The Issues New Zealand Faces: the International Context

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. [1] 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.

[1] 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).

Are Our Decisions Based on the Influence Of Irrelevant Factors?

Listener: 12 May, 2012.

Keywords: History of Ideas, Methodology & Philosophy;

Economists have long assumed individuals try to do what they judge best, but from the 1970s a notion of “super-rationality” became popular. This assumed that decision-makers took everything into account and made optimal choices. This assumption simplified some otherwise tricky mathematics, but its greatest attraction was its politics. If someone is making decisions in her or his best interests, what justification is there for intervention by the state to change the outcome? Need the Government do anything? Economists were criticised for assuming this extreme rationality.

Probably their best defence was that they did not want to descend into pop psychology; what was the rigorous alternative? Also about 30 years ago, a couple of Israeli psychologists, Daniel Kahneman and Amos Tversky, began collecting evidence of how people made decisions. They concluded that people did so in fundamentally different ways from the economists’ theory of super-rationality. Kahneman has said when he showed the findings to his mother, she told him she knew them already. He suggested it took years studying economics at university to find his research surprising.

In 2002, he was awarded a Nobel prize in economics. (Tversky, alas, died in 1996.) The field of behavioural economics has evolved since and now has a set of well-established findings based on the evidence of what humans actually do, rather than assuming they are “Econs” who pursue super-rationality. Some of the research is quite astonishing. It is not just that people can make inconsistent decisions, but their decisions can be influenced by factors that they are told are irrelevant. In one experiment, the spin of a chocolate wheel affected guesses of the proportion of people starving in Africa. Unfortunately the resulting models of behaviour are much more complicated – more like us, in fact – but key themes are: People make heuristic decisions based on rules of thumb, not those of mathematically sophisticated super-rationality.

People frame their decisions through anecdotes and stereotypes that enable them to understand and respond to events but which may mislead them. As Richard Thaler and Cass Sunstein say in their book Nudge, “People often make poor choices – and look back at them with bafflement!… We do this because as human beings, we all are susceptible to a wide array of routine biases that can lead to an equally wide array of embarrassing blunders in education, personal finance, health care, mortgages and credit cards, happiness and even the planet itself.”

Awareness of the approach can help individuals live more sensibly. Sometimes people make instant decisions, which earlier they thought they wouldn’t. Later they regret that decision. Some New Zealand gambling addicts have asked casinos to exclude them in case, in the heat of the moment, they restart their addiction. Wise recovering alcoholics won’t touch the stuff ever again, in case the first drink leads to the next.

Kahneman and Tversky’s findings do not necessarily justify government intervention in our lives (although there are economists who are so anti-government that they hold onto versions of super-rationality to defend their political ideology). What the research suggests is that when we consider public policy, it is arrogant and wrong-headed to assume people will behave totally rationally. Perhaps the government should “nudge” people in rational directions. For instance, people starting a new job must join KiwiSaver but may opt out. The  research evidence is that individuals are less likely to make decisions they regret with this arrangement than through the “opting-in” alternative. In the advocates’ jargon, the authors support “libertarian paternalism” and actively engineer the “architecture of choice”.

The point is, as the private sector well knows, the way options are presented can determine outcomes. Austrians have an opt-out provision for organ donations; Germany has an opt-in. Almost all (99%) Austrians agree to donate after their death, but only 12% of Germans. This tendency is so important that there is much more to be written about behavioural economics, as practical economists say goodbye to rational economic man and increasingly consider flawed but wonderfully complex human beings.

NZ Government’s Influence on Economic Growth

Listener: 26 April, 2012.

Keywords: Growth & Innovation;  Macroeconomics & Money;

New Zealand has had two great economic booms – during the Liberal era from about 1895, and from about 1935 while the first Labour Government was in power. In each case, per capita GDP doubled in about a decade; each followed a depression (since I’m not making a political point, the depression-recovery phase is excluded).

I have followed historians’ standard conventions of labelling each period by the incumbent government, but I don’t think the reasons for the boom should be particularly attributed to them.

In the postwar era, with two exceptions, the New Zealand economy grew more slowly than during the earlier booms but at the same rate as other rich economies.

One exception is in the decade after the wool price collapsed in 1966; you don’t have to have a PhD in economics to work out that if the price of your dominant export (as wool was for almost 100 years after 1870) falls 40%, the economy is in trouble. An economic slowdown during the adjustment is virtually inevitable. And so New Zealand got behind the rest of the rich world.

The other exceptional period was the eight years from 1985 to 1993 when the economic policies we call Rogernomics ruled. At the end of the period, per capita GDP was the same level as it had been at the beginning. In those years we got behind the rest of the OECD by a further 15% or so; we have not caught up.

It is easy to attribute the stagnation to the incompetence of the economic management of the era. Unlike many, however, I do not argue all the policy changes were a failure, or that all the failed policy changes – like the privatisation programme – can explain the poor economic performance. But inept economic management by the Rogernomes remains the best explanation we have.

Because I am a scientist – albeit one writing a history – I seek the best alternative explanation against which to test my account. You might have thought that the Rogernomes would be eager to explain why the Rogernomic stagnation was not a result of their policies. They have been silent, ignoring the poor performance on their watch.

Instead they make misleading and non-factual claims like Roderick Deane’s “New Zealand achieved its fastest growth rate ever in the 1990s, post the reforms” (“Out there”, March 17). Without the “ever”, the statement is trivially true. The growth rate during the reforms was zero. We went back to the usual growth rate afterwards.

But Deane seems to making a wider point, for which there is no factual justification. After 1993 the economy did not do better than during the Liberal and Labour booms. It is not even true that the post-Rogernomics economy did markedly better than the National boom from 1949 to 1966 and the late Muldoon boom from 1978 to 1985 (that was associated with high inflation, of course). It grew at about the same rate – perhaps fractionally below.

A curiosity of the statement is that it does not acknowledge that the post-Rogernomics growth boom lasted through to 2007. One cannot avoid the suspicion that the omission is to avoid acknowledging that the Labour-led Government that followed the National Government of the 1990s also had a good growth record. But except for the Rogernomics period, I am not sure the Government had much influence on the growth performance in the medium term. I do think that some things the Clark-Cullen Government did are helping us today.

Their prudent management of government finances – resisting the irresponsible tax-cut rhetoric of the Rogernomes and keeping government debt down – gave the Key-English Government much more room to move when the global financial crisis hit. The sort of superfi cial analysis of the Rogernomes – this time from the other political extreme – is likely to blame the National Government for the current great stagnation.

Whatever the ideological rhetoric unconnected to any facts, the reality is that the entire rich world is in a stagnation phase and we are parallelling it, just as we usually did when it was booming.

Auckland Council’s Draft Long-term Plan 2012-2022:

ASSESSING THE FINANCIAL PROJECTIONS

Paper prepared for Land Solutions Ltd for submission to the  Auckland Council

Keywords: Governance;

Summary Conclusions and Recommendations

S1:       Were I an Auckland councillor or a citizen of Auckland I would be reluctant to agree to the financial components of the Draft Plan.

S2:       The Draft Plan is misleading for the size of the borrowing to fund current activities is not transparent because some sources of capital funding are treated as current revenue. This can be readily addressed.

S3:       It would make it clear that the Draft Plan proposes considerable borrowing for current consumption which occurs throughout the entire ten years.

S4:       The Draft Plan is based on optimistic assumptions about the future of the economy and the willingness of central government to fund Auckland activities, with little attention to the real possibility that actual outcomes will be less favourable than the assumptions.

S5:       There appears to be no flexibility to meet contingencies.

S6:       Despite the optimistic assumptions, the projected debt path of the Draft Plan is high. Given the uncertainties and the favourable assumptions there is a possibility that the Council will face a major financial crisis, even before the decade is over, when lenders are no longer willing to roll-over existing debt nor advance new loans.

S7:       This report suggests an alternative interpretation of the fiscal projections in the Draft Plan. They show there is a structural financial deficiency which generates a need for further sources of revenue (and so not relying as much on borrowing or on central government subventions) if major reductions in current spending and capital investment are to be avoided.

S8:       In particular the report recommends urgent attention be given to

– markedly increasing and widening transport levies;

– introducing a region-wide tax, such as a sales tax.

S9:       The report is dismissive of derivatives, asset sales and private public partnerships being able to make much difference to the financial situation over the entire decade of a plan (although it allows there may be other reasons for utilising them).

S10:     While the report encourages refining user charges, it doubts that they can be raised or extended sufficiently to cover the gap.

S11:     The financial component of the Draft Plan should only be adopted if its structural imbalance is presented more clearly and there is a commitment to seek alternative forms of financing or – if alternatives prove impossible – to cut back projected expenditures.

1. Introduction

1.0.1 My name is Brian Henry Easton. I am an economist, social statistician and public policy analyst. I hold a D.Sc in economics from the University of Canterbury, have other formal qualifications in economics, mathematics and statistics, and hold research positions in five New Zealand universities, including being an Adjunct Professor at the Institute of Public Policy in the Auckland University of Technology. I work as an independent scholar and consultant. I have considerable experience in the areas which I am about to address, some of which will be mentioned in the course of this submission. A fuller curriculum vitae is available on request.

1.02 I have been commissioned by Land Solutions Ltd to give an assessment of the financial aspects of the Draft Long-Term Plan 2012-2022 of the Auckland Council from the perspective of economics and public policy.

(1.0.3 While I have no expertise as an accountant, I have over the years, as a consequence of both my general work as an economist and because of various contractual projects, worked with, and become very fluent dealing with, the Public Accounts as prepared by the New Zealand Treasury. While accepting the Auditor General’s opinion that the Auckland City Draft Plan accounts (which is the focus of this report) meet the requirements of the Local Government Act 2002, in my opinion they are more difficult to follow than the Public Accounts.)

1.1 The Treasury Long Term Fiscal Projection

1.1.1 Before addressing the particularities of the Draft Plan some general issues need to be covered. The New Zealand Treasury is required by statute to prepare a Long Term Fiscal Projection at regular intervals. It is currently going through that exercise with an expected publication date in 2013, following the technical work and public consultation this year (2012). It is to be regretted that the Auckland Council has not had those Treasury deliberations available to it. There has been so much financial turmoil in the last five years that, in my opinion, the earlier 2006 Treasury projection cannot be used as an alternative base.

1.1.2 Instead the Council has instead consulted BERL, a group of respected economic consultants. I have not seen their report.

1.1.3 I must mention that I am one of the consultants which the Treasury has approached to assist them with their Long Term Fiscal Projection. However my involvement in the work relevant to the Auckland Council Plan has yet to be undertaken. Therefore nothing in this report reflects the Treasury projections or understandings, although I am using the same analytical skills.

1.2 The Ten Year Economic Outlook

1.2.1 In the last few years the world economy has entered a different phase from the long boom which ended in about 2008. In particular the rich Western economies have been a period of slow growth or stagnation. No one is certain how long ‘The Long Recession’ will be. It is already much longer than a conventional business cycle. A not irresponsible view is that it may last another five years, but any forecast of the beginning of a strong upturn is subject to a wide margin of error.

1.2.2 The analysis is complicated because many developing economies including those in East Asia are still expanding strongly. Since they are a major export destination for New Zealand their stimulus to the economy has partly offset the depressing effect of the rich western economies’ stagnation.

1.2.3 Even so, New Zealand seems also to be in a long stagnation. While there is a tendency to assume that rich capitalist economies always grow, in a paper I gave to to the Treasury in July 2011 (and to the Australia and Pacific Economic and Business History Conference in February 2012) I pointed out that since 1860 (the historically quantifiable period) there have been five long stagnations in New Zealand. They cover about a third of the time. We may be in a sixth. Five Great Stagnations, http://www.eastonbh.ac.nz/?p=1515.

1.2.4 The implication is that we should be very cautious about assuming strong economic growth in the decade to 2022, especially over the next five years. The Draft Plan assumes an average growth in Auckland’s Regional Domestic Product of 2.88% p.a. over the ten year period, or 1.4% p.a. on a labour force productivity basis. (Volume Three, p.84) I have not seen the underlying papers which are the source of these projections, but they broadly correspond to trends before 2007.

1.2.5 The Draft Plan describes development growth assumptions (of population, dwellings and labour force) having ‘significant’ uncertainty, and the economic growth ones as having ‘moderate’ uncertainty. In my opinion the economic growth assumptions are more uncertain than the development growth ones; their downside risk is greater and the financial forecasts are less robust to this assumption.

1.2.6 It is useful to record here that the Draft Plan seems to be premised upon a growth of the nominal Auckland economy of about 6.5% p.a. over the decade, consisting of the aforesaid (real) volume growth rate of 2.9% p.a. and an inflation rate of 3.5% p.a. (Vol 3, p.87).

1.2.7 I have not contested the inflation assumption. In regard to real production and expenditure and the prudential ratios with which the report provides, long term forecasts are typically almost neutral to the inflation rate (on the assumption that real – not nominal – interest is correct).

1.3 Auckland in the New Zealand Economy

1.3.1 I was on the Prime Minister’ s Growth and Innovation Advisory Board which, in the middle of the last decade, was one of the drivers for the current transformation of Auckland. There are many factors which contribute to a policy as substantial as this one. Here is my interpretation of the economic ones.

1.3.2 Because much economic growth in the world occurs in large vibrant urban centres driven by the effects of the economies of agglomeration (in which local interactions reduce overall production costs), it was recognised that in order to reap the benefits of agglomeration it was necessary to accelerate and improve the development of New Zealand’s largest urban area, Auckland. Without that, key opportunities, industries and jobs would relocate in Sydney and Melbourne to detriment of the whole of New Zealand.

1.3.3 It was also observed that Auckland’s governance structures had been inhibiting that development and that much of its infrastructure was inadequate. This is the background for the governance reforms which have led to the Auckland Council and for the substantial investment in recent years by central government in Auckland’s infrastructure (especially the transport network).

1.3.4 There has been an implication of this strategy which may not be fully appreciated. Essentially the government is putting a lot of effort into Auckland – in effect subsidising Auckland above the rest of the country – because it expects there to be a return on its investment for all New Zealanders. Auckland cannot expect those exceptional subsidies to continue indefinitely. Instead at some stage the city economy is expected to ‘take-off’ and contribute to the national economy, rather than needing proportionally more subsidies than the rest of the country.

1.3.5 I have not formed an opinion when the take-off point occurs, but I would be astonished if it were after 2022. That means that Auckland has to expect some time during the plan decade that the exceptional central government spending will be wound back and that the city will have to be more financially self-sufficient.

1.3.6 This is offset by a second effect. Arguably all urban centres – and not just Auckland – suffer from a weakness in their funding base because of their over-dependence on property rates. This becomes a demand for central government funding which has greater powers of raising current revenue via its tax base. This point not particular to Auckland but to all urban centres (although it may be more acute in Auckland because it is the largest urban area). The consequence is a structural financial deficit and the need for an alternative sources of funding.

2. The Financial Strategy [1]

2.1 The Operating Funding Deficit Strategy

2.1.1 The financial strategy in the Auckland Council’s Draft Plan reflects the amalgamation of the past decisions and practices of the legacy councils which preceded it. In particular they were not fully funding their current spending, but borrowing to cover the gap with revenue. This was obscured by using some of the provision for depreciation to fill the gap. The economist’s term for this practice is ‘consuming some of its own capital’. The consequence is that there has to be borrowing to fund some of the replacement capital which has been depreciated.

2.1.2 The Draft Plan is explicit about this, stating:

Auckland Council’s starting position is not a balanced budget, primarily because the legacy councils did not fully fund their depreciation expense. The financial strategy proposes a move to fully funding depreciation expenses over the next 13 (sic) years. (Volume One, p.29) [2]

2.1.3 While one accepts that the transition to unified authority requires time that is, in my opinion, no reason to treat the consumption of capital in this way. The amalgamation offers the opportunity for a fresh start, and that should include the attribution of all the depreciation to a source for funding capital investment. (A similar issue may apply to the development contributions charged to current spending, to offset financial costs.)

2.1.4 To do this would result in the financial accounts showing a much larger operating funding deficit. According to the Draft Plan the Auckland Council is going to borrow to support its current spending – more than it admits – (just as the legacy councils did).

2.1.5 This peculiar treatment of depreciation and the, in effect, larger operating deficit will be evident enough to accountants, credit-rating agencies and lenders despite the obscurity in the accounts. Those likely to be misled by the appearance of the accounts as they are currently set out are the people of Auckland and their elected representatives.

2.1.6 The approach means that the financial accounts look more satisfactory than they are. Currently they imply that the Council plans to over-spend each year, perhaps by an accumulated deficit of about $740m over the decade, or around a dollar a week per Aucklander. In addition some $1417m of the provision for depreciation is not used for capital funding. The two together add to$2157m, which may give a better picture of the amount of net borrowing over the decade for non-investment purposes.[3]

2.1.7 Aucklanders are entitled to know that there is substantial borrowing for current spending (and to take some comfort that the planned operating deficit is on a downward track). Unless they know this they cannot understand the substantial financial challenges their council faces.

2.1.8 The point here is not to challenge the strategy of unification over a long transition period. What is important is that the accounts should be transparent about the consequences of a prolonged transition. One of the most important issues is that the Auckland Council proposes to borrow a substantial amount over a long period to facilitate the transition; that is not immediately evident from the accounts.

2.2 The Borrowing Strategy

2.2.1 The Draft Plan states that :

The council proposes to set limits on its borrowing to maintain debt at a sustainable level and provide flexibility to deal with shocks. While debt increases substantially over the next ten years, it is still at a prudent level in comparison to our income and can be managed within our limits on rates and debt. Council considers this increase in debt to be appropriate on the basis that it is primarily driven by investment in new assets and the benefit of the expenditure is spread over time, thereby promoting intergenerational equity. (Volume One, p.29)

2.2.2 The statement is evaluated in the next section. For the record the Prospective Prudential Financial Ratios are as follows (with the projected ratios in 2012 in brackets):

Net debt as a percentage of total revenue:     less that 275% (219%)

Net Interest to total revenue:                          less than 15% (13.8%)

Net interest as a percentage of annual

rates incomes                           less than 25% (22.8%)

(Volume Three, p.35)

2.2.3 Note that if the accounts excluded depreciation (and the development) contributions the first projected ratio is 225% (rather than 219%) and the second would have been 14.1%, so both remain projected to be within the limits the Draft Plan sets for them.

2.2.4 There is a small but fundamental correction necessary to the overview. It states ‘Council group debt … is expected to increase steadily to reach a peak of $12.5 billion in 2021/22.’ (Volume One, p.37) It seems very unlikely that the debt reaches a peak in 2021/22. All the indications are that it can be expected to continue rise after that date.

2.2.5 The Draft Plan explains that it is raising the net debt as a percentage of total revenue ratio for the following reason:

The previous limit within the liability management policy limiting net debt as a percentage of total revenue to less than 175% was consistent with the financial projections in the previous Long–term plan. Given the new financial projections in this plan, it is necessary to reassess the appropriateness of this debt limit ratio. While the other debt ratios require no amendment, it is necessary to increase this ratio to reflect the additional investment within the region funded by debt. (Volume Three, p.244)

2.2.6. The explanation seems to be that since the Draft Plan cannot keep to the existing ceiling (it proposes crossing it in ) the ceiling is raised. The possibility that the existing ceiling was an indication of the infeasibility of the borrowing proposals is not considered.

2.2.7 any the upper limit needs to be accompanied by a long term target level, just as the New Zealand government sets a comparable upper limit but it also sets a lower level (which is about half the ceiling) which it aims for in the longer term. The Auckland Council Draft Plan has no long term target. Without one the ceiling becomes the target with the likelihood for the actual level to drift up to it and breach it.

2.2.7. One might have hoped instead to see the expected debt path to move towards a realistic ceiling and then turn down after, say, after five years and move towards the target level (probably below 100%) reaching it by the end of the plan decade (2022) or a little after.

3 The Debt Projections

3.0.1 Recent experiences of some countries following the Global Financial Crisis confirm what has been long known: the debt path is critical to the viability of any financial plan.

3.0.2 The Prospective Statement of Financial Position shows a substantial rise in the net level of debt from about $2.93b in 2012 to $8.43b in 2022, an almost trebling. It represents an average increase of 11.1 percent p.a.

3.0.3 That rate may be compared with the assumed nominal rate of growth of the Auckland economy of about 6.5 percent p.a., so the Council debt is projected to grow at about 4.4 percent p.a. faster, a rate which would double net debt to regional GDP ratio in 16 years or so. This is longer than the forecasting period, but warns that the Council may be committed to a large increase in its relative debt.

3.0.4 Whatever the citizens of Auckland may think about this rise (and part is matched against desired assets, although some borrowing is for current spending) the critical issue is what the lenders of the debt think. A detailed analysis would be speculative but we have guidance from their behaviour before and after the Global Financial Crisis.

3.0.5 In summary, we might expect at some stage the lenders may well become cautious – even anxious – about continuing to roll-over and extend loans to the Council at the rates environed in the Draft Plan. This issue is implicitly recognised in the discussion of the credit rating assumption which states that ‘the council has assumed that its credit rating will fall one notch from its current rating of AA to a revised rating of AA- in 2012’. (Volume Three, p.63)

3.0.6 The Treasury Management Policy adds an objective to the liability management policy for Council to maintain a minimum credit rating of ‘A+’”

The council’s credit rating from Standard and Poors rating agency is currently “AA”. The credit rating is currently on Credit Watch negative. It is appropriate to include a minimum credit rating objective so that any future decision making with regard to liability management will consider the impact on council’s credit rating. A credit rating is an assessment of the ability of an organisation to meet interest and principle payments on borrowings in a timely manner. Typically, a lower credit rating will lead to a borrower paying a higher interest rate on that borrowing. (Volume Three, p.244)

3.07 It makes no attempt to consider whether the objective is feasible in the light of the heavy borrowing proposals of the Draft Plan. It does suggests there is a moderate level of uncertainty of it maintaining its current AA- rating. (Volume Three, p.63) I would judge the uncertainty higher, not only because of the heavy borrowing discussed in this report, but because there is a low-to-moderate possibility that the national credit rating could be downgraded and other New Zealand institutions’ credit rating would follow. (The New Zealand government is very aware of this possibility and is working to minimise it.)

3.0.8 The debt to revenue ratio rises to above double the total revenue level in 2017, and continues above that level. It is projected to be 219.4% in 2022, and while it is slightly higher in 2020 (237.1%) there is no significant indication that it will fall back to a realistic medium term level shortly after.

3.0.9 Moreover given an unexpected adverse event or that the assumptions under-pinning the projections prove too optimistic the actual debt level could exceed the stated limit after 2017. Lenders may then be unwilling to advance further funds, or require a considerably higher interest rate. At which point the Council may face a financial crisis. Such an outcome is not certain, but there is a not insignificant possibility of this happening.

3.0.10 Lenders will be aware that if Auckland Council’s debt appears to be getting out of control there will be few of its assets which can be sold (i.e. privatised) to repay debt. Unlike a corporation, the vast majority of assets of a local authority are ‘non-performing’ in the financial sense of not producing a flow of revenue. Of course they contribute to the well-being of Auckland citizens who pay local authority rates in order to fund the assets they value and service the debt they generate. Ultimately then, the vast majority of the borrowings are secured by the revenue from the local authority rates.

3.1 Interest Rate Assumptions

3.1.1 The Draft Plan reports that ‘[n]et interest as a percentage of annual rate income rises from 11.9% in 2010 to 22.8%’, although it peaks at 24.0% in 2020 (quite close to the recommended upper limit of 25 percent). It is reasonable to assume that there will be some anxiety by lenders from this path (moreso as they will add in the capital revenue items treated as current revenue). There may also be less enthusiasm from ratepayers when they realise that almost a quarter of their rates are eventually planned to service debt.

3.1.2 On the other hand, rates revenue is projected to rise at 5.2% p.a., slightly lower than the growth of the region’s production (6.5% p.a.). This will give some comfort to lenders since they might assume that if things go wrong the level of rates could be further increased. This is not to argue that rates should rise faster, but to point out that the capacity to further raise them mitigates the risk of lender resistance (and possibly a debt crisis).

3.1.3 The average interest rate on the net debt is 5.7% p.a. in 2012, and is projected to rise to 6.2 % p.a. in 2022, or by half a percentage point (50 basis points). These projections are based upon bench mark assumptions of 6.04% p.a. in the 2013 year to 6.12% in the 2022 year, a smaller increase. (Volume Three, p.87-88) I take it the difference between the assumed and revealed rates reflects the effects of changes in the structure of the financial borrowings (as well as that new borrowing will be more expensive than past levels).

3.1.4 One could be more pessimistic. Real interest rates are at historic lows, reflecting the subdued state of the world economy. If the economy returns to a normal expansion – the implication of the economic growth rate assumption for Auckland – one would expect interest rates to return to historic levels. In mid-2007, just before the New Zealand economy entered its current stagnation (and about the time the US economy entered its one), interest yields on in the secondary market for government bonds were typically in excess of 7% p.a. (This was on a lower expectation of inflation than the 3.5% p.a. assumed in the Council Draft Plan.)

3.1.5 The Draft Plan states that ‘[t]he council’s treasury group has mitigated these risks with a prudent hedging programme.’ (Volume Three, p.87, see also Vol One, p.38). It is unlikely that any treasury group can, over a long period, reduce annual interest rates by 1 percentage point.

3.1.6 There is little room in the financial projections for contingencies (there appears to be no provision in the Draft Plan, although the New Zealand government fiscal statements includes some). If a event with a major negative financial impact were to occur there will be little room to respond other than by breaching the debt and interest rate ceilings which the Draft Plan sets.

3.1.7 In conclusion, the projected level of borrowings is high, and the cost of borrowing is probably underestimated. In my judgement the debt path is a more risky undertaking that the Draft Plan represents it.

4 The Funding of Capital Investment

4.0.1 The Draft Plan projects that over the ten years to there will a total capital expenditure (including watertightness claims) of $20.71b. (Volume Two, p.157) Some $0.468b of the funding comes from asset sales and $7.45b comes from ‘funded depreciation and operating surplus’. The remainder, which is the spending on net new capital, amounts to $12.79b. Of this $3.07b (24%) is projected to come from capital subsidies, $1.71b (13%) from development contributions, and the remainder $8.01b (63%) from borrowing.[4] Assessing each source of funding in turn.

4.1 Capital Subsidies

4.1.1 Capital Subsidies are contributions by central government to council works. In 2012 they amounted to $176m. They are projected to rise to $503m in 2015 and then decline in the following years to $177m in 2022, averaging $307m a year. Thus the Draft Plan depends upon an even greater central government annual contribution than the current level . As far as is known there is no agreement by Central Government that it will contribute at this level.

4.1.2 It seems unlikely it will, for at least two reasons. The first is the central government finances are currently under rigorous expenditure control, with the objective of attaining a fiscal surplus by 2015, the year when the Draft Plan makes the biggest demand upon it. Second, as already discussed, it seems likely that at some point the special treatment of Auckland will be wound back, so that any demand by the Auckland Council will be magnified by giving a similar treatment to the rest of the country. (This would have the effect of tripling the cost to central government of any capital subsidy to Auckland since it would be obliged to fund the other two-thirds of the economy at comparable levels.)

4.1.3 The likelihood, then, seems to be that unless the Council can make a greater contribution to capital works from its operating surplus, or can find new sources of funding, some of the works projected in the Draft Plan may not proceed as scheduled.

4.1.4 This assessment says nothing about the merits of the proposed capital works program; the reservations are whether it will be able to rely on capital grants from central government to the extent which is assumed.

4.2 Development Contributions

4.2.1 Development contributions are projected as a steadily increasing source of revenue. The sort of time profile the Draft Plan assumes is a reasonable approach given the contributions’ potential volatility. What is important is the extent to which capital spending can be altered if the contributions move markedly off trend. If there is a downswing in development spending can capital works be held over, since the Council probably does not want to, nor have the capacity to, borrow in addition to the current projections?

4.2.2 There is no need to apologise for drawing attention to the volatility problem. The Irish economy treated its revenue from such development activity as a current income. One of the current difficulties it faces is that when development reversed this revenue stream stopped, following the Global Financial Crisis, it faced a fiscal crisis (in addition to its banking crisis). New Zealand accounting practices would not permit such a financial mistake, but the problem of volatility of the revenue remains.

4.3 Borrowing

4.3.1 The issue of overall Council borrowing was covered earlier. An alternative way of presenting the data based on the cash flow projections.

4.3.2 In 2012 borrowings exceed the repayment of borrowings by $619 million. Five years into the 10 year period of the Draft Plan, new borrowings exceed repayments by $808 million. By the end of the period, repayments have increased significantly and new borrowings are only $429 million higher than repayments. The conclusion is that the Auckland Council is projected to be borrowing heavily throughout the period.

4.3.3 The report has already concluded that the borrowing track seems to be near the top of or above what is prudent, and that it relies on a willingness of lenders to roll over existing debt and provide new debt which may not continue. The implication is that if other sources of capital funding revenue prove weaker than projected, there is little capacity to borrow more to maintain the capital expenditure plans.

5. The Risks the Financial Projections Present

5.0.1 The financial projections are subject to four caveats.

5.0.2 The first is about the macroeconomic context. While it is nigh impossible to get the forecast right, the concern here is that in the case of growth (especially in the first years of the projection period) and interest rates the assumptions are optimistic. The downside is more likely than the upside with the consequence that there is a substantial risk that the financial outcomes will be worse than projected.

5.0.3 The second is that the capital funding budget is optimistic (even unrealistic) as to the amount of capital subsidies the central government is likely to advance.

5.0.4 Third, the borrowing program is heavy and may well be at the upper limit of what lenders will advance. It is both close to the limit judged to be prudent, and there is no evidence of restraint after 2012 with a possibility that the borrowing requirement will exceed perhaps as early as a few years into the Draft Plan if some sorts of adverse events occur. Lenders may well be especially cautious given that they are being asked to finance current spending and not just capital spending.

5.0.5 Given the three caveats, the fourth becomes a large one. There are no contingency provisions and, except for delaying capital spending, there seems little flexibility if outcomes prove worse than projected. (Presumably, though, the promise to restrain rate rises could be abandoned, although this might well be unacceptable to ratepayers.)

5.0.6 In summary, the Draft Plan makes a number of assumptions which may seem overly optimistic. If outcomes are less favourable, the Auckland Council may face a major financial crisis towards the end of the plan period, or shortly after.

6. An Alternative Approach to the Financial Implications of the Draft Plan

6.0.1 An alternative interpretation of the financial projections is that they show that the Auckland Council faces a major structural problem in its finances. It does not have the financial resources to pursue the objectives that it has identified in its Draft Long-term Plan. That is the significance of financial projections which depend heavily – too heavily – on outside funding from the central government and lenders.

6.0.2 Given the structural imbalance, the Council might consider scaling back its ambition. Before taking that course it would want to consider the possibility of other funding options. There are four options that need to be quickly dismissed.

6.0.3 The Council should be prudent in the use of derivatives, using them to neutralise risks rather that address the structural imbalance. Otherwise it risks a major financial crisis as have some local authorities (e.g. Orange County) and businesses (e.g. Barings).

6.0.4 A program of privatisation of assets does not address the structural problem. There may be good reasons for some privatisation (e.g. assets surplus to requirements or which command a higher price in the private sector), but in financial terms the sale of an asset reduces borrowing requirements in the year of sale, but reduces revenue in subsequent years – the one normally offsetting the other over the long term. Thus they do not have much impact on any long term structural problem. (A good example of the failure of a privatisation program was that of the late 1980s which promised to reduce the central government’s debt but which still left the structural imbalance which was dealt with by severe expenditure cuts in the early 1990s.)

6.0.5 Similarly public-private-partnerships do not address the structural problem either. Again there may be other good reasons for them but, as in the case of privatisation, they simply change the revenue and spending flows, reducing outlays in one year and increasing them in others, without affecting the long-term structural problem.

(6.0.6 PPPs may seem a seductive means of funding new capital developments. They may be effective in particular circumstances, but the British experience is very relevant. Often they were used to keep capital commitments off the balance sheet while committing the government to a funding flow in the future, thus appearing elsewhere (and later) in the accounts, illustrating the principle that PPPs shift flows but do not resolve structural problems. What was unfortunate was that the British government often found itself taking all the downside risk when the financial projections for an individual PPP proved wrong; ultimately many proved a very expensive source of funding. The classic New Zealand example was the Major Energy Projects (Think Big) of the late 1970s and early 1980s, which were PPPs before the term was used. Again the government took almost all the downside risk, to an eventual considerable cost to the taxpayer.)

6.0.7 Raising the dividend requirements from Council owned enterprises is not really an option, in that the Council should have set its targets on the basis of prudent management and feasibility anyway.

6.0.8 There are three relevant option already mentioned:

6.0.9 It may be necessary to delay or abandon some proposed capital projects.

6.0.10 The Council may raise the level of rates (abandoning the promise made in the Draft Plan to restrain them). Local authority rates are not a particularly effective tax for they hardly reflect ability to pay. The main justification for them is there are hardly any alternatives for local body funding. Even so, the logic of the current financial projections is that rates will have to be raised faster than promised and there will have to be spending cuts, unless an alternative source of revenue can be identified.

6.0.11 The council may also raise activity and user charges. It is assumed that they are already set at a fair, realistic and economic rational level.

6.0.12 Given the overall pressures the above list of options if implemented is almost certainly insufficient to fund the spending ambitions without high of levels borrowing. One is driven to considering alternative sources of revenue.

6.0.12 The Draft Plan properly raises the possibility of various direct transport levies such as road tolls. (Volume Three, p.86) They are attractive because the revenue implicitly offsets some of the interest charges which are generated from the roading capital works and may also be treated as contributing to the maintenance of the road system.

6.0.13 Typically such levies cannot be designed to fall exactly fairly on individual road users, but their incidence is fairer than charging the interest and other road costs to the public at large through rates (or to future generations through borrowing).

6.0.14 Moreover, well-designed levies can contribute to more efficient use of the transport network by discouraging low value uses or encouraging switching to times and routes where there is more capacity. They may even reduce the demand for some capital works.

6.0.14 Based on the structural problems in the Draft Plan there is an urgent need for consideration and implementation of a more extensive range of road user levies at as early a time as is feasible.

6.0.15 There is always a need to seek further user charges, although these should not compromise the fairness or efficiency of the service delivery.

6.0.16 However, while it is difficult to be certain from the provided financial accounts it seems likely that even were road charges extended there is a need to find a further source of region-wide funding as an alternative to higher rates. Among the options would be a sales tax or a surcharge on GST.

6.0.17 A central government is always jealous of the use of its power to tax, and would be reluctant to agree to the introduction of a region-wide tax (which would require a statute). There are two general points to offset this.

6.0.18 First, as already argued, there is some risk that the borrowing program currently envisioned in the Draft Plan will lead to a financial crisis, the resolution of which will certainly involve the central government and probably involve substantial central government financial subventions. Better to act now to prevent one than wait to act after the crisis when involvement will be more expensive.

6.0.19 A natural reaction from central government will be to scale back the Draft Plan’s proposed spending and investment plans. If the Council is confident that is what the people of Auckland want and are willing to pay for then the Council should resist unreasonable scale-backs, emphasising it is responding to the wishes of a democracy.

6.0.20 The second critical point is that the Government of New Zealand has established the Auckland Council. It must give it the tools to enable to pursue its mandate.

6.0.21 So the Auckland Council should give urgent attention to the imposition of a region-wide tax to be implemented early in the second half of the decade of the Draft Plan.

6.022 If alternative sources of revenue cannot be found, the indications are that spending and investment plans as set out in the Draft Plan will have to be substantially scaled down.

Notes

[1]  The financial year of the Auckland Council ends in June. Unless there is an indication to the contrary all plan years referred to in the text are June ended years.

[2] Footnote 15 on page 158 of Volume Two adds that only a proportion of the depreciation is to be a source of capital funding. The proportion is to rise from 67% in 2012 to 90% in 2022.

[3] If it were decided that the development contributions are not really a current revenue item either, a further $164m would be added to the operating funding deficit.

[4]  Correcting this by transferring the depreciation which is treated as current revenue to capital funding, the figures become

$8.87m comes from ‘funded depreciation and operating surplus’. The remainder, which is the spending on net new capital, amounts to $11.47b Of this $3.07b (27%) is projected to come from capital subsidies, $1.71b (15%) from development contributions, and the remainder $6.69b (58%) from borrowing.

Lenders would normally look benignly on a funding proposal in which more resources are being sourced from the borrowers’ own funds. However in this case, they are also being asked to fund current spending.

Rogernomics and the Left

For Bruce Jesson: We Miss You

Published in the CAFCA “Foreign Control Watchdog”, April 2012, No 129, p.46-55.

Keywords: History of Ideas, Methodology & Philosophy; Political Economy & History;

The rise of the left and its socialist analysis was a response to the disruption and hardships of the nineteenth-century industrialisation (which we now know morphed into today’s globalisation). The ‘left’ analysis was not isolated from the main streams of European thought. Both its Marxist and democratic socialist (greatly influenced by Methodism) variants were deeply engaged with, and contributed to, the evolving social sciences.

New Zealand Labour came to power in 1935 with its leadership, on the whole, close to social science orthodoxy albeit with different social objectives, especially a concern for the economically weak and workers who had been hammered by the Great Depression. Within the caucus there were those of a more radical disposition, but the more vociferous were money reformers who, like the leadership, accepted the market economic system but also wanted to change the banking system. All, to some degree, saw an importance for the common (or public) ownership of the means of production, distribution and exchange, but while there was the odd nationalisation – the Bank of New Zealand for the monetary reformers, the mines because private enterprise managed them so badly – public ownership was not high on Labour’s agenda. (It turned down a proposal to nationalise the predecessor of Fletcher Building.)

To summarise their vision of the economy – although few if any them would have articulated it quite this way – Labour wanted not public ownership but social control of the means of production, distribution and exchange. Public ownership is one means of doing this but so is the use of markets which are particularly effective where there is a demand for diversity and choice. The distinction between democratic socialists and social democrats may be one of means; the former giving greater emphasis to social ownership, the latter to social control (although I have never met a social democrat who did not see the need for some community ownership).

The War Economy, the Post-War Economy and After

Ultimately it is difficult to assess what exactly Labour thought when it was first elected , because the war economy required a more centralised form of economic management, with its focus on commanding as many resources as possible to prosecute military success, an objective which had almost universal support. Centralised economic control was not then unique to New Zealand; it was practised to some extent by every economy deeply involved in the Second World War.

The consequence for economic thinking was that much of the New Zealand left, whatever its views before the war, became heavily committed to the controlling approach of the war economy. This has continued although the Second World War was 65 years ago with a standard of living around a third of today’s, with technologically primitive production by today’s standards with a very different relationship with the rest of the world and where there was much less social and consumer diversity. The sixteen-year post-war economic boom – with its low unemployment and, by today’s standards, high growth of material output – seduced many New Zealanders into thinking the controlled economy which came out of the war was broadly right, so they were more reluctant than those in other rich economies to abandon the controls.

The post-war boom came to an end in 1966 when the price of wool, which then earned two-fifths of export revenue fell (almost) permanently by about 40 percent. With the collapse of its principal foreign exchange earner (over half of export revenue came from sheep) the economy had to change dramatically; there was a major external diversification over the next two decades as new export markets and new export products were developed. However there was a reluctance to change the internal configuration of the economy even though a controlled domestic economy could not cope (indeed it could barely cope with the increasing diversity of consumer choice).

Critically the diversity of exporting impacted on domestic production. It was no longer possible to isolate the export economy from the rest, as had happened when over ninety percent of exports were wool, meat, dairy and other pastoral products. A diversity of exporters required more sophisticated external services than, say, routine foreign exchange dealing, while international competition meant they need sophisticated inputs of components and labour. In the 1970s exporting began to affect almost every part of the economy.

Muldoon to Douglas

During the War a handful of men could control the economy, even to the extent of prescribing the length of skirts (matrons’ hems were permitted to be nearer the ground); today the plethora of boutique fashion shops would make such an attempt impossibly laughable. Similarly as New Zealand began exporting myriads of products to as many markets, the central control of a few products which went mainly to Britain became impractical.

The great diversification following the wool price collapse of 1966 was presided over by Rob Muldoon (as Minister of Finance and later as also Prime Minister) for the following 18 years (except from 1972 to 1975 when there was a Labour government). Initially Muldoon tried to liberalise markets, withdrawing direct controls. In almost every case each reduction in intervention undermined a politically powerful sector which was privileged by the controls. Any affinity Muldoon may have had for ‘more market’ and less central control was over-ridden by his political instinct with its need to maintain his power base. (Muldoon was more decisive about liberalisation when it was workers who suffered.) Additionally there was inflation. In the hundred-odd years before 1966, prices had trebled. Now they were trebling every ten or so years.

In the end Muldoon gave up systematic market liberalisation – with a few exceptions – when in 1982 he imposed the most draconian wage and price freeze that New Zealand had ever experienced.

In July 1984 the tired and exhausted man was swept out of office by the Fourth Labour Government led by Prime Minister David Lange with Roger Douglas as its Minister of Finance. Its approach to economic management had not been resolved when the snap election was called; its manifesto was the result of a clumsy compromise among the warring factions within the party.

Traditionalists, Social Democrats and Neo-Liberals

By the middle of the twentieth century, the nineteenth century symbiosis between left thinking and the social sciences had begun breaking down as the society and economy developed. The left analysis began to fossilise, getting increasingly detached from the social sciences and the changing society despite, ironically, having had a major and positive impact on that evolution.

With its attention focused on foreign affairs and human rights, much of the left had long ceased to be interested in modern economic thinking, and were satisfied by the controlled economy. (In the 1980s a minister, expressing genuine surprise at the resistance to Labour’s economic policies, remarked to me that Labour annual conferences spent more time on Nicaragua than economic policies; for those born recently, the leftish Sandinistas had just attained power and were opposed by the Reagan administration.) This group might be called the economic ‘traditionalists’.

Labour’s economic ‘modernisers’ were a much smaller group. They recognised that the economic mechanism relying on central controls was becoming increasingly obsolete, that issues which Muldoon should have addressed had been avoided, and that decisive measures were necessary. The majority of social democrats wanted to adopt an approach similar to that of the Australian Labor Government (elected in 1983). With hindsight they were over-optimistic about the ability of the New Zealand unions to deliver in the way the Australian unions had. They lacked the coherence of their trans-Tasman counterparts, were poorly led, and the Labour cabinet had little union experience. (Whereas the Australians were led by Bob Hawke who had previously led the ACTU, the highest ranked New Zealand Labour Party cabinet minister with significant union experience was Stan Rodger at number 16 – from the state sector background.)

For a while the ‘third way’ was fashionable with some modernisers. The main theoretician was the eminent British sociologist Anthony Giddens, who was deeply grounded in the nineteenth century social sciences. While he was aware of Marxian thought he was not a Marxist but a social democrat (and aware of developments in the thinking and approaches on the European continent). He saw that the nineteenth century simplification of society into two classes (or three if landowners are included) was no longer tenable, and sought to provide a more complex account with a matching political program. Alas its political reputation was severely damaged by Tony Blair’s adoption of the ‘third way’ slogan although not the spirit of its analysis.

Unbeknown to just about everyone there was another group of modernisers in the party. Today they are called ‘Rogernomes’ but internationally they would be called ‘neo-liberals’. (Many traditionalists call all modernisers, including social democrat, neo-liberals in a manner similar to the right calling everybody to their left ‘Communists’ .)

The key politicians who were Rogernomes were the troika of Labour’s finance ministers – Roger Douglas, Richard Prebble and David Caygill – although many other cabinet ministers sufficiently allied themselves with them to be called Rogernomes (including Phil Goff who was leader of the Labour Party from 2008 to 2011 and Michael Bassett who became the Rogernomes’ quasi-official historian). Many of the Rogernomes’ allies had little genuine commitment to neo-liberalism but opportunists – like the Vicar of Bray – took advantage of the openings it created for them; as Rogernomics faded away they rearranged their resumés to disguise their youthful, but advantageous, indiscretions (some were promoted by the Clark-Cullen government).

How the troika were captured by the ideology has yet to be detailed, but their intellectual fire-power came from a group who at the time were public servants. Certainly the hierarchical decision process was critical. First capture the Ministers of Finance, who would bring Prime Minister Lange and Deputy Prime Minister Geoffrey Palmer on board (sometimes, presumably, voting 3 to 2 or 4 to 1); the five would have a majority in the inner cabinet, which was again bound to vote together in the full cabinet; similarly the cabinet, bound by unanimity, dominated the caucus.

That does not explain the ineffective resistance to the Rogernome policies outside the caucus. It was partly that the hardest hit were those represented by the Labour Party who wanted to be loyal to ‘their government’. There was also the fratricide which takes place after a coup; a bit like the Spanish Civil War where the left was so busy settling old disputes that it let the fascists win. Some modernisers got out of left politics altogether – notably Rob Campbell and Alf Kirk who had written the thoughtful pro-union After the Freeze in 1983. A consequence was that when the traditionalists needed to understand the neo-liberal policies there were few modernisers to consult; instead they made up fantastical conspiratorial accounts of what they imagined was happening.

The Rogernomes took no prisoners either – with numerous promising careers destroyed by their backroom manipulation. Lenin said the first thing after the revolution was to kill the intellectuals. The social democrats were put down vigorously because the neo-liberals were arguing there were no alternatives (except Muldoonism): those who could offer alternatives had to be eliminated from the public debate – even to the extent of approaching editors to say that certain persons should not be used – some journalists who acquiesced may be still so embarrassed that twenty years later they dont approach the black-listed.

There are few places to shelter for people treated this way. New Zealand does not have the plethora of independent think-tanks characteristic of, say, America and Britain, while those in power who were not Rogernomes did little to shelter potential allies (or prepare for the time when they would be in opposition). The universities proved as impotent as the Labour Party; not only did those who opposed Rogernomics find their careers blocked while its third rate supporters were promoted, but when it came their turn to be undermined by the Rogernomes the universities meekly acquiesced.

The modernising sympathies of both the social democrats and the neo-liberals meant that many traditionalists lumped them together. What was not appreciated was they had quite distinctive approaches to the market. The social democrats had social objectives; for them the market was a mechanism by which they could more efficiently pursue these objectives. In particular they saw the centralisation that the traditionalists relied upon as increasingly obsolete as the economy and society became more complicated. In any case there was an element of social libertarianism which distrusted the state and favoured individualism. (Social anarchism is an integral part of the left traditions, although it tends to get played down because some anarchism was very violent.) That meant that they did not unqualifiedly favour government intervention as a solution to all problems. Nor were they totally antagonistic to private property (although they were wary of it as it accumulated in corporations and financial institutions). A social democrat asks whether private ownership and the market is to be master or whether it is be the servant of society.

The neo-liberals had no doubt about the answer; for them the unconstrained market based on private property gave the right social objectives. There was no need to control it for the social good – commercial relations automatically gave the public good. Their rhetoric said it gave economic growth, low unemployment and ‘freedom’, although there was surprisingly little analysis or evidence to back these claims, especially given the absolute certainty with which they were held and promulgated.

Or at least – in one version of their argument – the unconstrained market was better than anything the government could do. If there was a need for a government it was to be a minimalist one – in justice and defence only. As much as possible was to be left to private enterprise and voluntary exchange. (We eschew discussion here just how ‘voluntary’ is an exchange between a huge corporation and one of its workers.)

Ironically, the chief advocates of Rogernomics had initially been public servants when they came to their conclusions. That might explain their deep scepticism of the government, for they had worked under Muldoon – they had hardly worked under any other Minister of Finance – and they had seen how corrupting politics could be. (The concern here is not financial corruption, but the way the politicians (i.e. Muldoon) had distorted the economy and society for short term political ends.) But deep in the bowels of the state services they had little experience of the private sector which they idealised. In a much quoted economic joke, they gave the prize to the second diva in an aria competition having only heard the first.

The Rogernomes’ vision of government was greatly influenced by American neo-liberals. Now it is hard to be generous to the American political system (including the way that political pressures from private enterprise have corrupted it) but the New Zealand system – and indeed the systems of most social democracies – is very different. (One American economist criticised Keynesianism because it assumed that there could be an impartial, competent and uncorrupt civil service – oblivious to there being one in Keynes’ London.) Such political systems may not be ideal – which are? – but neither is unconstrained private enterprise. So besotted were the Rogernomes with the American ideologists that they supported changes to the New Zealand public service which made it more like the American one, wearing their colonial cringe as a badge of honour (if they were aware of it at all).

A contempt of government permeated the neo-liberal thinking, so much so they had to assume an idealisation of human behaviour which markedly reduced the need for it. Subsequent research has showed that economic man is a very crude approximation of reality. It is said that when Daniel Kahneman collected together the research that showed the disconnection of rational economic man from reality, his mother told him she knew that already; it took three years studying economics at a university to find the research surprising and worthy of the Nobel prize in economics he received in 2002.

As a result its description of behaviour has been described as ‘autistic’. None of the Rogernomes I know are like rational economic men in their private lives (their marriages would be hell if they were). I mention this to draw attention to the divergence yet again between the world as it is and the neo-liberal account of it.

For the Rogernomes were detached from New Zealand political traditions. Their knowledge of New Zealand history and political theory was thin to non-existent; the public servants had little connection with ordinary New Zealanders and – ultimately – neither had the key politicians who were generally elected to safe Labour seats where a donkey would have been elected with the same majority had the Labour Party put one up (on occasions it did).

The much missed Bruce Jesson said ‘only their purpose is mad’. Certainly the neo-liberal agenda would be judged by most to be bizarre once it was transparent, but much of their analysis was faulty as a consequence of trying to get the real world to fit it. (I have provided a detailed critique of their analyses in The Commercialisation of New Zealand; characteristically the Rogernomes did not take up the challenge it presented to them.)

Rogernomics is Implemented

There is a sense that the Fourth Labour Government was the most revolutionary government since the signing of Te Tiriti o Waitangi. We think of the First Liberal and Labour Governments as being revolutionary but while they dramatically progressed the nation, their framework had roots in the governments before, in the long-held aspirations of most New Zealanders and in the reality of the political economy of New Zealand.

Rogernomics rejected all of this, even to the point it preferred to recruit foreign ideas and foreigners to run the show. Understandably so, for New Zealand ideas, New Zealand evidence and New Zealanders contradicted their beliefs and policies. Neo-liberals knew the truth without fear of contradiction. There was no room for doubt. People who disagreed were obviously wrong, and so measures to eliminate them were justified. The populace might not understand what was being done on their behalf, but when they saw the better outcomes they would come around. Ultimately the Rogernomes wanted to change the way that New Zealanders thought about the world and behaved in it. (The parallels with the rhetoric of authoritarian regimes may not have escaped the reader, but the Rogernomes missed them.)

The promised outcomes never appeared. Per capita incomes were much the same in 1994 as they were in 1984 after dipping in between. Ten years of Rogernomics (including its successor Ruthanasia) were a period of economic stagnation while the rest of the world economy steamed ahead. New Zealand has had five periods of prolonged economic stagnation since 1840 (we are probably in our sixth). The Rogernomics recession is unique in that every other one is associated with poor performance also occurring in the world economy. The Rogernomes brought the stagnation upon us.

Fifteen years on, the Rogernomes have still not addressed this failure. Perhaps it was because their theories say that it could not happen so they did not observe the failures, but another factor was that the fall in incomes did not happen to them. Taxes were cut on the top ten percent of households so their real incomes continued to grow at the same rate as they did when Muldoon was prime minister. The reductions were paid by higher taxation on the lower four-fifths and by cuts in social security benefits and other public expenditure, so the incomes of the rich continued to rise at the expense of reduced incomes for the rest of the population (and inequality increased). The breakdown of social cohesion meant that the Rogernomes and their friends were so isolated from the rest of society that they had no sense of the pain most New Zealanders suffered. In a four year period from 1989 to 1992 about half of the labour force experienced unemployment, but that hardly crossed the Rogernomes’ radar. By undermining social research – which they thought had to be wrong since it demonstrated outcomes their theory said would not happen – the Rogernomes reduced the possibility of monitoring the hardship.

True, many Rogernomes suffered from the 1987 sharemarket bust (as did most modest investors). The boom was an early example of the failure of Rogernomic theories, but the conclusion the Rogernomes drew was that any failure occurred because their policies were not being pursued intensely enough.

Even so their friends and relations were suffering. The neo-liberal rules said the state must not help them out. Not quite. They could be given further tax cuts at the expense of the rest of the population, so taxes on them were further reduced in 1988. And then there was privatisation. Many see the policy in terms of the alienation of public assets to the private sector, others that many of the privatisations were manifest failures in the public interest – the state had to buy back Air New Zealand and New Zealand Rail because of private mismanagement, set up Kiwibank because the private banks ignored its potential customers. It took two decades to unscramble the resulting telecommunications monopoly, while privatisation of safety led to deaths in mines and factories, and privatisation of the building regulations led to 110,000 leaky homes, as well as similar conditions in factories and public buildings, schools and hospitals.

The immediate effect of the privatisations was that the financial sector earned huge fees (mainly paid by the taxpayer) when the assets were sold (and more when they had to be brought back). No doubt the Rogernomes will swear this was not intended, but the record is that the sales policies benefited their friends and relations. (The logic of their analysis was to allow Maori the benefits of the privatisation, but they were not – then – friends and relations so they missed out.)

Any close observer concluded by the early 1990s that Rogernomics had manifestly failed in terms of its own objectives, although journalists would not declare the failure until the economic downturn of the mid-1990s. It was Jim Bolger who put a halt to its expansion, after being tricked by Ruth Richardson into adopting a mass of ineffective policies in the ‘Mother of All Budgets’ (which is why the period is known as Ruthanasia and not Bolgernomics). However it would be the Clark-Cullen government elected in 1999 which would reverse some, but not all, of the most egregious errors (more later).

Nevertheless despite Bolger ‘sacking’ Richardson, there remained a considerable overhang from the Rogernomic past. Many key positions in public life had been filled with Rogernomes – some overt like Don Brash at the Reserve Bank, others covert. Within the National cabinet there were those who had tasted the blood and could not be restrained, while such had been the demotion of the social democrats and their institutions that there was really no alternative except to muddle on.

Rogernomics also changed the political structure of New Zealand. In the Muldoon era there were a range of bureaucratic interventions (such as import licences) which made individual businesses dependent on bureaucratic (and hence political) goodwill. Today business is much more independent of government (although it still demands subsidies from the Treasury). So there is a strong public voice speaking on behalf of the business community (especially the Auckland business community – which very much has the ear of the Key government; its views are frequently expressed via Fran O’Sullivan in the New Zealand Herald.) The business community is privately very dismissive of Rogernomics although it is easy to confuse their demands for greater market freedom with that ideology.

There have been two further institutions which gave the impression to the casual that Rogernomics was thriving.

ACT

One was the Association of Consumers and Taxpayers Party (ACT), which has held a small number of seats in Parliament and occasionally ministerial positions. Its establishment followed the 1993 publication of Unfinished Business by Roger Douglas, which set out much of its underlying agenda for the next two decades.

Despite its homilies the book is a far better argued document than one normally expected from Douglas – it does reflect his concerns – and one cannot help wondering whether there was not only a ghost writer (mentioned in the acknowledgements) but a ghost thinker – possibly Roger Kerr (below). Especially chilling is the so-called ‘Blitzkrieg’ principles, where the book sets out political principles of reform with which Lenin would sympathise; the reformers should capture the centres of power, implement their policies without the consent of the public but in their interest, and they would come on board when they saw the success. (But what if the policies did not succeed? Fortunately democracies prevent the Stalinist stage of development.) A crucial assumption is that the bolsheviks know what are the ‘right’ policies and implement them with total confidence. That is why consultation is unnecessary. But suppose there is a mistake. Suppose they identify the wrong village as enemies; the population could be wiped out before the error is identified. Without any self-correcting mechanism – such as consultation or reference to the facts – the approach was not going to win the hearts and minds of the people, and any errors would magnified rather than minimised. (‘It must be the next village which is against us.’)

ACT was launched promising it had support of over 50 percent of the population, reduced later to 30 percent and more recently to 15 percent. It entered the election campaign when MMP made it possible to win seats in parliament without much electorate support; its average list vote support has been 4.4 percent. That followed after adopting morally conservative policies despite some of its advocates being moral liberals and the figure includes National voters disillusioned with the current state of their party who voted to ACT in 1999 and 2002. Despite National backing their Epsom candidate, ACT obtained only 1.1 percent of the vote in the 2011 election. (Perhaps in part because their principles required them to be led by an ideologically correct, socially inept, political naif.)

Ironically, although its natural inclination is towards an FPP electoral regime, ACT’s political success as a party is a consequence of MMP which was introduced to prevent the elected dictatorship that the neo-liberals exploited. The blitzkrieg strategy was to get elected by sufficient voters to impose their secret agenda without any need to consult. (Even in 2011 its manifesto included an innocuous sentiment on education which after the election proved to be a commitment to the contentious and – on the evidence – ineffective charter schools.) So confused is ACT on electoral reform that despite MMP being in its interests in terms of electing MPs, its 2011 leader supported the SM approach which would give them fewer seats but enables a return to elected dictatorships.

The future of ACT may depend on any changes to the details of MMP, but it is not easy to see, after the 2011 election, it becoming a vital political force in the near future (unless National makes an ass of itself). Their sole MP, John Banks, is more a moral conservative than a Rogernome (indicated by his overtures to the Conservative – i.e. Christian – Party immediately after the election). ACT’s electoral strength has been the funding from its rich supporters rather than from voter support – it spends more per vote than any other party, usually by a generous margin. It is not obvious, given its weak performance, that its private funders will continue to be as generous, although that we should never discount the passion of some of its rich supporters. (The smug rich think their fortune – whether the result of leverage from family inheritance, judgement or luck (and usually all of them) – demonstrates abilities in quite different dimensions; Methodists might remind them they need to unload their camels to get through the eye of the needle – the small postern gate – into the city.)

It is not obvious that the National Party needs the minuscule ACT support (the Conservative Party looks more attractive), although it has continued to tolerate Peter Dunne despite support for United Future proving equally insignificant.

The New Zealand Business Roundtable

The other centre for the advocacy of neo-liberal ideas over the last two decades has been the New Zealand Business Roundtable (BRT). Originally modelled on an Australian equivalent it developed in the late 1970s as an informal meeting place for chief executives of major businesses. (Adam Smith – otherwise much quoted by the neo-liberals – famously remarked that ‘People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public.’) In 1986 the BRT appointed Roger Kerr as its chief executive, who as a Treasury officer had actively promoted neo-liberal policies, and it became more publicly prominent as an active promoter of neo-liberals (rather than business) policies, especially if it thought the government’s resolve was weakening or needed extra support. It proudly claims it persuaded business to pursue policies which were against its immediate interests (yeah right).

While BRT activity did not diminish as Rogernomics fell out of favour, its advocacy became less effective as neo-liberal policies were seen increasingly to be irrelevant, except by journalists. (I once heard a couple of senior businessmen discussing one – not unreasonable – policy which they favoured, but not wanting to be associated with it because it was also being publicly promoted by the BRT.)

The trick of neo-liberal economics is that, like traditionalist economics, it skips over all the complexities and is so easy to understand and expound – even for a journalist. Too often we forget that there is always a simple, easy solution to any problem; and it is wrong.

Originally the BRT membership was chief executives of businesses (mainly industry) but – partly because a number fell (not least because of neo-liberal policies) – membership became more dominated by financial institutions, by the end of the 1980s. Apparently some of the more consumer-exposed institutions withdrew in the 1990s, although some may have returned as the BRT profile fell as the public became less agitated. Today it consists of about 50 members including various honorary ones.

In a certain sense it has been New Zealand’s premier thinktank; generously funded, very active but increasingly marginalised because like Rogernomics it has not been well connected to New Zealand reality. One could say its primary purpose has been to provide a platform for Roger Kerr. (He, not incidentally, was married to the president of the ACT Party).

It is too early to do a full assessment of Roger Kerr, but something can be said about the quality of the BRT’s work. It gets much praise from other neo-liberals but, as Mandy Rice-Davies might say, ‘they would wouldnt they’. There has also been much admiration within the business community although along the lines of ‘it is of high quality but impractical’. However businessmen and women are hardly judges of intellectual quality. There is very little comment on the Business Roundtable reports by New Zealand academics (other than the odd neo-liberal), partly reflecting how unconnected the academy is with public debate.

I have, on occasions, reviewed some of the BRT reports and have been less impressed. Despite the puffery about the expert credentials of the consultants. they were frequently both out of their depth and out of touch with New Zealand. A couple of examples will do.

An Anglo-American with neo-liberals credentials was brought over to support the BRT position on the health changes of the early 1990s. (The redisorganisation proved unworkable, and soon returned to the broad track before health minister Simon Upton got the bee in his bonnet.) It turned out the ‘expert’ knew little about health systems (her speciality was health insurance). At one seminar the pro-public health experts from New Zealand tormented her by arguing from a perspective on her right (that is, for greater privatisation) which totally stranded her because they were not keeping to the script. (A good analyst understands the other side’s arguments well enough to be able to make a fair fist of arguing them.)

On another occasion the BRT hired an Australian neo-liberal to write on immigration policy. I did not think it a great report despite the BRT claims that he was an expert; a little later I was looking at a comprehensive Australian bibliography on the economics of migration – pages of it – and the said Australian export did not have a single entry.

Despite the generosity of its funding, the BRT was never a thinktank in the way that the American Enterprise Institute, the Brookings Institute or their other American and British equivalents were. The BRT was not just insulated from the New Zealand community by the narrowness of its membership and its lack of research, which would have connected it to the society as a whole; it was isolated from the evolving New Zealand economy despite that being the focus of its concerns. That is why so much of the Auckland Business Community turned its back on the BRT; it was no longer talking about the economy they knew.

For the BRT was a thinktank which proselytised with an ideology; there was never any research dimension in its work – it would not even understand today’s notion of empirical research. The most pertinent parallel might be medieval scholasticism in its most restricted form. There was a well-defined orthodoxy based on a set of approved texts, which could be elaborated but could not be subject to the sort of critical analysis that Karl Popper, say, advocated. The orthodoxy was certainly not to be tested against reality; instead the world was to be reinterpreted to fit the texts. The BRT could only dismiss its critics, never engage with them. So it could not progress; instead it vegetated. (Fairness requires pointing out that some left thinking has been equally scholastically stagnant.)

Sadly then, the child of the post-Muldoon (or anti-Muldoon) era never grew up, but kept struggling with the Muldoon demons long after he had died and long after anyone of significance took Muldoon seriously (perhaps a slight exaggeration since both John Banks and Winston Peters might be said to be the last Muldoonists in parliament).

Whatever the limitations of the BRT, Roger Kerr’s extraordinary energy and commitment is impressive. There is a long entry on his blog filed but three days before he died at the end of October 2011 (at the age of 66). Will the BRT be able to recover from the loss of its key player?

Apparently the BRT is proposing to merge with the New Zealand Institute. Ironically, the NZI was established about a decade ago when the Auckland Business Community became impatient with the BRT’s extremism and stagnation and sought its own thinktank (which started out well but which, alas, has slid into a kind of platitudinous management-journalism). The merger is about as logical as ACT linking up with the Christian Conservatives, but indicative how irrelevant the neo-liberals in New Zealand are becoming.

Neo-Liberalism As Zombies

Neo-liberalism has been described as ‘zombie economics’. The end of ACT as a neo-liberal party, or the BRT as a neo-liberal think tank will not finish off neo-liberalism in New Zealand nor anywhere else; its living-dead will continue to haunt us.

The Global Financial Crisis has persuaded but few neo-liberals that their theory is wrong, even though on objective grounds it is hard not to conclude that the application of the neo-liberal principles has been a factor in the crash, while it was neo-liberals who once celebrated the financial boom’s success as the sober worried about its sustainability. (Among those who have retracted, at least to some degree, are Alan Greenspan and Richard Posner.) Instead, the more competent neo-liberals have been almost silent (sometimes providing helpful critiques when the critics have got it wrong), although there are numerous duffers trying to defend the indefensible, typically by misrepresenting the facts or the critics (but they have had a lot of practice doing that). The challenge the world faces is that beneficiaries of and believers in neo-liberalism are riddled through the institutions that matter and are unlikely to change their minds.

That does not mean that a new paradigm will soon replace the neo-liberal one. It is likely to be based on the old orthodoxy – sometimes called neo-Keynesianism, sometimes ‘saltwater’ (an allusion to the main American advocates being from universities on the eastern and western seaboards of the continent whereas the ‘freshwater’ neo-liberals came from inland universities). I rather liked Christine Romer – sometime adviser to President Obama – who eschewed such categories and said she was driven by the empirical evidence; neo-liberals are rarely evidence driven. (Another division is those who ‘calibrate’ – that is make the facts in their models fit their theories – and those who ‘estimate’, that is, who test their theories against the facts. The division is almost exactly freshwater versus saltwater.)

A Social Democrat Revival?

While this battle rages overseas the New Zealand left is faced with the challenge of renewal too. Neo-liberals may be zombies but every reader of thrillers knows that is not enough for social democrats to triumph. Neo-liberalism has been a much more fearsome opponent than the conservatism that the left faced in the nineteenth century. The likelihood is that in due course – perhaps after they open themselves up to the evidence and criticism – there will be some sort of neo-liberal revival. The traditional battle of radicals versus conservatives may be a thing of the past, or at least cut across by radicals of the right versus radicals of the left.

If trends continue, today’s left may continue to drift into the irrelevance that its traditionalism offers. Certainly its concerns of foreign policy, civil rights and social diversity are very important but over half the respondents to a survey just before the 2011 election said their main concern was the economy or one of its manifestations of failure, such as unemployment. (Expect the proportion to go up during the next three years.) Adding poverty and inequality to the traditionalists’ concerns does not help much unless there is a coherent explanation of how they occur and how to address them. Nor is adding a spiritual concern with the environment of much use unless there is a robust analysis of how the economy impacts on the environment. So we are back to a social democratic analysis.

Ultimately social democracy is a radical modernising vision. Yet there are only a the handful of battered and tattered remnants, who have desperately clung on after the traditionalist and neo-liberal assaults. There is a need for recruits and for a renewed vigorous vision more rigorous than uninformed but hopeful post-modernism (which may be characterised by its lack of attention to evidence in a manner similar to neo-liberalism). What are the key points which form the necessary framework of the social democratic analysis?

First, modernisation is an ongoing process whose need did not finish at some mythical date in the past – like 1938. (That means there is a need to know a bit of history.)

Second, the left analysis has to be symbiotic with the social sciences. Not in their post-modernist form which is as antagonistic to empirical analysis as neo-liberalism. That means following closely those who anchor the theories in an empirical reality and not – like the neo-liberals – ignoring or misrepresenting anything that is inconvenient.

Third, the left needs to stay in touch with – indeed closely follow – the social democratic debates which are occurring overseas, but it also needs to adapt them for New Zealand circumstances, rather than facilely imitating them. The colonial cringe has not been confined to neo-liberals.

Fourth, the left needs to reconnect with the whole of the New Zealand community and not to isolate itself, as did the neo-liberals, in the narrow – and almost uncertainly unrepresentative – community in which individuals live. An empirical based social science is a way of connecting to the whole society.

Fifth, it must tolerate, and even promote, intellectual diversity and dissent – unlike the neo-liberals and, sadly, too many traditionalists. While many dissenters prove wrong – and some go on obsessively long after they are proved wrong or proved that they have misunderstood the issues – some dissenters, often those who have been following the first four principles most closely, are reporting developments which the conventional wisdom will identify long after, and – of course – without acknowledgement of the pioneers.

Finally there is a need to develop institutions where social democrats can function. There is not going to be the generosity of the magnitude of those who funded the BRT; how sad so much of it was wasted on useless theories. (In passing one much admires those who support Murray Horton as the CAFCA organiser, but I suspect that Murray lives more frugally than most BRT acolytes.) Equally sadly any support from the universities – which once fostered the social sciences, modernisers, social democracy and debate – is likely to be accidental and small.

The evidence of recent months is not so much the diminishing of the New Zealand institutions which may promoted neo-liberalism; that process has been going on for two decades. (In any case the overseas neo-liberals remain active, well funded and vociferous despite their ineffectual response to the course of the Long Recession following the Global Financial Crisis). The real message is that the electorate has firmly told the Labour Party it has little confidence in its vision – if it can discern one.

Deduct Labour loyalists – the core vote which is diminishing over time – and the number of those who supported Labour actively must be pathetic. Some of the potential support voted Green in despair; others in their despair resorted to the apathy of not voting.

Indicative of the dilemma the left faces is the fate of the Clark-Cullen government which reversed some of the extremes of Rogernomics early in its term, but afterwards ran out of a vision or a program. The successor Key government has adopted more of the Clark-Cullen agenda than either side would admit – but it knows how to run better parties.

It is too easy to argue that the National Party has a secret neo-liberal agenda (a consequence of the neo-liberals secretly preparing to implement a blitzkrieg). There may be a handful of neo-liberals in it, while sometimes business interests advocate policies which sound neo-liberal but need not be; they will pursue others in their interests which are the opposite (the residual of neo-liberals are fuming over the broadband roll out).

Basically Key leads a business government heavily influenced by the social democrat innovations of the past – if more concerned with private sector solutions than public sector ones, more with the rich than the poor.

But while governments of the right may adopt past social democratic innovations, both by nature and by the interest groups they nurture, they will not progress them much. The likelihood is that the Key government will be too timid to address the evolving issues facing New Zealand including big ones like globalisation, social inequality and the environment as well as a myriad of smaller issues.

The danger remains that there may be a repeat of Muldoon’s legacy in which a future government of the left has to introduce major radical modernisation to resolve its predecessor’s failures to respond to change, while handicapped by the limitations that these failures cause. Will the incoming government be as bereft of analysis and vision as the left was after Muldoon? Last time the consequence was Rogernomics.

Don’t Privatise Without Regulation

Listener: 14 April, 2012.

Keywords: Business & Finance; Regulation & Taxation;

Last year, this column argued for the mixed-ownership model of some state-owned enterprises as a means of deepening the capital market for private savers. Even then, it argued that not all partial privatisations were sensible. It depends on the market structure and the way it is regulated. The lesson was ignored 20 years ago in the rush to sell off state trading assets. We still suffer the consequences.

The British took considerable trouble to prepare their privatisations, including paying attention to market regulation. The New Zealand Telecom privatisation bill was rushed through Parliament in the dead of night, without any consideration of the regulatory environment. For two decades the monopoly plundered consumers while the New Zealand tele communications sector fell behind the rest of the world. At last we have separated the network arm (Chorus) from the services arm (Tele com).

Meanwhile, commuters in some urban areas still suffer because the privatisation of public transport left a number of providers and no seamless transition between them. We still have not learnt. The proposal to partially privatise the state-owned electricity companies may be repeating the regulatory blunders. We have been fiddling with the industry structure over the past decade.

Last year Genesis took over the Tekapo power stations from Meridian, at the Government’s direction. The industry structure is hardly stable. A particular issue is the feed-in tariff to the grid by small suppliers – households, businesses, farmers – who produce renewable energy from wind generation, biomass and solar sources. New Zealand is behind other countries. Some argue that New Zealand seems very backward, that failing to set a mandatory tariff for feed-ins from small suppliers gives too much power to big producers.

Others argue that some countries subsidise their small suppliers at the expense of higher prices to consumers. We also seem to be a bit backward in smart metering, which will give households better control over their electricity usage (that is, lower overall prices), although widespread adoption of the metering may just be a matter of time. Why, then, go ahead with the partial privatisations when the sector remains in regulatory uncertainty? Why especially when it seems likely, according to the Treasury, that the sale prices will be too low to cover the loss of profits to the Government?

This is not an ideological Government, I think, although some will see the mixed-ownership model as a step towards full privatisation. However, like every government, this one is beholden to its political backers, which include the financial community that will be a beneficiary from the deals that go with the sale. Is the Government repeating the post-1987 strategy of supporting the business sector by hasty privatisations (except this time it is helping them not because of a sharemarket crash but because of the stagnation from the global financial crisis)?

As in the case of the Telecom privatisation, not all businesses will benefit. Some grumbled greatly – I would say, justifiably – over the high prices and poor service the botched privatisation generated. Something to be repeated? There is a danger that careless privatisation will fossilise the industry, as has already happened with the ports. Given the increasing size of ships and their need for deeper ports, structural change is inevitable. Co-ordination of the development is blocked because of the differing ownership of the ports of Auckland and Tauranga as a result of hasty privatisations.

Suppose we decide in a few years’ time that the electricity industry structure is still wrong. Partial private ownership would add to the rigidity of the structural change, as it has done with telecommunications and is doing with the ports and urban commuting. This time, the partial privatisation bill will go before a select committee of Parliament (thank you, MMP). There should be at least one report on the regulatory framework.

Until Parliament is satisfied about the market environment of the electricity sector (or that privatisation will not delay progressing it), the bill should not proceed. Margaret Thatcher was right: get the regulatory framework of the sector robust before you privatise.

Light Regulation Has Failed

Listener: 31 March, 2012.

Keywords: Regulation & Taxation;

It would be wrong to prejudge the findings of the royal commissions on the Pike River coal mine deaths and the Canterbury earthquakes. But it’s still a good idea to respond promptly to the available evidence and take necessary measures, as the Department of Labour did by setting up a High Hazards Unit (especially as the commissions’ reporting times have been delayed by six months).

In that spirit I draw attention to a wider problem of which these events are examples. Governments have repeatedly failed to regulate markets adequately, a conclusion backed up by numerous other examples. To list but three: the finance company collapses have been attributed to a failure of adequate regulation – Parliament has passed legislation to supervise the sector better (shifting responsibility from the Securities Commission to the Reserve Bank); as many as 110,000 homes and many public and commercial buildings have been caught up in leaky building syndrome, which is a failure of just about the whole building industry; and our high rate of industrial accidents is commonly attributed to inadequate safety inspection.

It is hard enough to quantify the financial losses of these failures. More difficult (and usually more pertinent) are the wider human costs, which may include death and injury and almost always include misery and suffering. The generic cause of these failures, and of many others, has been the “lighthanded regulation” regime that began in about 1990 and which is based on two assumptions.

The first is the belief that the private sector, left to itself, will adequately police safety and quality standards. Businesses will be careful, so it is assumed, to avoid reputation damage and embarrassing court cases. The Pike River Mine exploded that logic: the company that owns it is bankrupt, and the court proceedings and lost reputation count for nought. But this is also true for leaky buildings, where many builders and other culpable parties have long disappeared before their loss of reputation or court proceedings begin to bite.

The second assumption is that because the private sector can be relied on, any public sector supervision can be wound down at a saving to the public purse. Except that when things go wrong, taxpayers find themselves forking out vastly more than the cost of that supervision (and the public also bears considerable non-taxpayer costs).

If this seems extravagant, surveys show New Zealanders are willing to pay almost $4 million to avoid an accidental death. (That may seem a large sum but it’s only about 85c a New Zealander.) On this basis, we would have been willing to pay about $110 million to avoid the 29 deaths at Pike River, say $11 million a year. We didn’t. Each failure inevitably leads to an inquiry that usually concludes light-handed regulation has failed and we need more public regulation.

Eleven people died in a balloon crash, so we decide to inspect all hot-air balloons. We are world experts at shutting the door after the horse has bolted. Stable doors remain swinging loose. What is there to prevent something similar to leaky building syndrome happening in the construction industry in future? In other markets public regulation is feeble and catastrophe is yet to come. We need to break away from the lighthanded regulation mentality and instead have a coherent policy of adequate public regulation of markets.

It won’t stop every death and all the destruction, but it can minimise them in a cost-efficient way. The Regulatory Standards Bill before Parliament aims to improve laws and regulations by specifying principles of responsible regulatory management. Many see it as ideological because it may block state supervision, leaving regulation even more in private hands. No doubt Parliament will address that question.

Let me offer a modest proposal. MPs should judge the bill on the basis of whether, had it been in force from 1990, it would have stopped (or limited) the human suffering and capital destruction from the finance company collapses, from the leaky building fiasco, from industrial accidents, from the Pike River disaster, from the Canterbury earthquakes and from a lot of other smaller failures as well.

New Zealand Should Tax Financial Transactions

Listener: 17 Match, 2012.

Keywords: Macroeconomics & Money; Regulation & Taxation;

Eminent economist James Tobin in 1972 suggested a financial transaction tax on spot-market currency conversions. Many others have supported him. That includes people who don’t like money and think of a financial transaction tax as a sin tax. (Tobin certainly did not. He was awarded a Nobel Prize for contributions to monetary theory; he knew money was necessary for the specialisation that gives a high standard of living.)

Others saw it as an easy way to raise tax revenue; it is not. They thought it would raise huge quantities of revenue; it won’t. A number of our minor parties support some sort of financial transaction tax, but they overestimate the revenue it will raise and underestimate the complexity of its application.

Tobin’s concern was that there was an imbalance in the speed of transactions between the real (production and expenditure) economy and the financial sector. Many of the economic management changes of the past few decades have been aimed at speeding up the real economy, but people are not going to change their jobs every minute or two – and that would be very slow in some financial markets.

My thinking is influenced by the extraordinary fact that trading in the New Zealand dollar is far out of line with the size of our economy; by some measures it is the most extreme of global currencies. The financial sector will argue that it contributes to the economy in terms of jobs and profits. So does the Cosa Nostra. Does that mean it makes a positive contribution?

Recent events suggest that although the financial system carries out many useful functions, some of its activities amount to gambling with other people’s money – profiting from charging the client, not from taking the risk. When it all turned to custard, the financiers were hardly exposed; when they were, they expected the taxpayer to bail them out.

It’s not unlike what is happening in cricket. A 20/20 match may be a spectacle, but it is driven by betting, for which this form of the game offers a wealth of opportunities. Many gamblers are offshore, but the consequences are onshore. I am not against 20/20 cricket, although many commentators think the shorter game damages serious cricket and regret that distortion.

Likewise gambling on the New Zealand dollar probably undermines New Zealand business outside the financial system. A low turnover tax will discourage some gambling excesses, making the financial system more efficient and effective. About 1000 economists – some as eminent as Tobin was, some as lowly as me – have signed a petition supporting a financial transaction tax.

Recently the European Union proposed adopting one. The great financial centres of London and New York are strongly resisting the idea, and their East Asian equivalents are not showing much enthusiasm either. In January, French President Nicolas Sarkozy announced that France would impose a tax on high-frequency trading, at a rate of 0.1%. He expects it to raise ?1 billion a year (a New Zealand equivalent would bring in about $170 million).

The new tax will cut the French deficit and Sarkozy hopes other members of the European Monetary Union will follow. A financial transaction tax works best if applied by a large block of countries; it would be foolish for a tiddler like New Zealand to go it alone. Instead we should be a “fast follower”, so when the EU introduces one we should do so soon after, as far as possible aligning our tax coverage with Europe’s. And we should encourage other countries to join us.

Hopefully, in the depths of the bureaucracy, a small team is pondering such a tax for New Zealand. They have probably already concluded it won’t generate a lot of revenue – perhaps $100 million after the clumsy stamp duties are abolished – although any extra revenue would be welcome. More importantly, it would reduce some of the dangers that high-spinning financial transactions expose the economy to. And it would do so without wrecking the constructive contribution to prosperity that specialisation provides.

A Canterbury Earthquake Levy Would Be Prudent

Listener: 3 March 2012.

Keywords: Macroeconomics & Money; Regulation & Taxation;

Forecasts for the New Zealand economy have been wound back since last year. Given the deteriorating state of the world economy, they will probably be wound back even further. And that’s going to make it even harder for the Government to meet its election promise of having its accounts in surplus by 2014/15 – tax revenue will be down and unemployment and hardship up. The forecasts depend on reductions in public spending. However, too-rapid cuts to core government spending reduce the capacity to deal with unexpected issues.

The Government is already embarrassed by revelations of past failures in civil defence (the Canterbury earthquakes), immigration (Kim Dotcom), marine management (Rena) and mine safety (Pike River). Cutting the incomes of beneficiaries, families with children, savers and students, just as hardship increases, would not be a good political look.

Meanwhile, the bill for the Canterbury earthquakes continues to grow. Here, as elsewhere, the Government contrives to make its accounts look stronger than they actually are by deferring decisions. Too often it fails to face up to the challenges, partly reflecting the desperate shortage of ministerial leadership, but also because of a tendency to substitute optimism for intestinal fortitude. The resulting problems accumulate and compound.

What are the options for the May 2012 Budget? The easy course is to hope that things don’t deteriorate further; if they do, panic measures may be necessary by the end of the year. This could mean cuts in spending to achieve the desired short-term Budget outcome, which could be politically and economically disastrous in the long term. Another strategy is to abandon the 2014/15 Budget surplus target. This would be best done by steadily lowering public expectations. The Prime Minister’s January state of the nation speech could have been the beginning of this campaign.

Scrapping the top plank in an election manifesto is always painful, but there are technical reasons for doing so. Failing to act would once again be putting off hard decisions that may create severe damage for the Government by the next election. The Reserve Bank would have to tighten monetary policy earlier than expected to offset the loose fiscal stance. On top of that, this would reinforce international doubts about whether New Zealand is on a sustainable debt path, increasing the likelihood of further – and increasingly painful – credit downgrades, with their higher interest rates.

Prudence suggests the Government should be developing a backup strategy. One possibility is a Canterbury earthquake levy, a surcharge of, say, 3% on each person’s income tax bill. The levy would be used to pay off the government’s earthquake expenses that couldn’t be recovered from insurance and the like. There would be a special account to which these expenses were charged (including those already incurred); proceeds from the levy would be credited to it as long as the account was in deficit – probably for at least 12 years.

The public narrative would be that, earthquake to one side, the government accounts are on track. Rather than overreacting to the shock of the quake and deviating from its path, the government, by introducing the levy, would be making separate provision and spreading the cost over time and according to people’s ability to pay. It would do the same for other large catastrophes – if, say, a volcano erupted in Auckland – so everybody has an interest in this kind of solution.

To the credit rating agencies and those lending us money (including rolling over debt), the message would be very similar (avoiding the forked tongue, for a change): Government spending and taxation is on track for the desired surplus, with steady efficiency-improving cuts to spending; you wouldn’t want to penalise New Zealand with higher interest rates for something entirely out of its control, and which is being addressed in a prudent and fair way, would you?

The alternative? Hopeful thinking, followed by panic and damaging measures.

The Course Of Prices: 1860 to Today

An appendix for Not in Narrow Seas: New Zealand History from an Economic Perspective

The work was funded by a grant from the Reserve Bank of New Zealand which is not responsible for any errors or interpretations. A version was presented to an RBNZ seminar on 1 March 2012.

Keywords: Macroeconomics & Money; Political Economy & History; Statistics;

This appendix is primarily about the course of the level of various groups of aggregate prices. Historically economic historians monitored prices because they were readily available, while measures of output were not, although the sophisticated theory of the construction of price indexes is more recent, as are modern theories of the determinants of prices.

Price comparisons – over time (or between locations) – are more complicated that the casual way we often make use of them; consider comparing the price of today’s car with that of a car a hundred years ago. Price indexes (which involve the aggregation of prices) have the additional complication of changing patterns of consumption with new products entering and old ones leaving – there were no cars two hundred years ago while horse and buggies hardly exist today. Add to these deep conceptual issues, that the early data are rarely collected in a systematic way. (Meanwhile technicians will grumble about the treatment of durables, especially housing in the consumer price index, and borrowing costs have varied over time). Despite all these caveats, the overall pattern of price change over the history of New Zealand is clear enough, providing we dont insist on accuracy to the last decimal point.

New Zealand price indexes go back 150 odd years to about 1860. We shall look here at those for imports and exports, and for consumers. Additionally we add the GDP deflator (GDEF) which goes back to 1914/5, explaining below why for some purposes it is a better indicator of price changes that the Consumer Price Index (CPI).

The Course of External Prices: New Zealand and British External Prices

Because New Zealand is a small dependent economy, we begin with comparing the New Zealand experience with that of Britain, because it was the main source of imports and destination for exports for most of New Zealand’s history. The comparison ends in 1971, when the New Zealand currency disconnected itself from sterling following the Smithsonian upheaval when the world ended any pretence that it was on a gold standard. By that time Britain was becoming a less important economy to New Zealand.[2]

A natural comparison is to compare New Zealand import prices (the indexes go back to 1861) with the British export prices. Since the products ought to be of roughly comparable composition, we might expect the two move in parallel in the long run. However as Graph II.1 shows the relative price of British exports to New Zealand imports roughly halved between the mid-nineteenth century and the mid-twentieth.[3] It is such a dramatic change one might wonder if it is part a statistical artefact, although other than that the nineteenth century New Zealand import price indexes are not that reliable there is no obvious explanation. [4] In any case the fall seems to continue after 1914 when an official import price index cuts in.

Since prices are measure at the wharf of arrival, the two price sets are not quite comparable. Either transport costs (freight and insurance but also holding costs) should be deducted from the New Zealand import prices (at the New Zealand wharf) to compare them with British export prices (at the British wharf) or the transport costs should be added to the British prices.

Now there have been dramatic improvements in transport – the switch from sail to steam, the shorter route through the Panama Canal, the greater reliability of the trips, improved handling on wharves, and so on – one might expect the ratio of New Zealand prices (on its wharves) to British prices (on its wharves) to fall. But that dramatically? It is noticeable that from the 1930s there appears to be little reduction – did containers have only a marginal effect? Perhaps there is a composition effect which is not being allowed for.

To add to the puzzle Graph II.1 also shows the New Zealand export prices relative to British import prices has been constant.[5] In this case the composition of the two indexes is quite different, since New Zealand was a specialised exporter to Britain while Britain imported many other products which New Zealand did not provide. However when the British import prices are confined to food only (including grain) the patterns remain much the same.

Assuming that there was some fall in transport costs too, the implication is that the prices for New Zealand exports (mainly pastoral products) was falling relative to the price of most British imports.

The Terms of Trade: The Balance Between Export and Import Prices

The ratio of export prices to import prices (measured at the same wharves) is called the (commodity) ‘terms of trade’. Their importance arises from the purpose of exports is to earn foreign exchange in order to the purchase of imports. If the relative price of exports goes up (the terms of trade rise) the foreign exchange earnings from the same volume of exports can purchase more imports. Insofar as imports are vital for prosperity, a rise in the terms of trade is greatly beneficial to the economy.

Note that New Zealand has little influence over its terms of trade (an exchange rate change changes the New Zealand value of the export and import prices by the same proportion so their ratio does not change). That means practically they may be treated as exogenous for analytic purposes.[6]

As Graph II.2 shows there is considerable year to year fluctuations. To assist interpretation a nine year moving average is also shown, but that still shows some cyclical fluctuations . Additionally four trends are imposed and are discussed below. An overall conclusion might be that the much of New Zealand’s economic performance is driven in part by the terms of trade.

(Until the mid 1980s, about half the time the actual terms of trade are at least 10 percent from the shown trend lines. Given that exports are about a third of GDP, this means that about a quarter of the time national income adjusted for the purchasing power of imports is about 3 percent or more than in simple production terms, and about a quarter it is 3 percent or less. Given that normal per capita growth is about 1.5 percent a year, the New Zealand economy experienced violent fluctuations from the changing balance between export and import prices.)

Nineteenth Century to about 1908

Graph II.2 shows a rise in the terms of trade from the 1860s to 1908 – an increase of about 36 percent in 42 years, a not inconsiderable gain (say a 12 percent boost in income relative to production). As it happens this is a period of relatively strong growth of the New Zealand economy (aside from the stagnation of the Long Depression). It is instructive that the peak tends to be in the middle of the first decade of the twentieth century when other indicators also suggest New Zealand went through a climacteric.

1908 to 1949

From 1908 the rising trend reverses although the decline is not quite as steep. There is a problem of just how to interpret the end of the 1940s, perhaps because the pattern is about to change. (We shall meet the same problem in regard to the early 1980s.) But if we think of the decline continuing then, by the end of the 1940s the terms of trade were similar to the level of about 1880. That is a fall of around 20 percent. That is consistent with the period largely being one of economic stagnation, the post-recession and war boom aside.

(There is a possible alternative interpretation of the terms of trade up to 1950, in which their trend is flat – or even slightly falling – except there is a lift between 1895 and 1908, followed by a fall back to the previous level by 1921. That possibility is also shown in Graph II.2)

1950 to 1985

Perhaps the best explanation for the level in immediate post-wear era is that, although it did not seem so at the time, post-war affluence was underway, but inertia initially depressed the prices for New Zealand exports relative to its imports. The Korean war triggered a readjustment unleashing the demand for New Zealand pastoral products, thereby lifting the terms of trade.

In any case, the terms of trade leap up in 1950 in a way which at first was not too different from past experiences. However this time they did not as quickly collapse, the decline was much more slowly, through to the early 1980s – back to a level similar to the late 1940s. In the early 1960s the terms of trade will still above the 1908 trend peak (although there had been a bit of a panic in the later 1950s when there had been a cyclical downturn of export prices).

From about the 1970s, New Zealand’s pattern of exports underwent a major diversification (Chapter 3X) which is part of the explanation of the diminishing violence of the fluctuations. Before then the vast majority of exports by value were pastoral products.

The diversification complicates the interpretation of what was going on in the early 1980s, where there appears to be a flat bottom, perhaps waiting for a turn-around similar to the late 1940s.

1985 to 2010

After hitting the bottom in the early 1980s, the terms of trade began to rise again. (The reasons are discussed in Chapter XX but, briefly, the world had gone into a new phase with the rise of hungry industrialisation in East Asia.) By 2010 relative export prices are back to where they were in the mid 1950s (although this time was it was dairy prices rather than wool which led the way). That was about a 30 percent gain, lifting incomes by about 10 percent more than production from the nadir of the 1980s.

Probably because of the diversification there is a decrease in the fluctuations about the trend. Between 1985 and 2010 the terms of trade were only once more than 10 percent away from the trend – in 1989.

In summary, the terms of trade have been one of the main drivers of the New Zealand economy. Their short term fluctuations were a source of fluctuations and cycles in the New Zealand economy, but they also had a longer term effect, for the additional income they created or destroyed affected not only consumption, but savings, capital formation and, hence, productivity growth.

The Real Exchange Rate: The Balance between External and Internal Prices

(A matter of definitions: the discussion in this section divides the economy into the tradeable sector and the non-tradeable sector. The tradeable sector consists of those industries whose products can be sold overseas (although some will be consumed in New Zealand) or produced overseas and sold here. Traditionally the tradeable sector has been the primary (e.g. agriculture, fishing forestry, mining) and secondary (manufacturing) sectors, although nowadays it includes some services (called ‘tradeable services’) such as tourism, but also IT services, consultancy and some education (e.g. students coming to New Zealand). The non-tradeable sector generates products which can be neither exported nor imported. It includes most of the service sector, including government and personal services and internal transport. Formally the real exchange rate is the relative price of non-tradeables to tradeables, although as the final paragraph of this section explains it has been necessary to fudge this definition because of measurement limitations.)

It is possible to construct a Real Exchange Rate back to 1960. It is shown as Graph1rex. The story it tells is that the rate was reasonably constant until 1985then increased in a leap by 50 percent, and seems to have been rising secularly since to a level double that of the 1960s and 1970s. The leap is at the time when the exchange rate was floated. (A complication is that we cannot allow for changes in import protection and export subsidisation which would increase the difference between the pre- and post-1985 level further.)

We cannot tell from this whether the earlier period from 1960 to 1985 or the later one from 1986 to today is unusual. A rigorous measure of the real exchange rate is not available, so we shall have to use less satisfactory one. [7]

The longest available index of internal prices is what is loosely called the Consumer Price Index, although before 1948 it went by other names, such as the Retail Price Index, indicating that there were conceptual differences in its construction. Even after 1948 there have been changes to the treatment of housing and credit which probably means that the index is not quite consistent after that either (Additionally the changing composition of the regimen – the ‘basket’ – as new products are added and old ones deleted and as the weights change, add to the complexity of consistency over time – but this is an integral problem with any price index.)

The official CPI (and its predecessors) was introduced following the 1912 Royal Commission on the Cost of Living, and entered the popular consciousness from about 1920 as the Court of Arbitration began using it in its wage setting. As a consequence it has a public significance far in excess of its economic importance.[8] It covers only about 60 percent of total expenditure, omitting investment and public sector spending. Not all of the prices in that 60 percent are set by New Zealand suppliers, since up to 40 percent (i.e. up to 24 percent of aggregate expenditure) is consumption goods and services sourced from overseas with their prices (or contribution of price to final product) set there.

A further complication is that indirect taxes are usually designed to impact more heavily on consumption spending than on other activities like investment and exporting. Additionally, the external price indexes are not adjusted for border protection nor for export subsidies.

While an expenditure based index is useful for looking at changes in the spending power of New Zealand incomes, it cannot fully reflect the prices which New Zealand producers set. A better measures of those prices set is the GDP deflator (GDEF).

Because GDEF measures the price of value added, it does not directly include import prices. If a producer uses imports, the price in the index is the margin between the price (unit value) of the final product and the price of its import content. If a producer sets its output price to align or be competitive with import prices, then import prices indirectly affect GDEF. [9] A similar argument applies to exports. GDEF includes the price of exports set (or taken) by New Zealand producers, even though the final product may not be consumed in New Zealand.

GDEF is available from March year 1915. The CPI is available from 1861 so Graph II.3 includes them both. [10] That they do not exactly correspond indicates that from year to year consumer expenditure and production prices are not closely aligned, and the CPI is not a very good indicator of producer price setting. [11]

Graph II.3 also shows the balance between internal prices (GDEF or CPI) and external prices as well as Rex. In each case the level of external prices is measured by a weighted (harmonic) average of export and import prices.

A lower ratio means that external prices are relatively higher than internal prices (which is a price signal to export and import substitute). That situation occurred in the period of the Great War and in the post-war period to the end of the 1950s. Especially discouraging conditions for tradeable production was in the 1930s and late 1960s and 1970s.

However the period of greatest discouragement has been since 1985. Either ratio (of GDEF and CPI to the tradeable index) has been higher than at any time in past – even when it was at its lowest in 2001.

More refined analysis might allow a rising trend in the ratios reflecting that the productivity gains in the non-tradeable sector are generally – but not always – lower than in the tradeable sector. (Examples of where gains may be high include telecommunications and transport.) Even so, after 1985 the ratio of non-tradable prices to tradeable prices is considerably higher than can be explained by this.

The New Zealand dollar was floated in March 1985, breaking the traditional linkage between tradeable and non-tradeable prices. In the past New Zealand had been subject to a borrowing limitation because the majority of the borrowing had been done by the government who were subject to close scrutiny and strict disciplines. Under floating, the private sector no longer had to obtain the foreign exchange it wanted by earning it (or from the government) but could directly go borrow offshore (or through the trading banks). Now there was no need to earn it by exporting (or save it by import substitution). Given there were not the need to provide the same incentives to earn and save foreign exchange, the economy reduced the price of tradeable relative to the of non-tradeables, and so the ratio rose. The way it does this is by the exchange rate appreciating. The consequences belong to the main narrative.

The Consequences of a High Real Exchange Rate

The standard trade model shows that a higher real exchange rate causes a greater production of non-tradeables relative to tradeables; that is the economy exports relatively less and does relatively less import substitution. (A consequence is that aggregate productivity will grow more slowly.)

The same standard model can be elaborated to show that when there is full employment a high real exchange rate is associated with a overseas borrowing and a low real exchange rate is associated with overseas lending, although it does say which causes which (and indeed it depends on the economic management regime).

The implications of the high real exchange rates of the floating exchange regime have yet to be fully explored.

The Course of Prices

Earlier we used two indicators of economy-wide prices: GDEF, the price of New Zealand production , and CPI, the price of consumer expenditure. Their level, since when they became available, is shown in Graph II.4 (which uses a ratio or logarithmic scale so that equal distances on the vertical axis represent the same proportional increases). While a trained eye can see patterns, evident to all is the enormous change in the price level – 86 times between the bottom in the 1890s to the top in the last year (2011).

An alternative is to look at the annual changes. They are showed in Graph II.5, as a three year moving average. This period reflects the sort of horizon that current economic policy thinks about inflation. (Note that historically there has been a lot of volatility on the three year moving average – some may be a consequence of measurement error.) Current policy settings suggest that we might interpret the range of 0 to 3 percent p.a. ( averaged over a three years) as periods of ‘low inflation’. If so we can identify the following broad periods.

Up to about 1900: Disinflation

This was a period of disinflation (falling prices) parallelling falling prices in Britain. Prices fell at a rate of 1.2 percent p.a. in the 38 years from the beginning (1861) to the nadir (1899).

From about 1900 to 1935: Low Inflation with Interruptions

The first third of the twentieth century was a period of low inflation with two major interruptions.

The first was the Great War and its aftermath (from about 1915 to 1920) which was a period of high inflation, although consumer prices rose faster than producer prices (because import prices – driven by British inflation) – rose dramatically) and then fell more sharply. The second interruption was the Great Depression when there was for a few years of severe disinflation.

1935 to 1966

In this period annual inflation averaged about 3 percent so it was right at the top of the ‘low inflation’ range. It is noticeable that GDEF and the CPI do not track as closely as at other periods, probably because there was a conscious effort to suppress consumer inflation, although the suppression tended to delay rather than eliminate consumer price rises. (Chapters 28 and 30). There was a second bout of higher inflation after the war with producer prices – mainly export prices – leading consumer prices, but inflation settled down into the low inflation range in the late 1950s and early 1960s.

1966 to 1992: The Great Inflation

For much of the period inflation was persistent and high, running at ‘double digits’, that is exceeding 10 percent p.a. Over the quarter of a century the consumer price level increased more than 11 times, considerably more that the three times in the 105 years between 1861 and 1966.[12] Indeed they increased three times between 1966 and 1978, and trebled again between 1978 and 1987, and the great inflation was still not yet exhausted.

While other OECD countries experienced similar high inflation in the early 1970s (Graph II.3), they soon had in under control, while New Zealand prices continued to inflate. Chapter 3X argues that New Zealand’s exceptionalism followed the collapse of wool prices in 1966 which severely disrupted the economy; inflation was a consequence of the clumsy – and prolonged – adjustment. New Zealand came out of its great inflation with its prices almost doubled (1.8-1.9 times) relative to the weighted OECD average.

After 1992: The Great Moderation

New Zealand returned to a period of low inflation – a little lower than the OECD weighted average.

Appendix: The Data Series

British Import and Export Price Series

B. R. Mitchell (1988) British Historical Statistics, p.526-527. (December years)

The food and import price index was based on data in the tables on pages 456-8, 521-3, 767.

New Zealand Export and Import Price Series and Consumer Price Index (CPI)

Statistics New Zealand Long Term Data Series:

http://www.stats.govt.nz/browse_for_stats/economic_indicators/nationalaccounts/long-term-data-series.aspx,

updated from the Statistics New Zealand current data base.

(December Years)

New Zealand Gross Domestic Product Deflator (GDEF)

1914/15- 1954/5: B. H. Easton (1990) A GDP Deflator Series for New Zealand: 1913/4-1976/7. (Equation 2).

1954/5 – : Ratio of nominal to volume GDP.

(March year data. For the purposes of comparisons with the other series, the March year data is treated as the data for the preceding December year – the OECD has a similar practice.)

OECD CPI [14]

An equally weighted average of the American Australian, British, Japanese, G7, OECD Europe and OECD all price increases.

http://stats.oecd.org/Index.aspx?querytype=view&queryname=221

(December Years)

Endnotes

[1]  Noting that some New Zealand imports and exports were shipped through Australia, and that while Australia was a major source of imports, its prices were dependent upon British price levels.

[2]  A later section compares the New Zealand CPI with a weighted OECD one since 1969.

[3]  The New Zealand index is converted into sterling where the currencies are not at parity.

[4]  I constructed the indexes, so I know.

[5]  Gold is not treated as an export for these purposes. It is frequently left out of export price indexes because specie movement is treated as a capital flow (although perhaps newly recovered gold should be treated differently).

[6]  The minor caveats are that it is said that import licensing encouraged long established suppliers not always to source the cheapest import, while the SMP subsidies for mutton (in the early 1980s) led to over-supply which reduced export prices. Both effects reduce the terms of trade but probably not by much. A more significant possibility is that protection of manufactures restricted supply of farm products which, given New Zealand had an significant share of supply into some markets may raise export prices.

[7]  Formally the real exchange rate (REX) is the ratio non-tradeable prices to tradeable prices. This section has used GDEF (and to a lesser extent the CPI) as a proxy for non-tradeable prices. because there is no separate series for non-tradeable prices.However GDEF also contains tradeable prices. The relationship between the true exchange rate and the GDEF to tradeable price ratio is given by

REX = (GDEF/tradeable price – X)/(1-X)

where X is the proportion of tradeables in GDP.

Elementary algebra shows that providing X is reasonably stable – it is – REX and the GDEF/tradeable price ratio move in a similar manner.

[8] It could be argued though, that because of its public significance it has a particular economic importance in that the public’s inflationary expectations are formed about it.

[9]  This property of the price index being based on a regimen which includes imports is a major advantage of GDEF, over the wholesale price index, or the producer price indexes. It is also for a much longer period than the PPIs, and a similar period to the WPI.

[10]  GDEF is set back to the previous December year.

[11]  Between 1970 and 1973, GDEF rose about 10 percent less than the CPI. B. H. Easton (1990) A GDP Deflator Series for New Zealand: 1913/4-1976/7. p. 85.

[12]  Prices fell in the nineteenth century. In 1966 they were five times higher than at the nadir in 1899.

[13]  I am able to construct one from 1959, but it is not long enough for the purposes of this study.

[14] See B. H. Easton (1996) In Stormy Seas, p.61 for a comparison of the NZGDEF relative to the OECD GDEF 1954-1994.

The Future Of the South Island

Listener: 18 February, 2012.

Keywords: Growth & Innovation;

Last century when we had ministers of regional development, the policy seemed to be to have greater economic growth in the regions than in the country overall. But these days, a greater emphasis goes on concentrating economic activity in Auckland. This change reflects the realisation that viable industrial growth depends on economies of agglomeration: the clustering together of industries.

Economies of agglomeration arise out of larger locality size, which lowers average costs (as long as the economic disadvantage of congestion can be dealt with). This applies particularly to knowledge-based industries and manufacturing, and comes about mainly because of specialisation in labour markets and business services, as well as technological spillovers (because knowledge cannot be contained exclusively in bunkers).

If we want certain sorts of economic activities – especially knowledge-based ones such as biotechnology, finance and advanced information technology and manufacturing – to survive in New Zealand, we need localities of economic concentration. Only Auckland is near the minimum size for international success. For some activities it may still be too small, although biotech in Hamilton is probably viable within a greater Auckland. Meanwhile, Tauranga is probably going to end up the port of Auckland, because the Waitemata Harbour is too shallow and too cramped.

So the region of urban Auckland is not just the CBD or even the supercity: it includes the provincial cities around it. How big is Auckland’s region? One rule of thumb is that it covers anywhere you can truck from overnight, which is almost the whole of the North Island, including Wellington. So boosting Auckland benefits all of the North Island, providing the connections – rail, road and broadband – are maintained and upgraded. (If our seat of government were to move – to, say, Canberra – Wellington would become a much smaller city with an economic core of tourism and transport. But while the government remains there, information management may be a city specialty.)

What about the South Island? A strong Auckland means Mainlanders may be visiting their grandchildren in Auckland rather than Sydney. But across Cook Strait is certainly not within trucking distance of Auckland. And although Christchurch cannot offer the “full menu” of Auckland – its population is about a third of Auckland’s – it offers the possibility of a cluster of industries that would not survive anywhere else in the South Island.

When I raised this some years ago, the fathers of Christchurch were not interested. The city was booming with tourism, the dairy industry and a host of small-to-medium-sized export-oriented businesses. (It is strong in IT, but weak in biotech.) The earthquakes may have jolted the city fathers out of their complacency, although they’ve severely overdone it. The focus today, understandably, is how to reconstruct the city infrastructure. This is a real issue about which an economist has not a lot to say (except it is going to be bloody expensive, and the human costs may be higher).

But at some stage the city is going to have to consider its economic future. There is a concern that while some of the population has been leaving the city, so too have businesses. Some have moved south to Timaru and Dunedin, more to Auckland, a few to Wellington and Nelson, and some to Australia. Although the South Island will be glad of any retention, without a thriving Christchurch, the Mainland’s prospects are limited.

To understand this, suppose Auckland was hit by a volcanic eruption and businesses moved to Sydney. Hamilton and Tauranga would get some of the Auckland jobs, but ultimately their economies would suffer without a booming Auckland feeding them opportunities. The same applies to Dunedin and the South Island’s other urban centres if Christchurch stagnates or contracts. Dunedin’s population is less than a third of Christchurch’s, so it is not big enough to lead the whole of the South Island. One may hope it will be a significant adjunct to New Zealand’s biotechnology prospects but, as well as Auckland, it needs a prospering Christchurch to do that.

Or it may be that the South Island will have to settle for being a rural Arcadia, beloved by tourists, with the odd tertiary institution in a pastoral setting.

Dealing with No Ordinary Commodity: Alcohol

Global Alcohol Policy Conference: Thailand, 14-16 February as Honorary Research Fellow at SHORE, Massey University.

Keywords: Health; Regulation & Taxation; Social Policy;

The theme of this presentation is that alcohol is no ordinary commodity; economic policy has to think about it differently.

The alcoholic beverages industry, of course, produces jobs and profits for investors, just like any other industry. And just like them, if purchases of its product fall off there are fewer jobs and lower profits in the industry. But, of course, consumer would switch their purchases to other industries and there would be an offsetting expansion of jobs and profits there. There is nothing special about the production side of the alcoholic beverages industry, although we should observe that it is increasingly monopolised by a few suppliers – but again that is true for many other products.

Why Alcohol Is No Ordinary Commodity

Three things make alcohol unusual. The brief economic expression for the one is ‘externalities’, for the second it is ‘time-inconsistent decision-making’, and the third is ‘learning’.

Externalities

The payment for most commodities covers the social costs of the consumption, in particular the fact that the resources used in making the product could have been used for some other purposes. When a person purchases a product they are making a judgement that its consumption is worth more to them than it is to the rest of society, as signalled by the price embodied in the product. Economists say that these social costs are ‘internalised’ in the decision-making.

The consumption of alcohol is distinctive because sometimes – perhaps often – there are significant social costs which are not included in the price the purchaser pays (unless there is an excise duty which I will explain about shortly) and are likely to be ignored in the individual’s decision-making. The list of these ‘externalities’ – social costs which are not internalised – is long: direct harm to others including violence to innocent people, damage to property including car crashes, and health and social service costs from alcohol misuse which the alcohol user cannot or does not pay. A range of studies in many countries show that the external costs of alcohol consumption (i.e. those not incorporated in the private price of alcohol) are very large.

The most efficient way to deal with externalities is to internalise them and include them in the price of the purchase, which can be the effect of excise duties on alcohol. Unfortunately the unit cost of the externalities varies with the numbers of drinks and may also be influenced by who, where and when. There is no practical excise duty which can efficiently and fairly deal with all the externalities.

The best strategy seems to be, as far as possible, to  deal directly with the source of externality, including, if necessary, using prohibition. For instance, many societies have increasingly clamped down on drink-driving.  Another common action is to prohibit purchase by particular age groups or by time or place.

Typically these measures are clumsy – like excise duty, I suppose – but insofar as they are effective, they reduce the required level of excise duty. I shall have more to say about excise duty

issues below.

Time-inconsistent Decision-making

Implicit in the previous discussion was the assumption that consumers make rational decisions in which the benefits to themselves from their consumption are offset against its social costs.

It is a fundamental tenet of liberal societies that individuals know what is best for them. In only a few highly select instances do such societies assume otherwise – children and the senile are examples. The liberal society treats the individual as a mature adult able to make the best decision for themselves – or at least to make a better decision than anyone else; it therefore does not generally say you are wrong to drink alcohol (or to drink too much alcohol) providing you pay the full social cost.

However, behavioural economics has convincing research evidence that individual decision-making is more complex than pure rationality, and that sometimes people make decisions which later they regret. I’ll avoid the details here, but a good example is the person who goes into a bar planning to have a couple of drinks, abandons the plan and drinks half a dozen, and the following morning regrets that they did so, as they knew they would before entering the bar. This is called ‘time-inconsistent decision-making’, in that the individual decisions are not consistent with rational decisions through time.

Sometimes there are strategies available to an individual to deal with time -inconsistent decision-making, as when a recovering gambling addict arranges for a casino to exclude them in case, in the heat of the moment, they try to restart their addiction. Similarly most successful recovering alcoholics refuse all alcoholic drinks.

Economists are struggling with the policy implications of this finding; how to – in the jargon – engineer the ‘architecture of choice’ in the context of ‘libertarian paternalism’. One conclusion which may be relevant to alcohol policy, is that taxes on alcohol (above those necessary to internalise externalities) may reduce the size of the regret. In terms of my illustration you have drunk less after going into the bar because the price was higher, and the next morning you are pleased you did.

Another example might be smaller packages so that you can purchase a 600ml bottle of wine and not be tempted to drink the last 150mls.

Learning

One has to learn to drink properly. It is normal to expect the young to learn how to engage in many adult activities; that is one of the functions of the education system. However there are some things to be learned for which school teaching is impractical, perhaps because the relevant age is after school. Sometimes the learner is in danger until the mastery is obtained. How do we provide a safe learning environment?

Since a car can be lethal weapon, the young typically learns to drive under supervision, and in stages. Even after obtaining a licence there may be restrictions on the driving for a time.

Learning to drink safely is a far more complicated exercise that learning to drive, but we are more casual about how individuals acquire their skills – which no doubt is why many people are worse drinkers that they are drivers, and why the drinking behaviour of too many parents is such poor example to their children. This not to argue we should require a license to drink, but it suggests we should have a public strategy with the objective of teaching the young how to drink safely. Developing one is not in an economists’ skill-set, but no doubt it includes some restrictions of access by the young, which are phased out as the young learn to drink safely.

Policy Responses

I have already mentioned that it makes sense to address the externalities by internalising them – like drunk-driving laws. Economists don’t have much expertise in this area.

I’ve also pointed out that because all externalities cannot be adequately addressed in this direct way, there is a strong case for levying a specific tax on alcohol. Much of the remainder of this paper will elaborate this approach but before doing so something needs to be said about restricting supply.

Every country has unique institutional arrangements so it is hard to be too specific about what each should do. Many have licensing laws which restrict who may sell, when they may sell, and to whom they may sell, together with other limitations as well.

To give an example: in my own country, New Zealand, we seem to be having a growing problem of the off-licence drinking of alcohol, particularly among the young. That does not mean we have solved all the on-licence problem drinking, but the host-responsibility strategy and making providers more responsible for drunkenness has had some success.

Among the measures taken or being considered to deal with off-licence drinking problems has been raising the age of purchase (which may not, of course, affect the age of consumption much). Particular consideration is being given to a lower age of on-licence purchase, which is under supervision, than off-licence purchase. There are also increasing restrictions on drinking in public places. We are also fiddling around with restricting sales outlets, and so on. I am not saying that New Zealand has the solution, but these are illustrative of the sorts of things which may be done. The justification for each of these policies is that alcohol is no ordinary commodity; there are aspects of all the three reasons – externalities, time-inconsistent decision-making, and learning – underpinning the interventions.

One problem New Zealand has not hit yet, but Britain has, is that some of its off-licence supermarkets appear to use liquor as a loss-leader to attract business making the offsetting profits from their sales of other commodities. While economists tend to frown on loss-leaders as anti-competitive, that alcohol is no ordinary commodity gives an additional reason for prohibiting the practice in its case. The liquor seller is privileged to be licensed, and may as a result have extra impositions on them. I shall be talking about minimum price strategies shortly.

Taxation

Historically alcohol has been the subject of special taxation because it was relatively easily to impose and a significant generator of revenue. Often the taxation was designed to impact more heavily on the rich than the poor, by higher rates on their drinks of choice. There was also an element of moral disapproval of drinking in the justification of the so-called sin tax.

In recent years there has been a greater focus on an economic rationale for a specific tax on alcohol. The usual case is based on the externality argument – the internalisation of the social costs which are not included in the private cost of the alcohol.

It might seem that the aim should be that the revenue from the specific tax should cover the social costs – the entire social costs including those which impact on the private sector such as domestic violence, as well as those which impact on the public sector, such as extra expenditure by the public health system. However economic theory focuses on the margin, and so the relevant social cost is that generated by the last drink in a session. Since, unlike in the case of tobacco whose social cost is much the same for each cigarette, the social cost rises with each drink in a session, the marginal social cost is greater than the average social cost, so the total revenue from the specific tax should exceed the total social costs.

Additionally, there may be a case for an additional levy – and hence greater revenue – to reduce time-inconsistent decision-making.

How should the alcohol be levied? The optimal levy would correspond as closely as possible to the incidence of social costs. There is little evidence that absolute alcohol from different types of drinks have different social costs. Until there is, the economic advice would be that as far as possible to levy the tax in proportion to the absolute alcohol content.

This would mean that the taxation content in the price of cheap alcohol would be a higher proportion than in expensive alcohol. I shall have more to say about this shortly, but here I need to say something about the argument that it is a regressive tax because the poor pay proportionally more. True, but that is not a case against levying according to absolute alcohol content. Giving the poor any tax break on alcohol is equivalent to subsidising domestic violence on the poor’s families. Better to recycle the extra revenue that a uniform levy will bring in to

the poor in terms of lower taxes on lower incomes, higher benefits and social assistance or subsidised nutrition, education and health services.

Given the convenience of taxing alcohol there is a temptation to impose additional taxes on higher valued alcohol – say by a sale tax. Whatever the merits of taxing luxuries, such taxes are not really part of alcohol policy, and the revenue should not be included when calculating the contribution to social costs.

(As an aside, I am amazed that the international alcohol lobby has not paid more attention to the duty free exemption on alcoholic products for travellers. It is hard to find a justification for it. This is an international issue and cannot be tackled at the national level, so it is an ideal matter to be raised at a forum such as this. For those who are concerned that government revenue would increase, perhaps the additional funds could be used for eliminating departure taxes.)

Whatever the counsel of perfection, most countries – including my own – are some distance from implementing it. Moreover, the issue of the minimum price of alcohol suggests a useful modification.

The Minimum Price of Alcohol

That individuals purchase absolute alcohol at a variety of prices indicates they are purchasing other characteristics such as taste, quality and consumption venue. Since none of these have as much impact on externalities, this reinforces the case for paying greater attention to absolute alcohol.

A further step has been to argue that a key economic policy variable is the minimum price of alcohol; that, in effect, for public policy purposes the focus should be on drinkers as if they are purchasing only absolute alcohol.

If people act in this way a rise in excise duty on alcohol may have little impact. Suppose someone purchases a ten dollar bottle of wine and an extra dollar is imposed on all bottles. Then they can buy what was previously a nine-dollar bottle, and get the same amount of absolute alcohol for their ten dollars. The only group who cannot do this trading down in the face of a tax rise is those who are already paying the minimum price for their absolute alcohol. Since that group includes alcoholics and heavy drinkers targeting the minimum price makes policy sense.

The next step is not so clear. We have already suggested that commercial and licensing law can be used for excessive price discounting. I shall come back to tax policy in a minute. A curious proposal is to regulate a set minimum price, which would mean that the proceeds from the higher price would go to the production and distribution industry – I doubt that the advocates of the policy think that would be a good thing.

Of course the excise duty could be raised further pushing up the minimum price of absolute alcohol, and also the price of all other drinks although not in proportion and – what may not be an unimportant consideration – the price of off-licence purchasers relative to on-licence purchases. (Minimum price strategies are likely to have more effect on off-licence drinking than on-licence drinking.)

(A variation on the minimum price strategy is to tax different sorts of alcohol at different rates. The excise duty on spirits in New Zealand is higher; perhaps the justification is that production costs of spirits are lower than for beer or wine, and the higher rate brings the selling price of absolute alcohol from spirits more in line with the other alcohol forms.)

Attractive as is the option of higher levies on alcohol to the alcohol lobby (and those trying to balance the government’s books), its difficulty is that there would be much resistance from those who are moderate drinkers and already paying for more than absolute alcohol. In some jurisdictions their political strength is sufficient to block such an increase.

There is another option which may be politically more attractive, in which there is a special tax on the cheapest drink, but it phases out (or ‘draws back’) as the prices of the drink rises. Thus it would hike the minimum price for purchasing absolute alcohol but have little impact on moderate drinking in which absolute alcohol was but one dimension of the total consumption decision and its price was higher.

What is being implicitly argued is that low price absolute alcohol is associated with much higher externalities than high price alcohol. That seems a reasonable proposition, although the systematic empirical evidence has not yet been brought together to validate it.

A major issue is whether the special tax with a drawback is administratively practical and not subject to avoidance. I think that it would be possible to design a reasonably effective regime in New Zealand – and probably in other countries with sophisticated distribution systems – but it may not be easy.

In summary there is a strong case for paying attention to the minimum price of absolute alcohol – collecting data would be a first step – and, one way or another, raising it without adding to the profits of suppliers.

Conclusion

While the analysis of why alcohol is not an ordinary commodity applies to all countries, perhaps with some minor for culturally specific situations, the policy responses set out here assume that the production and distribution system is of a modern sophisticated economy. Many developing economies still have much of the supply and consumption in the informal economy, which require different measures since those involving licensing and other supply restrictions and taxation cannot be as easily imposed.

However in many economies the informal alcohol supply industry is being replaced by (often international) corporations who will introduce and extend the structures which enable the policies proposed here to be implemented. There is usually apprehension about this change since the liquor corporations aggressively market their products and stubbornly resist the imposition of policies which effect safer and more socially acceptable drinking. The irony should not escape those who seek them for the most effective policies require the structures that the corporations create.