The Macroeconomic Crisis: Policy Implications

Paper for the 6th Annual Policy Evolution Conference; 16 March, 2009, Wellington (Revised) 

Keywords: Macroeconomics & Money; Regulation & Taxation; 

The International Financial Crisis 

I have but a short time for my presentation, so I am going to focus on a single facet of the macroeconomics of social policy, the coming fiscal crisis. 

By way of context I need to say that the world economy faces the greatest economic crisis since the Great Depression in the early 1930s – it is possible that it will be even greater. I shant go through how we got there. When the ship is leaking, headed for the rocks and not responding to the helm analysing foolish decisions of the past is not a priority, although we should note that while some of the passengers were as foolish as those who sail the ship of the international economy, there are others on it unwillingly or unknowingly. 

The reason the wheel is not working is the world’s monetary system is jammed. Credit is needed for trade, for business investment, for house purchase and for public works – all integral to the effective running of the economy. At the moment there is a desperate shortage of credit for periods longer than about a month. The reason is that most of the big trading banks which underpin the world’s credit system have weak balance sheets. In particular they include what are know as toxic assets – the euphemism is ‘troubled assets’. These are assets in their balance sheets which were purchased at prices well above their current worth; often we dont know what a toxic asset is worth today. As a consequence they have to write down the values in their balance sheets, although no one knows by how much. 

In order to function a trading bank has to have an adequate margin of its assets over its liabilities. If it does not, then others wont loan to it, because they fear that the bank will fall over and they will lose their investments. If enough banks are thought problematic then there cannot be the interbank lending which underpins the credit system. 

We just dont know how many banks have problematic margins. The worst possibility is that the margin is negative and liabilities exceed assets. Without implicit government guarantees such institutions would be ‘bankrupt’. Some of these guarantees have been converted into partial nationalisation of the banks and other financial institutions in order to add cash to cover the deficits in the assets in the balance sheet. 

Rather than call the financial institutions ‘potentially bankrupt’, some Americans describe them as ‘upside down’. A New Yorker correspondent recently wrote ‘I heard a senior US Administration official remark that seventy-five per cent of the country¹s banks are probably upside down.‘ Even if the true proportion was a tenth of that, there would still be a problem since nobody knows for sure which are banks are upside down, nor which other financial institutions are exposed to them and so could be upside downed if the insolvent ones go under. 

The point about this background is that it would be unwise for New Zealand to be over-dependent on non-existent credit to solve the nation’s economic problems. It is like trying to rescue a drifting ship by assuming the wind and tide are favourable. They are not. 

The Implications for New Zealand 

I need to make it clear that the New Zealand trading banks seem solvent – they are the right way up. Their problem is that they are heavily borrowed offshore, have to rollover those debts and borrow more in order to cover a further net saving deficit over the next few years. But it is only ‘immediately’ their problem; they can borrow from the Reserve Bank, which makes it ‘our’ problem. And since the Reserve Bank can issue only New Zealand dollars, whereas the new and rolling-over overseas loans are in American dollars, we have to borrow offshore to obtain them. I so often observe this simple proposition being ignored allow me to repeat it. We have to borrow well over $100 billion from overseas sources in foreign exchange – individually, corporately, the Reserve Bank, the trading banks, the government. We are all in this together. 

Think of us as the dinghy attached to the ship heading for the rocks. Our fate is inextricably tied up with the international economy, but in a different way from the big economies. The dinghy is shipshape but if we cast the painter off, we get swept onto the rocks quicker. 

The government is dealing with the international crisis in a perfectly orthodox way, by increasing the fiscal deficit – the amount it spends above its revenue – in order to maintain demand in the economy. However there is a limit to how much the government can borrow. The government has opened the deficit as much as it dares – as much as it thinks it can prudently borrow. It daren’t have a bigger deficit because it may not be able to find willing lenders at reasonable cost. Indeed there is even the possibility that if the world financial system remains gummed up, we may have difficulties borrowing the amount that the fiscal stance is currently committed to. 

The Medium Term Fiscal Prospect 

Today I want to look at the medium term fiscal prospect. That is the macroeconomic framework a ‘Policy Evolution’ conference needs. 

The best forecast we currently have of the fiscal future comes from the Government’s 2009 fiscal strategy paper released in February. It is based on the Treasury forecasts released in December 2008 – three months ago. Since then many economists have become even more pessimistic. For instance, last December the N.Z. Institute of Economic Research predicted that the current recession would be over by the middle of this (2009) year. Three months later (this March) it changed its forecast, announcing that the recession ‘may last four years’. That is how dramatically some economists are changing their views of the world. The Treasury may not change its forecast economic track as much, but almost certainly the December forecast is on the optimistic side. 

If so the revenue track may stay flat for longer than is currently forecast, in which case the structural gap between the two tracks will be even bigger. Another uncertainty is how the economy will recover. Will it go back to the track of the last few years, or will it grow along a lower track – the answer probably depends as much on the future of the world economy as it does about anything we can do. So I am taking the Treasury forecast as a cautious one, and I shant be surprised if in the budget forecast the gap between revenue and spending will be larger. 

The Treasury’s fiscal track shows that up to the June year 2008 government revenue was a little more than government expenses, as we built up a surplus for the stormy weather ahead. From the 2009 year – the current one – the public expenses are expected to grow broadly on trend, but the public revenue (mainly taxes) stagnates through to 2011, partly as a result of the recession but also because of the various income tax cuts. 

So when the economy moves out of recession from 2010, revenue remains below expenses. The small surpluses of the pre 2009 regime are replaced by an ongoing structural deficit of around $7 billion a year. (A ‘structural’ deficit persists over the business cycle.) That is what the Minister of Finance is referring to by ‘decades of deficits’. 

He rightly says such permanent deficits are not feasible. The government may be able to borrow $7b in a few exceptional years (especially to cover a recession) – as I have said, ‘may’ is the operative word. Borrowing that amount every year will be difficult, The debt servicing could well become unmanageable as the government debt rapidly grows and its net worth diminishes. 

That is a fiscal track similar to the 1970s. The gap then was largely covered by double digit inflation, which had the effect of taxing New Zealanders who held their assets in fixed interest deposits and the like. Whether we have that option in today’s globalised world with its fluid financial markets is not obvious. But even if it were feasible, inflation is not a strategy that has much to commend it, especially as a means of resolving a fiscal crisis. As the Muldoon years show, it merely prolonged it. 

It is the Treasury nightmare; the sheer misery of trying to control a huge fiscal deficit and trying to fund the gap which is left, and knowing the failure is either inflation or increasingly excessive overseas borrowing and usually both. The 1970s structural deficit was addressed by the Ruth Richardson measures of 1990 and 1991. Their painful memory lingers on; you may recall the summary: it converted ‘the economic deficit into a social deficit’. 

Dealing With The Fiscal Crisis 

There are those who promise economic growth higher than that built into the Treasury forecasts. The idea is that there would be a growth in tax revenue while spending could be kept on its current track and so the gap would close. However, those promising a higher productivity growth have been doing so for almost 50 years with a notable absence of success. You will recall that the policies of the Rogernomes led to stagnation and recession; and we still have not caught up to the loss relative to other rich countries. When advocates talk of getting back to the top half of the OECD, they are saying they want to get back to where we were just before the Rogernomic policies were implemented. Why will repeating failed policies reverse the relative economic decline they seem to have caused? 

Analysis of the Treasury data shows that both sides contribute to the gap. Lower tax rates mean that revenue is falling off relative to economic growth and it does not recover when the economy begins to grow again. Meanwhile spending (including debt servicing) is expected to power ahead, even though the economy does not. I reckon that the contribution to the permanent gap is about one part tax cuts to two parts spending increases. 

Other countries have dealt with the required short term fiscal injection with a different balance. The one-off cash grants of Australia’s Rudd government need not be repeated in future years; infrastructure spending can be turned off as the economy returns to a growth track, financial institutions which are nationalised can be privatised when they are sound again. 

The spending crisis wont be reduced by sale (privatisation) of public assets. That is just a temporary alternative to borrowing, and in any case there is only a limited amount of family silver that can be sold. There may be good reasons for a policy of privatisation. Covering fiscal deficits is not one of them, while the promises of the Rogernomes that there would be productivity gains has been refuted by experience. 

One contribution which might eventually be acceptable to the current government is to increase GST to, say, 15 percent at some time in the future. That would increase annual revenue by about $2.5 billion, so there would remain a large deficit of around $4.5 billion a year. You can now see why the Government is contemplating spending cuts. 

Some have questioned whether spending cuts should occur during the recession. The government seems to take the view that any savings can be temporarily used for infrastructural investment. Unlike the current spending the government hopes to cut, their construction comes to an end, and the excess outlays can be turned off as the economy recovers. 

Cutting Government Spending 

The total cutting requirement, amounting to about ten percent of total expenses (or 6 percent with the GST hike) is daunting. Do not confuse it with the usual re-prioritisation program in which an incoming government cuts some of the previous government’s spending, and puts in its own favourites instead. Such cuts are marginal, although I fear the police, justice and corrections spending may get out of hand. The right likes to take a tough line on law and order because it does not seem to infringe its economic libertarianism, but that ignores the public expense it generates. 

Whatever the marginal spending cuts in minor expenditure portfolios such as culture, the environment and foreign affairs, and the effect of increases in user charges – which are indirect taxes by another name – any large government expenses cut almost certainly has to target the big ticket items of education, health and welfare. 

That will involve cost shifting from the taxpayer to the general public. They are the same of course, except different people will be affected differently. Making us pay for our own health is a tax on the sick. Requiring us to take out private health insurance is a tax by another name. One hopes that cutting social security benefits will not be high on the restraint agenda, for there has been no real increase in the base social security benefit since its level was heavily cut in 1991. Meanwhile others’ incomes have risen with the consequence, as the recent MSD report shows, of rising relative policy in an era of increasing employment. 

Clearly the government – and therefore the country – faces a very grave challenge. 

The Politics of the Medium Term Fiscal Crisis 

The government appeared to have had no inkling of this fiscal and macroeconomic challenge when it was campaigning last year. Its economic policies were largely framed around the situation in early 2007 with the assumption that the world economy would continue to flourish. Thus their election campaign seems to have been uninfluenced by the events of August 2007 which signalled the boom had ended, and of September 2008 which repeated the signal so powerfully that it was even understood by the ideologically committed who up to then had expected the system to correct itself. However the new government has got the message of the underlying fiscal realities. But you have to read their statements very closely to see this. 

It would be helpful if the government were clearer. It was instructive that over three-quarters of the proposals at the Employment Summit were things that should be done anyway, boom or bust (including those that were impotently platitudinous). I am not sure the remaining quarter were much help either, since they were not sensitive to the fiscal realities we operate under. 

Other than the unwillingness to contemplate the repeal the income tax cuts in the medium term, the current vigorous scrutiny of government spending does not reflect an ideological drive. Were there today a government of the left, it would probably have just as large a fiscal deficit, constrained by the nation’s ability to borrow offshore. And it would be as acutely aware of the problem of the fiscal deficit not closing after the economy recovered and be looking at how to address the ongoing gap. 

<>Where right and left governments will disagree is who should bear the burden of the fiscal cut – the package of spending cuts and tax increases. That seems to me to be the big challenge facing social policy analysis: to offer an independent framework which can be used to assess the allocation of the burden of the medium term measures. Such a framework could also be used to also assess the burden of the current downturn. I hope this conference will contribute to its evolution, and I wish the conference participants well as they develop their policy analysis and proposals in such a robust framework.