Time for a New Strategy

The Zombienomics policies of the past few decades have not been working.

Listener: 27 November, 2010.

Keywords: Macroeconomics & Money;

Economic theories are going through a major revision in the wake of the global financial crisis. I doubt that the foundations, built over the past 200 years, will markedly change but their superstructure (the bit being publicly discussed) may radically alter – particularly the pieces created in the past few decades.

Of course, there will still be zombies who cling to failed theories despite the evidence to the contrary. Rogernomics policies were associated with a 15% fall in output compared with Australia between 1985 and 1994, but ideologists continue to promote them.

Where will the theories end up? Critically for New Zealand, they will apply differently in our small open multi-sectoral economy. Although we should closely follow the US economic debate, we need to adapt it to local circumstances. Our economic-policy framework has been evolving; even politicians have to respond to brutal reality, although they have not completely rid themselves of the zombies.

The Labour Party recently announced developments in its thinking, although much of what it proposes is concerned with equity and sustainability (to which any political party needs to pay attention) but will have little effect on economic growth and unemployment. Its “big” macro%economic announcement is a proposal to change the exchange-rate regime.

Zombies aside, one can hardly quarrel with the idea that our Reserve Bank’s legislation be more like Australia’s, which also has operational independence but with policy goals wider than just price s%tability. The Australian experience suggests there will be little practical difference. I favour the change, because it would free up the economic advisers to have a proper debate about what the Reserve Bank (and the Treasury) can and cannot do, without being limited by the legislation that the rogernomes imposed.

What about requiring the Reserve Bank to buy and sell foreign exchange to change the level of the exchange rate? The bank is already doing this to smooth out the market volatility, but it is not targeting any predetermined long-term exchange rate. Should it be?

The extreme would be fixing the exchange rate at some level (as happened before 1985). If there is a private shortage of foreign exchange, the bank supplies it. Since it cannot create US dollars, yen, euros, sterling or yuan, the Government has to borrow the currencies. The resulting debts accumulate, and when the New Zealand dollar is forced to devalue, the taxpayer makes a whopping loss. The advisers will modestly say they cannot predict the right medium-term level to avoid devaluations (and if they could they would make a killing as foreign-exchange dealers).

But macroeconomic policy can influence the medium-term exchange rate. The economy needs so much foreign exchange to pay for imports and to service debt. What it cannot borrow is supplied by export revenue. If borrowing goes up, exports get squeezed by reduced profitability. Since the exchange rate is the inverse of export profitability, it rises. Focusing on exchange-rate management is like treating a high body temperature as the problem rather than as a symptom. Ice may sometimes be required, but a proper treatment focuses on the cause of the temperature.

This is a static analysis. The dynamic version recognises that in the long term, any offshore borrowing requires exporting to cover future debt servicing, whereas in the short term it undermines the tradable sector, the ultimate driver of growth in a small open economy like ours. So a short-term borrowing boom is at the cost of long-term economic stagnation.

To avoid the stagnation, we have to provide more of our investment from our own savings. That means increased savings (and less borrowing for consumption), with more of the savings going into investment for exports and less into housing and property speculation.

Such a strategy requires more restraint and more – or perhaps a different kind of – government intervention compared with the slackness of the past three decades. That is where Zombienomics wins out. Its mantra of anything goes – and tax cuts are even better – provides a simple, easy to understand policy; it just doesn’t work.