Balancing Act

What goes down may well come back up, but who knows when? 


Listener: 7 February, 2009 


Keywords: Macroeconomics & Money;  


The economic situation, both locally and internationally, is in such a state of confusion that anyone who says they know what is happening doesn’t understand the mess we are in. This is new territory, and there is much we do not know. 


New Zealand probably entered into a recession at the beginning of last year. What a “recession” is can be difficult to judge. There is no “official” definition, although the media tend to say it’s when the GDP falls for two consecutive quarters. My guess is the downswing was part of the medium-term exchange rate cycle that New Zealand experiences. (This is the third.) However, the world financial crisis, which began in August 2007, contributed to the bursting of the housing and property market bubbles, which compounded the downswing. 


The 2008 recession seems to have been mild. I mention this because it would be unwise to judge the future on what happened last year. Had the local recession been the only problem, we would have probably begun the recovery phase by the middle of this year. However, the world economy is in considerable trouble. It has two major dimensions. 


The first is that there has been a major malfunction in the world’s monetary system. Despite monetary authorities pumping cash (liquidity) into it, international money markets remain gummed up, so it is extremely difficult to borrow in the medium to long term. 


This particularly affects New Zealand because our trading banks have borrowed heavily offshore, onlending mainly to household mortgages. If the money markets remain jammed, loans may not be able to be rolled over. 


This is not a matter for panic, but as the resolution may involve higher interest rates, it will not be pleasant for borrowers. (We focus too much on the Official Cash Rate and ignore the higher medium-term interest rates critical for investment.) 


For more than a year, commentators have been confidently promising that money markets would free up. Suppose they do – the second difficulty remains. 


The world economy appears to be going into an unusually deep, prolonged, recession. We are not sure how that will affect New Zealand. 


Historically, overseas economic troubles have lowered prices for our exports. Lower terms of trade – the ratio of the price of exports to the price of imports – do not just affect farmers and those who supply them. The whole economy has to work harder for the same real income. The latest official estimates of the terms of trade suggest they are higher than a couple of years ago, but are a few months out of date. The forward indicators are more pessimistic. 


In any case, now New Zealand is no longer totally dependent on pastoral products, our exports are more diversified. Other products may not experience lower prices but a falling off of demand. The tourist industry, our largest export sector, is struggling from a fall in the number of overseas visitors. 


This is despite most of its plans having been made before the troubles became really obvious last October (when the merchant bank Lehman Brothers collapsed and the US and other governments began nationalising big financial institutions at a rate that made even socialists blanch). We can expect fewer tourists in the next few years. Other exports may face a falling off in demand, too. 


If so, the economy will sink and any recovery from the domestically induced recession will be overruled by the external shock, probably giving us a longer and deeper recession. Unemployment and prices will rise. 


The Government is taking action to sustain the economy through tax cuts, which lift private consumption, and government spending on infrastructure. One effect will be an increase in imports and overseas borrowing. (So let’s hope the money markets do unjam.) 


<>Writing this, I have been aware of all sorts of caveats and intricacies in the analysis, and uncertainties in current and future happenings. Sorry about that; you can get much more confident accounts from others. They are probably wrong, too.