Peter Lyons: Obsession with inflation damaging and distorting

New Zealand may have recently achieved a dubious world first.

It is unlikely that any other sovereign nation has had government officials travel abroad to actively discourage overseas investors from investing in their country. Media reports state that Reserve Bank officials recently visited Japan in an attempt to dissuade the Japanese from lending to us.

Alan Bollard, the Governor of the Reserve Bank, is damned if he does and damned if he doesn't. He is responsible for keeping New Zealand's inflation rate between 1-3 per cent in the face of a continuous domestic spending binge, largely funded by overseas lenders.

He has repeatedly castigated his countrymen for their prolific borrowing and spending habits. This has had little result. He has now targeted "misguided foreign investors" eager to lend to us because of our high interest rates.

New Zealand's economic situation could best be described as lopsided and bizarre.

We are near full employment after years of strong economic growth. To an extent, this has been fuelled by consumer spending, largely the result of the feel-good factor of a rampant housing market and the availability of easy credit. Some commentators believe high levels of employment underpin the housing market and consumer spending but it is difficult to determine whether high employment levels are a cause or effect.

Because of this boom we are experiencing inflationary pressures. We have the highest interest rates in the Western world but this hasn't dampened the festive mood of consumers and property buyers.

Our exchange rate is overvalued because of the demand for the New Zealand dollar by overseas investors eager to lend our dollars back to us.

The high New Zealand dollar is throttling our exporters and contributed to a blowout in the current account deficit. This means we are spending far more than what we are earning in our dealings with the rest of the world.

Bollard has laid the blame on New Zealanders and their willingness to take on debt to fund their excessive spending habits. He has also blamed overseas lenders for their inability to appreciate the risks they are taking by lending to us. Unsurprisingly he does not acknowledge the role of the Reserve Bank's monetary policy in underpinning the entire process.

The process can be described very simply. The Reserve Bank must control inflation between 1-3 per cent. If it is concerned about inflation it raises short term interest rates in New Zealand to reduce demand.

In the global financial market, high New Zealand interest rates make us attractive to lend to for overseas lenders.

Financial institutions can borrow cheaply overseas and pump this money into the loans market in New Zealand. This helps fuel the housing boom and consumer spending creating further inflationary pressures and the circular process continues.

Switch on the telly at prime time and numerous ads exhort us to take the money from kindly leading institutions who care about us and our financial and housing needs.

The present situation is not about the ignorance of overseas lenders or the prolific spending habits of New Zealanders. It will not be resolved by nagging either party.

Introducing clumsy controls on bank lending or house buying are unlikely to be effective or politically acceptable. The heart of the problem is the obsession with controlling inflation and the subsequent need for an explicit target of 1-3 per cent.

An explicit and narrow inflation target provides financial institutions with a very pleasant trading environment. They can predict with relative accuracy what will be happening to interest rates in New Zealand.

This allows them to access cheap finance overseas and pump it into the loans market in New Zealand. You can almost hear the chortles in the bank boardrooms in Sydney.

The obsession with rigorously controlling inflation is a legacy of the 1970s and 80s when New Zealand was subject to the effects of an inflationary spiral. The oil price shocks of the 1970s led to wage and price hikes fuelling further inflation and further wage and price increases in a continuous process.

Protectionist trade policies restricting imports allowed firms to raise their prices because of a lack of competition either domestically or from abroad.

Most workers were unionised with national awards determining wages. Government spending habits such as Think Big and supplementary minimum prices for farmers helped fuel inflationary pressures. We were a tightly insulated, highly regulated cost plus economy infected by an inflationary virus.

Nowadays the New Zealand economy is a completely different beast. The stringent monetarist approach to managing the economy is based on a misguided fear of returning to the distorting double digit inflation of 1970s and 80s. Over time the cure has become as damaging and distorting as the disease.

Bollard should be inviting debate about the merits of continuing such a rigid monetary stance and whether less destructive options are available. This is unlikely to happen because few institutions have the objectivity or courage to question the validity and effectiveness of their own key function.

* Peter Lyons lectures in Foundation Studies at Otago University.