A note prepared for some colleagues
As its subtitle says, the Treasury’s 2025 Long-term Insights Briefing: Sustainable and resilient fiscal policy through economic shocks and cycles focuses on economic shocks and cycles. This commentary takes a slightly different point of view because it includes all shocks to the economy, not just economic ones. Among the non-economic shocks which may require a fiscal response are natural disasters, pandemics including biosecurity invasions, and warfare. (There are also technological shocks which are not covered much in this paper. They tend not to be as abrupt.)[1]
To be explicit about economic cycles, the author was initially trained in very traditional economic theory which saw the ‘trade’ cycle as endogenously repeating itself.[2] However, the practical experience suggested that the cycle is usually a response to an exogenous shock. Moreover, it is typically damped with only a single fluctuation of any significance.[3] This commentary focuses on responding to such shocks.[4]
Kinds of Shocks
Shocks to the economy are common. A useful parallel is that New Zealand experiences about 20,000 earthquakes a year.[5] However, the vast majority are small and are easily accommodated, just as a household deals with the local dairy running out of bread or the slightly large shock of the dairy closing down. Most shocks do not require central government intervention.
There are only around 400 earthquakes in an average year – just over one a day – above Magnitude 4. There are about two annually of Magnitude 6 or more, only some of which are in areas with significant population.
The nation copes with these larger shocks by constructing resilient buildings and infrastructure and by precautionary activities such as earthquake drills, insurance, and prepared emergency services. Generally, these measure are sufficient to cope with a moderate shock. However, an earthquake in a populated locality – as happened in Canterbury in 2010 – requires some, sometimes substantial, central government responses.
Dealing with Small and Moderate Shocks to the Economy
The parallel is not exact but it draws attention to the gradation of shocks, and the gradation of preparedness and responses.[6] There has been greater reliance on flexible market mechanisms, since – say – 1984, for dealing with the more frequent small and medium shocks thereby leaving the primary responses to local initiatives in the private sector (and local authorities). On the whole that has been successful and central government has been able to be less involved. That does not apply to the bigger shocks.
Moreover, there have also been developed public institutional arrangements which have supported the strategy by cushioning the cycle which follows a shock: the Natural Hazards Commission[7] and, the soon-to-be-introduced, Depositor Compensation Scheme.[8] Progression in the tax revenue system is another automatic stabiliser although, because the system is less progressive than it was before 1984, its contribution is modest. Changes in timing of the administration of the tax regime means it is not as pro-cyclic (anti-stabiliser) as it once was. Similarly, the benefit system is an automatic stabiliser but because it is less generous than in the past, it now has a weaker contribution.
There remain some pro-cyclic (anti-stabiliser) arrangements. The one I am aware of is that under Working for Families, when a worker gets laid off, they lose the support and suffer a major decrease in spending power. [9]
Perhaps the Reserve Bank’s independent setting of the OCR is a kind of automatic stabiliser. It is discussed further below.
Recommendation: The aim should be to design the economy so that small and moderate shocks are left to the private sector and to automatic stabilisers to deal with.
Dealing with Medium and Larger Shocks
Medium and larger shocks are rare. That means we have less experience of them. The largest ones tend to have unique characteristics.
It is a natural response of the economics profession to tackle a new event by resort to theory. To markedly misquote Keynes, ‘I do not know which makes an economist more out of touch with reality – to know nothing but theory, or nothing but history.’[10] Any theoretical understandings need to be supported by understandings of past relevant shocks. (This was brilliantly illustrated by the successful US response to the Global Financial Crisis, which was led by economists who had researched the Great Depression.)
Recommendation: The Treasury should maintain an extensive archive of studies of significant economic and non-economic shocks – including those which occurred overseas. It should commission studies to pull the literature together and to review New Zealand ones for which there are not currently comprehensive studies.
While each study will reveal nuances, there will also be some general lessons.
The first lesson is that we don’t always understand the nature of a shock when it occurs. The 1966 Wool Price Crash was initially treated as temporary. Decades after it happened, the New Zealand Planning Council still did not understand its significance.[11] It could be argued that there was little public appreciation that the Darfield Earthquake of 2010 could be followed by an even more damaging one a few months later. Initially the nature of the Covid19 virus seems to have misunderstood.[12] Sometimes there is an over-reaction to a shock.
I am not sure how to deal with this issue except to encourage approaching each new shock with a supple and open mind – and to reread a lot of the background literature (as proposed to be collected in an archive). Robust automatic stabilisers are useful at this point of ignorance – especially for avoiding overreactions – but they may not be enough.
The second lesson is that any response has significant time lags. (Soberity of response may not be assisted by public demands that ‘something should be done’ immediately!)
After the initial shock there is typically weeks and months in each of the following stages.
1. Identification, analysis and policy formulation;
2. Political agreement to the policy response;
3. Implementation of the policy response;
4. The policy response coming into effect.
It is not uncommon for there to be confusion between when a policy is implemented and when it takes effect. An example is that the Reserve Bank can react quickly to shocks by changing its OCR. Financial markets immediately respond. However, the effect of a change in the OCR on the real economy typically takes months and even years. Another example is that it is common for the media to seek a response to a tax change days after the formal change of a rate has been implemented.
The lags can influence the choice of effective policy responses. For instance, varying income tax rates and benefits to change disposable income may take longer than changing the OCR, but the resulting change in aggregate demand is likely to be quicker.[13]
The third lesson is that the political response of ‘never waste a crisis’, generates a danger of compromising the sustainable economy and its fiscal position. For example, wrongly in my view, there were permanent cuts in income tax rates as a part of the response to the GFC which made fiscal management difficult for some time after. What was needed was a single and substantial cash injection (see the previous endnote).
Given that we will often be unsure initially about the exact nature of the shock, and that in many cases it will be damped to a single cycle, the immediate need – automatic stabilisers aside – is changes of setting which are short term or reversible. These include one-off income support measures (discussed above). Another one is to introduce a committed policy earlier (like a benefit hike on 1 January rather than 1 April).
An interesting example is that, despite it rarely being mentioned as one of its strengths, it is accepted that the Reserve Bank can move its OCR setting in both directions – including increasing it and later reversing the the setting. It is much more difficult to do this with income tax rates.
Another short-term reversible instrument is that the government can speed up payments.[14] Some government agencies have projects standing by for early implementation if need be. (In practice after many shocks – natural disasters, say – they will reprioritise projects to release resources in order to deal with the emergency. On the other hand, terms of trade shocks, say, may initially be dealt with in part by bringing projects forward.)
An obvious but critical caution is that the intervention should match the shock. I am not accusing officials of making that mistake, but I was struck that following the recent world price shock, much of the commentariat were arguing for what amounted to the Reserve Bank reversing it. It does not have the heft. Instead, and more correctly, the Bank was concerned to ensure that the external price shock should not trigger ongoing domestic inflation.[15]
Recommendation: Treasury should be sure the government has the capacity to institute, reasonably quickly, various easily reversible interventions.
Responding to a Longer Term Impact
If the shock has a longer term impact it is likely to have unique features which are difficult to prepare for (although a resort to the archive may turn up some useful parallels). Best wishes to those charged with advising them.
However, there is one critical policy issue which is likely to occur to some extent for every largish shock. The government almost certainly will contemplate that it may have to increase its domestic and/or external borrowing. Preserving the capacity to borrow in normal times is critical. That means managing fiscal and monetary policy in a prudent way which is respected by potential lenders. Similarly, there must be an acceptable level of public debt, the assessment of which will include the degree of government’s contingent liabilities and other implicit liabilities – such as the need to bail out private banks to preserve the payments system and public confidence. During the GFC New Zealand was one of only a handful of countries with which the US Fed was prepared to arrange currency swaps. This is one good test of the quality of New Zealand’s fiscal and monetary management and its respectable debt level.[16] A small economy on the margins of the world has little more to offer.[17] Debt crises – shocks induced by New Zealand borrowing – have been an integral part of New Zealand’s economic history.
Recommendation: The Government must maintain the quality of New Zealand’s fiscal and monetary management and a respectable level of debt in order to cope with largish crises which are likely to involve borrowing.
Endnotes:
[1] This paper does not refer much to the ‘Rogernomics shock’ of the late 1980s, which I have studied. It was a unique event in which political decisions played such an important role. I have yet to review the economics of the Covid shock.
[2] E.g. J.R. Hicks The Trade Cycle (1950). In fairness, I was aware of Frisch’s work on trade cycles as responses to exogenous shocks, but it was not taught.
[3] B.H. Easton, In Stormy Seas. (Although published in 1996, the subsequent experience is consistent with its generalisations.)
[4] The LTIB gives more weight to endogenous cycles than to exogenously induced cycles. My judgement of their importance is the other way around.
[5] About the same number as the breaths a person takes in a day. Both are quite normal.
[6] There is a useful list of relevant shocks since 1987 on page 23 of the draft of the 2025 LTIB. Most are judged to be small by their fiscal impact. Typically, the listed do not cost much in fiscal terms – at most around 1% of GDP. (The costs to the private sector are only partially quantified.) There are two ‘biggies’: the Canterbury Earthquakes in 2010-2011 (11.3%) and the COVID-19 pandemic of 2020-2022 (20.4%). Curiously, neither the International Share Market Crisis of 1987 nor the Global Financial Crisis of 2008-2009 is listed. (I would also include the Asian Financial Crisis of 1997.) The list does not include big earthquake shocks in low population areas with low fiscal impact and, fortunately, there have been no major tsunamis or volcanic episodes in the period, Droughts are a potential shock but they are not so instantaneous.
[7] There is an odd feature of the NHC which is opposite to the generalisation here. The NHC involves the government covering the first $300,000 loss following a disaster, and private sector insurance for losses above that amount (if it is taken out). The usual way the New Zealand arrangements work is that the private sector covers the initial losses and the public sector covers the larger ones.
[8] The proposed Social Unemployment Insurance Scheme would have had a similar role, but it is not currently being proceeded with.
[9] The effect could be moderated by a system which extended the WFF support following an involuntary layoff, for, say, six months; most of those laid off will have found new work by then.
[10] What Keynes actually said was ‘I do not know which makes a man more conservative—to know nothing but the present, or nothing but the past’. (1926).
[11] I confess that I did not pick up its significance until 1974 (although I was not in New Zealand when the crash happened). It forced me to shift my thinking from a macroeconomic model with a single commodity to one with multiple commodities. (In Stormy Seas 1996)
[12] Fortunately, the policy response based on the misunderstanding also applied for the actual virus. I plead guilty to the initial misunderstanding too.
[13] I understand that today Inland Revenue can change tax rates and benefit levels quickly compared to after the GFC when a single lump sum income injection, similar to the Australian response, may have been a more effective means of stimulating aggregate demand.
[14] Currently, Inland Revenue has about $160m of outstanding tax refunds.
[15] This is an example of the confusion between a change in a level (e.g. a price shock) and the rate of increase of the level (inflation) – between speed and acceleration. This mistake is unlikely to be made by a trained economist, but policy managers need to be mindful that it is common in the public’s mind (and in that of some of the commentariat, alas).
[16] It might be worth noting that responding to a shock with borrowing will increase the debt level, and raise questions about further lending for a second major shock which occurred before the target debt level was restored. One of the difficulties dealing with the Canterbury 2010-11 earthquakes was that the fiscal position was still recovering from the response to the GFC.
[17] Private (Debt) Worries, Listener, 11, November 2000