Listener: 16 June, 2007
Keywords: Macroeconomics & Money;
When the Reserve Bank Act was passed in 1989, there were those who warned that it would not work. To be sure, the principle of making the bank responsible for operating monetary policy while the government of the day set the policy objective is a good one. The interference experienced by Reserve Bankers in Robert Muldoon’s time demonstrated that. But the objective of exclusively targeting inflation was not as well conceived.
If it were properly conceived at all. None of the papers – I repeat, not one of the papers – prepared in the run-up to the Act’s passing discussed whether inflation control was feasible. Apparently it was thought that monetary policy could sustainably influence the inflation rate (rather than, say, growth or employment) in the medium term at least, but I find no argument for this belief.
In any case, the path taken by monetary policy on its way to the medium term may determine what the economy is like when it gets there.
As was pointed out by dissenters at the time, the Reserve Bank can control inflation by means of a high exchange rate. That way, low import prices keep consumer prices down, directly when consumers buy imports and indirectly when competition from imports forces down the price of home production. But exporting becomes less profitable, is choked off and economic growth slows.
Which is exactly what happened, although even the dissenters failed to predict the six consecutive years of recession (falling per capita output) that occurred between 1986 and 1993.
Much of what I have just written is now the conventional wisdom – suggesting that it has taken up to two decades for sensible analysis to become accepted.
Once more we face a high real-exchange rate, exporters are suffering and economic growth appears to be slowing, although probably not to the point of stagnation. The Reserve Bank’s actions have exacerbated this.
But they are not the main culprits. The US, running a huge budget deficit, is injecting liquidity into the world economy because the US dollar is the internationally preferred currency. Consequently, it is depreciating, which makes other currencies – including our dollar – appreciate. The smaller and more open an economy, the more it is affected.
The intricacies of these processes are too complex to analyse in a paragraph, so let’s put it this way: we are all on the soccer field, but the biggest player, who is also the referee, is playing rugby. What game to play?
Unless the irrelevant monetarist framework is abandoned, the answer is far from obvious. I would be careful of overseas expertise based on theories steeped in the economics of the large and relatively closed US economy. The central characteristics of the New Zealand economy are that it is small and open, with sectors that respond differently to price, monetary and exchange-rate changes.
There are economists trying to think outside the constricting framework. They observe that if there are two objectives – inflation and the exchange rate – we cannot ask the Reserve Bank to tackle both with only one policy instrument. (Currently, it is the official cash rate – the OCR – that underpins short-term interest rates.)
Many of the nostrums proposed for dealing with the current situation – such as capital-gains taxes on housing – are outside monetary policy. That may implicitly critique the narrowness of the monetarist framework that the current Reserve Bank incumbents have inherited. But they do not address how to deal with the world monetary disequilibrium.
This column will try to keep you in touch with the thinking that may become the conventional wisdom one day. Meanwhile, we may be dominated by ideologues who made their reputations on the wrong framework. John Kenneth Galbraith, in his readable and insightful Money: Whence It Came, Where It Went, remarks that John Maynard Keynes “was not forgiven for his compassion, and later events made him even less eligible for absolution, for men of reputation naturally see the person who has been right as a threat to their own eminence”. We need a new Keynes and, even more important, we need to listen to him – or her.