US Cliffhanger

This entry was posted in Listener, Macroeconomics & Money on 13th December 2012 by Brian Easton.

He won the battle for the White House, but Obama’s fiscal war continues.

Listener: 13 December, 2012.

The day after Barack Obama was re-elected President, attention turned to America’s “fiscal cliff”, despite there being nary a reference to it in the campaign. Another reminder that elections are rarely about the real issues: recall how when New Zealand went to the polls in 2008, politicians and commentators avoided mentioning that the world was in the greatest global financial crisis since the 1930s.

On January 1, various tax reductions end and automatic expenditure cuts take effect. In total, this budgetary precipice amounts to 5% of GDP; going over the edge would cause the US economy to contract sharply. Because the US GDP is such a large chunk of the world economy, the international economy would suffer, too.

Unlike the Westminster system in which the Prime Minister leads Parliament, the US president is elected independently of the House of Representatives and Senate. Obama’s Democratic Party has a majority in the latter, but the House is dominated by the opposition Republicans (dominance that is partly a result of gerrymandering their electorates – redrawing boundaries to give incumbents safe majorities). In any case, there is little party discipline as we know it, so neither Republicans nor Democrats can be relied on to support party policy, which barely exists anyway.

Political commentators tend to see the world in a winner-takes-all way. Obama certainly had a comfortable majority in the Electoral College, but he was only 3.3 percentage points ahead of Mitt Romney in the popular vote. Nevertheless the Republicans have taken their defeat badly. They lost seats in Congress, but more fundamentally, their strategy failed. In 2010, there was a sharp swing to the Republicans, who then pursued an obstructionist strategy, rather than co-operating with the President. They hoped deadlock would bring Obama down this year. It did not.

Obstructionist elements remain among the Republicans (fewer, though, after the election), but the more thoughtful Republicans see the need for a different strategy, especially as opinion polls suggest the public blame them for the economic mess.

Among the fiscal issues is just how much the promised tax increases will be wound back and who will be affected. Similarly, which spending cuts are to be reinstated? It would be foolish at this stage to predict the outcome. The negotiations on the edge of the cliff involve the outgoing more-Republican, more-obstructionist Congress, rather than the one just elected, which does not take office until the end of January.

One option is for Obama to allow the economy to tip over, citing Republican poor faith, and then negotiate the tax and spending proposals with the incoming Congress. It turns out that it is not really a cliff so much as, at first, a gentle slope – although one would not want to roll down it to where things get out of hand.

I wouldn’t be surprised if the eventual package is a mixture of some sensible policies and some self-interested ones, many of which will have to be revisited after the mid-term elections in 2014 or the next presidential election in 2016.

What is surprising is how quiet the “fiscal hawks” have been. Despite their squawking before the election, nobody is now saying the economy would be better off if the US deficit was eliminated, which would be the effect of blundering over the cliff. Even so, a fiscal conservative might hope the new package will have measures that reduce the deficit as the US economy recovers.

There may not be much here to influence New Zealand policy, although there will be a lot of damage to us and the rest of the world if the US ultimately goes over the edge. The US is a large economy that issues the world’s currency. We are neither. It can get away with some unsustainable fiscal indiscipline in the medium run. We can’t.

What is cause for unease is that the world’s largest economy has a dysfunctional political system that is creating a long-run fiscal crisis. Ultimately it will weaken the US economy, and the international one will suffer, too.

Housing: a Pricey Problem

This entry was posted in Listener, Macroeconomics & Money on 29th November 2012 by Brian Easton.

What we really need to do to get house prices back on track.

Listener: 29 November, 2012.

A friend was enthusiastic about various unorthodox money measures, such as quantitative easing and cutting the official cash rate. I asked him how they would work. He had no idea. His was the New Zealand way: “Bugger the analysis; let’s get on with the policy.”

I am reminded of something French political commentator André Siegfried said 100 years ago: New Zealanders’ “outlook – not too carefully reasoned, and no doubtful scornful of scientific thought – makes them incapable of selfdistrust. Like almost all men of action, they have a contempt for theories; yet they are often captured by the first theory that turns up, if it is demonstrated to them with an appearance of logic sufficient to impose upon them. In most cases, they do not seem to see difficulties, and they propose simple solutions for the most complex problems with astonishing audacity.”

And so it is with the Government’s recently proposed package for affordable housing, which may – or may not – do some good but will have little effect on the price of housing. It, too, was bereft of any clear analysis of the history of house prices. The price of housing began to diverge from its long-run trend around 2002, about the time President George W Bush started injecting liquidity into the world economy through a very large US Government (fiscal) deficit. New Zealand banks borrowed some of these funds, which they lent to New Zealanders who used them to buy houses.

Some funds were used to build new houses. But a maximum construction effort cannot increase the total housing stock much, because additions are small compared with the houses already built. So the additional borrowing flowed into higher house prices. It was the offshore borrowing that accelerated house price rises.

Why did people use the available funds? The short answer is that although some may have prudent reasons to change their housing – relocation, retirement, change of family size – the base reason for much of the borrowing was speculation. Buyers saw housing prices were rising and used the opportunity of changing houses to make leveraged purchases – that is, to increase their debt – to obtain a better return in the long run, on the assumption house prices would rise for ever.

But we need to ask where the funds ultimately ended up. Some went on new construction, but major beneficiaries were those involved in the buying and selling – real estate agents, lawyers and valuers. Some funds were probably extracted from housing markets and used for other purposes, such as overseas travel and investment in finance companies. Hence the general mood of prosperity when the borrowing was heavy before the housing bubble popped.

The ideal would be for housing prices to return to their long-run track. When I did an analysis in April 2007, I thought housing was overvalued by about a third and that even if prices stabilised they would not be back on track before 2015 (“Housing prices relative to consumer prices” http://www.eastonbh.ac.nz/?p=837). Space restricts detailing the analytic reasons that a major slump in prices is unlikely.

What can be done? First, we need to take the speculative top off the market with some form of capital gains tax, perhaps only on second houses. Second, we need to encourage those with mortgage debt to pay down their mortgages rather than leveraging up. Can we structure the regulation of banks so they encourage people to reduce their mortgages rather than keep on borrowing more? Third, we need to give those who have paid off their mortgages better opportunities to save and invest without the need to gamble. In the jargon we need to “deepen our capital markets”.

If houses are used for speculative investments, they will not be affordable for new purchasers. The young won’t be able to buy in unless we address that core problem. In doing so, we’ll also take pressure off the exchange rate and help exporters. Easier said than done, but likely to be a lot more effective than a superficial solution proposed without analysis.

Seismic Shift

This entry was posted in Listener, Political Economy & History, Social Policy on 15th November 2012 by Brian Easton.

Canterbury earthquake victims might have received quite different help but for a 1990 change in the political landscape.

Listener: 15 November, 2012.

In 1988, a ministerial paper proposed reforms to New Zealand’s earthquake insurance. It came 44 years after the Government had established the Earthquake and War Damage Commission that would pay out for damages from a levy. The commission kept reserves in the event of The Big One striking, but they were inadequate. The thinking at the time was a major disaster could cost $36 billion in today’s prices. In the event, the Canterbury earthquakes are expected to cost $20-30 billion. A major Wellington quake or an Auckland volcanic eruption could be considerably costlier.

The commission’s reserves, however, were a piffling $3.6 billion. Because the Government guarantees the fund, the taxpayer is expected to make up the difference. Since the reserves were kept in government bonds, the effect is that taxpayers will pay the lot anyway. In 1988, Associate Finance Minister Peter Neilson’s commission reform paper gave the assurance that “this [Labour] Government will always be compassionate in its approach to providing relief to disaster victims”. Not that future governments would be bound by the statement.

The Government’s main proposals were:

The establishment of a new agency, the Earthquake Commission, to cover natural disasters, but not war damage. (Not mentioned, but one of its successes, has been the promotion of mitigation policies, including research.)
Businesses would not be covered; they could take out private insurance. This reflected the view that the Government should not provide as much protection to businesses as households (businesses are not covered by the Credit Contracts and Consumer Finance Act 2003, either).
The commission would provide comprehensive and compulsory insurance for residences (with some limitations and the possibility of voluntary exemptions).

An electoral earthquake – the 1990 defeat of Labour – meant the bill didn’t make it into law. Instead, in 1993, the National Government passed the Earthquake Commission Act, which dispensed with Labour’s proposal for compulsory disaster insurance for all residential properties on the grounds that regulation and bureaucracy would increase.

The new law meant those residences that were privately insured against fire would get disaster protection of up to $180,000 in today’s prices from the commission. Cover above that would be provided by the private insurer. Those without private insurance also missed out on the commission’s disaster cover. The change perhaps reflects the different ideologies of the two political parties: one keener to use the power of the state; the other more sympathetic to private provision. But there was another important difference: the Crown’s exposure was capped. The 1993 limit was not increased, so with inflation, its value has diminished to $100,000.

The new system covered minor shocks reasonably well. But it seems to have failed the people of Canterbury in at least two respects. First, the interface between the commission and private insurers has generated unnecessary transaction costs (like those incurred by the accident compensation system before the Woodhouse proposals eliminated them). The National Government’s 1991 claim that avoiding compulsion would reduce bureaucracy must seem farcical to Cantabrians tangled in private red tape.

Second, multiple centres of authority work badly for major disasters. That’s why the Government established the Canterbury Earthquake Recovery Authority (although it is too involved in policy decisions for my democratic taste). The rights of private insurance companies have prevented a single authority from dealing with the damage to Christchurch residences. Underlying this is the role of the Crown, a legal entity that acts on New Zealanders’ behalf. Too often, however, Government thinking has been based on the fallacy that Crown interests are separate from those of “us”.

To ask the question that I have put previously in relation to the Accident Compensation Corporation, whose side is the Crown on? A comprehensive answer is not easy. But as far as disasters are concerned, I favour Neilson’s view that the Government should always be compassionate in its approach to providing relief to disaster victims. At the same time individuals should be expected to take as much responsibility as practical to minimise a disaster’s impact.

Is New Zealand Still Fair?

This entry was posted in Political Economy & History on 15th November 2012 by Brian Easton.

Review in New Zealand Books: Summer 2012, p.23.

While references to ‘fairness’ are riddled through New Zealand’s public rhetoric, how important is the notion in actual public policy? Every day someone sensitive to the issues of equity and inequality meets examples where their concerns are breached by those who, at best pay, lip service to them or, more frequently, ignore them altogether. Are we really committed to fairness, whatever that means, or is it a fossilised term whose meaning is long forgotten – as when we say “goodbye’”which once meant “god be with you”?

Eminent American historian David Hackett Fischer was so struck by the importance of fairness in our public rhetoric when he visited in 1994 that he wrote a (just published) book, Fairness and Freedom: A History of Two Open Societies, contrasting New Zealand with the United States, where the stress is on ‘freedom’. Here are two open settler societies which ought to have much in common but seem to diverge on a crucial matter of public priorities.

Although the difference is explored in the chapters which parallel the histories of the two countries, the answer is provided in the introduction. Fischer uses the word count in Google’s million book corpus to show that “liberty” was frequently used in the period up to about 1825, while ‘fairness’ only became important after. It would appear that America, founded in the earlier period, latched onto freedom, while New Zealand, founded later, was more influenced by fairness. Apparently each notion has persisted in the political culture for generations.

The story is more complicated. “Liberty” was initially about freedom of religious belief. Although it has morphed into a much wider agenda, the notion of religious liberty is still there, not only as a human right but popping up in strange ways; almost half the citizens of the US describe themselves as “Christians” rather than Americans.

Of course liberty issues were not resolved by the nineteenth century, but arguably there had been good progress in Britain, whence much New Zealand culture came. (Te Tiriti o Waitangi guaranteed to Maori the rights of British subjects. Although they were not as extensive as they are today, they were thought sufficiently important to be incorporated in the treaty.)

A number of reviewers, misunderstanding Fischer’s book, have suggested it indicated New Zealand was an exception. While it is apparently a balanced account of the two countries’ histories, it is really a plea to Americans from a Boston liberal to give greater weight to fairness in public life. It is the US which is the exception. A recent Pew Research Centre survey found Britain, France, Germany and Spain all gave it greater weight than the Americans – just like us.

This might be interpreted to suggest that America’s public values are a hangover from the eighteenth century, whereas Western Europe continued to evolve past liberty to incorporate fairness in the public’s thinking. If so, the American right’s insistence on liberty as the direction of the future is rather a redirection to the past. Of course those liberties are important – authoritarian regimes need to be replaced by systems which respect individuals, giving them the human rights we take for granted. But while necessary they are not sufficient. We live in communities which we want to regulate by fairness.

Market mechanisms operate on the basis of individuality and can undermine community, as the development of New Zealand since the 1980s well illustrates. Much of Fischer’s account of New Zealand reflects the country before the Rogernomics Revolution more than today’s. He seems to have been misled by the nostalgia of the New Zealanders he met and the public rhetoric which is still couched in the language of fairness, even if equity is no longer as central in public practice and much higher levels of inequality seem acceptable.

Why did this happen? The American right points to the inevitability of liberty as the destination of humanity. Certainly there is a strong element of this approach in today’s New Zealand right which I do not recall in the 1970s. The alternative (Burkean) tradition in the New Zealand political right represented – although not first expressed – by Harry Atkinson continues through to at least Jim Bolger. But there has never been anyone who articulated a distinctive New Zealand version; perhaps the closest is the almost forgotten William Downie Stewart (1878-1949) with his State Socialism in New Zealand, co-authored with James Le Rossignol in 1910.

The case for market freedom, aside from historical determinism, is that increasing complexity of social life – much of which has been destructive of traditional communities – meant that the paternalistic state could no longer directly regulate as much of life as it had. (In any case communities evolve more slowly than the external shocks which disturb them.) It seems likely that any policy responding to the challenges posed in the 1980s had to break some of the tight linkages (say in remuneration rates), thereby disrupting traditional notions of fairness. However that does not explain why public policy concerns about equity have become increasingly abandoned (while the rhetoric was retained).

There are at least two reasons. The first is that there were few experts on distributional policies – although everyone has ill-informed opinions. Since 1984 those experts have been excluded from the policy process, which has meant the most anti-egalitarian policies could be introduced without anyone seriously challenging them. Some Labour politicians thought they were being fair while they steadily retreated from their egalitarian traditions. Sometimes the most ludicrous arguments were advanced to justify patently unfair policies, perhaps no more so than during National’s attempt to privatise the public health system in the early 1990s.

The second reason was that the insiders were increasingly influenced by American thinking, even when it was not particularly relevant to New Zealand. (Ours is not a large economy which issues the international currency.) That thinking is, of course, an idealised account of America – to be fair to Fischer he goes over the stain of slavery in its foundation – but then it is hard for a New Zealand historian not to idealise our history too – or to go to the other extreme.

There are areas where we remain committed to “fairness” – more or less: in gender relations, race relations and towards the tangata whenua. But notions of economic fairness are drifting off the public agenda while remaining there in a fading public rhetoric. When was fairness a last driver of change in distributional policy (except in the grumble that it was not fair the rich paid so much tax)? Hardly anyone mentions that we have not raised the real level of social security benefits since they were cut in 1991, over twenty years ago. Is it fair that beneficiaries dont share in the nation’s prosperity?

There is a real sense that much of our public policy is becoming more like that of the US. It is not just because the US has a major role in the world – militarily, economically and culturally. We share a common language with few of us competent in those which articulate different social philosophies. It is not perhaps coincidental that of the four large European countries, Britain gives a higher priority to freedom and lower to fairness than the other three.

Soon the generations who remember a New Zealand when there was a strong commitment to egalitarianism will have passed on. Will all that will be left be its echoes in the rhetoric of fairness, as we become overwhelmed by notions of liberty without community?

How to evolve an alternative? It cannot be a matter of just going back to the past. If future generations want to reestablish equity as a worthwhile social goal, they will have to do so in a fresh way, for our traditional communities have evolved; today’s New Zealand society is much more market-driven . How does one combine individual freedom with community concern and a commitment to some sort of nationhood, especially in an increasingly globalised world? Are we up to the challenge or, as the last quarter of a century suggests, will we fail to engage and slowly succumb to a neoliberal vision of a world which Thomas Hobbes described as “solitary, poor, nasty, brutish, and short”?

Fischer’s book does not answer such questions for it is a view of the past not the future. Despite being littered with historical errors, it has done us a service by provoking us to think about these issues in a fresh way. But it is we New Zealanders, not Americans, who must do our thinking.

ACC: an Accident Waiting to Happen

This entry was posted in Listener, Social Policy on 10th November 2012 by Brian Easton.

Meddling ministers and overzealous case managers are undermining ACC.

Listener: 10 November, 2012.

Once upon a time, accident victims had to go through a long, complicated legal process to obtain compensation, with the possibility of an arbitrary and unfair outcome. In 1967 a Royal Commission chaired by Owen Woodhouse recommended an alternative that focused on remedies rather than causes and made accident prevention a priority. Today our Accident Compensation Corporation is the envy of much of the world (excluding lawyers who lost their outrageous fees from the old scheme). It is not perfect, of course – nothing is – but the imperfections gave politicians, pressured by special interests, an excuse for meddling.

Big business has grumbled about its cost, but that has been largely addressed by the Accredited Employer Scheme. More recently, the private insurance industry has wanted to be involved. A hyperactive minister began preparing the way for partial privatisation, but the insurance industry aside, there was no enthusiasm; it would have worsened the scheme. All the meddling has damaged the scheme’s reputation. What New Zealanders want after an accident is early rehabilitation and, where that is not possible, fair compensation. A system that minimises accidents would also be desirable. And no one wants to pay excessive levies or see anyone ripping the scheme off by making unreasonable demands.

What seems to have happened is cost minimisation has become more important than the fairness objective. I have friends – and have read of other people – who have been harassed by ACC until they become almost paranoid about its intentions, believing its aim is to shift them to the cheaper invalids benefit. That is despite, as far as I can judge, their being exactly the sort of unfortunates ACC should be supporting. After all, they paid their levies on that understanding. I readily accept there are some accident victims who should return to employment (perhaps with a top-up for the loss of earning power). But some can’t, regardless of the wishes of their case managers. I once accompanied a friend to a meeting with a case manager who was extremely tough, as one might have to be to identify skivers. It was a trial for the victim, but the assessor got it right in the end.

ACC employees as committed and professional as that case manager deserve admiration. But I have also come across inept ACC staff who should be transferred to the invalids benefit themselves. No matter how professional most might be, recent stories emerging from ACC are disturbing. Apparent casualness about privacy suggests a corporate culture in which accident victims are not respected. The fairness objective in the treatment of victims is contradicted by setting targets for case managers to get claimants off ACC’s books, whatever the justice of their claims. “Consultants” seem to be selected for their high rejection rate rather than for expert assessments. Sadly, the failures undermine the reputation of the many fine public servants who work for ACC.

Ultimately failure comes from the top. Too often ministers have lost sight of the Woodhouse principles. Their concerns seem to be cost-minimisation at the expense of fair treatment and private involvement at the cost of efficiency. As a result some genuine accident victims seem to get a poor deal. There would be few of us – excluding pressure groups pursuing their own narrow interests – who do not want a scheme that provides early rehabilitation, fair compensation and that prioritises prevention.

Net National Savings and the Real Exchange Rate

This entry was posted in Macroeconomics & Money on 30th October 2012 by Brian Easton.

This unpublished paper contains figures in its full version. Unfortunately I can’t work out how to include them. I’ll send the figures if requested.

Summary

This paper derives a locus between the real exchange rate and net national savings (gross savings less gross investment). Its essence is that a rise in net savings reduces the real exchange rate. Conversely a rise in dis-savings increases the real exchange rate.

The derivation is based on the assumptions of standard trade theory and uses a standard model in which is introduced a third (non-tradeable) commodity of production and consumption. The standard assumption of full employment may be crucial.

The paper is in three main sections. The first gives a verbal intuition of the result; the second derives the formal result using a standard graphical model (an appendix derives the same result using simple algebra); the third explores the assumptions of the model and some possible extensions.

Interpretation of the relationship tends to be in terms of the net savings (and dis-savings) setting the real exchange rate. However what is derived here is a locus, so that in principle it might suggest that a real exchange rate determines net national savings, although it is harder to envisage circumstances in which the real exchange rate is exogenous (a government may fix the nominal exchange rate, but the domestic prices may alter to thwart any fixing of the real exchange rate).

1. Intuition

<>This intuition is an edited version of a column ‘Boom time Rats’ published in “The New Zealand Listener”, 24 October, 2009. (http://www.eastonbh.ac.nz/?p=1033)

Suppose a large highly productive foreign exchange earning sector evolved. It would squeeze the existing tradeable sector, which was not able to supply or conserve foreign exchange so efficiently including competing successfully for inputs from it. Ultimately the squeeze would operate by a lifting of the exchange rate, making the existing businesses earning or conserving foreign exchange earning less profitable.

That’s what happened in New Zealand about a century ago. Refrigeration unleashed the pastoral sector, enabling it to export meat and dairy products. Manufacturing was squeezed, falling from about 25% to 15% of the labour force. (Excluding the freezing and dairy processing industries, the fall was even more dramatic.) The new growth industry was more productive than those it displaced, so the economy was better off. The grumbles came from those in the displaced industries.

The scenario also applies when the emerging industry is mining. The exploitation of the North Sea gas fields reduced Holland’s manufacturing industry or during the mineral boom in Australia. The phenomenon is sometimes called the “Dutch disease” (after what happened to Dutch manufacturing when their offshore gas fields started producing)or the “Gregory effect” (after Australian economist Bob Gregory). It’s called a disease because when the gas or minerals run out, the country needs to expand its manufacturing industry to replace the lost earnings. But that is difficult, because of the enfeebled state of the industry.

We can simplify the analysis by imagining the mine is a vault containing bars of gold, which are exchanged for US dollars to buy imports. Same conclusion: up goes the exchange rate at the expense of tradeable production; exporting and import-substituting production diminishes.

Or suppose the vault contained IOUs that could be converted into US dollars. It is another source of foreign exchange, so the analysis is much the same. The exchange rate would rise and the tradeable sector would suffer because borrowing is an easier way to get foreign exchange.

But when this vault runs out, the situation is worse. Not only has the sustainable tradeable sector been damaged, as in the Dutch disease case, but the borrowings have to be serviced (and perhaps repaid), so there is an even greater need for foreign exchange in the long run.

In summary capital inflows lift the exchange rate at the expense of the ability of the economy to earn and conserve foreign exchange by production and sales.

That is exactly what has happened to the New Zealand economy since 2002, when it embarked on a splurge of foreign borrowing. Not surprisingly, the tradeable sector stagnated while the non-tradeable sector expanded rapidly, fuelled by the borrowing.

It is absurd to expect a central bank to hold down the currency while the country continues to borrow heavily offshore. Admittedly, some short-term measures can influence the exchange rate, but in the medium term the bank cannot keep the dollar low when there is heavy offshore net borrowing.

2. A Graphical Representation

Figure 1 has non-tradeable production on the vertical axis and tradeable production on the horizontal axis. PP’ is a conventional production possibility frontier (shown as a quarter circle).

It is assumed that the community consumption preferences are lexicographic – that is, the proportion of consumed non-tradeables and tradeables is fixed. This assumption is entirely for presentational convenience; the standard analysis of indifference curves which allow substation in consumption preferences could be included but it only adds to the complexity without adding to insights. (The algebraic formulation in the appendix has substitution at a cost of an extra parameter.)

More subtly the horizontal tradeable axis is measuring two different tradeable commodities. For the production frontier it measures the exportable commodity, but for consumption it measures the importable commodity. The analysis assumes there is a fixed terms of trade between the two (that is this is a small economy). The implications of a change in the terms of trade are discussed in the third section.

The lexicographic community consumption preference is represented by a diagonal OC from the origin which cuts the Production Possibility Frontier at E. This is the point where the economy consumes exactly what it produces (after exchanging its exportables for importables).

At E the real exchange rate (the price of tradeables divided by the price of importables) is tangential to the Production Possibility Frontier. It is represented by the line R₁R_1′.

Now suppose (for some reason) the real exchange rate is actually the line R₂R₂‘, which is a higher real exchange rate (that is, tradeables are cheaper relative to non tradeables.). The economy now produces at AB on the production possibility frontier (assuming full employment). At this point production of the non-tradeable amounts to AO and the production of the tradeable amounts to OB.

However given that all the production of the non-tradeables is consumed, it follows that the consumption point will be where the A to AB line intersects with the consumption line at AC, giving a total consumption of the tradeables as OC. Since production is only OB, the economy has to borrow CB measured in tradeables.

So we get the fundamental result. As the real exchange rate rises the amount of borrowing rises (or perhaps causally in the opposite direction).

Figure 2 shows the result which is derived from directly for Figure 1. Its exact shape depends on the various parameters but basically it is monotonically rising (as a consequence of the convexity of the production possibility frontier). Net borrowing is zero (in this example) where the real exchange rate is unity.

2. Questions and Extensions

How important is the lexicographic consumption assumption?

Not at all. Suppose substitution were allowed. As The real exchange rate rose, importables became cheaper and would increase relative to non-tradeable consumption. Thus C shifts out, the borrowing increases and the locus in Figure 2 is steeper.

What about the terms of trade?

The effect of an increase the terms of trade is to increase the amount of importables for a given amount of exportables. This will rotate the consumption preference line (and E) in an anti-clockwise direction. For a given real exchange rate the quantity of borrowing is reduced.

The reason is that the real exchange rate sets the production and consumption of non-tradeables, and now fewer exportables are necessary to pay for the matching importables. So there is less borrowing. Of course the real exchange rate may change when there is a change in the terms of trade, but that lies outside the scope of this model.

If a country is borrowing offshore, then doesn’t it have to service the debt?

Yes, Figure 1 describes an economy which has no offshore debt and it has just begun borrowing. Figure 3 generalises to when the economy has been borrowing and has to service OO’ debt (measured in tradeable prices). The lexicographic consumption function shifts left but remains parallel to the old one,now intersecting the horizontal axis at O’ rather than the origin. The line of non-tradeable production and consumption determined by the real exchange rate (A-AB-AC) intersects the new consumption line at AC’ (where AC’- AC equals O’-O).

The debt servicing appears as additional borrowing. Note that as the debt servicing rises E’ rotates in a clockwise direction, implying a need to reduce the real exchange rate if exportables and importables are to balance.

Stein’s Law says this if it cannot go on forever, it wont. Doesn’t the model contradict Stein’s Law because it involves unlimited borrowing?

Not really. The model assumes that lenders will continue to provide the funds to pay for the borrowing. They wont.

At some time the funding will be restricted. What that means is that net dis-savings (offshore borrowing) has to be reduced (sounds familiar?) and the real exchange rate has to fall (if full employment is to be maintained) and so will production in the non-tradeable economy as resources shift to the exportable sector.

That sounds like a tricky transition. Absolutely. These international trade models are not very rigorous when the economy shifts off the production frontier, while the shift along it is typically a long term process so they sd not rigorously describe the transition.

Where do Interest Rates fit In?

Presumably lenders require higher interest rates as the amount of borrowing increases. The exact behavioural function is a bit tricky, because it will depend on many things (including expectations and the state of the international economy). Whatever, it will be upward sloping.

Both the offshore debt and the current borrowing requirements will be important;the higher either is the higher will be the interest rate. What this means is the higher the real exchange rate the higher will be the interest rate that lenders require. The more prolonged the high interest rate – and hence the higher offshore debt – the higher will be the required interest rate too.

Stein’s law implies that sometimes the interest rate function will go inelastic, that is, no increase in interest rates will induce more funds to be borrowed. That’s when the phase comes to an end.

Does that mean that interest rates are externally determined and the central bank has little influence on them?

Apparently. It may be that there is some jiggle room, say fine tuning on the production frontier, or perhaps changing net dis-saving by encouraging savings and discouraging investment. That could lead to a fall in the real exchange rate. Contrary to the conventional wisdom this requires a higher exchange rate (to reduce the dis-saving) in order to reduce the real exchange rate. This needs to be explored.

Appendix: A Simple Mathematical Formulation

Suppose the economy consists of Non Tradeables (N) and produced/exported Tradeables (T).

Suppose the Production Possibility Frontier is given by

N² + T² = 1.

Suppose the real exchange rate (the price of non-tradeables relative to the price of tradeables) is r. (The economy will operate where the tangent touches the production possibility curve, in which case dT/dN = -r.)

The economy will produce at

N = r/ (1+r²)^(½)

T = 1/ (1+r²)^(½)

(The results can be derived a number of ways; perhaps the most elegant is to use trigonometrywith r = tan(θ). Substitution will show both conditions are met.)

Since the consumption of tradeables equals N, total borrowing is given by N-T or

(r-1)/ (1+r²)^(½)

which is the shape of Figure 2.

If the demand for consumption goods is not lexicographic, the demand for tradeables for consumption might be represented by r^αN, where α>1 (because one consumes more tradeables as the relative price of non-tradeables rise.

From which it follows that the offshore borrowing is

(r^(1+α)-1)/ (1+r²)^(½)

which is greater than (r-1)/ (1+r²)^(½).

The Relationship Between the Net National Savings and the Real Exchange Rate

This entry was posted in Macroeconomics & Money on 30th October 2012 by Brian Easton.

<>A note prepared in October 2012

Keywords: Macroeconomics & Money;

Summary

Interpretation of the relationship tends to be in terms of the net savings (and dis-savings) setting the real exchange rate. However what is derived here is a locus, so that in principle it might suggest that a real exchange rate determines net national savings, although it is harder to envisage circumstances in which the real exchange rate is exogenous (a government may fix the nominal exchange rate, but the domestic price level may alter to thwart any fixing of the real exchange rate).

1. Intuition

This intuition is an edited version of a column ‘Boom time Rats’ published in “The New Zealand Listener”, 24 October, 2009.

In summary capital inflows lift the exchange rate at the expense of the ability of the economy to earn and conserve foreign exchange by production and sales.

2. A Graphical Representation

Figure 1 has non-tradeable production on the vertical axis and tradeable production on the horizontal axis. PP’ is a conventional production possibility frontier (shown as a quarter circle),

It is assumed that the community consumption preferences are lexicographic – that is, the proportion of consumed non-tradeables and tradeables is fixed. This assumption is entirely for presentational convenience; the standard analysis of indifference curves which allow substitution in consumption preferences could be included but it only adds to the complexity without adding to insights.

At E the real exchange rate (the price of tradeables divided by the price of importables) is tangential to the Production Possibility Frontier. It is represented by the line R₁R_1′.

However given that all the production of the non-tradeables is consumed domestically, it follows that the consumption point will be where the A to AB line intersects with the consumption line at AC, giving a total consumption of the tradeables as OC. Since production is only OB, the economy has to borrow CB measured in tradeables.

So we get the fundamental result. As the real exchange rate rises the amount of borrowing rises (or perhaps causally in the opposite direction).

2. Questions and Extensions

How important is the lexicographic consumption assumption?

Not at all. Suppose substitution were allowed. As the real exchange rate rose, importables became cheaper and would increase relative to non-tradeable consumption. Thus C shifts out, the borrowing increases and the locus in Figure 2 is steeper.

What about the terms of trade?

If a country is borrowing offshore, then doesn’t it have to service the debt?

Yes, Figure 1 describes an economy which has no offshore debt and has just begun borrowing. Figure 3 generalises to when the economy has been borrowing and has to service OO’ debt (measured in tradeable prices). The lexicographic consumption function shifts left but remains parallel to the old one, now intersecting the horizontal axis at O’ rather than the origin. The line of non-tradeable production and consumption determined by the real exchange rate (A-AB-AC) intersects the new consumption line at AC’ (where AC’- AC equals O’-O)

Stein’s Law says this if it cannot go on forever, it wont. Doesn’t the model contradict Stein’s Law because it involves unlimited borrowing?

Not really. The model assumes that lenders will continue to provide the funds to pay for the borrowing. They wont.

That sounds like a tricky transition.

Absolutely. These international trade models are not very rigorous when the economy shifts off the production frontier, while the shift along it is typically a long term process so they sd not rigorously describe the transition.

Where Do Interest Rates Fit In?

Both the offshore debt and the current borrowing requirements will be important; the higher either is the higher will be the interest rate. What this means is the higher the real exchange rate the higher will be the interest rate that lenders require. The more prolonged the high interest rate – and hence the higher offshore debt – the higher will be the required interest rate too.

Stein’s law say that sometimes the interest rate function will go inelastic, that is, no increase in interest rates will induce more funds to be borrowed. That’s when the phase comes to an end.

Does that mean that interest rates are externally determined and the central bank has little influence on them?

Apparently. It may be that there is some jiggle room, say fine tuning on the production frontier, or perhaps changing net dis-saving by encouraging savings and discouraging investment. That could lead to a fall in the real exchange rate. Contrary to the conventional wisdom this requires a higher interest rate (to reduce the dis-saving) in order to reduce the real exchange rate. This needs to be explored.

Appendix: A Simple Mathematical Formulation

Suppose the economy consists of Non Tradeables (N) and produced/exported Tradeables (T).

Suppose the Production Possibility Frontier is given by

N² + T² = 1.

The economy will produce at

N = r/ (1+r²)^(½)

T = 1/ (1+r²)^(½)

(The results can be derived a number of ways; perhaps the most elegant is to use trigonometry with r = tan(θ). Substitution will show both conditions are met.)

Since the consumption of tradeables equals N, total borrowing is given by N-T or

(r-1)/ (1+r²)^(½)

which is the shape of Figure 2.

From which it follows that the offshore borrowing is

(r^(1+α)-1)/ (1+r²)^(½)

which is greater than (r-1)/ (1+r²)^(½).

The ‘Critical Threshold’ for Fiscal Projections and Policy

This entry was posted in Macroeconomics & Money, Regulation & Taxation on 29th October 2012 by Brian Easton.

A Note prepared in October 2012.

Keywords: Macroeconomics & Money; Regulation & Taxation;

Introduction

I have argued there is a critical threshold where if the fiscal deficit exceeds it public debt grows unsustainability faster than the ability of the economy to service it (usually measured by GDP). This note quantifies the threshold into a simple formula.

The threshold is related to the size of the government deficit. It should be clearly understood that crossing the threshold, so that the deficit is too large, does not immediately precipitate the government accounts into crisis like the Greek one. The arrival of the crisis is incremental. Each period it gets harder to reverse the trend: harder to cut back on expenditure, harder to raise revenue, while debt servicing remorselessly rises (and interest rates, but initially slowly). Eventually a second threshold is met; the point where lenders are no longer willing to advance loans, even at very high interest rates, because they do not expect them to be repaid. Providing the fiscal deficit is below the critical threshold this wont happen.

The threshold is a medium-to-long term notion so that it might be temporarily exceeded at some point during the business cycle; that is not unsustainable if on average the fiscal position remains below the threshold.

Note a slightly confusing element is that the threshold is measured by the primary surplus (see below) which typically needs to be positive. Add in the debt servicing and the current account is likely to be in deficit. Assessed by the primary surplus the accounts need to be above the threshold (higher). Assessed by the total fiscal deficit the accounts need to be below the threshold (lower).

In a way all this paper does is to argue that we need to pay more attention to the primary surplus. This is not to say the total fiscal deficit is irrelevant; just that the measure of the primary surplus is a powerful assistance to understanding the debt path.

Definitions

First a few simple symbols to simplify exposition (such mathematics there is, is in the appendix).

D = the public debt at the beginning of the period;

D* = the public debt at the end of the period;

PS = the primary surplus in the period (to be explained below);

r = the nominal interest rate on public debt;

g = the nominal growth rate of GDP.

The primary surplus is the current revenue less current expenditure (this could include investment which does not directly generate revenue). Debt servicing is excluded, so the primary surplus is not the same thing as the fiscal surplus.

There are two reasons why the primary surplus might be of interest. First, if a country decides to abandon servicing its debt (not something one would recommend) then it needs a primary surplus. A primary deficit means that the government has to borrow to cover its expenditures even though it is not debt servicing its debt; such borrowing is unlikely to be forthcoming if it refuses to service old debt.

Second, the mathematics (such as it is) is simpler.

The Total Fiscal Deficit is the primary surplus less the debt servicing (mainly interest paid on debt).

The Critical Threshold Formula

The critical threshold is given by

PS = (r-g)D.

If the primary surplus exceeds (r-g)D then the debt path is sustainable, if the primary surplus is less than (r-g)D then the debt path is potentially unsustainable with net debt growing faster than GDP.

Intuitively the formula makes sense.

In order to prevent an unsustainable debt path, the primary surplus needs to be higher when

– the interest rate is higher;

and/or

– the net debt is higher.

On the other hand, if the economy is growing faster the primary surplus can be a little lower lower without compromising the debt path.

A useful variation of the formula is given by

PS/Y = (r-g)d

(Note that the appendix describes PS at the critical threshold as PS#.)

Where

Y = GDP

d = the Net Debt to GDP ratio (= D/Y)

An Example

The current Treasury long-term projections have

r = 6.0% p.a.

g = 4.5% p.a. (made up of 1.5% p.a. for productivity growth, 1.0% p.a. for population growth and 2.0% p.a. for price growth.)

There is no projected net debt to GDP ratio, but the current government target is 20%.

So the critical threshold is given by (6% – 4.5%) times a fifth or 0.3%.

Given a GDP of about $210b This amounts to about $630m.

The primary surplus forecast for the 2013 year is around minus $4billion (that is Crown expenditures before debt servicing exceed current revenues by around $4billion). However the Crown accounts are not cast into a form which makes an exact measure easy to elicit. In any case the government would argue that this is a cyclical effect and the government accounts are on a track to return to the primary balance to above the critical threshold. Additionally the government is borrowing at lower interest rates than the long term projection but the economy is growing slower. Even so it might seem that the Crown’s primary balance is too negative.

Note

There is a similar critical threshold for the economy as a whole. The equivalent of the Crown’s fiscal surplus is the current account surplus excluding debt servicing (basically exports of goods and services less imports of goods and services). Assuming the same interest rate (although the private borrowing rate is likely to be higher) and observing a net public and private debt to GDP ratio of about 75% the critical threshold for the economy as a whole is an external primary surplus of $2.4b. In fact the external primary surplus is currently close to zero.

Conclusion

Critical thresholds are one useful way for thinking about a sustainable debt path, for the government or for the economy as a whole. They are the point at which the debt is a constant proportion of GDP.

If the deficit is larger than that indicated by the critical threshold, then debt is rising faster than GDP; if the deficit remains in this larger state then eventually the debt will rise to the point where there will be a debt crisis (similar to the current experience of Greece).

If the deficit is smaller than that indicated by the critical threshold, then debt is rising more slowly than GDP.

For short term macroeconomic purposes – whether for monitoring the fiscal position or the external position – it is useful to compare the actual position with the threshold – perhaps even to plot it over time.

For long term fiscal projections, which tend to track linearly or exponentially/log linearly, the point in time at which the deficit crosses through the critical threshold is a way of summarising the sustainability of the fiscal path. Ideally, given that the long term track does not include the business cycle, the ideal is that the point should never exist.

APPENDIX: The mathematical derivation of the formula.

Given the definitions it follows that

D* = (1+r)D – PS,

The critical threshold is at the point where

D* = (1+g)D

Which gives

PS# = (r-g)D.

Where PS# is the primary surplus at the critical threshold.

The Power Myth of the Reserve Bank

This entry was posted in Listener, Macroeconomics & Money on 27th October 2012 by Brian Easton.

The just-departed Reserve Bank Governor had less power than people think.

Listener: 27 October, 2012.

Alan Bollard, the just-retired Governor of the Reserve Bank of New Zealand, is a genial man with a wry sense of humour. He is also a great public servant for whom we have much to thank. He will be best remembered for steering us through the trauma of the global financial crisis, which began in September 2008. Before his decade-long Reserve Bank role, Bollard was Treasury Secretary for four years, and he was chairman of the Commerce Commission for four years before that. At the commission, he thought a lot about how to regulate businesses when the market could not be relied on to give a good outcome by itself. Unlike his Reserve Bank predecessor, he was comfortable with developing comprehensive financial surveillance and regulation processes.

The contribution of his deputy, Grant Spencer, who was charged with the implementing the strategy, should also be acknowledged. Sure, there was skill, courage – and luck – in dealing with the financial crisis, but there had been considerable earlier efforts to develop the capacity of the monetary system to deal with shocks. Although Bollard departs from the job with affection and respect, an unresolved matter remains from his watch. Has the bank’s interest-setting regime hiked the exchange rate to the detriment of the export sector, jobs, economic growth and our overall well-being? Some argue that the Reserve Bank should be directed to operate its interest rate policy to lower the exchange rate. In his last official interview, Bollard rejected this view.

The issue centres on how influential a central bank is. Critics of the Reserve Bank think it wields more power than it does. They are like economist Milton Friedman, who focused almost exclusively on the importance of monetary policy. Whatever you might think of his ideology, Friedman’s position is more defensible in the US, whose currency is the international medium of exchange, and where Congress is slow, clumsy and ineffective at managing the Government’s tax, spending and borrowing. Neither characteristic is true of New Zealand. Our dollar is hardly important internationally; our Government has considerably more control over its fiscal stance.

The critics may be appalled to be bracketed with Friedman. That arises because of his inordinate influence on our 1989 Reserve Bank Act. It’s a national tragedy that we keep latching on to defunct economists. The myth evolved that we had an extremely powerful central bank, and that its governor was the most powerful person in the land. I doubt Bollard thought he was. Over the years the Reserve Bank learnt it has much less freedom to move than the public rhetoric assumes. There is much publicity when the bank announces the Official Cash Rate, which it fixes with care. But the exercise is usually routine, as shown by commentators’ ability to forecast each new setting.

The world financial system probably has more effect on New Zealand interest rates than anything the Reserve Bank can do. When the country is borrowing heavily overseas, those lending to us will want a higher interest rate. The Reserve Bank has a little wriggle room, but only around a level set internationally.

As I explained in an earlier column, the effect of offshore borrowing is to raise the real exchange rate, with the bad results the critics warn us of. (“Boom time rats”, October 24, 2009: http://www.eastonbh.ac.nz/?p=1033) It is our overseas borrowing that is giving us a high exchange rate, not the actions of the Reserve Bank. Overseas borrowing is a consequence of a national savings deficit. If we don’t address that, we cannot effectively control the exchange rate. Nostrums such as fixing the exchange rate or quantitative easing will cause long-run difficulties – especially inflation – unless we save more.

This explains why the Reserve Bank is so cautious. It does not have the means to address the exchange rate level because the problem is a shortage of savings, not monetary policy. As Bollard would say, the bank is not that powerful.

Our Kermadecs

This entry was posted in Literature and Culture on 19th October 2012 by Brian Easton.

Response to an Exhibition at the Wellington City Gallery

Off the Eastern coast of Asia are uninhabited islands, such as the Spratley Islands in the South China Sea and the Diaoyus (if you are Chinese) or the Senkakus (Japanese), where territorial disputes could lead to war. Fortunately we have no such disputes, so we don’t need to show the military flag. Even so, we need to take an active interest in them; otherwise someone else might. But how?

What about the Kermadecs – 15 rocks and islands 1000kms or so north of the North Island? Other than the meteorological station and a hostel for conservationist on Raoul Island – the largest – there are no human inhabitants. Are they really ours, even in a katiaki/guardianship role?

We dont have to show military might. In 2011 the (American ) PEW Environment Global Ocean Legacy Program enabled nine of our artists – Phil Dadson, Bruce Foster, Fiona Hall, Gregory O’Brien, Jason O’Hara, John Pule, John Reynolds, Elizabeth Thomson and Robin White – to explore the islands (they were on a voyage by HMNZ Otago on a trip to Tonga). Some of their responses are on show at the Wellington City Art Gallery (having previously been shown at the Tauranga Art Gallery).

Each artist’s work is largely familiar, but each has responded to their new experiences in a way which is both an extension of their work and which is ‘ours’.

The Kermadecs had not loomed large on my radar, and I dont expect ever to visit them. That single exhibition has probably done more to engage me with them than all the past fragmentary references. The biological statistics are stunning; they contain a third of all the fish species found in New Zealand – see I am treating them as a part of us – and one in nine of all the seabirds in the world – 3 million breeding pairs. The Islands are a part of the world’s longest chain of undersea volcanos, and were described as ‘pristine’ by National Geographic in 2010. (Alas, as Bruce Foster’s photographs record, there is human flotsam on their beaches.)

The PEW foundation wants to make them the world’s largest marine reserve. I left the exhibition asking why not?

The Kermadecs are not alone in our using the arts to claim a kind of sovereignty. We gave up our claims to the Ross Sea Dependency (dreadful name, let’s have a competition for a better one) as a part of the 1958 Antarctic Treaty, but it is still ‘ours’ isn’t it? Any claim is based on our long-term scientific research program supplemented since 1997/8 by a program taking artists and writers down there to respond to the place – just as those who went to the Kermadecs.

Similarly we used being nation of honour at the Frankfurt Book Fair to extend the nation’s reach. Some of the literary community told me they were ‘pissed-off’ by the way they seemed marginalised as others took over the event. Isnt it wonderful, though, that our writing and publishing can be used for wider national purposes? Not just some icing on the top of the cake, but an integral part of it. We need to remember when the arts ask for more public funding, it is a lot cheaper than funding the military.

Alas the exhibition, which closes in Wellington in February 2013, is not going elsewhere in New Zealand; it is going to Chile. But there is an accompanying catalogue ‘The Kermadecs’ if you miss out.

The Poverty Trap

This entry was posted in Listener, Social Policy on 13th October 2012 by Brian Easton.

We need a child-focused approach to dealing with poverty.

Listener: 13 October, 2012.

Around 40 years ago, social scientists estimated that well over half of New Zealand’s poor were children and their parents, and pointed out the lack of sufficient income would stifle the development of these children. To this day, children and their parents remain our largest group of poor. Over the past four decades, a huge pile of reports on child poverty has built up. As is characteristic of New Zealand studies, they are strong on measuring and describing the phenomenon, strong at urging policies of various degrees of effectiveness, and lamentably weak at analysing why the poverty exists – which may be the reason so little has been done to address it. We have just had another outbreak of such reports, which have generated another round of tut-tutting. But will they do any better?

Children consume about $20 billion a year, about a sixth of the total private consumption. This excludes the cost of public education and health, and also the labour cost of parents caring for their children – for some parents this means lower or even zero incomes. Only about $5 billion of that consumption is funded by the New Zealand Government in social security and tax transfers. The rest comes from parental contributions, averaging about $300 a week for each child. Although poverty is caused by insufficient income, one of the more foolish responses is to try to solve child poverty with higher wages. Many wage earners do not have children, and many parents do not have paid jobs. If we want to eliminate poverty, it is going to have to be by transfers from the state. But do we want to?

Two broad models shed light on this. One is that children are like pets – something that enhances parental welfare – and therefore the parents should pay for them. No one argues that social security should be extended to cats and dogs. (Because livestock are treated as a cost of production for tax purposes, the Government treats cows and sheep better than children; even the costs of a livestock manager’s efforts are tax deductible – parents’ are not.)

The second model is that children are an investment in our future. When we retire, we depend on them to produce the goods and services (and pay the taxes for New Zealand Superannuation). If families under-invest in their children – and when their income is seriously constrained, that is inevitable – the children will suffer. But so will society as a whole. Not only will the retired suffer when it becomes the younger generation’s turn to fund them, but the underinvested-in children will cause more government spending, such as on law and order and healthcare, and other government spending – on education – will be inefficient. If we under-invest in our children, we will all suffer. Claims New Zealand is a great country to raise children in are not borne out by our health statistics.

There is a third approach that usually gets overlooked: the perspective of the child. The neglect is nicely illustrated by the bill before Parliament that would empower the Government to cut the benefit payments of households that do not look after their children. Children who are already victims will suffer further. The practice in some countries of punishing rape victims is barbaric; this bill is equally barbaric, as are those who promote it. A child-focused approach observes that children do not choose to come into this world; when they do, we are responsible for giving them a decent opportunity to establish themselves. It certainly says we should not victimise them. Michael Joseph Savage famously said the first call upon the state should be the young, the sick and the elderly. Nowadays when a child calls the state, it does not bother to reply.

Forty years ago, there were kids in poverty who just never had a chance. They became parents, and today some are even grandparents; many of their grandchildren are still in poverty. The sins of the community are still being visited on the children.

The Role Of the Environment in History

This entry was posted in Environment & Resources, Political Economy & History on 4th October 2012 by Brian Easton.

This was an essay I wrote for a competition; when I realised it it did not not meet the competition rules, I did not submit it.

While writing a history of New Zealand from an economic perspective, I have been continually confronted by the environment as an integral part of New Zealand’s history. This is not the same thing as a history of the environment where we have a number of useful contributions. In contrast the majority of New Zealand conventional histories neglect the impact of the environment thereby omitting a critical dimension of the nation’s story, just as – and this is the main theme of the book – a neglect of the economy gives a limited and distorted account of our nation’s story.

Why should an economist pay attention to the environment? Just as economics, if you understand it in any depth, is founded on the laws of thermodynamics, there is a sense in which economic history is equally dependent on the environment. This essay illustrates the dependency with (mainly) nineteenth-century examples, although there are –of course – many twentieth-century examples, and there will be many twenty-first century ones too.

The book starts off 600 million years ago, before New Zealand existed in any form. (Our oldest rocks are 510 million years old.) New Zealand – or more precisely the continent Zealandia, most of which is under the sea – is the erosion from the Gondwanaland craton which sedimented off the east coast of Australia. About 85 million years ago it unzipped and began drifting east, opening up the Tasman. Because the earth’s crust was being stretched, the continent began spreading out and sinking. It could have ended up under the sea for ever, but about 23 million years ago the Pacific tectonic plate began expanding, smashed into the Austro-Indian plate, driving up the land we know as New Zealand.

Being on the plate boundary explains why the country is a long straggly one, why we have rough mountain chains and why we have earthquakes. Big shocks can be a bloody nuisance, but it is well to remember that were there not the forces that create them, there would be no New Zealand at all.

A consequence of our geology is that, aside from coal and hydrocarbons, New Zealand has few commercially interesting minerals. Generally its soils are also of poor quality and thin (thanks to the ravages of the ice ages and volcanic eruptions), lacking the nutritive minerals and the physical properties which make them good for farming.

When our European forefathers first arrived, they saw lush bush and assumed that meant fertile soils, not realising that the vegetation had evolved over the millennia to cope with the soil deficiencies. It often took many times the cost of the land purchase to make it suitable for farming. The cost of converting, in the 1840s, a hundred acres of Hutt Valley land purchased for £100 could involve an investment of £2,500-£3,000, with the calculation taking no account of expenditure on residences, fencing, nor even the hireage of casual labour, nor the subsistence requirements of the land owner and his family. Similarly the Waikato swamplands confiscated from Maori were sold cheaply by the government at 6d a acre, but the cost of converting one into farmland could be close to £100; not surprisingly many of the investors were bankrupted or near bankrupted by the venture.

The impoverished land is nicely illustrated in the early part of the twentieth century when there was no growth in farm productivity. A farmer opening up new land would get a reasonable crop for up to four years, exhaust the soils and then struggle on, although he might not notice because those first years involved the hard grind of establishing the farm. It was not until the mid-1920s, when farmers begin spreading phosphates, that farm productivity took off. When they stopped using fertilizer – in the 1930s when they were broke, in the war years when the phosphates were diverted to explosives – land productivity fell.

Exhausting the soils and mining phosphates – even from overseas sources – are ultimately unsustainable activities. Political economists call it ‘the quarry’. New Zealand histories tend to play down the significance of quarrying despite it dominating the economic activity of the first Europeans; instead they give the impression that the European settlement was sustained by farming from the beginning.

However the first Europeans exploited seals, whales, fish, timber, kauri gum and gold. The initial prosperity of Wellington depended upon the whales that came through Cook Strait; within a decade of settlement they became almost extinct. Fortunately by then the Wairarapa wool cheques had started coming in.

Other towns were sustained by gold: Dunedin, Auckland, even Christchurch, which prospered from supplying the Victorian goldfields (as did Wellington) as well as local ones. Another unsustainable activity was warfare. There is much about the battles and the politics in our conventional histories, but few observe that Wellington in the 1840s and Auckland in the 1860s were military camps. Local farmers supplied the quartermasters as well as the goldfields.

After the quarrying phase the economies of the southern towns were based on a wool economy. Wool became the single largest export from the late 1860s, as the alluvial goldfields were exhausted, and it remained so for a century. (The collapse of the price of wool at the end of 1966 was to have a dramatic effect on the course of New Zealand thereafter; but that is another essay.)

Auckland, however, was excluded from the wool economy, for the top half of the North Island suffered the consequences of events 1650 years earlier in 233CE or so, when the Taupo volcano had its last major super volcanic eruption. (Around 1314 Mount Tarawera erupted; although it was a much smaller eruption – perhaps a twentieth of Taupo’s – its Kaharoa ash spread, as far north as the Bay of Islands, added to the soil impoverishment.)

The ash which spread to the north and west was deficient in trace minerals, especially cobalt and selenium. Stock which grazed on it wasted from bush sickness. New Zealand scientists identified the soil deficiencies in the middle of the twentieth century – one of their outstanding scientific achievements– and today the missing minerals are added to livestock’s diets.

After the volcanic explosion there was a great lake in the Waikato river basin where the water broke out of the caldera – Lake Taupo – and found its way to the sea. The swamp meant footrot for sheep. It was not until the Waikato railways were established in the early twentieth century that dairying could take off. Cows are not prone to footrot but their produce – butter and cheese – needs heavy transport.

The consequence for the city of Auckland was that it remained a port servicing quarrying activities – gold, timber, kauri gum – until a generation later than the southern towns. Moreover Coromandel gold was in hard rock, not alluvial which can be panned by individual miners. Hardrock gold requires substantial investment in underground mines and rock-crushing batteries. The risky capital to fund the enterprises led to the development of an Auckland business community built round a share market. Other centres had smaller ones, but without the same need to raise capital they were neither as vigorous nor as vulgar as Auckland’s. Thus was laid the foundations of today’s Auckland’s business predominance.

Not only did the Taupo volcano cleave the settler economy in two – south and north of the lake – it also had a major impact on Maori economic development. In a period when the nation’s economic thrust was growing wool, the majority of Maori lived in the sheepless areas. North of Taupo there were 7 percent of the sheep and 60 percent of the Maori (compared to 20 percent of the settlers). It is true Maori had lost a lot of land, but they retained much – on some measures more per capita than the settlers – enough to develop a viable sheep industry. We know this because Maori sheep flocks south of Taupo were comparable – relative to their population – with settler flocks. But there were far fewer Maori there.

So as far as their economic development was concerned, too many Maori were located in the wrong places in the nineteenth century. By the time economic activity moved north to dairying early in the twentieth century, Maori were too impoverished to go into dairy farming, which required greater investment than sheep farming.

The proto-Maori, when they first arrived, quarried the environment just like the Europeans did. We cannot be sure what led to the extinction of the moa, but it would seem likely that their hunting by the Maori was important. Archaeologists know from the middens that early Maori fished out some species, and know that the seal line – where the seals were – steadily retreated south during their first five centuries.

It is broadly true that Maori were living in a sustainable balance with the environment just before the Europeans arrived. For the politically correct it is inconceivable that their actions could have led to the extinction of species. What they forget is that the proto-Maori, who arrived 700 hundred plus years ago, came from a tropical environment and would have made environmental blunders because of their ignorance too. But there were fewer of them; their environmental destruction was not as great.

If this essay focuses on the way in which the environment shaped New Zealand before the twentieth century it is only space rather than significance which precludes a similarly detailed discussion of what happened after 1900. Quarries remained important especially coal, while the economy and society became dependent upon imported oil and phosphates quarried offshore. There was a constant interaction with the natural environment, not only with the soil but with the native bush which was sufficiently depleted that a plantation forest program was introduced at the beginning of the twentieth century. As population numbers increased and the economy expanded, waste disposal intensified, including the contamination of the waterways. Natural catastrophes disrupted and and reshaped localities, both physically and in the way people lived. In the case of the Canterbury earthquakes the impact may prove to be national; they almost certainly affect the future of the whole of the South Island.

The relationship between New Zealand’s history and its environment is ongoing and integral, not to be ignored or shunted into a separate chapter – although the numerous monographs on books on the history of the environment are invaluable to a writer of a general history. The serious scholar must take up the challenge rather than ignore it.

In turn readers can marvel at the story and the extraordinary progress science has made towards our understanding of the environment. In the end they may reflect too on its lessons. Perhaps the most salient one is that over the five hundred years after their arrival Maori developed a sustainable lifestyle. We shall have to learn from their example although it is much harder in a globalised economy – and we have less time to do it.

Another Financial Crisis on the Rise?

This entry was posted in Globalisation & Trade, Listener, Macroeconomics & Money on 29th September 2012 by Brian Easton.

Listener: 29 September, 2012.

The world economy remains fragile. There may be another major economic crisis, but if not, things will continue to drift – or possibly sink. Here are some of the major known unknowns facing the world – and us. It’s hard to say much about the United States economy. The country is in policy gridlock until the November election. What happens after that depends on the resulting political balance. The stasis may continue, with the world’s single largest economy continuing to drift, to the detriment of the rest of world, too. Greece may or may not leave the European Monetary Union (EMU), but the underlying issue is much larger: what to do when there are major structural imbalances among members. The EMU’s architecture places the responsibility for dealing with them largely on the individual countries: one with excessive debt has to reduce its national expenditure. But because disinflation affects people, mass protests occur; Greece, among others, is heading into a political deadlock.

The EMU leadership is fiddling around with banking reform – necessary but it’s not enough. My guess is there has to be some fiscal transfers among the economies, a policy currently unacceptable to Germany, which will be the major bearer of the burden. Expansionary policies by the strongest economies are also needed. Again Germany is reluctant. “Grexit” – a Greek exit – won’t even solve that country’s problems, either. Having some control over its exchange rate would give it an additional policy instrument, but the Greeks would still have to reduce their aggregate spending, with much less support from the EMU. (The adjustment might occur via severe inflation.) Even if Greece leaves and the contagion does not extend to Cyprus, Italy, Portugal, Spain and perhaps Slovenia, the EMU still has to get its architecture right. Unless it does, a Greek-like crisis will occur in some other member some other time.

Unexpectedly, the US is facing a severe drought and its agricultural production is down. That will probably affect the world food system as food prices rise. That may lead to food riots and starvation elsewhere. The effect on our meat sales is likely to be perverse at first. Higher grain prices will probably raise the US livestock slaughter rate. As more meat goes onto the international market, the price will weaken. Later, the smaller herds will mean less meat produced, and our farmers with grass-fed animals will benefit (providing they have not gone bankrupt). Our struggling dairy industry may already be benefiting from the feed shortages.

China is more problematic than the media commentaries would suggest. Its strong economy has protected many (including us) from the global financial crisis, but it is weakening. The country’s property bubble seems to have burst and the market looks a bit like the US in 2007. Because the Chinese Government owns most of the banks, it may react differently from the Americans and Europeans. We just don’t know. There is growing evidence that Chinese manufacturers are building up their inventory as they continue production (and employment) despite sales being down. Presumably they are being bailed out by the Chinese banks, which are also coping with the property bust. Manufacturers will cut production when their credit runs out. That will directly affect the whole of East Asia, from where they source their components.

New Zealand won’t escape – our coal, dairy and wool prices are already down. The Auckland property market may be especially hit. It has been fired up by Chinese purchases, presumably funded from their banks. If the Chinese banks have a credit squeeze, they may call in loans. Not only will Chinese purchasers pull out of the market but there may be some distress selling. That bubble may soon be popped. You may have noticed some New Zealand businesses are reporting poor profit performance and the trickle of layoffs and plant closures is becoming a flood. They are not alone. It is happening throughout the world. I am unable to write a column on the unknown unknowns.

Projecting Government Spending

This entry was posted in Regulation & Taxation, Social Policy, Statistics on 26th September 2012 by Brian Easton.

Presentation to a Treasury Workshop on the Long-Term Fiscal Projections; 26 September, 2012.

I am writing a history of New Zealand from an economic perspective. The manuscript – 250,000 words and I am only up to the 1970s – includes a number of appendices looking at the data. One is on government spending. The Treasury has made a contribution to the writing of this appendix; it contains material which is helpful, I think, to long term fiscal projections.

The consistency of the long-term data bases over time is deeply problematic, despite some Herculean efforts by Matthew Gibbons – we should all be very grateful to him.

There is far too much detail to describe the entire appendix here. This brief summary comes to a profound, dismaying conclusion. While population presents a problem, a greater challenge is the upward pressures of expenditure.

I begin with the following graph which shows Central Government Expenditure as percentage of GDP back to 1876. The aggregate excludes social security spending (to which I shall return), war expenditure, and debt servicing and other financing costs.

It is possible to discern a couple of micro-patterns in the graph, which will not surprise us. First, in war time, other spending is relatively lower and, second, government spending tends to be relatively higher when the economy is depressed compared to when it is booming.

But I can see no political pattern in the spending. The changes for the red – leftish – years look much the same as for the blue – rightish – years. The claim that Labour are the big spenders and National are frugal is not supported by the evidence. However, the Muldoon era aside, it is true that the left tends to outlay more on social transfers than National.

That each party favours its own voters is not surprising. What is surprising is that there is not an obvious pattern for other expenditure items; a comfort to long term projecting since it is not necessary to assume a future government of one colour or the other.

The big issue from the graph is there is unquestionable upward long run trend, amounting to 1.3 percentage points of GDP a decade. If the long-term trend continues we might expect trend government expenditure to be 6.5 percentage points of GDP higher in 2061 than it is today plus whatever happens to debt servicing and social transfers. (If there is war, all bets are off.)

For my projections I am going to use the shorter data base since 1947; it is more detailed (and consistent). First I illustrate the general approach by heath spending.

The long-term series shown that growth of health spending begins in the 1940s. Here the political narrative is correct – it was initiated by a Labour Government but after that both Labour and National increased spending as time went on. (Part of the early increase in expenditure is the ending of the contribution from local authority rates and charity.)

Why the additional spending? Briefly there were four effects:

new treatments such as drugs and surgical treatments;
affluence means we want higher quality of treatment;
the price of services rises relative to goods, because productivity rises are slower (the Baumol effect);
population aging.

We can only measure the last effect, which arises because older people require more health care than younger people. The graph shows that aging has added about 1.0 percentage point to spending since 1950. However the other three effects were stronger, adding 2.5 percentage points in the last fifty years.

Here is a table in which I have itemised the various expenditure categories, and shown what the logic of past rising spending patterns means for

Projections of Expenditure Class: 2010-260

	2010	2060 This Paper’s Projections			2060
Expenditure Class	Base Year	Aging Effect	Spending Pressure	Total	Current Projection
Health	6.9	3.2	2.5	12.6	11.1
Education	6.2	-1.8	2.0	6.4	5.2
Law & Order	1.7	-0.3	1.5	2.9	7.3
Heritage, Recreation Culture, Primary	1.2		1.5	2.7
Other government	5.5			5.5
NZ Superannuation	4.4	3.6		8.0	8.0
Social Security	6.8			6.8	3.3
TOTAL	32.7	4.7	7.5	44.9	34.9

In summary the table shows a much stronger government expenditure growth than the current projections, suggesting that the 2060 government spending will be about 12.1 percentage points of GDP higher than it is today. Of this 4.7 percentage points come from the changing age composition, while 7.5 percentage points come from additional spending pressures.

Since this projection and the current one use the same population projections, the main source of the divergence is the spending pressures. These are but (broadly) a projection of the trends of the last 50 years.

There is one other source of a divergence between the two projections. The current projection assumes that there will be no real increase in benefit levels for a further 50 years (70 years in all, given there has been none since 1991). Currently the gross unemployment benefit rate for a single adult is 26 percent of the average wage; it is projected to be 12 percent in 2060. [1]

Such a decline in the relative value of benefits would result in a huge increase in inequality and relative poverty, which is unlikely to politically sustainable (or possibly it will lead to mischief ranging from substantially increased government spending in health, education and law and order at one end to civil riots and worse at the other).

(This projection of New Zealand Superannuation is the same as for the current one which is a real increase in line with other incomes. I have some hesitations with that assumption. NZS is based on a single income household of two people. That situation is becoming sufficiently rare to raise the possibility that there will need to be some recalibration of NZS.)

The point of the long term fiscal projections is to identify pressure points. Thus far the projections have recognised that there is an issue of a sustainable path for the debt (and hence the fiscal deficit) and that the aging population is putting severe pressures on fiscal management. All this paper has done is point out that another source of pressure – apparently almost twice as severe than the age composition one – is the public’s demand for publicly provided services. It is of course possible that the public’s demand will abate but in terms of our current understandings, that seems unlikely in the immediate future.

I am acutely aware that this conclusion will be of no comfort to the Treasury. I have worked with it – off and on – for almost 50 years and know much of its history back to 1840. Expenditure pressures and controls have preoccupied them over all that time. The fiscal situation a Treasury faces is either: stress, great stress or intolerable stress.

My gloomy message is that the stress is not going away; it would be unwise to project that it will.

[1] The gross benefit rate in second quarter 2012, was $229.01 p.w, and the gross average wage was $884.75 p.w. including overtime.

Exercises in New Zealand’s Demography and Economic History

This entry was posted in Maori, Political Economy & History, Statistics on 21st September 2012 by Brian Easton.

This is an earlier version of a paper published in New Zealand Population Review, which was a festschrift to D. Ian Pool (Vol 7, 2011 p.178-182)

<>Introduction

In the course of writing Not in Narrow Seas: New Zealand History from an Economic Perspective I was found myself not only reporting demographic history, but using demography as a lens to investigate some economic questions. After the introduction there are two extracts from the yet-to-be published (indeed yet-to-be completed) text – modified for presentational purposes. here The lens-maker is of course, Ian Pool (and his students and colleagues), who has also commented on earlier versions of the text. [1]

Economic development – and therefore economic history – has been intimately tied up with demography, at least since Thomas Malthus, a great economic thinker best known for combining the law of diminishing returns with the less diminishing forces of procreation to conclude that humankind was in a poverty trap, because any increase in production would be absorbed by population growth.

Such is the clarity of his analysis we can identify precisely why his prediction has not come about. Agricultural productivity has increased markedly, couples have shown more restraint (as he might have said), and additional productive lands were opened up in the Americas, Australia and South African. While economists have been cautious of stagnationist predictions as a result of such a fine economist getting his predictions wrong, those who expect doom from ‘peak oil’ are essentially using a Malthusian framework. Even closer is the fear of a water crisis as aquifers are run down and rivers drained and polluted. In some ways salt-free water is even more important than land for food production; there is plenty of land in the Sahara desert.

Economists working in the fields of contemporary economic development have been very aware of population pressures. Fertility control has been a constant theme, although perhaps they have yet to turn their minds sufficiently to the consequential population imbalances which can follow some decades later – already a serious issue in China and in many rich countries.

Population change is also a serious issue in economic history. The Malthusian analysis is never far way from consideration of the path of the long established societies. The more recently settled ones require a different approach because they commence with a surplus of land (and other resources) relative to population.

Pre-Contact Demography (From Chapter 3)

The Polynesian settlement of New Zealand in the thirteen century makes Aotearoa a recently settled area. Unfortunately there is no documentary evidence about Maori life until the arrival of Cook and Tupaia in 1769. As best we understand it, proto-Maori morphed into what may be called the ‘classical’ Maori without any sharp technological or external changes. Technological change was not rapid; the likelihood is that it took generations for cultivating kumera to percolate down to the southern kumera line; long ocean voyaging seemed to have ceased for some reason – perhaps a climate change – from early in the fourteenth century, and Tasman aside, we know of no visitors that connected to them for 450 years until the arrival of Cook and Tupaia.

The population path of early New Zealand is fraught with difficulties. We are not sure how many Pacific Islanders arrived. An estimated base on the DNA evidence is 70 to 100 females. The population in Cook’s time is also uncertain; he estimated 100,000.

Suppose that there were 85 women in 1269 plus 85 men. Probably there were few children but we need to add in a ‘shadow’ number, of, say, 85, assuming a child to women ratio of 100%. (See below.) That is an equivalent population of 255. If it grew at 1.2 percent p.a. for the next 500 years, there would have been around 100,000 in 1769.

That rate would appear to be a very high population growth rate in Pool’s judgement; he says that a ‘rate of 0.5 percent would be a rather rapid growth figure for antiquity, and even for much of history’.[2] Perhaps we could allow a slightly higher rate because there was more than adequate food. But double Pool’s conjecture seems unlikely.

Additionally it is possible that the fifteenth century tsunami(s), which Bruce McFadgen has identified, destroyed as much as half the population; the oral tradition suggests at least one occurred during daylight hours when those who worked on the shores – most women and children – would have been relatively vulnerable.[3] If so we need double the number of canoes which first arrived or raise the fertility rate fractionally.

I am loathe to keep increasing the number of canoes. As I have argued elsewhere in my book, the more there were, the more likely that one would have brought breeding pigs. I am inclined to the view that Cook may have overestimated the late eighteenth century population, but that suggests a lower rate population decline through to 1840 than Pool thinks.[4]

We are left with the uneasy conclusion that the available data is not entirely consistent; hopefully the future will find a resolution.

The population story is important for an economist, because at some stage the Maori population would have grown to the point where available resources were fully utilised, as predicted by Malthus. But what was the limit and was it reached?

Pool reports that the Maori population density was low at the time of European arrival compared to other Polynesian Island groups.[5] Even if the numerator is arable land, the New Zealand figure is a sixth of the next lowest (Easter Island and the Marquesas). It could be argued that New Zealand did not have the crops to make full use of its arable land, but even so, one might conclude that the Maori population was not near its Malthusian limit in the late eighteenth century. (There is no evidence of a protein shortage then.)

It is sometimes argued that the increasing number of pa (fortified villages) demonstrates a response to rising to population pressures. The first sites begin to appear shortly after the tsunami (although the serious building program seems to be in the seventeenth century). Are the two events connected? McFadgen thinks so, but it is not obvious.

But was the rise of the pa driven by population pressures? Given our fragmentary understanding of the population dynamics of the times, this is but a conjecture. An alternative is that the capital base had reached the stage where it had to be protected. Or perhaps, with increasing affluence and with opportunities for discovery exhausted, adventuring now meant raids on other communities. [6] But these are but conjectures too.

Nineteenth Century Maori (Chapter 13)

From the middle of the nineteenth century, regular census enumerations provide estimates on the Maori population, although there was almost certainly an undercount in the early ones. Demographers may grumble about their data on the nineteenth-century Maori population, but there is hardly any economic data across all Maori before the 1951 census. (Income questions were not asked even of non-Maori until 1926.)

Throughout the nineteenth century Maori faced a rising European population. It had passed the Maori numbers in 1858, was five times as great at the end of the wars in 1872, and seventeen times as great near the Maori population nadir in 1896.[7] (These are national totals – there remained regions where Maori made up a significant proportion of the population.)

There were even those who saw eventual extinction of the ‘Maori race’. Infamously, Isaac Featherston, a doctor before he became a politician and land dealer, said in parliament in 1856 (before the main wars) ‘[t]he Maoris are dying out, and nothing can save them. Our plain duty, as good compassionate colonists, is to smooth down their dying pillow. Then history will have nothing to reproach us with.’[8] (In fact Maori have easily outlived him.) After the wars, in 1881, another doctor, Alfred K. Newman, who also took up commercial pursuits, entitled an address ‘A Study in the Causes Leading to the Extinction of the Maori’.[9] It is a reminder of the standard warning to economists that they should not make predictions, especially about the future.

The decline of the Maori population was slower after 1874 than it was before 1858.[10] Pool uses the child-woman ratio as a measure of the demographic health of iwi.[11] The ratio reflects fertility rates and morbidity, the likelihood that those born would reach adulthood, and that the adults would survive. It is not a familiar statistic but a sense of its magnitude can be gained from the 2006 Census, which reported – when the fertility rate was near replacement – the New Zealand ratio was about 85 percent – that is, there were 85 children under the age of 15 for every 100 women aged 15 to 49. [12] Given the higher child mortality, a higher C-W ratio would be necessary for the Maori fertility to be at the replacement level.

Pool estimates that the child-woman ratio for Maori was 70 percent in 1844, 87 percent in 1857/58, and 116 percent in 1874. The growth broadly flattens out to 120 in 1891, and then the ratio begins to climb again to over 150 percent in 1921. The stagnation period can be largely attributed to measles and whooping cough epidemics which killed more children. Some commentators had the insensitivity to report of the 1875 epidemics that they were ‘mild’ because few Maori ‘succumbed’ to the disease ‘except for children’.[13]

There was considerable regional variation. When in 1874 the average child to woman ratio was 116 percent, it was a healthy 154 in Northland and a struggling 81 percent in the Whanganui-Rangitikei region.[14] The regional patterns are complicated (especially if one is cautious – as Pool is – because of measurement error). On the whole, all regions experienced gains in the ratio over the second half of the nineteenth century, although some dropped in the period before 1874, especially in the Thames-Coromandel and the Waikato-King Country, recovering by the end of the century.

Since the two just-mentioned regions were central to the New Zealand Wars, it is tempting to use the coincidence to explain their demographic decline. Yet it is unlikely the war directly caused the low ratio, since that would involve the British troops killing Maori children in greater numbers than their mothers. Perhaps it could be explained by starvation after the war and less hygienic living as they retreated to less healthy pa, causing greater mortality among children than adults, and also lower fertility of the women (although it is usual to assume fertility rises with warfare). But there were iwi which did not suffer confiscation but also had a low ratio.

Pool focuses on the ‘immunological virginity’ of the pre-European Maori populations, with high death rates as new diseases were introduced, and some diseases lowering fertility – he mentions particularly gonorrhea – and increasing child mortality.[15] In which case iwi which lived where the European had arrived earlier, suffered their population decline earlier, recovered from the disease onslaught earlier, and so later ended up with the above average ratios. Thus in 1857 the Northland and Auckland regions’ ratios were among the lowest, although they showed a rapid recovery in the following 17 years. The deceleration (slowing down of the decline) was probably due to better resistance to disease, in part because the more vulnerable had died off, in part because of better hygiene and medical care (including vaccination against smallpox).

Thus the-after-the-war explanation of the Maori poverty is not particularly supported by the demographics, and while the popular ‘dying pillow’ thesis correctly observed the declining population, it did not pick the underlying recovery, which was under way decades before the nadir of the early 1890s.

In 1956 Keith Sorrenson proposed that the population decline was explained better by the loss of land per se, irrespective of the cause of the loss, rather than just the land that was confiscated.[16] Maori land had been alienated from the arrival of the settlers, as confirmed (but only limited) by the Spain Commission. The entire South Island, excluding Nelson, had been bought by the Government by 1860 (Stewart Island in 1863), although the reserves promised to Maori were not set aside for them. However most of North Island land was still Maori in 1860, the main exceptions being around the European settlements, most of the Wairarapa, much of Hawkes Bay and about half of Northland.[17] The confiscated lands were only a part of an alienation which accelerated in the 1860s.

In 1840 the entirety of New Zealand – all 66.4 million acres – was possessed by Maori (although some Europeans had some property rights). By 1870 the Maori owned just over a quarter (27.6 percent ); it was a sixth (16.6 percent) at the population nadir in 1891, and kept falling, to 7.1 percent in 1920.

Table 13.1: Land Holdings

	POPULATION			LAND OWNED
	Maori	European	Maori %of Total	Maori %of Total	Acres per Maori	Acres per European
1840	80,000	2,050	97.5	100	830	negligible
1850	65,651	22,108	74.8
1860	54,877	79,711	40.8
1870	49,374	248,400	16.6	27.6	371	194
1880	45,549	482,518	8.7	22.1	320	107
1890	44,127	623,350	6.6	16.6	249	89
1900	44,862	763,270	5.6	12.0	178	77
1910	52,240	998,170	5.0	12.0	153	59
1920	56,189	1,201,422	4.7	7.1	84	51

Sources: Population : SNZ Long Term Data Series (Maori population interpolated in non-census years, where not available). Land: Brooking (1996) Lands for the people?: the Highland clearances and the colonisation of New Zealand : a biography of John McKenzie p.136

Pool sets out a framework to explain the demographic changes in the Maori population.[18] It begins with growth of the Pakeha population and has four channels to high mortality

the introduction of pathogens
court hearings which increased exposure to pathogens [19]
land alienation which led to a decline in Maori food production and malnutrition
social disorganisation from land purchases and confiscation.

Pool certainly shows there is an association between land alienation and low child-to-woman ratios. However, as he regularly argues, correlation is not causation; the land alienation would have brought in the European population which spread the pathogens.

Pool gives no indication of the importance of each channel, although the weight of his text is towards the pathogen channels. At best it might be interpreted that the land alienation and the concomitant social disorganisation accelerated the decline, as well as possibly delaying the population recovery.

We should be sceptical that there was necessarily lower food production following the land alienation; if there was malnutrition it may have been part result of the depletion of sea, estuarine and shore resources and the soils from environmental degradation.[20]

There is another problem with the claim that land alienation was seriously damaging. Certainly Maori lost land, but they retained a lot. In 1870 there was around 371 acres per Maori, less than the 830 acres each had in 1840, but almost double the settler share of 194 acres per head.(A small holding, sufficient for a family of four, might be about 40 acres.) Per capita land holdings continued to fall as more land was alienated and as, after 1896, the Maori population grew. At the population nadir there were 249 acres a Maori, almost three times the 89 acres a settler. By 1930 it was down to 54 acres per Maori. These are but averages so there would have been some who were very much worse off for land, and some who were better off.

(It should also be emphasised that these calculations in no way justify the illegality or quasi-illegality of the way that much of the land was alienated. Nor should we forget that spiritual and ancestral links with particular parts of the land were torn asunder. But if this impacted on the population it is but the demoralisation thesis in another guise – as may be the thesis that social disorganisation directly led to mortality.)

It could be argued that the settlers had the better land, although some of their quota included ‘waste lands’ like the Southern Alps. On the other hand, by 1870 almost all the valuable urban land was in settler hands. Much of the farm land Maori were left with is highly productive today, but only after much developmental labour and capital. More damaging to Maori aspirations was the fact that the transport network which opened the land was often not there for theirs in the nineteenth century and was even slow to arrive in the twentieth.

The difficulty with the land alienation hypothesis on Maori mortality is that while land was certainly alienated – and too often unjustly – it does not readily fit the regional and timing patterns. In the end, one is left with the only rigorous explanation of the arrival of pathogens from an alien population. The direct impact of land loss seems to have been more on the Maori standard of living and developmental path, than on the population.

Conclusion

Even given the uncertainties and lack of solid information, demography has helped us think more systematically about the economics of pre-contact and late nineteenth century Maori.

There are perhaps two other conclusions to be drawn.

The first is that Malthus would have been fascinated by the pre-contact Maori story. It did not end in stagnation, despite the assumptions of his model applying almost exactly. That was because it was taking more than 500 years to get there. When we present the model we usually compare the disequilibrium and equilibrium states, but we do not usually discuss how long it takes to get from one of the other. There is a demographic limit on the speed of transition. Of course Malthus was writing about economies which were close to their stagnationist equilibria, but it is well to observe that it has not always been like that.

Second, while we should respect that Sorrenson was progressing an analysis by identifying a correlation between land loss and mortality which applied irrespective of the form of alienation. Pool offered a mechanism to explain the underlying causal process …

… as Ian has done in so many other areas of demography and which extend into economics and history.

Endnotes

[1]The central source for this paper and in the topic rea generally is D. I. Pool (1991) Te Iwi Maori: a New Zealand population, past, present & projected.

[2] Pool op. cit. p.37.

[3] B. McFadgen (2007) Hostile Shores p.262.

[4] Pool op. cit. p. 56.

[5] Pool op. cit. p. 41

[6] The book argues that pre-contact warfare may have been a leisure activity, not unlike rugby.

[7] The numbers used here exclude ‘half castes living as Europeans’. In 1891 they would have added about 5 percent of the Maori population, The totals include a similar number of ‘half castes living as Maori’.

[8] B. J. Foster (1966) ‘Dr Isaac Earl Featherston’ The Encyclopedia of New Zealand.

[9] Trans. Proc. New Zealand Inst., v.14, p.58-77.

[10] Phil Briggs (2003) Looking at the Numbers : a View of New Zealand’s Economic History has a lower decline rate after 1858, but Pool (1991) op. cit. p.76. does not have the lowering until 1875 (p.76) Neither implies that the wars accelerated the Maori decline outside the war period. (The difference between the two may be that the latter allows for the deaths as a direct consequence of the wars.)

[11] Pool op. cit., chapter 4.

[12] The upper age being chosen to reflect the shorter Maori life span in the nineteenth century.

[13] Pool op. cit., p.67.

[14] Pool op. cit., p.245.

[15] Elsewhere I had commented that the archaeological records which show similar longevity in the sixteenth century for Maori and more affluent Europeans might suggest they had similar standards of living. Ian has reminded me that Maori, being an isolated population, were not subject to the same diseases; they would be with the arrival of the European, and their longevity suffered accordingly. In such circumstances it is difficult to compare the material standards of living.

[16] M. P. K. Sorrenson (1956) ‘Land Purchase Methods and the Effect on Maori Population, 1865-1901’, J. Polynesian Society, v.65, 3, p.183-199.

[17] H Miller (1966) Race Conflict in New Zealand, p. 37.

[18} Pool op. cit., p.67.

[19] An economist might want to extend this to all commercial interactions.

[20} Depletion of the forests would have reduced the available edible bird life.

Leaky Legislation

This entry was posted in Business & Finance, Governance, Listener, Social Policy, Statistics on 15th September 2012 by Brian Easton.

Listener: 15 September, 2012.

Austrian philosopher Ivan Illich coined the expression “iatrogenic medicine” to describe illness generated by the actions of physicians. An example is when the doctors prescribe some medicine, with resultant side effects, which are treated by further medication. The cycle repeats until a specialist reviews the patient’s entire record and stops all the medication – and the patient is cured (perhaps). The specialist was thinking holistically and fundamentally, instead of just reacting to the latest upset. Iatrogenic policy failure is even more common, probably because genuine policy specialists are rare, and so we thoughtlessly react to the latest upset rather than going back to basics. An example is a recent reaction to the leaky building crisis, which involved numerous badly built homes and public and commercial buildings. The fundamental failure – light-handed regulation – was itself a classic case of iatrogenic policy, a thoughtless reaction to the over-regulation of the last round of iatrogenesis.

The current upset is over who is to pay to fix the failure. The law could identify the share of total responsibility carried by each involved professional – such as architect, builder, subcontractor, inspector – although the legal process is clumsy, expensive and erratic. In principle, each should contribute to the reparation in proportion to their share. However, many of them are dead, have disappeared or are broke and can’t pay. Under the current law of joint and several liability, some of the remainder may have to pay the full costs. Since the local authorities, which were responsible for inspecting the construction, are always there, they can become liable to compensate for the misdeeds of all those unable to pay. Their culpability may be 20%, but they may have to pay 100%, which hardly seems fair to ratepayers. The iatrogenic response has been a proposal – not yet enacted – to repeal the law on joint and several responsibilities.

Side effect resolved. The new side effect is there is no longer full compensation to the innocent party for a ruined building. This is so patently unjust that there will be another iatrogenic proposal to remedy it, and so on. We need to go back to fundamentals instead of treating the last symptom. The naive mechanisms to guarantee the provision of the quality consumers thought they were buying did not work. The list of failed mechanisms is long, but particularly pertinent are consumers’ inability to judge quality and the likelihood that the professionals they rely on may not be around when the defects eventually appear. Perhaps we need a permanent agency that takes some responsibility for the quality of a building from beginning to its end – paid for by a levy on the consumer. There was such an institution in the 1980s: the Building Performance Guarantee Corporation(BPGC). However, it was abolished for the standard neo-liberal reason: it did not conform to their naive market model, while – horrors – it required government involvement in the regulation of the market.

Would it have prevented leaky buildings? Probably not. But it would have limited the numbers involved, for as soon as the first leaky building became evident, the BPGC would have had to react, tightening up on its inspections and imposing standards on those designing and building the structures. It would have also limited the need for long and expensive litigation with erratic outcomes. The result would have been fewer disasters, less waste and far less heartbreak. There is an interesting parallel with the Accident Compensation Corporation (which the neo-liberals also tried to neuter). A major reason for its introduction was to eliminate expensive litigation with erratic outcomes. Under the old regime, 40% of the insurance levy was being spent on litigation; today it is about 10% on administration.

The Woodhouse Commission, which first proposed the ACC, laid considerable stress on prevention, although this was not always pursued with the diligence that Woodhouse envisaged. (It is better nowadays.) Should we revive the BPGC? It would certainly be worthwhile exploring the issue. But it requires the vision, integrity and intellectual power of a Woodhouse Commission. How to keep away the superficial, whose achievements are yet more iatrogenic policies?

The Context of Light-handed Regulation

This entry was posted in History of Ideas, Methodology, Philosophy, Political Economy & History, Regulation & Taxation on 10th September 2012 by Brian Easton.

Introduction to a Fabian Society series on Light-handed Regulation, Wellington.10 September 2012

This is the first of five presentations on light-handed regulation. Its critics sometimes call it “light-headed” regulation, referring to the simple mindedness of the idea, or “light-fingered” regulation, referring to the way a goodly number used it to line their own pockets at the public’s expense. More formally light-handed regulation is the notion that the market can be left to self regulation by private interests with a minimum of public regulation through law and supervision.

This presentation begins by putting light-handed regulation in an historical and intellectual context. Then it goes on to explain why this is an issue again facing New Zealand, thereby preparing the way for the remaining lectures. The lectures are not regularly spaced but are scheduled to coincide with important events, including the release of a couple of pertinent Royal Commission reports.

It will be necessary in this overview to illustrate some of the general propositions from the areas of the other presenters. But each will have a much richer story to tell. I will be listening to them closely, because while the last lecture begins with the failures in the building industry, by this time we should have the report of the royal commission on the effects of the Christchurch earthquakes. But I shall finish off suggesting what needs to be done.

There are other examples of light-handed regulation which the series is not covering. The choices are some of the most currently prominent ones. There are others including alcohol policy, broadcasting, aspects of consumer policy, and employment relations under the Employment Contracts Acts. In each there has been a strong “anything goes” element with the market defining the outcome rather than being used to shape it..

To begin almost at the beginning, after centuries of slowly building up, the economic forces were unleashed in the nineteenth century which transformed much of Europe from an agrarian and rural society to an urban and industrial one. It was a period of economic, social and political turmoil. Perhaps the forces were instigated by science and the enlightenment, but the central economic drivers were money, capital accumulation and the market; the greatest of them being the market.

There were two sorts of interdependent responses. One we know as the Left-Right dimension. The Left wanted to use democratic institutions – and therefore collective ones – to respond to the new economy, while the right preferred to leave these matters to individual initiative which, of course, were biassed towards the rich. Paul Samuelson, in his famous textbook principles, nicely – and ironically – captured the dichotomy when he pointed out the market was a kind of voting system in which you use dollars rather than a ballot paper to determine outcomes. Some people have more dollars.

The other response dimension was a modernisation stance versus conserving traditional society. This was not just an issue for the right, which saw the replacement of the aristocratic land holding class with a capitalist one, not all of whom where the descendants of the aristocracy. But it also applied to the left as well. The French social anarchist Jean-Pierre Proudhon is an exemplar of the traditional left approach when he advocated returning to a rural agrarian Arcadia of an idealised eighteenth century. However many socialists did not think this was either practical or desirable. They were the modernisers.

Socialism was a both a critique of urban-industrial society and a program of how to respond to it. The critique had two major dimensions. One was a deeply moral response, something which the left expresses passionately to this day. But socialism was never only a moral crusade – although sometimes it appears to present itself as solely one. As an analytical critique it was also an integral part of the development of the emerging social sciences. Many of the great economists of the nineteenth century were socialists – John Stuart Mill, Alfred Marshall, and Karl Marx.

Marx’s significance has been lost in the misinterpretations of his followers. He said he was arguing for ‘scientific socialism’ in contrast to those he saw as traditionalists, who may have been moral but were nostalgic for the Arcadian idealised past. Instead, Marx argued, the drivers of industrialisation and urbanisation were unstoppable. Just being moral about it was like lying in front of a train. That is why Marx described his approach as “scientific”, for it tried to analyse what was happening and predict the future. Marx’s prediction had a cheerful twist. He accepted that there was enormous suffering and distress from the industrialisation but his theory said that ultimately the world would be a better place – he called it ‘communism’.

Marx’s prediction proved correct insofar as that we are better off on many measures today than our ancestors were in the nineteenth century. Even Africa – the poorest of all continents – has a material standard of living three times higher than at the beginning of the nineteenth century. (Ours is twenty times higher.) But his prediction was very wrong in that the world has not reached some communist nirvana ruled by workers. It is an interesting exercise to explain what was wrong with his economic model, but let us skip onto the next group of socialists who were modernisers without forgetting Marx’s central lesson – we need to analyse as well as moralise.

The modernising group I want to talk about are the Fabians who were around later than Marx, by which time Britain was highly industrialised and highly urban. They were deeply moral; they knew many lived in dreadful circumstances in late nineteenth century Britain. But they were also analytic. I read Fabian literature before I began studying economics. Many years later I reread The Fabian Essays, and was astonished at the quality of its economics. Of course they were not up to the latest economic developments of the times, but they were no further behind than, say, today’s New Zealand university’s economic departments. Their writings are a part of the great social science investigations of the times.

The Fabians accepted urban industrial society. Their program was to mitigate its worst aspects. They named themselves after the Roman general, Fabius Maximus, whose tactics against the superior forces of the Carthaginian army were of harassment and attrition rather than head-on battles. Yet, like the general, the Fabian socialist’s mitigating policies were intended to eventually win – to transform society in the long run. Theirs was evolutionary socialism but the ultimate goal was a revolution – a socialist society.

To what? In 1918 the British Labour Party adopted a motion about its goals, moved by the major Fabian thinker, Sidney Webb. It was to secure for the workers by hand or by brain the full fruits of their industry and the most equitable distribution thereof that may be possible upon the basis of the common ownership of the means of production, distribution and exchange, and the best obtainable system of popular administration and control of each industry or service.

Later it became the well-known and well-fought-over “clause four”: the goal of the public ownership of the means of production, distribution and exchange.

Many years later I was puzzled why if public ownership was the ultimate destination of a socialist regime; did we not want to nationalise corner dairies? In the 1960s some British left wing thinkers argued for a revision of clause four to ‘the social control of the means of production, distribution and exchange.

I found that enlightening. Democratic socialism has a central principle of “subsidiarity”, that decisions should be taken at the lowest effective level, as close to those who are affected as possible. The market is a means to do this because it is the individual who makes the decisions there, not big brother state.

A century ago the Fabians sought social control by public ownership. But in the subsequent hundred years, our increasing understanding of how markets work meant that we now know that, under certain conditions, market mechanisms are an effective means of social control, in the sense that they enable us to attain our social objectives better than any other way. The reason we do not nationalise corner dairies is that they do broadly what society wants from them under a properly regulated competitive market and we don’t know any better way.

How market transactions are regulated is, and has been, a central economic concern. It has also been a concern of modernising socialists. A question of terminology here. There are some who define socialists as committed to public ownership. If so, we might define those who focus more on social control as “Social Democrats”. I favour the broad church and try to eschew sectarianism. So I’ll refer to those who support social control also as socialists; if you are of a different mind you are welcome to substitute “social democrat” for “socialist” as I go along.

“Competition” and “proper regulation” are critical ideas. I am not going tonight say much about the notion of competitive market, except to encourage you to attend Geoff Bertram’s lecture in this series. We once had a rule of thumb that if there were five largish firms in an industry then it was near enough to being competitive for practical purposes. What Geoff’s work has shown that has not been true for New Zealand’s electricity sector; which has hiked prices at the expense of consumers.

He tells me he is going to talk about ‘workable competition’ which is how those 1960s socialists talked about the social control of strongly oligopolistic industries. It is an expression which has almost fallen out of use in New Zealand, and so has the analysis which goes with it. Geoff will reintroduce it. We need to. It is very rare that there are even four firms in many vital New Zealand industries.

The issue of properly regulated markets is the focus of the rest of this lecture, and – including workable competition – of the rest of this series. We begin by observing that the corner dairy is subject to various laws and regulations which cover food hygiene and consumer information and protection. Additionally – and importantly for later parts of the story – a wronged customer may be able to sue the dairy owner for damages. There are a plethora of these restraints over dairies. Market transactions which do not come under some legal restraints are extremely rare. The issue for those who favour social control is what are the relevant laws?

The notion of the market as a means of social control was not a popular view in New Zealand’s Left in the middle of the twentieth century. Its thinking had evolved out of the older economic tradition captured in the clause four approach to socialism. In any case, Labour had come into power in 1935 and had established a far more interventionist economic management than the social control approach subsequently suggested was necessary, although perhaps it reflected the economy of the times and its understandings.

The Muldoon government was the apogee of this approach. Of course Muldoon did not use the economic powers available to him for the purposes the Left desired, and there were many who saw the solution was to take over the same powers as Muldoon but apply them for other purposes. This overlooked the way that with affluence and complexity the economy was becoming increasingly difficult to control directly. In any case why neglect using the powerful mechanism of social control that the market offered?

The Labour government which came to power in 1984 sort-of realised that the regime that Muldoon managed could not continue. It did not, though, have much idea about how to replace it. It remains a mystery how the Fourth Labour government got captured by those who were pro-market but not from the Left and went on to abandon most of their socialist aspirations. One explanation was that they were modernisers and their Labour supporters were not, so they turned to the only group whose approach seemed to be addressing the problems which Muldoon’s management exposed.

That cannot be quite true. Many Labour supporters were economic traditionalists, but there were also a group of modernisers committed to traditional social values but who had thought about how to use the market for social control. The left wing modernisers saw the value of using the market as an instrument for social control in the pursuit of higher social ends; in contrast the right wingers saw the market as an end in itself.

Why did the Labour government not turn to the leftish modernisers for assistance, instead of letting its right wing advisers repress them? Again we do not know; such memoirs as we have avoid such issues. Certainly the neo-liberals saw this alternative as the greatest threat to the implementation of their agenda, and repressed them while the traditional left also turned their back on them. The repression set back the left for a quarter of a century; this Fabian Society is an attempt to re-establish the analytic approach of the left modernisers.

One factor may have been that the Labour traditionalists did not trust the Labour modernisers. Tony Judt accuses the left of being conservative. I think what he means is not only that they wish to preserve old values, but that they also want to preserve the institutions which they created in the past. Modernisers of the left or right threaten those institutions, albeit the left group may be progressive trying to adapt them for the evolving circumstances; while the right group – the neo-liberals – may be in favour of abandoning them. The Labour Traditionalists could not distinguish between the two, and so never turned to the Labour Modernisers for help against the neo-liberals.

(To illustrate the point, consider the social welfare record of the recent Labour Government. Its main advisers were essentially traditionalists, and with the occasional exception little was done to update the welfare state except at the margin. National has come in and tried to adapt the system for fundamental social change in the last forty years. In my opinion they are not doing it very well, but at least they recognise there is a problem. The traditional left is up in arms – as well they might be, given what amounts to pig ignorance and miserliness – but it is a conservative reaction which is hardly addressing the problems the social welfare system faces, just as they failed to do when they were in office.)

The fourth Labour Government did not implement the full neo-liberal program. As Roger Douglas wrote in the early 1990s there remained “unfinished business”. As we used to say before the Fourth Labour government was elected, the neo-liberals would not be satisfied until they abolished dog licences.

Initially the National government elected in 1990 determinedly pursued the agenda, never quite getting to the dog licences. To give it credit, the Fourth Labour government had put in some consumer law, which has been subsequently strengthened. There was also some worker protection law. Rather than repealing it, National’s neo-liberals undermined it by providing insufficient funding to enforce the law or weakening the institutions that were needed to make it work; as Hazel Armstrong will show, you cant have effective work safety in a dangerous work place without effective worker representation.

As a part of its approach this National government promoted the notion of light-handed regulation, where businesses were largely left to regulate themselves. The current government still does to some extent; a minister argued that it was unnecessary to impose particular regulations over the state owned assets they were trying to privatise, because the private sector would act in a socially responsible fashion.

Three broad reasons were advanced as to why private businesses would behave responsibly:

First, they would want to maintain their reputation in the community, to consumers and among workers. But reputation is of little value if the irresponsible behaviour leads to the firm’s demise. What is the Pike River coal mine’s reputation worth?

Second, there was the legal possibility of facing damages (preferably, if you were a neo-liberal, through the use of common law). Awareness of the possibility of damages would deter – it was said – businesses from misbehaviour. The reality is that it did not deter the building industry from constructing buildings which were not resilient to earthquakes nor ones that did not leak.

Third, it was said that the businessman and women would behave morally. It is hard to argue that happened in our finance sector, some members of which not only failed to behave morally, but broke the law to the point that they have been incarcerated. But their fraud is the tip of an iceberg. Consider all the so-called independent financial advisers who failed to mention to investors that they were paid by the businesses they were recommending investing in. In my view not indicating a conflict of interest – especially when it was as great as this – is immoral. (Observe that neither loss of reputation nor the threat of being sued had much effect either.)

The purpose of the three reasons – reputation, retribution and morality – was to justify light-handed regulation. The real reason neo-liberals supported it was that they had no confidence that the government could do any better. This was not the result of a careful assessment of the alternatives that a left moderniser might make. Rather it was part of a sweeping ideological belief that the government was always a part of the problem, never a part of the solution.

Alan Greenspan acknowledged the foolishness of such a universal condemnation, following the Global Financial Crash. He was a follower of Ayn Rand whose objectivist philosophy is an extreme form of neo-liberalism – Paul Ryan, the US Republican candidate for vice president is another follower of Rand. In the almost 20 years in which Greenspan was Chairman of the Federal Reserve of the United States he managed the stock of money – as Friedman advised. But he neglected regulating the American financial system, instead practising light-handed regulation. The practice contributed to the magnitude of the Global Financial Crisis.

Not long after it began, Greenspan was questioned by a congressional committee. Referring to his free-market ideology, he said

“I have found a flaw. I don’t know how significant or permanent it is. But I have been very distressed by that fact.”

He was pressed to clarify what he was saying. A congressman remarked:

“In other words, you found that your view of the world, your ideology, was not right, it was not working.”

To which Greenspan replied

“Absolutely, precisely. You know, that’s precisely the reason I was shocked, because I have been going for 40 years or more with very considerable evidence that it was working exceptionally well.”

To give Greenspan credit, he admitted he was wrong. Few of our practitioners of light-handed regulation have so fessed up. I’ll leave David Tripe to illustrate the failure in the New Zealand finance sector but allow me to insert a comment about our Reserve Bank.

I do not know how much objectivism influenced Don Brash who was its governor for the 14 years to 2002. His strategy broadly followed that of Greenspan, controlling the money supply but a hands-off approach to financial regulation other than by requiring public disclosure of the financial accounts. His successor, Alan Bollard who almost certainly knows about workable competition, took a more interventionist approach to regulating the banking sector. Almost certainly the measures he introduced moderated the impact of the Global Financial Crisis on New Zealand. However the Reserve Bank was not then responsible for the non-banking part of the financial sector. As David will report, that was regulated under light-handed principles and it failed miserably.

We should not conclude that light-handed regulation always leads to disaster. Where the threat of a loss of reputation or of being sued for damages are effective. business may be more easily left to itself. (I doubt one can rely on the morality of business in a capitalist system.) Typically that happens where a wrong may be identified reasonably shortly after the transaction. However where it takes time, the outcome can be catastrophic for the gulled consumer or investor.

Let me round off the political story with what happened under the Fifth Labour Government headed by Helen Clark and Michael Cullen. They were elected on a platform of reversing the extremes of the neo-liberal era; in many areas they did. You might say they were Fabian modernisers even if the neo-liberals saw them as reactionaries.

Very often they failed to complete the job. I am not sure of all the reasons but surely a key one was that the earlier repression of the left modernisers meant that the Clark-Cullen government lacked the fire-power to address some issues. This is no better illustrated than in the area of market regulation. When they came to power they established three reviews of areas where there were sharp problems..

To review monetary policy they chose a Swedish economist who supported the status quo; not surprisingly we got little from that report. While I have the greatest admiration for Alan Bollard, he leaves the job as governor this month with monetary policy still requiring an overhaul. It is not likely to happen until a new government is elected. Hopefully next time they will select their advisers a little more carefully.

The reviews of the telecommunications industry and the electricity industry did only a little better. Neither review team seemed to know much about workable competition. Fortunately, as far as telecommunications were concerned, there were officials who were practical and we have been slowly getting that sector under social control. Electricity has been even less successful, but I’ll leave Geoff Bertram to tell that story.

One thing you should notice is that in each case there were powerful business interests favouring reform. Exporters were suffering from the exchange rate consequences of monetary policy (still are). Suppliers of telecommunications services were finding themselves overwhelmed by the Telecom monopoly; their persistence may be why there has been progress here. As well as households, businesses consume electricity and they also they thought were getting a rough deal. But before you draw the lesson that the Fifth Labour government was not as sensitive to the interests of ordinary people, it did progress consumer protection legislation. I look forward to Hazel Armstrong assessing its contribution to safety in the workplace.

Hazel, and indeed the others, will draw attention to ongoing failures over the last two decades. The list is long. I am going to list some of the most appalling ones. It is not accidental that these are largely recent. Light-handed regulation works best in the short term. Long term problems accumulate and so they can be much more difficult to deal with when they become visible.

I begin with seven examples where the failure of light-handed regulation has led to greater direct regulation when the failure became evident.

1. Telecom, the dominant supplier to the telecommunication market, was privatised without any consideration of the regulatory environment. The government-owned business had been directed by the government to limit some of its monopoly behaviour; those practices were immediately abandoned by the new private owners. In recent years there has been increased intervention, including a telecommunications commissioner in the Commerce Commission and specific directions by him on how the industry should organise itself. The most important change has been the separation of line from other telecommunication businesses – the division into Chorus and Telecom. It probably should have been done when the firm was privatised in 1989; it was not even considered. For over two decades Telecom used the privilege of its monopoly position to prevent effective competition and gouge consumers – as its exceptional profitability shows – but there was also a cost that we got behind the rest of the rich world.

2. Because market competition in electricity supply has not always been effective, there is a supervising Electricity Authority and restrictions on the degree of vertical integration. Even so, as Geoff Bertram has reported and will report, electricity prices seem to have risen faster than they would have if there was real competition.

3. The finance industry is now regulated by the Reserve Bank of New Zealand following widespread business collapses in the 2007 to 2010 period, in part the result of inadequate supervision by the Securities Commission which practised light-handed regulation.

4. The investment advice industry now has an investment advisers’ act following its poor quality – indeed immoral – performance in the run up to the Global Financial Crisis, when many investors lost wealth.

5. In early 1998 the Auckland CBD suffered a blackout when the cables delivering electricity overheated and failed. This may not be quite as much a regulatory failure as the other examples, but it reflected a downgrading of engineering supervision with greater attention to commercial imperatives, similar to that which has occurred in some of the other examples. The board of the company consisted of business people none of who were competent engineers; it was an engineering matter when the cables failed.

6. Evidence to the Royal Commission inquiring into the Pike River Coal Mine disaster suggests that there had been inadequate levels of mine safety supervision. In August 2011, the Department of Labour’s head of health and safety policy, James Murphy, agreed that the department had taken a hands-off attitude to the detail of mine safety ‘and we are now thinking that actually we were too hands-off.’ A few days later, the Government announced it was setting up a High Hazards Unit, doubling the number of safety inspectors for the mining and petroleum industries.

7. The highly ideological Employment Contracts Act was introduced in 1991 with the effect that workers and their representatives would have reduced roles in regulating the work place. It has been replaced in 2000 by the Employment Relations Act. While the replacement act could be argued to reflect the changes of political power following the election of a Labour Government, there has been no strong reversal following the election of a National Government in 2008, although there is a weakening of some of its provisions. It is another example of neo-liberal innovation which has been repealed because the experience it did not work.

In each case light-handed regulation failed to the extent that the regime was replaced. But the costs were not just reduced economic performance and equity. Here are five examples where there was a loss of lives.

8. In April 1995 14 young people died and others sustained severe injuries when a platform overlooking Cave Creek collapsed. In his report on the incident, Judge Graeme Noble found one of the causes of the failure was inadequate supervision by the Department of Conservation. Behind the failure was the 1989 closure of the Ministry of Works and Development which meant their high standards of regulatory supervision of such constructions lapsed. Noble concluded ‘I am left with the overwhelming impression that the many people affected – victims and their families, department employees and their families, and others closely associated with the disaster – were all let down by the faults in the process of government departmental reforms.’ This might be thought of as a precursor of leaky buildings, where workers without the requisite expertise took on a construction task beyond them.

9. In April 2008, a coolstore in Tamahere, Hamilton exploded killing a fireman. The manager of Icepak told the inquest that his company operated without knowing it was putting people at risk, and had no one on staff with electrical or refrigeration expertise. Instead they relied on outside experts. A safety inspector said that an inspection three years earlier had found some safety issues, but there was no obligation for that to be followed up; it was the owners of coolstores who were to make sure plants complied with the law, because the industry was self-regulating. The company, the associated refrigeration company and the managing director pleaded guilty to charges of breaching health and safety employment regulations. Their fines plus reparations to the injured firemen and their families amounted to almost $400,000.

10. I have already mentioned the explosion of the Pike River Coal Mine as instigating a reversal of light-handed regulation. A factor was that 29 men died. The Royal Commission has yet to report, but the evidence to the enquiry suggested that had there not been the reductions in the frequency of mine inspections and the standard of mine safety supervision, the disaster may not have occurred.

11. The leaky building syndrome is an exemplar of the economic failure of light-handed regulation. The failure involves significant resource costs. The estimates depend on assumptions; currently the lowest is NZ$11.3 billion (i.e. 6% of annual GDP), with them going up to $33 billion (18 % of annual GDP).These estimates do not include the costs of similar failures in commercial buildings and public buildings such as parts of hospitals and schools. Moreover there has been severe personal and financial stress which has contributed to marriage breakups and suicides.

12. While much of the destruction from the Canterbury earthquakes was inevitable and some of the deaths unlucky, it is clear that the 115 deaths at the CTV building were the consequence of poor design and construction techniques which could have been avoided had there been adequate public and private supervision. We await the report of the Royal Commission of Inquiry.

This is a selective list, albeit one which highlights some of the worst catastrophes. But think of the number. Oscar Wilde’s Lady Bracknell famously said that to lose one parent was a misfortune but to lose two was sheer carelessness. When it comes to this number the carelessness is outrageous. What has to be done is not just to treat each instance as it occurs. Rather we need to see the regularities across a wide range of instances and address the mind-set of light-handed regulation.

The current policy stance seems to be that we practise light-handed regulation until we get caught, and then respond on an ad hoc basis. What is needed is a approach which is sufficiently worked out that the sixth Labour government, when it is elected, is committed to it and in a position to act comprehensively. If we don’t there will be more; we may not repeat leaky buildings but the likelihood remains there will be other construction disasters. Worker safety will remained compromised unless we tackle the issue holistically.

I am now going to set down some principles at the meta-level, those that set out a context for regulating an economy. I apologise that they are not as brief and elegant as Webb’s 1918 statement. The economy has got a lot more complex and our understandings are greater.

What I am setting down here is, of course, tentative. If someone offers a better set then I am happy to gracefully withdraw these (although I reserve the right to criticise alternatives if they are too complicated, inelegant, or prescriptive.) They are very much in the spirit of the left modernising approach.

Principle 1: The purpose of the economy is to contribute to higher social goals (which need to be set out, but not solely by economists). It is not the higher goal.

Principle 2: Businesses have a critical role in pursuing this economic purpose, irrespective of their form of ownership. This role should be respected, but it is one where business is the servant of society, not its master.

Principle 3: The government has a role to ensure there is social control of the means of production, distribution and exchange. (The modernised version of Clause Four.)

Principle 4: There are numerous ways of exercising social control including public ownership and regulation of private business. There is no prior preference for a particular approach. The test is what works, and the configuration of interventions will depend on the particular circumstances.

I am going to stop here because we are moving from the meta-principle level to how we might go about designing a system of social control. I have not yet made my mind up. I shall be listening very closely to Hazel, David and Geoff over the next three lectures. In my final contribution to this series I shall draw on their lectures and what I have learnt from the failure of regulation in the building industry to conclude by suggesting what a set of principles to regulate the economy might look like in today’s conditions.

We can use them as the basis for a discussion on the sort of approach the next leftish government might implement. Hopefully it will be a left modernising one.

The rest of the series are as follows:

Light-handed Regulation and Work Safety, presented by Hazel Armstrong on Monday 8 October;
Light-handed Regulation and the Finance Sector, presented by David Tripe on Wednesday 31 October;
Light-handed regulation and the Energy Sector, presented by Geoff Bertram on Monday 12 November; and
Light-handed Regulation and the Building Sector, presented by Brian Easton on Thursday 22 November.

All will be at Connolly Hall at 5:30pm.

A Framework for an Economic Strategy

This entry was posted in Business & Finance, Distributional Economics, Globalisation & Trade, Growth & Innovation, Macroeconomics & Money on 9th September 2012 by Brian Easton.

<>A note prepared for discussion in September 2012.

Keywords: Business & Finance; Distributional Economics; Globalisation & Trade; Growth & Innovation; Macroeconomics & Money;

What is the Purpose of the Economy?

* The purpose of the New Zealand economy is to maintain and increase the wellbeing of all New Zealanders. It is neither the maximising of material output (GDP) nor the maximisation of profit, although under some circumstances these can contribute to the purpose.

How Do We Seek to Improve the Wellbeing of New Zealanders?

* By the social control of the means of production, distribution and exchange. That control may be exercised by the government and other collective institutions, or it may be left to a properly regulated market.

What Is The Role of the Market?

* A fundamental principle of democracy is of ‘subsidiarity’, that decisions should be taken at the lowest effective level, as close to those who are affected as possible. The market is a means to do this. However markets do not always do this effectively.

How Do We Make the Market Work Effectively?

* Markets typically need a framework of laws and enforcement to work effectively. This includes

– laws which affect consumer information, safety, protection and transactions;

– where competition does not work well ,workable competition (which can include public ownership);

– in employment relations;

– health and safety (including worker health and safety);

– where transactions are complex and take time for the full outcome to become evident as for financial transactions and construction;

– where the actions produce economic ‘bads’ such as in the environment or from misuse of drugs (including legal drugs such as alcohol and tobacco).

– for goods and services which have a collective or a merit element.

What Is the Economic Role of Government?

* To regulate markets.

* To provide the goods and services in alternative ways where markets work particularly ineffectively. Examples include

– educational services;

– health care;

– public interest broadcasting;

– the underpinning of cultural and recreational activities;

– environmental services.

* To maintain full employment by providing an adequate level of effective aggregate demand through fiscal, monetary and exchange rate policies – without stimulating inflation.

* To offset market failure in the mechanisms which promote economic growth. (Especially important is the stimulation of technology and innovation).

* To provide protection and support for the weakest in society.

Who Are the Weakest in Society?

* The first priority of the government is to protect the young, the sick and disabled, and the elderly.

* Particular needs at the moment arise from

– the widespread poverty among children;

– those caring for the sick and disabled with inadequate public support;

– beneficiaries who have not had an increase in the level of their benefit above inflation since 1991.

* While education and health are always priorities of a caring government, New Zealand also faces a particular crisis in its housing stock from inadequate maintenance, poor supervision of building quality, the need to rebuild from the Canterbury earthquakes and the need to strengthen to meet future earthquakes. (The latter applies to many public buildings.)

How Should the Government Fund its Activities?

* The main source of revenue for government is taxation. Compared to the current taxation regime the government will need to raise taxation to meet its wider social objectives. Among the options that need to be explored are

– a higher top tax rate, so the rich make a fairer contribution to the nation’s overall welfare;

– a real capital gains tax;

– extending GST to cover offshore electronic transactions and personal imports;

– a financial transactions tax to be imposed with like-minded jurisdictions.

* Use of public resource (such as carbon credits) should be charged for instead of given away.

* Borrowing should generally be limited as the government should be contributing to the nation’s savings.

Why Are Savings Important?

* Without adequate savings the economy is unable to fund its physical investment, public investment (including infrastructure) and the necessary refurbishment and extension of the housing stock.

* Depending on foreign borrowing raises the exchange rate undermining the ability of the export sector to thrive.

* The inevitable consequence of foreign borrowing is that an increasing proportion of New Zealand land, resources and businesses will be owned offshore.

* To increase the nation’s saving the government should

– as far as practicable run a surplus on the current government account;

– make Kiwi saver compulsory and raise the contribution rates;

– discourage wasteful investment as occurred recently under the light-handed regulation of the finance company sector.

How Should New Zealand Connect with the Rest of the World

* New Zealand is a trading nation, specializing in some exports where it has a high productivity comparative and competitive advantage and importing goods and services which it has not.

* It should pursue free trade opportunities, but never where the concessions would compromise the long run wellbeing of New Zealanders (especially PHARMAC and intellectual property rights).

* It should be reasonably open to direct foreign investment, where the investors are bringing expertise not readily available in New Zealand, but foreign investment should not be an alternative to the failure of the New Zealand economy to save sufficiently.

* It should not get significantly involved in the high turnover finance markets which are destabilising, but seek like-minded international partners to insulate their economies from them; a multi-nation Financial Transactions Tax may be a means of doing this.

Economic Uncertainty

This entry was posted in Macroeconomics & Money, Political Economy & History on 4th September 2012 by Brian Easton.

St Andrew’s Study Trust lecture series: Living with Uncertainty; 4 September 2012

The notion of uncertainty – and risk, which as we shall see, is something else – is central to economics and the economies it describes. Of course there are external events which generate shocks like the Lisbon or Canterbury earthquakes. But today I am going to talk about the financial shocks which the economic system generates. It’s a complex story, so I am going to have to leave some important bits out to keep within the time.

Financial shocks occur almost exclusively in modern market economies: bubbles, panics, depressions and recessions and global financial crises are rare in traditional societies. One of the central characteristics of a market modern economy is that money is pervasive. Economists have long been aware that money, and some different but related phenomena which I shall call “financial paper”, are central to these shocks. Today’s presentation is about how they are.

While some talk of the “mystery of money”, the only mystery to an economist is why people get confused about it. Perhaps they do not think rigorously. For an economist “money” is the “medium of exchange”, what people are willing to accept in exchange when the sell something or settle a debt. There are other functions of money – a standard of value and a means of deferred payment – but these are convenient consequences of money being a medium of exchange.

I have not time to go into why some things are money and others are not. Perhaps in a modern economy the test is that if you can pay your taxes with something it is money. That includes coins, notes and cheques.

There are also things which are “near money” – that is they may be easily converted to money. If you have a bill – or taxes – to pay you can usually go into your bank and transfer from your savings account to your current account and write the cheque on that. A savings account is near money; a cheque account is money, you can pay bills directly with it.

That something as a dollar value attached to it does not mean it is money or near money. You can also sell your house to obtain the money you need to pay a bill. That is far more complicated, so it is hardly sensible to call your house “near money”. It is an “asset”. It is important for the story I am about to tell, that you are uncertain as to how much cash you will get when you sell your house. That is different from your bank deposit; you know exactly how much it is worth.

A particular group of assets are “financial paper”. They are contracts to pay a certain amount of money at some time in the future. They are neither money nor near money,

Perhaps the simplest example is an IOU, which is a contract – a promise to pay a certain amount in the future. If the IOU is from your much trusted brother-in-law who is a billionaire you are pretty certain it will be repaid. If it is in your balance sheet as an asset it is in the promisor’s balance sheet as a liability.

You may even sell it to someone – although its value might be discounted a little because the purchaser is not as trusting of your brother-in-law as you are. Much financial paper is not nearly so secure. For instance some New Zealanders have deposits in finance companies which have gone bankrupt. Whatever the face value of the deposit, the actual return will be zilch if the finance company is unable to pay it back. Sure, there is a contract that says the company will pay – give you money – in exchange for that deposit with them. But if they cant; the contract is worthless.

The value of an IOU is the money you can convert it into. That is different from an asset like a house. A house is a house is a house; it is something tangible with an intrinsic value. Certainly houses also have a monetary value, but an IOU, like all financial paper, has only monetary value.

IOUs and deposits in finance companies are simple forms of financial paper. There are many more complicated ones. In a modern financial system some of the most important financial paper are contracts where the pay-outs are dependent on contingent events.

An early form of contingent contracts was life insurance, which involve one party (say a person) paying another (a life insurance company) a certain amount, with the second party agreeing to pay a somewhat larger amount if a particular person died before a particular date. The reason they could offer such a deal is while we cannot be sure when a particular person will die, based on past experience the life companies have a good idea about how many in a pool of people will. So the risk of an individual dying can be calculated and the event insured against.

Is there a fundamental difference between investing in a contingent contract and gambling – between a contract insuring a life and a contract that if a thrown dice comes up even you get paid and if it comes up odd you pay? There is not a lot – the mathematics are much the same. The distinction is often made according to the usefulness of the insuring transaction. It would seems prudent for a firm to insure the life of its chief executive, since there would be great difficulties if he dies suddenly. But what about someone else betting on the chief executive dying? Maybe they are a shareholder in the firm, maybe they just want to gamble.

This becomes very pertinent when you can insure against a firm or a country going bust. There have been recent examples where the amounts insured far exceed what might be lost if the event occurs. Some must be gambling.

Insurance may be the simplest form of financial paper, that is a contract whose payment depends on a contingent event, but a whole raft of increasingly complex ones have developed; among them are “shares”, “futures”, “options”, “swaps”, “hedges” and “derivatives”. In each case some parties make a contract whose payout depends upon whether a particular event occurs.

We get mesmerised by the mind-boggling sums attached to the value of a particular piece of financial paper. However, behind the row of zeros is the simple idea that there is a contract in which one party has agreed to pay the other an amount if certain circumstances occur, and that one of the parties thinks that the value of that contract is this huge number.

It may not be, of course, since the contingent outcome may be different from what the valuing party assumes. But if enough of this financial paper is held in the investor’s portfolio, the wins and losses average to the average value of the portfolio.

Clearly it is critical how the financial paper – the contingent contracts – is valued. If this can be done in an objective way, so that we can all agree on its value, then the financial paper can be bought and sold. This liquidity makes the financial paper more attractive to investors, who may need the cash before the events in the contract have played out.

Over the years economists and others have developed very sophisticated techniques for valuing the contingent contracts – the financial paper – developing an analysis called “portfolio theory”. The valuation requires an assessment of the probability distribution which underpins the contingent events. I would lose many of the audience if I went through the mathematics. So let me just say it depends upon knowledge of a couple of parameters which underpin the probability of the various outcomes of the contingent events. (I’ll just squeeze in that they are the mean (or average) and the standard deviation.) Once given them, you can value a particular piece of financial paper and make an assessment of whether it should be in your portfolio.

But suppose you don’t know those parameters. John Maynard Keynes pointed out you then suffered uninsurable “uncertainty” rather than insurable risk. Risk is about known unknowns; uncertainty is about unknown unknowns

If there is uncertainty you cannot know those key parameters. Portfolio theory does not work. However some Bayesian statisticians said you could use your best guesses. The dispute is a bit complicated – you can read about it in Skildelsky’s Return of the Master.

But there are two key points. First, suppose everyone is wrong about the parameters they guess for the distribution. Then there may be major distress when the contingent event becomes a reality.

Second, and more subtly, the relevant parameters may be literally unknowable. I wont go through the details but the mathematician Benoit Mandelbrot observed ‘10 sigma’ storms in financial markets pointing out that “[a]ccording to portfolio theory, the probability of these large fluctuations would be a few millionths of a millionth of a millionth of a millionth….But in fact, one observes spikes on a regular basis – as often as every month – and their probability amounts to a few hundredths.” He warned of ten sigma storms a decade before the Global Financial Crisis, but no one listened. Why?

One kind of answer is that portfolio theory may have been imperfect but neither Keynes nor Mandlebrot offered an alternative so portfolio theory continued to be used. This is a nice illustration of the scientific truth that theories get replaced not because they are known to be wrong, but because some one finds a better theory.

Additionally some people became very rich from portfolio theory. They have a vested interest in defending the theory, and since we give great weight to the judgements of the rich on a whole range of issues outside any competence they have, everyone assumed that the portfolio theory that made them rich must be right.

Another kind of answer as to why we ignored the warnings was that portfolio theory seemed to work reasonably well up till then. Of course there had been the odd crisis; the dotcom bust, the Enron debacle, the failure of Long Term Capital Management, a firm whose board of directors includes a couple of economists who were Nobel laureates for their contributions to portfolio theory. Most of the time, the financial system manages to get through these crises. Firms are always falling over, contracts are always going wrong, most businesses have a list of bad debts. But the system had muddled through, and it was assumed that it would continue to do so.

Yet as Mandlebrot predicted, there would be occasions when there was perfect storm in which the financial system breaks down into a systemic crisis. The 2008 Global Financial Crisis was one. It was not the first systemic financial crisis – that is usually said to be the Dutch Tulip Bubble in the seventeenth century; there have been many more since. I doubt that the GFC will be the last. It is only unusual because of its size, reflecting the increasing global inter-dependence of the financial system. When the tulip market crashed in Amsterdam there was barely any impact on London just over the way.

There is perhaps an even more fundamental reason why financial paper has become so important. Karl Marx shrewdly summarised the changes in the evolving capitalist economy in the nineteenth century by a change in the role of money. Once. he said, the economy could be represented by

C –> M –> C’.

That is you started of with a commodity C (perhaps you made it yourself) which you converted it into money (M) in order to convert into another commodity C’(which you would rather have). Money in this circuit was a means to an end, not the end itself.

However Marx observed that as the economy evolved, a new circuit developed:

M–> C –> M+,

Here one starts with money, converts it into a commodity which in turn is used to convert into more money. That reverses the roles. Money becomes the end and commodities are a means to that end. Monetary values begin to supplant intrinsic values in the way we think about the economy.

More recently the commodity in the circuit has been replaced with financial paper.

M–> FP –> M+.

You no longer have to produce commodities to make money, you can do it by producing financial paper – contracts about contingent events.

How can that happen? The conventional wisdom said it arose because the financial system was organised around allocating risk between investors – there is no Keynes or Mandelbrot critique of the existence of uncertainty in the conventional wisdom. It said that some low-risk investors were willing to pay others – high-risk investors – to take over their more risky contracts, just as you will pay a life insurance office to reduce the risk of your partner living in penury if you die early.

I have not heard that explanation used since the 2008 Global Financial Crisis for it seems a bit naive when a lot of low-risk investors were hammered while some high-risk investors were barely touched. But even before then, high-risk investors and those transacting on their behalf seemed to be making a lot more income than could be justified by the marginal differences in risk they seemed to be trading.

So let me offer an alternative explanation as to why financial paper in the money to money circuit seem to generate profits in the good times? Financial paper are contracts about events in the future. We may attach probabilities to the outcomes of those events but until they actually happen we dont know the true value of the financial paper. In principle the combined positive and negative values of the financial paper ought to be zero in the world’s balance sheet. When someone has an investment portfolio with a billions dollars of financial paper as assets, somewhere else there are other balance sheets with the same financial paper as liabilities. In your household balance sheet there may be a deposit in a bank of $10,000. In the bank’s balance sheet there is an offsetting liability of that $10,000. When we add the two together they exactly cancel each other out.

But because financial paper involves guesses about the future they may be valued in different ways (with different parametres) the net position in the world’s balance sheet may be increased by financial paper. We have to guess at the underlying probabilities; different people make different guesses and the combination of their guesses may not obey the rules of probabilities. The mismatch can add to the sum of the world’s wealth in the short run.

This is such a startling phenomenon that I need to explain it step by step. I use an example of a housing bubble. Suppose one day someone authoritative announces that the value of all houses in New Zealand had doubled. All house owners dutifully enter the new value in their balance sheet – if they were meticulous enough to keep one – and feel they were much richer. Are they? This is only a change in the monetary value of your house; what it is worth if you sell it. The doubling of the market value of your house has little effect on its intrinsic value. You may say “I am twice as rich”; but you are unlikely to say “I am enjoying living in the house twice as much”.

A complication is mortgage debt, which acts as a brake on rising house prices. If the brake is weak, as is it was in much of the last decade when banks were flush with overseas funds, house prices rise as home owners try to show off their wealth with more grandiose homes, and as they try to increase their wealth from the capital gains which come from leveraged purchases in rising market.

One of the fundamental rules of economics is Stein’s law, which says “If it cant last, it wont.” House prices cannot rise forever, relative to ordinary prices, so at some time after a boom they will stagnate or even fall. You’d have thought investors could figure that out, but research increasingly shows that their behaviour is not entirely rational. Again this is a huge topic in its own right, so I shall have to skip it. If you are interested, read psychologist Daniel Kahneman’s Thinking Fast; Thinking Slow, and economist Robert Shiller’s Irrational Exuberance.

It is extraordinary just how irrational investment decisions can be. It probably arises because if one make an unwise investment decision one rarely get an immediate signal that it is stupid. Without early feedback, learning is dampened and, in any case, just about everyone else is doing it, so how can it be foolish? Or so it seems until the day of the crash.

The same applies to financial paper generally. Now you might think that while ordinary humans are unsound investors, surely those in the investment industry are not. It turns out they are just as unsound us – but richer.

Should not their judgements be disciplined by these powerful mathematical models they use? That only applies if the models are correct – recall that Keynes said they are fundamentally flawed because they pretend uncertainty can be converted into risk – and if they models have the right assumptions – Mandelbrot says they dont.

But surely the financial paper cannot add to net wealth since the contract values should net out? Only in the long run; in the interim the two sides of the contract may value them differently. A simple example may be that the NINJA – no income, no job, no assets – who borrows to purchase a house with no intention of paying the debt back and values his side of the mortgage in the balance sheet as zero. But the lender is likely to put the mortgage into her or his book at full – or perhaps partial – value. So the values do not net out when the two balance sheets are combined.

Unlike a house, there is no intrinsic value in the financial paper. Yoga Berra might have said the intrinsic values of financial paper is not worth the paper they are written on. Their value is the money you can turn it into by selling it to someone else. So nobody finds out the real value of the contract until it is settled. The US housing finance market started looking soggy in 2006 when the NINJAs began failing to pay.

Because there is no way to resolve the actual value of the financial paper – the contingent contract – until the settlement happens in the future, it is possible for the net value of the financial paper in the balance book of the world to be positive rather than zero. Investors act on the apparent, but deceptive, increase in wealth, which leads to bullish market activity we call a “bubble”. At some point reality undermines their speculations based on false assumptions, and the bubble pops, the financial system collapses and the economy goes into a downswing. During the reversal the false profits have to unwind, which is why we expect a long recession after a major crash. (We are already in the fifth year of the recession associated with the Global Financial Crisis, much longer than the shallow speculators thought in 2008; some informed commentators think it may last another five or more years.)

I could extend this story through to the details of how the Global Financial Crisis occurred, but instead I want to make four analytic points.

The first is that people become exposed to the financial paper without understanding how sound – or unsound – the underlying contracts are. It happens all the time. You dont know much about the bad debts that the bank you deposit with. You believe they are under control and that the equity of the shareholders provides a cushion to protect you. That may be broadly true for New Zealand’s conservative banks, but that was not always true for overseas instances.

The second point is that dealers profit as the financial paper was bought and sold. In the main their profits are offset by the losses of those on the wrong side of the contract. However the latter happens some time later so the dealers seem to be making a profit out of thin air; what they are really doing is taking over some investors’ savings.

Third, the system would work a lot better during the downturn if people had not borrowed to fund their investments. The problem in a housing boom is not the values of the houses no matter how ludicrous they are, but that people have mortgages which they used to pay the fictitious values.

The final point is that some of that debt was taken on in actions which were more like gambling than investment. As I said the distinction is not clear. Indeed the vernacular describes betting on the TAB as an “investment”. Now I have no problems with someone who punts on horses for recreational purposes, provided they do not bet more than they can afford. They may pretend they will win, but generally they don’t – the punting is for the fun, giving you an incentive to follow the horses more closely. The problem arises when you bet your house on a horse, or take out a mortgage to bet on some piece of dark horse of financial paper.

I am not the first to draw attention to the gambling in the financial system. When it was a lot less complex than it is today, Keynes waspishly described the share market as a casino, remarking “When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.” However the problem is not the gambling per se, but the gambling with other people’s assets, because that is what debt is – other people’s assets.

Should the gambling occur? Let me begin with an analogy from the Canterbury earthquake. It was a consequence of the Indo-Australian and Pacific tectonic plates ramming into one another; earthquakes largely occur near plate boundaries from releasing some of the titanic forces as they clash. If those two plates were not crashing into one another, the Zealandia continent would be almost entirely under the sea. It was heading that way 22 odd million years ago, until the Pacific tectonic plate began expanding. The smash into the Indo-Australian plate drove up part of the sunken Zealandia into the land mass we call New Zealand. If that had not happened we would not be here; all there would be is sea and there would be no earthquakes. They are the collateral damage of living in a New Zealand.

Financial crises are kinds of earthquakes. They too are a consequence of an upheaval – the market-money economy. No markets, no money, no financial crises. But we would be much poorer for it.

We may think that Africans are poor, and of course they are. But even their material standard of living is today about three times higher than it was two hundred years ago.(Ours is about twenty times.) That was the consequence of the market economy which enabled specialisation and encouraged innovation. But its downside is the occasional financial crisis.

Such crises are an inherent feature of our economic system, even if we restrict people from gambling with other people’s savings. The failure may well be compounded by stupidity of investors, by what economists tactfully describe as “misalignment of incentives” which sometimes amount to fraud and corruption, and by poor economic management. But the crises will happen even if these failures are addressed – perhaps less often, perhaps less violently, but they will occur.

Certainly we should address them as far as we are able with the humble recognition that human ingenuity tends to outwit the most careful institutional designer (and our designs are not always careful).

Perhaps we should think about to whom we should give the most protection. I am old-fashioned enough to think we should give first priority to children, the sick and the old – as Michael Joseph Savage once articulated. He would not be satisfied that we achieve his ambition today.

Where I might differ from Savage, is the realisation that the government has not an unlimited ability to protect everybody, to insulate the entire economy from uncertainty, except at a horrendous cost to our material standard of living. For as long as there is economic uncertainty there will be financial crises. That may be a cruel reality, but what a boring world it would be if everything was certain.

New Zealand Aid Programmes – Helping the Pacific Prosper

This entry was posted in Globalisation & Trade, Listener on 1st September 2012 by Brian Easton.

Listener: 1 September 1, 2012

New Zealand ran out of farmland in the mid-1950s. Of course, it has always been limited, but the opportunities to create new farms ran out and the existing ones were getting bigger, so the job opportunities on them did not increase. Countries short of farmland used to acquire more by conquest (or settlement; 19th-century Britain colonised lands like New Zealand to defeat – perhaps only temporarily – Malthus’s dire predictions of population overwhelming food resources). Seventy years ago, the war aims of Germany and Japan included conquering others’ lands to feed their populations. They learnt – as we all have – that it is cheaper and fairer to do this by international trade. Despite knowing the limitations of free trade, economists can be passionate about it because it is an alternative to war. New Zealand is no exception.

A hundred years ago we had imperial ambitions in the Pacific. Today we trade instead, including in products we can produce ourselves. Tonga, 2000 km to our northeast, is not so tropical it cannot produce a variety of temperate vegetables that look healthy and attractive in the Talamahu market in its capital, Nuku‘alofa. Some are exported to countries such as Japan and New Zealand. The catch is phytosanitary controls. If that word seems too complicated, how about “fruit flies” (although there are other pests)? Such controls need not only occur for international trade. If foot-and-mouth disease ever breaks out in one of our islands, restrictions across Cook Strait will be slapped down faster than a government backdown on increasing class sizes.

We saw the effort earlier this year when one tiny fruit fly in Auckland caused millions of dollars of effort to eliminate it and any of its mates. Less prominently, we had to give assurances to some of our export markets that our products were unaffected. And don’t forget the decades-long negotiations with the Australians to get them to abandon their embargo on our apples because we had a bacterial disease, fireblight, that they didn’t have. What they were really doing was protecting their apple producers from foreign competition. The Pacific has between 22 and 50 fruit fly species; three to five are in Tonga. Shouldn’t we follow the Australian example and exclude all Tongan imports to look after our own producers? Our approach has been exactly the opposite.

Our Pacific aid programmes help Pacific nations to manage the phytosanitary risks, including providing facilities to sterilise their exports from the threatened bugs. If we can’t find a solution, the fruit and veges can’t come. And if a product does slip through and arrives with an infection – watermelon with a fungal disease was a recent example – our border controls come into full force. But why undermine our producers (although, of course, among the 39 horticultural products Tonga could send us are tropicals we can’t easily grow)? The international trade answer is that we can use our horticultural land for other purposes that, ultimately, give a higher return – perhaps dairy farms or export flowers. We also have development commitments to Pacific nations. We want them to prosper. Those living there may be welcome to come to New Zealand, but we don’t want them pushed out by grotty living circumstances.

Sadly, some – especially among the young – are unemployed. I was reminded of the consequences in Nuku‘alofa, which had riots in 2006. Some larrikins joined a serious political protest about the degree of democracy in Tonga. Somehow fires were started and buildings burnt down. There was looting, including by families who should have known better; if they were identified they were prosecuted – neighbours were often keen to help the police. There were also tales of community solidarity and bravery; Chinese traders were targeted – neighbours stood between them and the hooligans. Six years later, there are vacant lots in Nuku‘alofa’s central business district, yet to be rebuilt on. It was not war, but the empty sections are a grim reminder of how unemployed youth with little investment in an economy can wreck it. Hopefully, our importing from the Pacific (and spending as tourists there) more creates more jobs for the young, thereby promoting peace.