Freeze and Thaw

Listener: 21 July, 1984.

Keywords: Macroeconomics & Money;

The publication of the June 1984 quarter Consumer Price Index increase will revive the issue of whether the freeze was successful. While the issue will not be settled in any scientific manner for several years, the research economist needs to provide some framework for the present public debate.

The first point to emphasise is that the freeze was not just the price controls which were imposed on June 22, 1982, and (partially) lifted on March 1, 1984. There were a number of other measures. The most important were:

(1) An exceptionally tough wage freeze (by previous standards) which is still in operation except that an $8 a week adjustment was implemented on April 1, 1984.

(2) The Government limited increases in its indirect taxation and public sector corporation charges, particularly after the July 1982 budget when they were all but frozen.

(3) The government also reduced some of the restrictions on competition (most notably CER and for transport), which resulted in lower costs.

(4) Controls on rents (relaxed in March 1984 ).

(5) On June 23. 1982, the fixed real exchange rate was replaced by a fixed nominal exchange rate, which meant that import prices rose more slowly. Note, however. that on March 3, 1983, the exchange rate was devalued by six per cent because of the Australian devaluation.

In addition, world inflation was falling in 1982 and 1983. The net effect of all these changes was that producers experienced lower costs, which made it a lot easier for them to hold their prices whereas previously wages. import these tax cuts it is almost certain that the freeze would have boiled up, because workers would not have tolerated the substantial cuts in their rea! incomes.

The difficulty with the strategy of substituting income tax cuts for wage increases is that the Government’s budget deficit was dramatically increased. This deficit has been at a rate of about nine per cent of GDP (around , $3000 million a year) for a record seven quarters, with the likelihood that it will continue for at least a further four quarters.

An example of how this turns into higher prices is in late 1983 when monetary control went a bit soft, and there was a surge in house prices, because of the easy money. The higher house prices appear in this June quarter consumer price index.

To fund the deficit properly the Government has had to borrow from the public, rather than have the Reserve Bank create money. Borrowing from the public is the same thing as selling Government debt. Successful selling requires an attractive price, and since the price of debt is the interest rate, real interest rates have to be high. Consequently interest rates, and hence interest costs, have not fallen as much as inflation. A lot of the Government’s interventions in finance markets have been a desperate attempt to get around this.

There was one further crucial factor which kept inflation down. The New Zealand economy was extremely depressed from mid-1982 to late 1983. Producers hold down their prices in such circumstances, preferring to take a smaller margin on sales than not to sell at all. (At the same time the depressed economy made it easier to fund the large Government deficit.)

By giving income tax reductions in lieu of wage increases and by restraining indirect tax and Government charges, the Government reduced production costs and consumer prices directly and indirectly. In doing so, it switched pressure from inflation to the deficit and thence to financial markets.

There are some economists who argue that inflation is merely suppressed and that it will break out again either from the monetary creation from the deficit or as a consequence of the measures that will have to be taken to reduce the deficit to a tolerable level. I would not rule out the possibility that the economic growth will be severely limited by the measures taken to resist either of these outcomes, with an explosion into inflation as competing groups dispute over the limited economic cake.