The old adage, "When the United States sneezes, the rest of the world catches a cold" still applies. The United States is the largest economy in the world by a country mile. Ben Bernanke, the governor of the US Federal Reserve, recently mentioned the possibility of reducing its policy of quantitative easing. Financial markets around the world started having fits. New Zealand's sharemarket slumped and the value of our currency fell against the US dollar.
Novice investors in Mighty River have been left puzzled about why their share price has dropped because there has been no bad news about the stock since its float. Decisions made by officials in foreign countries can quickly impact on financial markets far afield at the click of millions of computer mice.
The US economy has been in the doldrums since the global financial crisis. China's model of a state directed market economy has been heralded as a preferred route to economic success for a nation. But this ignores lessons from recent history.
In the 1950s, the Soviet Union was regarded as the paragon of economic success. Central planning seemed to ensure stellar economic growth.
Many newly independent countries, such as India, embraced central planning with dismal results. In the 1970s and 80s, Japan's version of corporate capitalism was touted as a major threat to American economic hegemony. The reality is these pretenders have lacked the essential feature of a successful market-driven economy. This concept was first expressed by the Austrian economist Joseph Schumpeter. It is the necessity for a market economy to accept "creative destruction".
Over the past five years the United States has experienced significant economic pain. House prices have plummeted, unemployment has hovered around 10 per cent and business confidence has been abysmal. The Americans have taken their medicine.
There are now distant signs that the US economy is starting to regain its footing. America is still the most dynamic economic system in the world in pushing technological frontiers. China remains the imitator in second place.
Chinese growth is still largely based on pouring low-cost resources into its economic machine. More importantly, the Chinese political system has yet to weather the impact of a period of creative destruction which is essential for a truly dynamic economy.
A resurgent American economy would have a major impact on New Zealand. The events of the past few weeks provide a taster. When the Federal Reserve starts mopping up the funds created by its money printing this will cause short-term interest rates in the US to rise. Hot money will quickly flow out of countries such as New Zealand seeking the relatively higher yields in the United States.
This outflow will cause our exchange rate to fall. It is also likely to depress our sharemarket. Both of these effects have been occurring in the past month based solely on the comments of Mr Bernanke. The Federal Reserve has yet to turn off the money tap. When it does, hold on to your hats. This has interesting implications for our Government's proposed asset sales. A bear market is not a good time to sell prime state assets.
A lower New Zealand dollar will eventually shift our economy towards a focus on export-led growth but there is likely to be pain along the way. A lower dollar will increase the prices of tradeable goods for local consumers. These goods include milk, cheese, meat, petrol, cellphones, computers, electronics, vehicles and any other items exported or imported. Our days of cheap overseas travel may be numbered. Our cost of living will start to rise.
The Reserve Bank is mandated to keep inflation between 1 and 3 per cent. As the prices of tradeable items start climbing it will inevitability raise interest rates to quell inflationary pressure.
The events of the past few weeks provide a distinct portent of things to come. The globalised nature of financial markets means the decisions of a central banker in a far away country can quickly impact on the day to day lives of all New Zealanders. Mr Bernanke's comments may prove premature, but the outcome should not be discounted.
Peter Lyons teaches economics at St Peters College in Epsom and has authored several economics texts.