Needless Casualties in the Economic War
On Anzac Day, we remembered the sacrifice made by thousands of young New Zealanders at Gallipoli – sent to their fate because those with the power to make decisions had neither the wit nor the courage to depart from a course that everyone knew was doomed to disaster.
A day after Anzac Day, we learned of another kind of sacrifice – of 350 jobs at one of New Zealand’s most iconic enterprises. This time, there was the same inevitability about the outcome of a strategy that everyone knew was failing but there were no incompetent and far-away British decision-makers to blame. This time, we were doing it to ourselves.
The Fisher and Paykel decision, after all, did not come out of the blue. We have been sleep-walking towards it for a very long time. Nor is it an isolated instance of policy failure. Behind this decision stand many other Fisher and Paykels, all facing the same imperatives, the same inevitability, the same disastrous consequences of a discredited orthodoxy that no one in power has the courage to challenge.
In theory, the current orthodoxy could not be simpler. Inflation is to be controlled by manipulating the price and therefore the supply of money, a task entrusted to technicians who are immune to political pressure. With the threat of inflation painlessly removed, the economy is free to flourish and investors can make their decisions with confidence.
We have now had a protracted opportunity to test this attractive theory in practice. We now know that, while increasingly ineffective and possibly even counter-productive as a counter-inflationary strategy, the orthodoxy is profoundly destructive of the high-productivity, export-oriented economy that our business and political leaders say they want.
Fisher and Paykel’s catastrophic loss of competitiveness as a New Zealand manufacturer represents just the first-order consequences of the high interest rate, high exchange rate regime that monetarist policy makes inevitable. Faced with an over-valued currency, all New Zealand enterprises that seek to do business in the internationally traded goods sector (including our own home market) face an unattractive choice; either they lose market share through declining competitiveness or they try to maintain price competitiveness by shaving margins and risk having to trade at a loss. For most, the outcome will be an even less attractive combination of both.
The medium-term impact is severely damaging to our economy. New Zealand companies struggling to maintain competitiveness find that shrinking markets and disappearing profits mean that they do not have the money to catch up on foreign competitors by re-investing in new technology or upskilling staff or conducting leading-edge research or mounting an effective sales campaign or offering improved after-sales service. The result? They fall behind in the productivity race, forced to lose yet more market share at home and to give up the attempt to export. If they do survive, they move offshore or are bought up by foreign competitors.
In the longer-term still, the consequences of an over-valued currency begin to shape our culture. The only people who make money are the speculators, who manipulate existing assets and create no new wealth. The best brains and best resources gravitate to the non-traded sector and we give up the attempt to move them to the traded sector where the real prospects for growth lie. We become risk-averse, preferring to invest in domestic assets, like housing, rather than chance investment in a high-risk productive enterprise where the threat of failure is ever-present.
In vain do our leaders berate us for our obsession with housing, our predilection for artificially cheap imports, our unwillingness to save. In vain are we urged to improve productivity, to spend less and to save more. Economics is a behavioural science. Like Fisher and Paykel, we each of us make the decisions made inevitable by the policies adopted by our leaders.
We are now being driven towards what everyone knows is literally a dead end. We have impaled ourselves on the horns of a dilemma of our own making. It is happening in the name of an orthodoxy that cannot deliver even the limited counter-inflationary outcomes that it promises. Ministerial exhortations do nothing but emphasise how far the dream of high productivity has become – by virtue of literally counter-productive policies – an unattainable chimera.
We cannot escape from this dilemma until we recognise what it is. The more we push up interest rates and the exchange rate, the less competitive we become and the more we fall behind in terms of international competitiveness. The less competitive our real economy, the more entrenched is our inability to pay our way in the world and the more dependent we are on short-term “hot money” to bale us out. The more we need “hot money”, the more we need to push up interest rates and the exchange rate, the more our competitiveness declines still further and the more threatening inflation becomes.
We must stop relying on interest rates and the exchange rate to perform tasks for which they are not suited. We should instead free our minds of current dogma, restore economic policy to democratic control and ensure that the economy is run in the common interest. That means a more accurate analysis of what is going wrong and what is needed to fix it. It means a better focus – not just on controlling inflation through fiscal measures, more effective controls on the level and purposes of bank lending, and measures to restrain the booming housing market – but on macro-economic measures to improve competitiveness and encourage growth and investment.
For the moment, however, there is only one question worth asking. How many more needless sacrifices must be made before we say that enough is enough and that a new course must be tried?
Bryan Gould
27 April 2007
Why Are Interest Rates Not Working?
In theory, it was all so simple. Since inflation could not happen if the money supply was held stable, all you had to do was control the money supply and – no more inflation! The productive economy would rapidly adjust to the new monetarist discipline and would benefit – along with everyone else – from low inflation.
True, early attempts to define the money supply ran into trouble, when money turned out to be a surprisingly slippery concept. The attempt to measure the money supply was therefore abandoned, and reliance was placed on the crude instrument of controlling money’s price. The simple task of raising or lowering interest rates as appropriate was handed over to bankers who could be relied upon not to be swayed by the inflationary pressures to which elected politicians were subject.
Raising interest rates, though, turned out to be far from painless and had a real and debilitating effect on many parts of the economy, not least on the wealth-creators as opposed to the wealth-owners. It was also, as a counter-inflation instrument, slow-acting and poorly focussed. But, despite these obvious downsides, it did seem to work, even if it took a long time and did a lot of damage in the process.
That is, until now. Alan Bollard has been raising interest rates for a couple of years now, but the housing market remains stubbornly buoyant, bank lending is correspondingly rising, domestic consumption refuses to die back, imports continue to surge, our current account is in record deficit. No one can be confident that these inflationary pressures will abate. So, where to from here?
Current orthodoxy allows the Reserve Bank few options. The Governor is now caught in a trap of his own making. If he raises interest rates yet further, this will in turn lift the exchange rate, sending our current account deeper into the red. The productive economy, on which our prosperity depends, will suffer further damage.
Most worryingly, if recent experience is anything to go by, inflation will go on unchecked, whatever damage is done to the real economy. If interest rates cause the dollar to rise, consumption will be stimulated. People will go out and spend on cheap imports for as long as every dollar will buy up to 20% more than it should. And they will stick with investing in houses rather productive industry for as long as monetarist orthodoxy and an overvalued dollar depress profits and growth in those industries and while high interest rates offer a better short-term return.
In vain will the Governor lecture New Zealanders on their failure to save and their predilection for investing in houses rather than in productive capacity. He has no one to blame but himself. Economics is a behavioural science. People do not respond to lectures, but to economic realities.
And the longer he persists, the worse his predicament becomes. The weaker our productive economy and the bigger our current account deficit, the more we need high interest rates to attract overseas “hot” money to finance it. And since even that inflow will not fill the gap, we have to sell off yet more assets to foreign owners, making our current account worse with the double whammy of increasingly high interest payments and larger volumes of profits repatriated overseas.
All of this might just about be tolerable if the medicine was working – but it isn’t. Interest rates are no longer effective as a counter-inflation instrument. Indeed, they might even be adding to inflationary pressures.
The initial impact of higher interest rates is of course to raise prices, not reduce them. The counter-inflationary effect is expected to come from restraining bank lending – by far the most potent inflationary factor in our economy – by making it more expensive. But what if borrowers simply absorb the increased cost and carry on regardless?
That is indeed what seems to be happening. This is partly because of the high proportion of New Zealand borrowers who have fixed rate mortgages, so that they are insulated for a time against rate increases, and partly because the continued strength of the housing market has taught home-owners that increased mortgage payments are only a minor offset compared to the constant capital appreciation against which they can borrow at the bank.
Higher interest rates simply become another cost increase which is painlessly absorbed into the cost and price structure of the housing market – and the overvalued dollar also chips in by raising the price of New Zealand assets against assets held overseas.
If the only monetarist means of slowing the housing market is to use an interest rate sledgehammer that kills everything, the time has surely come to look at other options, even if they may all have their downsides. Fiscal measures, particularly within the regime established by the Fiscal Responsibility Act, would certainly be more effective and better directed than interest rate rises. They could include investment incentives designed to promote productive investment. Restraints on certain kinds of bank lending could be put in place.
Monetarists take a surprisingly static view of how the economy works. Their insistence on using high interest rates to drive down prices has run us into a blind alley. Getting off the interest rate and exchange rate roller coaster, and giving priority to the real rather than the financial economy, might actually encourage some sustainable productive growth which would be the best counter-inflation strategy of all.
New Zealand led the way – misguidedly – into the more extreme versions of the monetarist revolution. We now have the chance to make amends by being the first advanced country to recognise the need to change course. The Governor himself has acknowledged the limitations of the current orthodoxy. Let the debate begin!
Bryan Gould
16 November 2006