Presentation for the Wellington Branch of the NZIIA, 15 May 2012
Keywords: Globalisation & Trade; Macroeconomics & Money;
Next week, the government will present its annual budget to parliament. There will be a lot more media space given to it than – say – to this paper, but its significance is much less than is justified by the pomp and circumstance. Far more crucial to the New Zealand economy is what is happening overseas.
Even so it how we respond to the international situation is important especially as our options are limited. But that will not be the way the budget is presented. Tonight I want to give its economic context; it is, of course, an international one.
What I shall do first is discuss the current economic situation in the context of a longer structural change; then I shall look at a couple of key international areas where we can engage – trade negotiations and offshore borrowing – and show how they, especially the borrowing, are shaping next week’s budget albeit in the context of the current dramas the world faces.
Basically components of the world economy – including the US and New Zealand – entered into a downturn in late 2007 and much of the rich world went in recession by early 2009, shortly after the Global Financial Crisis of September 2008. So the world economy is in the fourth and fifth year of what is increasingly looking like a long recession – far longer than the conventional business cycle recession phase, which is at most a year.
While there is an optimistic narrative of the world economy being in or near an upturn, the realistic view is that it is bumping along a bottom. Nobody knows when there will be a sustainable expansion, but a useful way to think about the recession is that it may run for another five years. The exact integer is not important; the point is that an effective world recovery is probably some time away and that New Zealand’s recovery will be similarly delayed to a time beyond the normal economic management horizon.
History as much as economic theory helps us understand what is happening. The best parallel with the current world economic situation may be the Long Depression which began in the 1870s with the recovery phase beginning in the mid-1890s. At its heart were financial imbalances which had to be purged out before the world economy could expand again. It was a long shallow period of stagnation taking almost twenty years, not at all like the sharp deep downturn of the Great Depression of the 1930s. There are many parallels between the 1880s and today, especially the story of financial imbalances which are a theme of this paper; let me mention but two others.
The first is brief. In the 1880s New Zealand was in a long recession too as a result of the low wool prices and the difficulties of offshore borrowing. Then as now we could not avoid the state of the world economy.
The second requires more attention. Long recessions accelerate structural change because dying industries and technologies suffer their cash flow crises earlier. For instance the media and publishing are facing enormous pressures from digital platforms and transmission. With advertising drying up, the traditional media are seeking new business models which will radically change their form, although given the difficulties the new forms are having of generating cash flow, nobody knows what newspapers and magazines, television, the internet, video stores. books and bookshops will look like in a decade – except that they will be different.
Structural change also happens at the international level. The world entered the nineteenth century Long Depression with Britain as the leading economy; it came out with the US economy as leader and Germany and Britain jostling for European economic supremacy, a transition which was to shape international relations in the first half of the twentieth century with two bloody world wars.
I think it almost certain that we shall see a relatively weaker United States at the end of this long recession even if it does not pursue the course of political suicide that too many of its politicians seem committed to. As I have argued in previous papers to the Institute that does not mean I expect there to be a hegemon which replaces the US.  Instead there is likely to be a contest for leadership between four or five major economies, in which none will be dominant.
The loss of a hegemon is challenging international trading relations. Let me skip the historical analysis and start with the observation that the Doha Round is not getting much traction because there is not a sufficiently powerful hegemonic leader – say the US – who can give direction to the Round. Much of the WTO’s activities – especially the inter-country litigation over trade grievances – toddles on, but the shift has been to Free Trade Agreements (FTAs), a host of bilateral and plurilateral arrangements that the GATT, and subsequently the WTO, were specifically designed to discourage in favour of a comprehensive multilateral one.
New Zealand is involved in the noodle bowl of FTAs as much as any country. Some would say we are overcommitted negotiating too many different deals. It is especially unfortunate that this should be happening while the Ministry is being restructured. I do not claim any insights on the non-trade activities of MFAT, but I am greatly disappointed that the redisorganisation – as some are wont to call it – is impacting on the Trade Negotiations Division. They are under enough stress; a mistake in one complicated deal can do irreparable damage.
Free Trade Agreements are no longer about border access. Except for a few products – most notably agricultural ones – border barriers such as tariffs and import controls are minor. FTAs now penetrate deep behind the borders, and there are greater opportunities to make mistakes. I was struck by the recent letter from a hundred lawyers who argued that the Trans Pacific Partnership (TPP) raised the possibility of a trade deal overriding the constitution, or at least modifying it in ways we may not expect. While I am not a lawyer I am not surprised that there is an ongoing tussle about how the economy should be run, between multinational corporations and nations and the people they represent. Certainly those people should be consulted through some parliamentary process, even though that will add further pressure on the negotiators.
There is a danger illustrated by the AUSFTA deal in which the Australian government became so committed to an FTA with the US, that the Americans could offer very little and the Australians had to take it. We must always be ready to walk away from a negotiation; it may be that, as in the US, greater parliamentary involvement may provide such a mechanism.
Sadly I doubt any of the FTAs will markedly change the world’s propensity to privilege domestic agriculture. There may be some gains for us – as there were in the China deal – but they will be not the transformational ones we hope for; I doubt there will great agricultural trade gains in the TPP.
I wonder if it is time for us to review our strategy against agricultural protection. The current one is more than forty years old. It has not been that successful, while the world food market seems to have entered a new phase. I know the TND is over pressured with individual negotiations and disrupted by its redisorganisation, but could it find a little time and resources for a reassessment?
I could spend the rest of the lecture focussing on the possibilities that the new world food economy presents to New Zealand and to our trade negotiations. But instead I return to the budget and the impact of the world recession on New Zealand.
Three of the potential five global powers bear close watching for the immediate future. China and India have not gone into recession but they are struggling, and they both may be slipping into a growth slowdown which would be equivalent to a recession, given their stage of development. Since exports to China, in particular, are a major generator of New Zealand economic activity, a weakening of the market there would add to our woes.
Which sadly, but nicely, illustrates the international phenomenon of financial imbalances. Many dairy farmers have very high debt on their farms. The wise are doing their best to reduce it; others are struggling to maintain it at current levels. Were there to be a significant fall in the milk payment it seems likely that some farms would go under – similar to that which happened in the 1880s when the price of wool fell. Some lenders might suffer too, from haircuts to their loans or absolute losses. So it is not just debtors whose balance sheets are out of kilter; there are lenders whose advances are backed by assets which are really less valuable than they currently appear in the books.
This, of course, almost exactly parallels the finance companies crash. It was not only borrowers who went under; lenders suffered serious losses too. Balance sheets can also be righted by inflation devaluing the liabilities side. Perhaps the healthiest way is increasing savings and paying off debt, although unemployment can rise if that happens too fast.
Notice I have slipped in the assumption that the financial unwindings are not over yet. The European Union – another of the five great economic powers – nicely illustrates they are not. It is helpful to group the European economies into four. The strongest group, led by Germany, have reasonable balance sheets, are not accumulating too much debt and have – on their measure – no serious unemployment. The second group – France is the most prominent example – are struggling because they face weak external demand and have some problem sectors. They need to restrain internal demand and unemployment is rising. (Sounds a bit like New Zealand really.) Third, there are a group of countries – illustrated by Ireland, Italy, Portugal and Spain – whose problem private sector balance sheets are more widespread, who are under severe fiscal restraint and where unemployment is serious. And then there is Greece.
The Greek economy is only a small part of Europe – about 2 percent – but its problems are so dire that all eyes are focussed on it. Basically the government is heavily in debt and yet it is continuing to overspend. Nobody knows what is happening in the private sector except it is not paying its taxes, with the implication that their balance sheets would look very unsound if they did. Because the Greek government has to keep borrowing, it must attain and maintain a fiscal path credible to lenders, but the consequence is that it reduces the standard of living of the public.
The ability of the Greeks to earn an adequate living is doubted too, given its high cost structure. Not only are others loathe to purchase its existing exports, but there is little incentive for Greek businesses to create new ones.
As well as what we can learn from malfunctioning economies, there is two issues of particular relevance to the world The first is whether Greece will stay in the European Monetary Union. I make no forecast, although I note that English speaking commentators – who generally see the euro as a threat to the US dollar (and UK sterling) – are hostile to the EMU, and their wishes for its end tend to dominate the sobriety of their forecasts.
But Greece leaving the EMU and floating its exchange rate will not solve its problems. A depreciation will enable it to get its cost structure down and become more export competitive, but any gains may be quickly wiped out by inflation. To anchor the real exchange rate they have to cut back on their consumption and increase their savings – which is exactly what they have to do should they remain in the EMU. So in or out of the euro area, Greece cannot avoid the fundamental of consuming less and saving more, and finding lenders willing to lend to it when the Greeks are not saving enough.
Second, Greece has just had an election, although it has yet to form a government. With a third of voters not making a choice, and a divided outcome among the other two-thirds, what they were saying is unclear. Certainly though, the election represented a major rejection of the incumbent parties, although it is far from obvious what voters think is a realistic alternative.
Ten out of the seventeen EMU countries have recently had national elections in which those in power have lost. Most of the other seven havnt had national elections recently, but lower level ones suggest that their governments would be voted out of power too. Even Angela Merkel’s coalition parties have been losing in Länder elections. The politics are not peculiar to the EMU countries; David Cameron’s Conservatives took a pasting in the recent local elections.
This is not a swing to the left or to the right. It is a swing against incumbents and, perforce, against the austerity strategies they are pursuing. It seems likely that the new governments will support more expansionist fiscal stances; I shant be surprised if Germany – the leader of those supporting austerity – reluctantly, and perhaps covertly, agrees. While Angela Merkel insists that austerity must be maintained, its Bundesbank, the most hawkish of central banks, has signalled it would accept slightly higher inflation in Germany as part of an economic rebalancing in the eurozone.
A clue about what is happening comes from a parallel with the nineteenth century’s Long Depression, where there was a major structural shift in power relations. What I am now going to say is yet to be fully formulated, but there seems to be a change in the balance of power between governments and financial capital.
New Zealanders have been long aware of the power of financiers because we have been borrowing from them for a long time. On occasions they would bully us. The most famous example is in 1939 when the London commercial banks demanded we should abandon our import controls and plans for a social security system. Fortunately, Montague Norman at the Bank of England bullied the trading banks – he seems to have been concerned about the impending threat of war – and they provided us with the finance albeit on tighter terms than we might have hoped. (The war meant the rolling over of the loans did not have to be seriously revisited in the 1940s.)
Given how low New Zealand is in the world pecking order, no one should be surprised at such bullying; other countries down at the bottom have similar stories. What seems to be happening today is that countries ranking well above us are facing similar difficulties when they try to borrow from the private financial system. Because it is a global financial system, today’s equivalents of the Bank of England – the IMF, the US Federal Reserve and the European Central Bank – do not have the bullying power over them that Montague Norman had.
The story is more complicated than this. Sovereign funds and private equity funds – and destabilising derivative markets – need to be added to it. I do not want to go as far as to argue that international financial sector is a sixth power in the evolving multipolar world; not yet anyway. They compete against one another, and they still need the contracts between them to be anchored in the law of a sovereign state. Those states are imposing the Bank of International Settlements’ Basel Accords requiring higher reserves in the banking system. And as we saw in September 2008, sovereign states remain the custodians of reserve banks able to generate cash and near cash; the commercial banks need that back up in a liquidity crisis.
The real lesson from all this is that anyone in debt is subservient to their lenders; if one is in a lot of debt then one is very subservient as the Greeks are learning. That applies to countries as much as individuals and corporations. Countries have been borrowing heavily since the early 1970s for various reasons. Much of the privatisation and lower taxes of the last thirty years has handed savings over to the wealthy private sector, empowering it with the wherewithal to lend. When governments are the borrowers, or become (even implicit) guarantors of the public’s savings, the lenders become even more powerful.
Perhaps if the IMF, US Fed and ECB were to unite, they would be considerably more powerful than the international financial system. That would require them to resist the private pressures, an unlikely scenario given the complicated symbiosis between the world’s central banks and the financial systems they regulate.
In summary, remember the golden rule; they who have the gold make the rules. The lenders are likely to remain in charge, as long as countries want to borrow more or need to roll over huge quantities of old debt.
What then we are seeing, in Europe anyway, is a wrestling between people, who are determining the governments of sovereign states, and the multinational financial institutions, which are not democratic institutions. Voters rejecting incumbent governments are demanding a different strategy, which is challenging the global financial sector. I am not sure what the alternative strategy is; I doubt most of the newly elected governments do either.
While cutting out a detailed discussion on what the alternatives are, as the Bundesbank acknowledges they probably amount to more inflation, although not necessarily hyperinflation. Ultimately, though, until we get a better balance in the world financial system, writing down of overvalues assets and the offsetting loans, we cannot get out of the long recession.
To be frank I do not know what will be the ultimate outcome of the stresses on the world economy, but neither does anyone else. It’s a bit like the old-time movie The Perils of Pauline in which each episode ends with Pauline in a terminally dangerous situation, which is miraculously resolved in the following episode only to have her in yet another peril at its end.
What is hanging over us, albeit poorly articulated, is that there is a real danger that there will be a second global financial crisis – even as early as the end of the year. This is not a forecast, for no-one is sure how it might happen, although there will be many I-told-you-sos after any event. My guess it will probably be precipitated by a sovereign default, and I cannot rule out that next time around, there could also be major corporate difficulties, something which thus far the world has avoided.
What does this mean for New Zealand? We see much of the answer implicitly next week in the presentation of the budget. The New Zealand government’s debt is not high by international standards, but because we have suffered more than once from being bullied by lenders, New Zealand has been naturally cautious.
The government has announced that it intends to reduce the budget deficit to zero in 2014/5, just three years off (and in the next election year too). This would mean there would be then no additional borrowing, although there would still be a need to roll-over old debt. With the exception of the Minister of Finance, nobody I know thinks the goal is achievable. Most of them thought that before the most recent data came in which is suggesting the economy is even more sluggish than was projected which means less revenue.
Their doubts centred on the ability of the government to cut government spending. To give it credit it seems to have abandoned the annual incremental increase in spending that was normal in budget projections a few years back. But given the sluggish economy will that will be enough? Thus far the cuts in government spending have been largely marginal.
The consequence of these cuts is an inferior government service to the community. Every week we see yet another example of this failure, often involving unnecessary deaths. But it is not just confined to the departments involved. Virtually every government department is overloaded with responsibilities relative to the resources at its disposal.
To add to the difficulties the government keeps redisorganising departments. It is not only MFAT suffering from such disruptions. Given that we are facing a series of crises, including a long recession and regulatory failure, why focus on new organisational structures rather than on the services they provide. Surely the disruption are weakening that focus? The government seems to be contracting the public sector because it wants to preserve the private sector outside Wellington. The public servants may be based in Wellington, but the services they provide affect everywhere.
We are not in the austerity phase of budgeting that much of Europe is, and we need to be firm about ensuring government spending is effective. The real need, though, is to lower the track of the nation’s spending, including lowering private spending by increasing savings and – if that is insufficient – by increasing taxation. (It is no secret I favoured a levy to pay for the Christchurch earthquake rather than trying to squeeze the costs out of public spending so that they impact on the poor and needy rather than are shared across the community in a fairer way.)
New Zealand is not at the stage of a Greek tragedy, not yet. The budget’s Perils of Pauline is being on a tightrope trying to balance the budget on one side and maintain high employment on the other. Get the balance wrong and we fall off, failing on both objectives.
All that said, the government is right and courageous to take a disciplined fiscal stance. This is not a case for austerity – not yet – but for prudence. Nobody is going to come to our rescue if the government loses fiscal discipline. They will lend to us for a while – raising everybody’s interest rates as they go – and then start demanding we make public policy concessions. At which point Pauline’s difficulties begin to look like a Greek tragedy.
The get-out-of-jail-card is the recent announcement by a credit rating agency that if the world economy deteriorates, then the target date for the zero budget deficit may be delayed, providing there is evidence of progress on the structural (or cyclically adjusted) deficit. That sounds great news but it is the equivalent of the tightrope breaking. (I cant recall what happens to Pauline in the next episode; does superman fly in and catch her?)
But the cards are dealt. While we are hardly players in the game, whatever is dealt – be it Jack, Joker, deuce or nine of spades – will have far greater impact on New Zealand’s prospects than next week’s budget. It is sobering to realise that what is happening in the Greek parliament may have far more impact on the New Zealand economy than what happens in our own.
 See e.g. A Multipolar World Economy? (http://www.eastonbh.ac.nz/?p=1046); What Does A Multipolar World Mean? (http://www.eastonbh.ac.nz/?p=1115); The Coming World Economic Order (http://www.eastonbh.ac.nz/?p=1486); Living in A Multipolar World (http://www.eastonbh.ac.nz/?p=1553).