From Run to Float: the Making Of the Rogernomics Exchange Rate Policy

Chapter 4 The Making of Rogernomics (AUP, 1989) pp.92-113.

Keywords: Macroeconomics & Money;

Beginning the run [1]

Whatever the political reasons for the calling of a snap election on Thursday 14 June 1984, there were many who thought that important factors were the state of the economy, the difficulty of locking up the Budget given the size of the deficit, the monetary stance, and the uncertainties of exchange rate policy.

On Friday morning Sir Robert Muldoon was questioned about this on National Radio’s ‘Morning Report’ programme, but denied the charges, claiming that the Budget was complete except that decisions had to be made about export incentives: to manufacturers and supplementary minimum payments to farmers. What he meant was that he was still talking to the manufacturers and farmers. but it sounded as if he had decided upon everything except exchange rate policy (Easton 1985).

The thought appears to have occurred to those who dealt in foreign exchange. Initially, many expected National to be returned. The others assumed that Labour was planning to devalue anyway. The 1983 Australian election, which was followed by a devaluation a few days after, may have been taken as an omen.

On the Friday the Reserve Bank of New Zealand sold $256 million of foreign exchange to the trading banks and other currency dealers. An indication of how large this was is that at the end of the day the Bank was left with only $240 million of liquid reserves (Memorandum for the Minister of Finance, 17 June 1984).

At that time New Zealand foreign exchange was on a fixed, or pegged, ‘exchange rate (Keenan 1985b). The value at which the currency was ‘bought and sold was fixed within narrow margins, with the Reserve Bank willing to buy and sell at this fixed rate

The prospect of an imminent .devaluation generated what has been called a ‘one-way bet’. If a foreign exchange dealer knows that, say, the currency is to be devalued in a month by 10 per cent, then the dealer converts all the local currency into a foreign currency by selling it to the Reserve Bank, and then converts these holdings after the devaluation back to the local currency by buying it from the Bank at a profit of 10 per cent. The difference is borne by the Reserve Bank, and ultimately by the taxpayer.[2]

Thus it was perfectly understandable, indeed predictable, that any election called with some possibility of a devaluation shortly after would cause a run on the dollar. The practice in previous elections had been for the Treasury and the Bank to increase the liquidity of their foreign exchange holdings as the country moved into the final stages of the election. This apparently had been planned for a November 1984 election, but a snap election five months early had not been allowed for. However, given the extent of the run that actually occurred, there may not have been enough official liquidity, even if the officials had anticipated the early election

The officials’ response

The officials’ confidential memorandum [3] to the Minister of Finance on Sunday 17 June is a gloomy one. After relating the size of the Friday run on the dollar, the shortage of liquid funds, and the expectations of large future international borrowing, it says, ‘We clearly have on our hands a foreign exchange crisis of a major kind. It is extremely difficult to predict how much worse it will get.’ (Para. 5.) It goes on to warn of the ‘indications of the potential for a substantial worsening from Monday onwards’.

The ‘policy options in order of preference [were ]
(a) Devalue
(b) Support the forward market
(c) Tighten exchange controls
(d) Tighten domestic credit
(e) Tighten import controls
(f) Decontrol short-term interest rates (which would be a useful adjunct to any of the other options)’ (para. 8).

The specific devaluation recommendation was ‘of 15 per cent and an immediate return to the crawling peg, which would be officials’ strong preference’ (para. 14). [4]

However the Minister of Finance approved the second option, of the Reserve Bank re-entering the forward market, [5] plus the liquefying of existing reserves and the drawing of credit standbys. He did not agree that the use of exchange and/or credit controls should be avoided, nor that consideration should be given to ‘de-controlling wholesale deposit interest rate controls, an option which officials would favour’ (para. 14).

The forward exchange option

A forward exchange market involves currency transactions occurring in the future (Keenan 1985b). The advantage to the Government was that the Reserve Bank would not have to supply foreign currency immediately. In the interim it could borrow or liquify its reserves to meet its part of the bargain. Ideally it might not even have to do this, because at the point of transaction the purchaser may have wanted to convert the foreign currency back to domestic currency immediately -a real possibility if the devaluation was no longer on, or had occurred.

The advantage to the dealers of purchasers is that they were able to participate in the one-way bet without putting up the money. In simple terms, a dealer agreed to buy the foreign currency at the current official rate at some point in the future, with the likelihood it could be immediately resold at a more favourable rate following the devaluation.

There is a premium in the forward market, not unlike an interest rate, which could have been raised by the Bank to discourage forward purchases. However that would have pushed the dealers back into the current (spot) market, which is what was being avoided.

That was not how it was presented to the public. Pressure went off the spot market and there were even sales of $80 million of foreign currency to the Reserve Bank on the Monday. Both matters were mentioned by Muldoon as evidence the crisis had been solved, a view he persisted with later (Muldoon 1985, pp.130-1).[6]

However the officials’ memoranda paint a different picture: ‘Although it would seem that an immediate crisis ,has been averted, albeit at the cost of a heavily oversold Reserve Bank forward position’ (18 June); ‘a total outflow for the month (of June is) NZ$766 million. …The Bank’s forward order book is oversold to the extent of NZ$507 million. … As of this morning, the Bank’s liquid reserves totalled NZ$406 million and Treasury’s available liquids were NZ$47 million, …The situation is clearly fragile.’ (28 June)

A political commitment during an election campaign not to devalue cannot be broken until after the election without the severest political consequences. The financial sector knew there was no need to speculate on the dollar until closer to election day. Indeed, given that the existing purchases had already caused a financial drain, and hence a domestic shortage of liquidity, it was better to leave the run to the final straight.

The confidence of such a strategy was reinforced by the widespread knowledge among financiers that Muldoon had been advised by officials on 17 June to devalue by 15 per cent.[7]

The choice of 15 per cent

The 15 per cent seems to have been a rough stab by the officials at what they thought was necessary. The minutes of Muldoon’s cross-examination of Dr Deane, then Deputy Governor of the Reserve Bank, In the Public Expenditure Committee read as follows:

“Sir Robert asked how the 15% was derived.
“Dr Deane said deriving the figure involved a lot of judgement and that it was d:nved from a range, of analyses, for example, econometric models and looking at a range of indicators, for example, terms of trade, profitability, of exports, indicators of competitiveness over a period of time. (p. 15)”

Muldoon then goes on to explore how far the recommendation was a response to the particular circumstance, and to what extent it reflected , the officials’ policy advice over many years. He mentioned that ‘a figure of 15% was recommended in a paper of December 1982′

Deane said that in February 1984 a case was made for devaluation, but no figure was mentioned in the committee. It seems reasonable to conclude from the interchange that in early 1984 officials were keen on a devaluation of at least 10 per cent, and the June run on the dollar gave them yet another opportunity to advance this case, compounded by the need to protect overseas reserves. In making this judgement, it is crucial to note that the officials’ view of a need for a devaluation was parallelled by the private sector assessment. Without the latter there would have been no run on the dollar.

As the Deane response shows, there was considerable uncertainty in assessing the degree of devaluation needed. Indeed the memorandum proposing it included the recommendation to return to the crawling peg exchange rate regime of 1979-82;[8] this ‘would allow us to adjust the rate further should this be justified later, without attracting undue attention. If the Australian experience is any guide, some revaluation may subsequently be possible.'(17 June)

The devaluation

In the interim between the decision not to devalue and the election, the drain on liquidity to fund the purchases of foreign currency was affecting the viability of some financial institutions. The long-standing but recently reinforced controls on portfolios and interest rates meant that the financial system could not easily adapt to this drain, and there was some concern as to whether some institutions would get into severe difficulty. There appears to have been some debate as to whether there should have been a monetary injection to ease the situation, but the officials took the view that any injection would leak through into further purchases of foreign exchange.[9]

As the memoranda warned, the second speculative attack occurred with a vengeance in the week before the election, at a rate of $100 million a day, with $180 million on the Friday.

The officials’ memorandum of 15 July, the Sunday after the election, reported that if the outflow continued at the previous week’s rate, overseas reserves would ‘expire within seven days. The enormous outflow has continued despite the fact that our total forward commitments are now NZ$1,222 million, of which $1,025 million falls due before the end of August.’

Almost everyone, with the outgoing Prime Minister the most prominent exception, thought a devaluation was inevitable. Whether it needed to be 20 per cent can be debated, although given that the June recommendation of 15 per cent was widely known, something in excess of this was perhaps necessary.

No crawling peg was recommended to the incoming Government. A new strategy is presented in the officials’ first letter to the incoming Prime Minister. After recommending a 20 per cent devaluation it goes on,

“We would also recommend an immediate investigation of the possibility of moving to more flexible exchange rate arrangements to avoid the possibility of this sort of problem recurring in the future. The possibility of floating the exchange rate is an option which has considerable appeal, as the Australians have found.[10] However, there are a number of policy and institutional matters which would first need to be attended to should the government wish to move in this direction. …The most important of these aspects are domestic interest rate flexibility, an appropriate fiscal and monetary mix, and a review of the institutional arrangements which apply to the foreign exchange dealers to ensure they could handle a market-determined exchange rate.” (p.6)

For two and more years the officials had been arguing with their Minister that the exchange rate had been overvalued and needed attention. Their advice appears to have been in an interventionist frame, which they presumably judged as acceptable to the. Minister: In the previous month they had gone through the harrowing. Experience of a run on the dollar, with predictable consequences but with no political will to face the issue. Whatever the theoretical stance they would take, in practice their preferred exchange rate policy .was likely. to be very different from the one that they had been administering in the past. A change of government was an obvious time to disclose their politically unconstrained wishes.

The meaning of the exchange rate terms

At this point it is necessary to say something about the meaning of various terms used to describe exchange rate management regimes. The convention is to use the expression ‘fixed exchange rate’ to refer to a regime where the domestic currency is set in terms of another currency, such as the US dollar or sterling, or of a basket of currencies. On infrequent occasions the ‘peg’ would be changed. This was the regime in New Zealand until July 1979, and between June 1982 and March 1985.

At the other .extreme is the ‘clean float’, commonly abbreviated the ‘float’.[11] This involves no fixed. or official exchange rate, explicitly or implicitly, and there is no Reserve Bank (or other official) intervention in the exchange rate market by the selling or purchasing currency to .maintain, or even nudge towards, a set level. This has been the regime from March 1985. A government can still affect the exchange rate in a clean float, but this is by indirect means through monetary and fiscal instruments, and not by direct currency transactions.

Between these two extremes are a raft of options loosely described’ as ‘managed exchange rate regimes’. They include the ‘crawling peg’, ‘wideband floating’ ( or, as the officials were to call it in late 1984, ‘constrained floating’), where the exchange rate is permitted to move within wide margins of an officially determined midpoint exchange rate (which may be a crawling peg);[12] and the ‘dirty float’ where the authorities intervene on occasions to maintain the currency near an undisclosed official rate or to ‘nudge’ it in that direction. The dirty float is the regime for many OECD countries, including Australia from late 1985. Few countries have clean floated for long (Brady & Duggan 1984, Appendix 3).

Such terminological distinctions become important because it is not clear that the officials were using them, despite their being the common terminology in New Zealand at the time (Buckle & Pope 1985, Keenan 1985). It seems that the expression ‘float’ may have meant for officials anything from a clean float to most forms of managed floats. Thus the invitation in the letter to Lange to consider a ‘floating exchange rate arrangement’ may not necessarily have meant a clean float.

The Reserve Bank post-election brief

Post-election briefs appear to have been a normal part of government for many years. During the election period the officials of most departments would prepare a report for briefing the incoming minister. Typically the brief would include an account of the workings of the department,[13] and a brief coverage of the major issues concerning the department, sometimes followed by a phrase such as ‘further material can be provided to the minister on request’. As well as its overt function, the departmental brief provides a background for its executive, and a triennial internal review.

There was, however, a further factor which perhaps dominated the Bank and Treasury briefs in 1984. Following a similar action in Australia after its 1983 federal election, the Labour Party had promised to ‘open the books’ if it because government; ‘the books’ were the post-election briefs. Thus the officials’ competence would be on public display.

The focus here is on the exchange rate policy chapters of the Bank and Treasury briefs.[14] In keeping with its generally slimmer presentation, the Reserve Bank chapter is a cautious and not very ambitious discussion on ‘the general principles underlying exchange rate policy’ ( 1984, p.48). The six pages cover the equilibrium exchange rate, the application of the notion, an assessment of the exchange rate in relation to the equilibrium rate, three paragraphs on adjusting the exchange rate, and a summary conclusion.

The policy conclusions (written before the 20 per cent devaluation) were:

“the New Zealand dollar is substantially overvalued at present, and a sizeable devaluation is required, supported by appropriately firm domestic monetary and other anti-inflationary policies and desirably accompanied by removal of the various exchange rate policy proxies from the past. Devaluation in a loose monetary policy environment would simply be inflationary, and no real benefits would be achieved. … devaluation and removal of the associated interventions such as export incentives, SMPs and border protection could require the development of more comprehensive policies for structural adjustment assistance.” (p.53)

This is cautious and orthodox. Clearly at this point the Bank was working within the policy framework of a fixed peg regime. There is one mention of floating:

“…neither polar case of a permanently fixed exchange rate or a perfectly floating exchange rate has ever been followed. Where the nominal rate has been fixed, discretionary changes in the rate have always occurred, even if infrequently. And in those countries which have floated, developments in the market exchange rate have never been a complete indifference to the authorities, and have often provoked policy responses. In other words, at the risk of oversimplifying, both the inflation rate and the nominal exchange rate seem to have been regarded as of ‘independent’ importance in all countries. “(p.50)

Given the limited objective of the chapter there is perhaps only one major criticism. Throughout the brief the role of monetary policy is given prominence, perhaps understandably by a Reserve Bank, but there is little reference to fiscal policy. The casual reader might conclude that the currency could be successfully floated irrespective of the size of the government deficit.

The Treasury post-election brief

The Treasury briefing on the exchange rate is much more ambitious. Chapter 3 discusses the interconnections between monetary, fiscal and exchange rate policies, including the prescient

“floating the exchange rate in conjunction with a large fiscal deficit and a tight monetary policy is an undesirable policy combination. The effect, as the United States economy is currently demonstrating, can be to keep the exchange rate at, or driving up to, a high level, inhibiting exports and promoting imports by reducing the competitiveness of those industries trying to compete with foreign competition. The costs of this depend upon the degree to which the size of the underlying fiscal deficit is justifiable. … If the foreign borrowing is essentially to finance current consumption, then the effect is to penalise future generations.” (p.137)

This chapter refers to ‘the need for greater flexibility in the exchange rate’ (p.137) and ‘the key requirements for macro policies (including) …a more market-determined exchange rate’ (p.141).

In Chapter 5, 13 pages long and more ambitious than the Reserve Bank equivalent, a more detailed policy option is indicated.

“Flexibility in the exchange rate is highly desirable for helping the economy adjust to changing circumstances. Such adjustments are likely to be achieved most efficiently with a floating exchange rate. However, such flexibility by itself is no panacea, since it cannot compensate for poor underlying monetary. fiscal and regulatory policies.” (p. 157)

The section on ‘Nominal Exchange Rate Determination; The Options’ opens promisingly with the statement that ‘countries have a wide range of choice about how to manage their exchange rates’, and a description of the ‘rigidly fixed’ and ‘floating’ exchange rates as extremes (p.164). It talks about ‘flexibility’, and mentions the crawling-peg regime of June 1979 to 1982.

However when it comes to describing the options, only the extremes of the fixed and floating are considered, with no mention of any of the options between. The result is a seriously imbalanced presentation. Given the experience under the Muldoon stewardship, and particularly of the run over the previous month, it was difficult to make a case for the fixed exchange rate. In effect the incoming Government was given only one option: that of a pure float.

Perhaps because the writers were so committed, the account of floating the exchange rate is somewhat idealised and the benefits overplayed, in contrast to the earlier cautions. Nowhere is this more evident than in the opening advantage ascribed to floating: ‘With floating the exchange rate, there is less risk th~t poor monetary and fiscal policies will impoverish those industries exposed to world trade while generating spiralling external debt problems.’ (p.166) The collapse in the syntax towards the end of the sentence warns there is something wrong. Fundamentally the sentence is almost contradicting the earlier warnings of the need for severe fiscal restraint in association with floating. And of course, as events were to prove, it was wrong.

Overshooting and the exchange rate

When assessing the officials’ advice we need to ask whether what actually happened was predictable both in terms of the officials’ account. And in the light of other contributions at the time.

Shortly after the floating the nominal value of the New Zealand dollar rose. More important, the real exchange rate, which both the Bank and Treasury briefings emphasise as critical, also rose, and remains at a high level compared to that when the election was called and before the 20 per cent devaluation.

The real exchange rate (the nominal exchange rate adjusted for domestic prices or costs relative to international ones) is important because it determines the profitability of exporting and importing. If the real rate is high, exporting is discouraged and importing is encouraged. For a given national income this means that the deficit on the current account of the external balance of payments will be larger, and more will have to be borrowed overseas to, in the words of the Treasury briefing, ‘penalise future generations’. [15]

During the 1970s and 1980s, structural analysis and policy had placed increasing emphasis upon the health of the tradeable sector for longterm sustainable economic growth (e.g. Economic Summit Conference 1984). Indeed it could be argued that two major strands of macroeconomic policy development –that and monetary policy -were never properly integrated. The practical point where the clash occurred was the exchange rate. If the exchange rate was to be too high for too long then the tradeable sector would suffer. And so would the productive economy. That is exactly what happened after the 1985 float.

Such an outcome was foreseen by economists outside government, particularly by the late Merv Pope, who in a number of articles written before the float had cautioned against the policy and indeed predicted the overshooting of the exchange rate (Pope 1984, Buckle & Pope 1985). In doing so, he, and the other less vocal critics, were repeating the lessons from the theoretical literature.

The Labour Government stance

Some mention of Labour’s views is appropriate. As reported in Chapter I, the Party in opposition had come to an uneasy compromise which amounted to not really having an exchange rate policy at all. However once they became government this ceased to be relevant for two reasons.

First there was the exchange rate crisis itself; the Party manifesto was of little guidance here.

And second, in practice policy becomes the responsibility of a minister (or ministers). There is no documentation yet on how the Labour Cabinet functioned in its first three years. Douglas (1987) talks about close consultation with his two Deputy Ministers, Caygill and Prebble, occasionally with Lange or Palmer.

Douglas had had a long interest in exchange rate policy. He was an ardent (fixed peg) devaluer in his 1980 manifesto. In October 1983 he prepared a paper advocating devaluation, which was circulated to his electorate just after the election was called. Muldoon drew public attention to the paper, but Douglas said that the option of devaluation had been discussed but had subsequently been rejected as policy by the Labour Party (Muldoon 1985, p.129; Douglas 1987 p:42). By mid February 1984 Douglas had decided to remove devaluation from his proposed policy. However that does not mean that he had abandoned the strategy.

Muldoon’s eagerness to identify Labour as having a policy of devaluation came partly from the officials’ paper of Sunday 15 May, which said, ‘It is well known that the Labour Party intend to devalue if they become the Government’ (p.2).

When Deane was asked at the Public Expenditure Committee the evidence for this statement, he replied that ‘he had learnt it from items in the news media, from material published by Mr Douglas, and through consultation with people in the financial markets’ (p.14). Because the enquiry was terminated we do not know which items the Deputy Governor had in mind.

Labour’s position on exchange rate management was towards flexibility,[16] although as late as February 1984 Douglas still supported devaluation, that is, a fixed-peg regime. Five months later, during the first days of office, he wanted to float, and was dissuaded by officials because the supporting policies and institutions were not yet in position.[17] This may explain why the officials and their policies appear to be working systematically towards floating after the 1984 election.

After the devaluation

On the basis of the available evidence the situation after the devaluation of 17 July was as follows.

All officials had been through the trauma of the June/ July run on the dollar (as well as difficulties of Muldoon’s fixed-peg exchange rate policies during the whole of his term of office), and would no doubt have supported something different. They probably thought the 20 per cent devaluation was a fraction high but necessary to regain market confidence. There is likely to have been considerable variation among officials, even within the same institution. For instance, a confidential discussion paper, dated March 1984, by the Deputy Governor of the Reserve Bank makes a strong case for floating quite unlike that of the Reserve Bank post-election briefing, but confirms Douglas’s description that Deane was a ‘driving force behind their arguments and [that he] had worked out earlier plans to Implement [floating] (1987, p.142).

The Reserve Bank appeared to be still thinking largely In terms of a managed-peg regime. It tended to focus upon monetary policy and play down the role of fiscal policy.

The Treasury strongly favoured floating; probably they meant clean floating. They were better at discussing fiscal policy in a general context, rather than in relation to the specifics of its role under a floating regime.

Even so the weight of the two institutions favoured not only a more flexible exchange rate regime, but an arrangement they would describe as floating (although the papers rarely ever defined exactly what that meant).

Douglas had a preference for floating in July 1984, but he was probably not well briefed on the monetary and fiscal implications. However he was to write that ‘by mid October it was clear that the float was desirable and there was increasing pressure for it’ (1987, p.142). He is deferring to monetary pressures. A paragraph earlier he argues that floating the dollar was ‘essential’ to control the money supply.

It is not obvious whether the rest of the Labour Government’s position mattered.

The officials’ letter to Lange (15 July) mentioned a series of measures which it considered prerequisites for floating. These were all taken up over the following months. Interest rate controls were removed at the same time as the currency was devalued and considerable effort was made in subsequent months to further liberalise money markets. The November 1984 Budget took a large range of measures aimed at reducing the government deficit, improving the tax base, and reducing border protection and export subsidies. And there were enough private official briefings, and circulation of the briefing papers, to indicate to financial markets that it would be wise to develop the institutional facilities for a floated exchange rate.

Fiscal policy and floating

At this stage a little has to be said about the relationship between fiscal policy and the exchange rate, albeit at an elementary level, and even much of that relegated to an endnote. The real exchange rate determines the size of the current account deficit for a given level of national income. At the same time that deficit represents the domestic net savings deficit which has to be borrowed overseas. The economy has to therefore reconcile its real exchange rate with its domestic savings plans. Crucial in this reconciliation is fiscal policy.[18]

We have already seen that the Reserve Bank briefing was muted about the importance of fiscal policy, while the Treasury briefing, more strident in principle, was misleading when discussing the float. In assessing their post-devaluation advice we need to be particularly interested about their approach to the fiscal stance.

[ Endnote 2 of Chapter 16 of In Stormy Seas (p.312-3) comments on this Chapter that it “contains an error, which I take this opportunity to correct. I reported that the Reserve Bank post-election briefing, (PEB) on exchange rate management was ‘cautious’ whereas the Treasury was more ambitious. (p. 98). The papers made available to me at the time did not include a section omitted from the Reserve Bank PEB, nor did I note there had been an omission of four paragraphs, evident in the numbering of the paragraphs on page 53, in the section ‘adjusting the exchange rate’. I have now seen them, and they show the Reserve Bank. was. far more enthusiastic for floating the exchange rate than the edited version implied. My remarks on the reversal of the Treasury and Reserve Bank’s enthusiasm for the float six months later are also wrong.”

“Perhaps I should also record that it was proper that those paragraphs should have been omitted in the published version of the Reserve Bank PEB, since the Bank was responsible for exchange rate management at the time. It was unfortunate that when I asked the Bank for its papers on exchange rate management, sometime after the float, that they did not include the omitted section. I am sure the mistake was unintended, for the papers they gave me were very comprehensive and when, having learned of the oversight, I requested the section, the missing paragraphs were provided promptly with an apology.”]

Official advice to the end of December

As Douglas indicated, exchange rate policy was under discussion throughout the second half of 1984,.but by December 1984 the issue was seen to be becoming more critical. An interesting background to the officials’ perspective comes from a Reserve Bank study, probably commissioned shortly after the July devaluation, going through a series of revisions and discussions, with a final version dated 27 November 1984 (Brady & Duggan).

Some 40 pages long, it is the most comprehensive official paper seen. While mentioning alternatives, it focuses on floating and covers ‘independent float’, ‘group float’, and ‘crawl’.[19] Much of the paper evaluates the performance of economies where currencies have been floated.[20] Its general approach is cautious.

“The experience of the last decade of floating the rate regimes among the major world currencies has not provided unqualified support for the claims of the early proponents [of floating].” (p.7)
“…the experience of the last decade has established the effectiveness of monetary policy [under a float] is not as obvious as [claimed]. (p.19)

The paper does not satisfactorily clarify what the options were; confusion about what floating actually means remains, and though a ‘flexible exchange rate system’ is favoured, this is not described with any precision.

Second, the paper has little discussion on fiscal policy. There is a section on ‘floating rates and monetary policy’ and the mandatory ‘fiscal laxity accommodated by monetary policy can lead to no relative price improvement from a nominal exchange rate adjustment’. Nevertheless one is left with the strong impression that the writers, perhaps reflecting the Bank’s implicit thinking, judged that fiscal laxity could be over-ridden by monetary tightness. Nor is there any indication of the way that monetary and fiscal stance would affect the exchange rate. Interestingly the points in Pope (1984) are not addressed, and the article is not included among the references.[21]

Third, particular attention is paid to the Australian experience.[22]

On 7 December the Reserve Bank put up to the Minister of Finance an 11-page memorandum. It is the first official paper thus far sighted which defines the various terms rather than assuming the reader knows them. It also offers a set of options – free float, moving peg (i.e. crawling peg), managed float intervention approach (i.e. -dirty float), managed constrained float (i.e. wideband float) – and makes no recommendation but merely provides a paper ‘on the assumption that you [the Minister] would prefer to conduct a detailed discussion of the options before moving towards a decision’ (p.11), although it does not attempt to defend a fixed-peg regime.[23] Again it makes no reference to the fiscal implications for the policies, and very little reference to monetary policy either. A charitable interpretation is that the Bank was satisfied that its present policies were adequate irrespective of the chosen regime.

On 12 December the Treasury put up a memorandum to the Minister which considers three options, a ‘flexible exchange rate regime’ by which it meant ‘a (clean) floating regime’,[24] a ‘managed float regime’ (or dirty float), and a ‘regime involving flexibility within a band’ (or wideband float). It reports on the current policy situation, and focuses on managing a transition to a more flexible exchange rate regime. Again there is a comparison with Australia, and little reference to fiscal policy, except for the paragraph

“Irrespective of the exchange rate regime the importance of disciplined monetary and fiscal policy must be stressed. Under flexible exchange rate systems any relaxation of domestic policies will feed through and influence the exchange rate. (Under a fixed exchange rate the impact is felt on the reserves and on the exposed sectors of the economy.)” (p.22)

and the remark that ‘a programme to progressively reduce the fiscal deficit is under way’ (p.23).

The inference of the quoted paragraph is that under a flexible exchange rate the exposed (tradeable) sector will not suffer, whereas under a fixed exchange rate it will. It also seems to be assumed that providing the deficit was coming down in the medium term, the short term deficit would not affect the exchange rate adversely.[25]

A new feature in the paper is a short discussion on sequencing, in particular whether the capital account should be liberalised before the current account (pp. 21-22). In practice this is whether foreign exchange controls on capital flows should be abandoned before the introduction of exchange rate flexibility. The alternative would have been to float first, liberalising the trade sector with reduced tariffs, abandoning import controls and export subsidies. The text favours the former strategy, but hardly gives a balanced account of the debate. Nor does it refer to labour market and domestic product market sequencing.

The paper’s recommendation is for note and discussion, but its thrust is found in the paragraph which says,

“In time, however, it will be necessary to consider increasing the flexibility [of] the exchange rate regime. If this were to be done quickly, then for reasons outlined above a managed regime rather than a free float could be considered until foreign exchange markets have further developed).” (p.22)

Any record of the meeting between officials and the Minister is not released. However, inferences about it can be derived from a letter from the Bank to the Minister on 18 December. Officials were worried that the capital inflow was increasing the money supply, and the Bank says that

While it would be our preference to see Government move to dismantle exchange controls either before or at the time of moving to a more flexible exchange rate, we are of the opinion that the urgency of the situation requires a more flexible regime with or without full removal of exchange controls.

In fact the response was the other way around. Steps to liberalise the foreign capital markets had been underway since October. As Douglas reports

“In December I decided the time had come for the last and most significant step before floating …. the removal of exchange controls which limited the outward and inward movement of foreign exchange transactions. The decision was more politically sensitive than all the other changes, including devaluation. The question of removal of exchange controls was really about whether New Zealanders should be allowed to join the rest of the free world or remain isolated in a protectionist environment. To take the step would male it clear to everyone that this Government was determined to change New. Zealand from a highly protected economy to one which permitted its citizens to move their own assets as they chose. It was one of the three or four most important decisions we made.” (1987 p.143)

The passage contains a number of interesting points. It justifies the move in largely ideological terms, with few of the technical considerations in the officials’ papers. The move is recognised as controversial, although it did, not seem so at the time because it was it announced on 21 December, so close to Christmas that there could be little political reaction. Third, while Douglas recalls that he is totally committed to floating, there is an ambiguity as to whether it was necessarily a clean float.

There is one crucial point to be made which is not evident in either Douglas’s story or the official papers. For years New Zealand residents had had their ability to hold foreign assets limited by the regulations. Presumably these regulations had had some effect. If so, and if they were abandoned, residents would rearrange their investment portfolios in order to hold more foreign assets. This would appear as a run on the dollar, for the residents would sell New Zealand dollars to the Reserve Bank to acquire the currencies to purchase the foreign assets. There could be some offset from foreigners more willing to hold New Zealand currency because of the abandonment of the controls, but the expectation would be a net outflow. There is no evidence in the papers that this was anticipated as serious.

After Christmas: to the float

On 16 January the Reserve Bank submitted a memorandum to the Minister recommending a ‘constrained’, or wideband, float to be implemented immediately, moving towards a managed, or dirty, float ‘later’. The Treasury reported on the Reserve Bank proposition the following day

“Treasury favours a move towards a more flexible exchange rate regime. The Reserve Bank believes that current conditions favour a move towards a more market determined exchange rate as soon as possible. Treasury considers that the benefits of this option and the alternative of maintaining the status quo a little longer may be more evenly balanced. Either option involves risks. However there is nothing in the current situation that would require the government to make an immediate move. If you decide not to make any changes at this time the situation should still be kept under active review in order to determine when the balance of risk favours an immediate move to a more flexible rate.” (17 January 1985)

Ironically, over the six months since the devaluation the positions of the Bank and the Treasury had reversed. Treasury caution seems to have predominated and nothing was done.

The Bank’s 19 February memorandum to the Minister concludes, ‘On balance, we would judge it preferable to proceed with the move to a constrained [wideband] float while taking appropriate steps to rectify the reserves position as soon as possible.’ The last reference is to a (mainly deleted) mention of a deterioration in the reserves position which the Bank attributes to ‘the difficult conditions prevailing in some capital markets at present’, rather than the removal of the capital controls.

The Treasury paper of two days later (21 February) is somewhat longer and rehearses some of the past arguments, with more attention to different macroeconomic outcomes from the contrasted regimes of fixed and float. The tone of the paper is captured in the following:

“While the immediate economic situation does not necessitate any precipitous [sic] action on the exchange rate, a careful co-ordination of monetary and exchange rate policy is essential if the government is to successfully respond to pressures on the external account. …” (p.6)


“Treasury favours a move towards a more flexible exchange rate regime. While there is nothing ill the current situation that requires the Government to make an immediate move, adopting the sort of regime described in this report is likely to ease the task of economic management over the coming months. The sort of regime envisaged would involve the Government in some intervention in the foreign exchange market if the exchange rate came under upward pressure. …After [a certain] point, upward movements in the rate would be allowed to be determined by market pressure. The exchange rate would be allowed to depreciate in response to market pressure. Although an immediate move to this sort of regime risks some initial market disruption, Treasury is now of the view that the advantages of such a move, introduced along the lines suggested by the Reserve Bank in its memorandum of 16 January outweigh the risks.” (p.8)

That Thursday afternoon a 40-minute meeting was held between Douglas and the officials. The discussion went over the details and current market conditions. The File Note describes the Minister’s position. ‘Mr Douglas. … indicat[ed] he had come to the conclusion that we probably needed to move. He favoured moving to a system where the point at which intervention would occur and its extent would not be announced, but felt that we must be ready to intervene, at ‘least in the early stages.’ That is, Douglas favoured either the recommended constrained (or wideband) float or even a dirty float, at least initially.

The File Note concluded, ‘Mr Douglas then outlined the programme that he proposed to follow in seeking to get the change implemented. He requested briefing papers on implementation considerations and presentational points to be made to Cabinet colleagues and the public. These to be available by 11 March when the Prime Minister returns from overseas. Mr Douglas re-emphasised the need to make progress on building up reserves again.’

This is all at leisure. However urgency is evident in the joint officials’ memorandum five days later on the ‘Current Exchange Market Situation’

“Events of the last two days are a cause of concern. Since the beginning of January there has been a steady outflow. …The outflow in January was $370 million with a further $567 million outflow arising from repayments under a Citicorp facility and a Shipping Corporation loan held by the Reserve Bank. …ln the period to 27 February [26] there has been a recorded outflow of $447 million plus official capital transactions which have generated a further outflow of $99 million. …there has been some heightened speculation on whether a move on the New Zealand exchange rate can be expected. … market sentiment [appears] to be moving to the view that the New Zealand dollar would depreciate if the rate were floated in the immediate future. … If a strong expectation of an imminent devaluation of the New Zealand dollar does develop the government could be faced with large capital outflows which are likely to continue unless there is further, and substantial, increases in the short term interest rates. If large outflows persist, the government also faces the possibility of substantial losses on foreign exchange transactions if the dollar does subsequently devalue.” (26 February)

A run was on again.

The final officials’ memorandum in the sequence is the following Saturday 2 March. It recommended an immediate announcement that the currency would be floated on the following Monday. It was to be a clean float: no bands were set, rules for government intervention were minimal – for its own purposes and for sampling. The memorandum says, ‘ Although it is not intended to exclude intervention beyond the transition phase, this intervention would usually only occur in response to extremely disorderly conditions prevailing in the market.’ No such occasions have yet occurred.

Douglas completes the story by reporting that Deane had been sent to. Britain to brief Lange, and he briefed Palmer as Acting Prime Minister. One wonders what Lange and Palmer were agreeing to. That measures had to be taken to deal with the run? Or to the precise form of exchange rate management, not just to deal with the run but for at least four years? And if it was the latter, did they understand all the ramifications of fiscal and monetary policy, the likelihood of overshooting, and the structural and performance consequences?


A change from a fixed-peg regime was almost inevitable, given the events ?f the June! july 1984 run, let alone the difficulties of exchange rate adjustment under Muldoon. Less certain was the regime that was finally chosen. The options ranged from a crawling peg to a clean float. In the end a clean float was chosen. Probably the following factors were important.

First, there was a group of enthusiastic officials including, according to Douglas, the Deputy Governor of the Reserve Bank and also those who wrote the exchange rate chapter in the Treasury post-election briefing. Why they were enthusiastic is less clear. It may have been because they had been traumatised by past exchange rate experiences, they may have been ideologically in favour of minimal government, and/or they may have had excessive faith in the efficacy of monetary control for macroeconomic management.

By July 1984 Douglas had joined the group. He argues that he did so mainly because of the issue of monetary control. Whether he was fully aware of the intricacies of the various exchange rate management regimes is unclear. Certainly as late as nine days before the float, Douglas still favoured a constrained, or even dirty, float.

It is interesting to speculate what would have happened if this policy had been followed. Presumably the mid-1985 appreciation of the exchange rate would have involved intervention and some major review of macroeconomic policy, as the direct intervention failed to restrain the appreciation or as the Government accumulated foreign reserves and injected domestic money. Presumably that review would have paid much greater attention to the role of fiscal policy, and to a revision in overall strategy. It is not unreasonable to argue that if the policy Douglas preferred a mere nine days before the float had been followed, the macroeconomic history of the New Zealand economy from mid 1985 would have been radically different, and much more successful.

But for most of the time the enthusiasts were held in check, particularly when practical policies had to be recommended. The discussions of the policies suffered front two fundamental weaknesses.

First, the officials never clarified their concepts, particularly as to the terminology, range, .and presumably details of the various exchange rate management regimes. That is why we must reasonably give Douglas the benefit of the doubt that he ever really understood the options facing him. This failure probably reflects the inexperience of officials in what was essentially a task of research and teaching – of mastering new concepts, applying them in creative ways, and communicating them to others.

Second is the extraordinary lack of attention to fiscal policy in the documents. The enthusiasts who wanted a clean float because they believed in the efficacy of monetary policy appear to have reigned theoretically supreme. Or perhaps the institutions’ thinking on the components of macroeconomic policy was excessively compartmentalised.

If so, this could have been a consequence of the Muldoon heritage, and its fixed exchange rate regime, which meant that officials could have only limited discussions on broad exchange rate matters, even within their institutional walls. The possibility cannot be ruled out that this censorship impaired their ability to think comprehensively about exchange rate issues. One cannot help wondering whether the analytic content and outcome would have been radically different if a few outsiders who had riot been so restricted had been involved in the discussions.

Behind all this is a greater issue, not unlike the curious incident in the Sherlock Holmes story of the dog which did nothing in the night-time. The history of the central economic debate in the late 1970s and the early 1980s was between the interventionists led by Muldoon, the monetarists, who are very evident in this story, and the structuralists. The latter group were Keynesians who saw New Zealand as a small open economy with its prospects dependent upon the thrust from the tradeable sector. For them, getting the real exchange rate right was critical. Where are their views in the official papers? One would not expect to see their views prominent in the Reserve Bank papers, but they are not in the Treasury papers either. It seems unlikely there were no structuralists in the Treasury in 1984. Were they cut out from the debate? Or were their contributions to the internal debate excised from the papers to the Minister, so as to preserve a picture of institutional coherence?

There were strong supporters of the role of the financial community among the government advisers. But who among them reflected upon the role of the producers? In such circumstances it is not surprising that the tradeable sector suffered after the float, while the financial sector boomed, until the profitability of the producers could no longer sustain the speculation of the financiers.

Ironically. it is the Keynesians who can give the best account of the. post-float behaviour of the economy, as the exchange rate of a savings deficit economy appreciated, crushing the tradeable sector and stilling growth. The detailed account lies outside the compass of this c~apter. But a marginally involved politician, such as Lange or Palmer, might reasonably ask where in the officials’ papers is an account which forecasts the actual behaviour of the economy after the float.

In his report on the float aftermath, Douglas describes some of the difficulties In the short-term financial markets following wrong assessments. He writes

“What was surprising was how little the players understood the way the new system would operate. Just about everyone got it wrong. ..It taught everyone an important lesson – before making a major change it pays to do your research carefully. There are more twists and developments than can ever be fully anticipated by all the players until you actually make the change.” (1987. p.148-9)

In the light of the longer-term events he could well apply the criticism to his officials – and even to himself.

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[1] I am grateful to E. Caffin, A. Endres, B. Wilkinson, and some unnamed officials for comments on this paper. An earlier version was delivered to the February 1989 Conference of the New Zealand Association of Economists.
[2] A complication to this story is the interest costs. But devaluations are large compared to interest rates; for instance to brake this 10 per cent expected devaluation, domestic interest rates would have to be 10 per cent a month, equivalent to an annual rate of over 200 per cent, above the world interest rate. In any case at that time the monetary situation was so loose, and interest rates were fixed, so that credit conditions would hardly have acted as a brake. It is not even necessary to be definitely sure there will be a devaluation. Under quite low probabilities the bet is still on. Suppose the cost of borrowing in New Zealand is I per cent a month, equivalent to 12.7 per cent a year, above the world rate. Then any devaluation probability above only one in ten still makes the ‘bet’ worthwhile. As the event gets closer, the minimum probability decreases, and the bet becomes more profitable.
[3] The paper followed earlier phone conversions between officials and the Minister. Page 17 of the unconfirmed Minutes of the Select Committee (1985) has the Deputy Governor of the Reserve Bank reporting that the officials had had ‘confirmed by telephone on 15 June the fact that devaluation was not an option the Minister wished and that they therefore presented other options’.
[4] Officials do not seem to have considered the possibility of a quasi-float, where the government would announce it would not, until after the election, require the Reserve Bank. to sell any further foreign currencies in exchange for local dollars. Backed by some liberalisation to the foreign exchange controls and perhaps price controls and tax interpretations which would have limited the recovery of costs arising from the purchase of foreign exchange at above official prices, this option would have protected the reserves and perhaps would have been more politically attractive to the Minister. In particular he could have blustered that the financial markets were off their head and that this was a temporary measure until they returned to sanity; bashing financiers has always offered good political mileage particularly in an election campaign. The danger of the strategy was that it could have appeared to support the New Zealand Party’s call for a floating of the currency.
[5] The Reserve Bank had withdrawn informally from the forward market In March 1983, and formally in August 1983. While it was active in the spot market, it was unnecessary also to be active in the forward market.
[6] During the first few days of the election campaign there were two minor events which caused Muldoon to claim that Labour had a secret plan to devalue. The effect of the allegations was to confirm in many market operators’ minds that Muldoon had a secret plan to devalue after winning the election, which he would then blame upon Labour. In my view Muldoon had. no such plan. He was so confident he did not have one, that he was innocently led to give public signals that were interpreted to the contrary.
[7] I was told on 19 June.
[8] A crawling-peg .exchange rate is one which is fixed each day but may change slightly (i.e. crawl) from day to day. New Zealand had a crawling peg arrangement from July ]979 to May 1982, when it was suspended as part of the freeze measures.
[9] References to this situation and debate will be found (or are alluded to) In. the Memoranda for the Minister of Finance, 29 June and 3 July; the File Note of the Meeting with the Prime Minister, 5 July; the Minutes of the Select Committee 1984, pp. 17, 19, 21-22; and Muldoon (1985), pp.131-2.
[10] The use of the word ‘possibility’ three times in four lines suggests that this section may have been the hardest to get agreement on, and was drafted late without time for it to be polished.
[11] It is also called a ‘free float’, a phrase this writer has difficulty with, given there is no such thing as a free lunch.
[12] The upper and lower limits in which the currency was permitted to float are called ‘bands’; hence the name ‘wideband’ floating.
[13] Although neither the 1984 or 1987 Treasury briefs provide such an account.
[14] For a detailed critique see Zannetti et al. (1984, 1985a). Official replies are Treasury (1985), Nicholl (1986), also Zannetti (1985b). Also see Read (1986).
[15] The caveat, ‘for a given national income’, is important because it relates to the savings balances in the economy, which are affected by the level of output. Here we focus upon the direct effect of an overvalued exchange rate on the tradeable sector, that is, on the part of the economy which exports and competes against imports. Unless there is an improvement in the terms of trade (the relative price of exportables to importables), or very strong world demand, the tradeable sector will contract.
[16] When preparing a feature article for the 1984 Listener election issue, I approached some of the Labour people. who were evasive –understandably. This was after the first run on the dollar was known about and gave a series of conflicting answers. These I interpreted to mean that Labour was not committed to an overnight devaluation. but expected to manage the exchange rate more actively, moving it down in a series of steps, presumably under some crawling peg regime.
[17] I have this from two reliable sources.
[18] In practice the reconciliation occurs through changes in income, changes in (gross) investment, or changes in the government net savings {indicated by government, or budget, deficit). For policy purposes this means that any real exchange rate is unsustainable unless there is a consistent monetary and fiscal policy. Conversely a particular monetary and fiscal policy will set a particular exchange rate. This is the rate sufficient to generate the balance of payments deficit equal to the domestic savings deficit. Government monetary and fiscal policy thus has a major influence on the exchange rate. Under a floating regime the rate is not set by the market; rather it is set by the market and the monetary and fiscal policy of the government.
If that fiscal policy is slack, with a large government deficit and if private sayings arc low, there will be a significant savings shortage and the current external deficit will have to be large. The high domestic deficit will generate high domestic interest rates necessary to attract foreign savings, and that will lift the real exchange rate to increase the balance of payments deficit. Thus the productive capacity of the economy will be compromised directly, by a contraction in the tradeable sector, and indirectly, by a reduction in investment as a result of high interest rates and economic stagnation, as happened after the March 1985 float.
[19] Where managed floating, as defined above, is included is unclear. One paragraph seems to suggest that a wide band float or a regular adjustment of the peg are classified as pegged floating, but they ‘resemble floaters’ (p.3). There is a table, presumably from an overseas source, which lists the 147 IMF country currency arrangements, including the United Kingdom and the United States as ‘independent floaters. (although there was management of both currencies at least via central bank interest rate intervention). Even more strangely New Zealand is listed as ‘managed floating’; most observers were under the impression that in September 1984 the currency was pegged to a basket of foreign currencies!
[20] The paper seems to require the interpretation of floating to mean somewhere near the clean float end of managed floating.
[21] This was in those halcyon days when economists outside government thought that their economic writings were read seriously by officials.
[22] Australia has now been off a clean float for over three years, but there has been no comparable change in New Zealand policy.
[23] But it is considered in Spencer (1986).
[24] Unlike the Bank, who seemed to mean any of the options which did not involve a fixed peg
[25] This would arise from the rational expectations analysis which is evident in the Treasury 1984 post-election briefing.
[26] Transactions shown for 27 February were actually initiated two days earlier.

Books and Articles
Bollard, A. E. and B. H. Easton, 1985. Markets. Regulation. and Pricing, Research Paper 31, Wellington, N. Z. Institute of Economic Research.
Brady, P. R. and K. G. Duggan, 1984. Exchange Rate Po/icy; Background Issues. Wellington, Reserve Bank of New Zealand.
Buckle, R. A. and M. J. Pope, 1985. ‘Do Exchange Rates Need un Anchor? NZIER Quarter/y Predictions, March, pp. 42-47.
Douglas, R., 1980. There’s Got To Be Better Way! Wellington, Fourth Estate
Douglas, R. and L. Callan, 1987. Toward Prosperity. Auckland, David Bateman.
Easton, Brian, 1985. ‘Devaluation!’, Listener, 27 July, p.30.
Economic Summit Conference, 1984. A Briefing on the New Zea/and Economy. Wellington, Government Printer.
Keenan, P., 1985a. ‘ A Case for Floating the Exchange Rate’, NZIER Quarterly Predictions, March, pp.48-53.
Keenan, P., 1985b. ‘Barriers to Entry in the Foreign Exchange Market’, in Bollard & Easton (1985), pp.19-52.
Muldoon, R. D., 1985. The New Zealand Economy; A Personal View. Auckland, Endeavour Press.
Nicholl, P. E., 1985. ‘Opening “The Books”: A Response’, N.Z. Economic Papers, v.19, pp.117-122.
Pope, M., 1984. Floating the Exchange Rate. Discussion Paper no.28, Victoria University of Wellington, Dept of Economics.
Read, P. L., 1986. ‘The Treasury’s Fundamental Framework.’ Paper to the N.Z. Association of Economists, Aug. 1986.
Reserve Bank of New Zealand, 1984. Post-Election Paper to the Minister of Finance on the Areas of Responsibility of the Reserve Bank. Wellington, Reserve Bank of New Zealand.
Reserve Bank of New Zealand, 1986. Financial Policy Reform. Wellington, Reserve Bank of New Zealand.
Sherwin, M. A., 1986. ‘Exchange Rate Policy Developments’, in Reserve Bank of New Zealand (1986), pp.127-134
Spencer, G. H., 1986. ‘A Comparison of Alternative Exchange Rate Regimes’, in Reserve Bank of New Zealand (1986), pp. 137-147.
Treasury, 1984. Economic Management. Wellington, Government Printer.
Zannetti, G., 1985. ‘Opening “The Books”: Reply’, N.Z. Economic Papers, v.19, pp.123-125.
Zannetti, G. et al. 1984. ‘Opening “The Books”: A Review Article’, N.Z. Economic Papers, v.18, pp.13-30.
Zannetti, G. et al. 1985. Opening the Books. Discussion Paper no.30, Victoria University of Wellington, Dept of Economics.

Official Papers
The list of the official papers used in preparing this chapter is available from the author. They have been mainly obtained by requests under the Official Information Act.

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