Tim Hazledine: Inflation fixation out of step

There is a saying to the effect that those who do not learn from the mistakes of history are condemned to repeat them. However, in economic policy it doesn't work quite like that. The fact is that history in the modern world is largely made by economics, and the catch is that it is made differently each time, because the economic problems are different each time.

Indeed, over the past 100 years, each great new economic problem has actually been the by-product of our successful attempt at solving the previous difficulty.

This is the true lesson of economic history - that there are no simple lessons or principles that can be reliably applied over and over again. And that the real danger is from those people in power who do not realise this; who carry on fighting yesterday's battles with yesterday's weapons when the conflict has moved elsewhere.

And, unfortunately, that is where we are in New Zealand right now, as manifested in the 30 per cent income gap that has opened up with Australia in just two decades, and of which one notable symptom is the quiet flood of Kiwis emigrating across the Tasman, as documented in the special series in the Herald this week.

How did this happen? I suggest that the culprit is inappropriate economic policies: specifically two sets of policies which may have made some sense as responses to the problems of the day when they were introduced, but which have been dogmatically persisted with (here but not in Australia) long past their use-by date, to the point where they have become actively harmful in the quite different economic environment of the 21st century.

To set the scene, let us go back to the first of what have been (so far) three great shocks to the economic system of the modern world: namely the Great Depression of the 1930s. Sure, there had been slumps and depressions before, but none as deep, widespread, and prolonged as this, and the reason was that the 1930s Depression was the by-product, the unintended consequence, of a highly successful economic programme which itself had been unprecedented.

Such was the spread of the doctrines of economic liberalism, which had enabled the Western World to take advantage of the late 19th-century innovations in transport and communications to "globalise" itself for the first time.

The problem was that, although the world's economies had thereby become interconnected to an unprecedented extent, the world's economic policies were not. Thus, when events like the 1929 Wall Street Crash sent shockwaves through the system there was nothing to stop the shocks spreading, literally, around the world.

So, new problem, new solution needed. Brainwave, please. It came from the great economist Maynard Keynes, whose new-fangled stabilisation policies, when widely implemented after the War, were largely responsible for a quarter-century "golden age" of economic growth and prosperity.

And what became the unintended consequence? It was, of course, inflation. Emboldened by the years, then unprecedented decades with no Depression or slumps, unions and firms started off on a spiral of wage and price increases that took us all into the hitherto uncharted territory of sustained double-digit inflation.

Enter monetarism and its handmaiden free trade. Stiff monetarist medicine would knock-out inflationary expectations, and opening markets to international competition would ensure that prices didn't rise up again. And it worked, too - spectacularly well.

Inflation subsided with remarkable speed to the low single digits and has stayed low ever since, even though unemployment has eased down to levels which in the 1970s would be almost guaranteed to incite price and wage increases.

New Zealand adopted monetarism and free trade with more fervour than anyone else, and has held on to these policies more rigidly than anyone, in particular more so than the Australians.

This is why we are suffering more than them from the third and latest "new" economic problem, namely stagnant incomes with increasing wealth disparities.

Our single-minded monetary policy, with its single dogmatic goal of CPI inflationstability, may have been good at knocking inflation on the head in 1989, but since then has been responsible for three bouts of overvalued exchange rates and too-high interest rates which have simply kicked the stuffing out of a wide tranche of our productive industries.

The approach of Australia and other more successful economies is now that monetary policy in the post-inflation environment is more of an art than a science, and certainly not a religion, as it remains in New Zealand.

As for free trade, here history makes painful reading. We led the world in unilaterally opening up our capital markets and exposing our farmers and manufacturers to "free" competition, and the world did not follow, not even to invest here, apart from scooping up the spoils of our fire-sale privatisations in the 1980s.

The new learning now is that each country must actively work to promote and support its productive sectors or they will fall off the pace set by global competition. Ironically, many Australians actually don't believe they are doing very well at this, but surely they still have a thing or two they could teach us here.

* Tim Hazledine is a Professor of Economics at the University of Auckland