Brian Fallow on the economy

Brian Fallow is the Herald's Economics Editor

Brian Fallow: Labour's plan a subtly blunt instrument

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Party's proposal must be viewed in the context of the chronic saving weakness from which the economy suffers.

Labour's finance spokesman  David Parker  has unveiled a broad economic policy. Photo / Sarah Ivey
Labour's finance spokesman David Parker has unveiled a broad economic policy. Photo / Sarah Ivey

Though billed as an "upgrade to the monetary policy framework", what we got from Labour's finance spokesman David Parker on Tuesday was a much broader economic policy than that would imply.

It is subtle and complex, and therefore hard for people to appraise in the context of sound bites and partisan pushing and shoving. They could always read the document, uncatchily titled: "Improving Macroeconomic Stability".

The changes Labour is proposing for the Reserve Bank - an amended statutory objective, the "big new tool" of variable KiwiSaver savings rates, and yet-to-be drafted changes to a policy targets agreement between the Government and the governor - have to be seen in the context of a focus on a chronic weakness from which the economy suffers.

It is our persistent unwillingness to save anything like enough to finance the economy's investment requirements.

The resulting shortfall, quantified in the current account of the balance of payments, has saddled us with consistently higher interest rates than comparable countries and overvalued exchange rates.

It represents a risk factor for the foreign savers and investors on whose ongoing willingness to finance the deficit we depend.

They do it, but it costs, and there is a danger that one day they refuse - the dreaded "sudden stop".

It requires foreigners' savings to be converted into New Zealand dollars, increasing demand for the currency over and above what our exports would create and exerting upward pressure on the exchange rate.

And the New Zealand banks and corporates who do the borrowing prudently lay off the risk that when the loans come to be repaid the exchange rate will have moved against them. The ability to peel off that risk through complicated swap arrangements requires there to be counterparties overseas willing to take on the risk - for a fee.

Read the full "Improving Macroeconomic Stability" document here:

Permanently narrowing the current account deficit means either investing less in the economy's capital stock (not a good idea) or increasing national savings. That includes the Government (by running surpluses) as well as households (by collectively spending less than we earn).

It means deferring consumption. It is not painless and the political challenge is how to distribute that pain.

One of the lessons of the global financial crisis is that there is more to macroeconomic stability than price stability. Keeping a lid on consumer price inflation is necessary but not sufficient.

The task of keeping the real economy on an even keel cannot just be outsourced to the central bank.

Labour recognises this. It is putting up a set of policies it expects to boost savings and improve the quality of investment.

They include a move to compulsory KiwiSaver contributions, a capital gains tax and accelerated deprecation (in some sectors).

It intends to amend the Reserve Bank Act so that the bank's objective of stability in the general level of prices is qualified by "in a manner which best assists in achieving a positive external balance over the economic cycle, thereby having the most favourable impact on the stability of economic growth and the level of employment".

The key and as yet unanswered question is how exactly that broader mandate would be crystallised for accountability purposes in a policy targets agreement (PTA), which is essentially the governor's employment contract.

Parker says the PTA would include both an objective range for the external balance for the medium term, and a longer-term trend objective towards a positive external balance.

"The objectives set by government will be influenced by projected long-term growth rates and the desired level of net international liabilities," he said.

"The achievement of a positive external balance will be a multi-year process and will involve a downward correction of the exchange rate to a sustainable level."

A macroeconomic strategy credibly focused on a more competitive exchange rate, he argues, would encourage more investment in the export sector than the present policy settings do.

Reassuringly the policy expressly proposes no greater use of the bank's existing, but rarely used, mandate to intervene directly in the foreign exchange market.

When asked which objective would be dominant in the event they conflicted, Parker said: "I don't agree they will conflict but we have made it clear their inflation target remains."

No potential governor in his or her right mind is going to agree to be accountable for a current account outcome, in the way they are for inflation. There are far too many drivers that the New Zealand central bank has no influence on at all, like commodity prices or the state of foreign equity markets. The list is long.

So any range enshrined in a PTA would have to be so wide as to be non-binding and kind of pointless.

In fact is it is normal when central banks have multiple objectives for them to be focused and precise about quantifying the inflation target but kind of hazy and non-committal about the others.

What is useful and innovative about the policy is that it creates a new tool for withdrawing some demand from the economy when it is heading (as it is now) into a period when willingness to spend is outstripping growth in the capacity to produce goods and services.

Such excess demand does us no good, of course. It creates an environment where firms can raise their prices with impunity and where we suck in more imports that we have to borrow to pay for.

That last point is worth bearing in mind. Loose monetary policy is not necessarily good for the external accounts.

The proposed variable savings rate (VSR) would be a new mechanism for reducing consumer spending power from the economy, and restoring it during periods of weakness.

It would be a blunt instrument, as the interest rate lever is, and it would affect a different, though overlapping, set of people.

There are over 1.4 million mortgages outstanding. Some people, especially owners of investment properties, have more than one. And there are business borrowers of course.

Compulsory KiwiSaver would affect most of the 2.3 million people employed.

The VSR is being promoted as an additional tool for the Reserve Bank's belt but in fact it is likely the final decisions about when and how hard to use it will rest with the Government.

Parker said on Tuesday it was still an open question whether the governor should simply have the power to recommend its use, with the implicit threat that if the Government says no it will carry the can for the alternative of higher interest rates, or whether the operational decision should be delegated, within a range, to the Reserve Bank.

He favours the former approach and rightly so because this is too much power to devolve to an unelected official.

Doing something that will reduce people's take-home pay will feel like a tax increase, even though the money goes not to the Government but into the employee's KiwiSaver account.

Some have seen this as compromising the bank's operational independence.

But really it just requires the Government to take more responsibility for the management of the economic cycle, rather than pretending that can be outsourced to the central bank.

It makes more explicit and transparent the tradeoffs between fiscal and monetary policy.

To be fair the Government acknowledges this. We will hear a lot in the forthcoming Budget about the value, at this stage of the cycle, of a fiscal policy which is contractionary and does not put upward pressure on interest rates.

Loan-to-value ratio restrictions, though primarily directed at financial stability, have the spillover benefit of sparing us one or maybe two turns of the interest rate screw.

The VSR might do the same, though bank economists - in a preliminary, before any proper modelling is done sort of way - are sceptical about how effective it might be in that respect.

The official cash rate would remain the most potent tool at the Reserve Bank's disposal. "You can't drop interest rates back to international norms immediately but you have got to start," Parker said. "This will start the process."

- NZ Herald

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