.

Listener: 6 February, 2010.

Keywords: Macroeconomics & Money;

The so-called recovery of the New Zealand economy could turn out to be L-shaped. Under this scenario, after the economy reaches the bottom of the contraction, it doesn’t move into an upswing, either rapidly (the V scenario) or sluggishly (U). Instead it bumps along the bottom, with short-term upswings followed by downswings or stagnation. The bottom could last a long time. It took seven years of the Rogernomics Recession of the 1980s and 1990s before the economy hit an upswing, and the Long Depression, which began in 1878, lasted 17 years.

The L scenario may apply to the global economy as a whole, or perhaps to some key economies such as North America and Europe while Asia expands. But let’s assume a steady upswing for the world. The New Zealand economy could still suffer an L.

This prognosis arises because the economy is suffering from some severe imbalances that have to be addressed before a smooth upswing is certain. Based on the long-term trends, house prices may be overvalued by as much as 50%. They are unlikely to collapse, and though they may bump around a bit, their trend may be stagnant for while. It may make sense to buy a first house, or to change your house for family or employment reasons, but there is probably not a lot of prospect in investing in rental housing for capital gain.

Interest rates are also out of kilter. The world monetary authorities are deliberately keeping them low to prevent a return to a global financial crisis. But as the world economy expands, they will increase. Ten-year government bond yields recently crept above 6% a year. That they are so near the floating interest rate for first mortgages says there is an imbalance. Householders are going to be paying higher interest on their debts.

Another source of the upward pressure on interest rates is that the banks have been borrowing short term where rates are cheapest.

That puts financial stability at risk, so the Reserve Bank is making banks borrow longer and therefore more expensively. Before you shout “unfair”, remember that financial instability comes at a cost to the taxpayer – and threatens your job.

Overpriced housing is not the only thing undermining the robustness of householders’ balance sheets. Many are suffering from collapsed investments in finance companies. Households are carrying too much debt given the true value of their assets, and most people are not saving enough for their hoped-for retirement incomes. The resulting stronger savings and weaker consumption will weaken any domestic expansion.

Businesses are also struggling, perhaps no more than expected during a deep recession, but business investment seems unlikely to pull us upwards. More businesses are going to fall over, some weak finance companies are still out there and some farmers have too much debt. Community organisations are suffering from a lack of donations and sponsorships.

The Treasury’s December “Half Year Economic and Fiscal Update” suggests government borrowings are too high, and public spending has to be pulled back (and/or taxes increased). So we cannot expect the Government to inject any more oomph into the economy, either.

Exporting should provide a bit of much-needed oomph, although that is being compromised by the high New Zealand dollar, which reflects the dreadful state of our foreign balance sheet and our propensity to keep borrowing offshore. This is yet another imbalance of the economy, mirroring those in household, business and government balance sheets.

See the problem? All the conventional sources of an economic expansion are weak. Some people will beat up the economy for their short-term profit, but the imbalances mean any short-term expansion will be undermined in the medium term (the W scenario).

And yet, and yet. The capitalist system is a bit like a bicycle – riddled with imbalances. When it is standing still, it falls over; when it is moving forward the imbalances don’t seem so severe – until it stops, and then it falls over, big time.