Some Preparatory Notes: ultimately not used.
Keywords: Globalisation & Trade; Macroeconomics & Money;
I am not sure you have asked the right person to be on the panel, since the topic is policy; my interests are research. So I thought I would consult an old friend, Cassandra. Fortunately I dont have to channel her; she has sent me a memory stick of what she has been saying for about thirty years. I’ll have to interject some comments because prophetesses can be a bit cryptic.
1. In a growing economy some sectors grow faster than others, some slower. The fast ones usually pull the rest of the economy along with them.
Sounds right. That is surely the evidence from economic history, and it has a certain commonsense to it as well.
2. In a small open economy, the fast-growing pulling sectors are some tradeables. In New Zealand that means exportables, because we havnt much of an importable sector left.
Cassandra is a bit of an old-fashioned girl, like Eartha Kitt really, and she will use the word ‘profit’. I apologise to those who think it an offensive word.
3. Profits are at the core of sector or business expansion; poor profits, poor expansion.
No smelling salts needed? She is going to use that word again.
4. A major element of the tradable sector profit rate is the inverse of the real exchange rate. When the exchange rate is high, the profit rate is low.
5. So the poor performance of our exportable sector can be attributed to an overvalued exchange rate.
Cassandra didnt tell you the research evidence. Perhaps one piece will do. In the last 30 years, New Zealand’s share of world exports has halved. Exporting and the concomitant importing have been the great driver of world economic growth. We have failed to back the fast horses.
6. The primary determinant of the exchange rate in the medium run is the capital account.
7. At any point in time the economy needs a certain quantity of foreign exchange for imports and debt servicing.
8. Some foreign exchange will be supplied from borrowing. The rest has to be supplied by exports.
9. As borrowing increases, the amount required from exporting decreases.
10. The borrowing chokes off exports by making them less profitable.
11. Borrowing makes exporting less profitable by raising the exchange rate.
12. The more the medium term borrowing, the greater the choke and hence the higher the exchange rate.
There is a supply-demand cross of foreign exchange to illustrate this; but I think Cassandra captures its main ideas.
13. A reduction in borrowing brings down the exchange rate.
You might say that excessive overseas borrowing is a seductive Trojan Horse; we ignored Cassandra’s advice not to bring it inside.
14. Direct subsidising of exporting breaks the nexus between high borrowing and a high effective exchange rate: the Muldoon strategy.
A subsidy puts a wedge between the market and the effective exchange rates. Cassandra is not arguing for this policy approach, but explaining why the later Muldoon years did so well.
15. About the only other way of bringing down the exchange rate in the medium term is reducing borrowing.
16. Reducing borrowing involves increasing national (public and private) saving.
17. Running a public surplus is a means of increasing national saving.
18. We dont know much about how to increase private saving.
19. We could start by creating better domestic markets and channels for saving.
I think Cassandra means that we should deepen our domestic capital markets, including allowing private investment in state owned enterprises. Its not a quick fix – of course – and any sell-offs have to be phased because in their current state the domestic capital markets have limited absorption.
20. The tax system needs to be inflation neutral.
I think she is arguing for discounting the inflation compensation element of interest for income tax purposes and imposing a real capital gains tax.
21. We need to remove encouragements to leveraged speculative investment; they have to come to grief in aggregate, and destroy savings.
Almost certainly Cassandra is grumbling about households blowing $30b in finance company collapses. That is damned near a year’s net national investment.
22. In any case such investment is often inefficient.
23. If we dont address the challenge of private saving, we will – as in the past – end up with an overvalued exchange rate, despite a public surplus.
24. Exports will continue to lag:
25. And without a driving sector, a poor growth record will follow.
The record for 30 odd years.
26. This is a structural problem. Short term measures dont work – except in the short term, as Muldoon demonstrated.
27. Sadly, despite and since Muldoon, our thinking has remained dominated by short term nostrums.
Like the panic for quick-fix measures when the US dollar exchange rate spiked a couple of weeks ago.
28. Monetary measures have only a limited role . Their effects are short term and dont address the underlying structural issues.
Actually, I didnt expect that one from Cassandra’s analysis. I think what she is saying is that while in the medium term monetary policy may be able to provide a price level anchor for the economy, interest rates have little effect on private savings – other than directing where it goes. As I have said, prophetesses can be a bit cryptic. I imagine she would assume that the interest rates choking off investment are not a good thing for growth.
29. Addressing the savings issue involves a medium term strategy, especially given that our export sector has low elasticities of supply in the short term.
Which is why doing anything serious is so politically unattractive.
30. That means any rebalancing of the structure of the economy requires considerable skill and patience.
Although me and Cassandra are almost twins, I dont agree with the detail of everything she says. In some places her argument is trickier than her exposition.
You have probably realised that I often channel Cassie – as I am allowed to call her – through to Listener columns. She has been running this model of economic behaviour for almost 30 years; nobody takes any notice, or even bothers to address any flaws they see in her logic. Her prediction that there will be poor economic growth if one does not think of the growth in terms of sectors and prices, including profitability and the exchange rate, has proved remarkably prescient for those thirty years.