A transformed country. Really?

I suppose Ministers of Finance don’t always get to approve the promotional material for their speaking engagements.

Yesterday, I got to the end of last week’s Spectator.  I don’t usually notice the back cover, but this time I couldn’t really miss the half page photo of Bill English, with the caption “This man runs harder than Sonny Bill”.  It was a promo for a Menzies Research Centre function next month: for A$220 a ticket our Minister of Finance, “co-architect of their resurgent economy” will “offer some insider tips on their game plan, because rugby isn’t the only thing the Kiwis are good at.  Tips that transformed the country”.

I’ve noted previously my puzzlement at this line from the right wing of the Australian commentator/think-tank community, who talk up New Zealand’s economic reforms, and policies.   I presume it is designed to exert some sort of leverage in Australia (“if even the Kiwis can do it, surely we can”).

Perhaps the rhetorical strategy works.  Perhaps it has a “feel-good” aspect to it.  Perhaps it just enables people to vent some frustration at their Senate. There was something a bit similar in late 80s and early 90s, when policy reform here was more extensive, and perhaps better-grounded in economic principles, than that in Australia.  I well remember that I was to pass through Sydney the Monday after the 1993 federal election.  The Liberals were widely expected to win, and I was lined up to do a lecture at the RBA about the Reserve Bank of New Zealand reforms in anticipation that John Hewson would soon do something similar.  Journalists were even invited.  And so it was all a bit awkward when Keating pulled off a late victory.

Back then perhaps there was a plausible story that we were doing reform better than they were.  Fans of compulsory savings would no doubt disagree.  There are still plenty of areas where I’d rate quality of regulation here better than there –  taxis are my favourite.   But the numbers favour them.  But to anyone looking into the numbers, all this talk now of New Zealand as a “transformed country” over recent years must seem almost completely wrongheaded.

There is one, non-trivial, dimension on which New Zealand might reasonably be judged to be doing better than Australia: our budget deficit is smaller than theirs.   But bear in mind that general government net debt, as a percentage of GDP, is still higher in New Zealand than in Australia (gross debt is identical).  The differences aren’t large, and neither country looks either that great or that bad by international standards.
nzau govt debt
If Australian deficits are still larger than ours, that partly reflects the timing of the respective terms of trade cycles.  Australia had a big boom over recent years that we did not really share in.  The terms of trade went sky high, as did business investment (which also means lots more depreciation expenses to offset against taxable incomes).  Their unemployment rate undershot ours for a while (that doesn’t usually happen) and their policy interest rates went above ours for a while (again, that is pretty rare).   Their terms of trade peaked in 2011, and now are almost back where they were in late 2007 (2007q4 is the conventional date for the last quarter prior to the recession).  New Zealand’s terms of trade didn’t go up so much (but exports are a larger share of GDP in NZ than they are in Australia), and peaked only last year.  Current revenue has until very recently been reflecting those peaks.  There are plenty of optimists around suggesting NZ commodity prices are just about to rebound.  Perhaps they’ll be right, but optimists were taken by surprise in Australia too


I’ve shown before the chart of productivity (real GDP per hour worked) for the two countries.  New Zealand has done really quite badly in the years since 2007 (absolutely and relative to Australia).

Neither country’s government has much influence over the respective terms of trade (I’d say none) but for what it is worth, here is the chart showing the real per capita real income measures (that capture the direct effects of the terms of trade) published by the ABS and SNZ.  Each country measures a slightly different thing, but for these purposes they are close enough.


Sure enough, using a base of 2007q4, New Zealand is now just a little higher than Australia.  That reflects the way our terms of trade, as at the end of last year, had not yet fallen very much in comparison to the fall in Australia.  But the end-point difference is trivial, and even if the two countries’ terms of trade level peg from here it would take a lot of years for NZ to make up for the loss of income relative to Australia in the previous 5-6 years.  And there is plenty of reason to expect our terms of trade to fall further.

In the end, as I’ve said, before I don’t really understand this Australian meme that somehow New Zealand has been managing itself much better than Australia.  The dominant story of the last 50 or more years is of how New Zealand has fallen behind Australia.  Nothing this government (or its predecessor for that matter) has done so far seems to have made much difference to that picture.  Some Australian commentators laud the 2010 tax package, but even then it is worth remembering that that package raised the effective tax rate on capital income (don’t take my word for it, it was in the Treasury numbers).  If anything, our productivity performance looks to have been drifting even further behind.

The net outflow of New Zealanders to Australia seems, at least temporarily, to have almost ended.  In itself that is encouraging, except that it probably reflects the fact that the unemployment rates in both countries are now quite high – historical relativities have been more or less restored.  And recall that post-1999 New Zealanders in Australia can’t now get welfare benefits when the Australian labour market turns down.

I don’t understand the meme, but perhaps it sells tickets.

How much should we rely on stress tests?

A commenter, Kelly, writes as follows:

Michael – is it necessarily true that the failure ( or lack thereof) of a bank stress test is the benchmark for assessing the worth and more specifically the legality ( in terms of consistency with the RBNZ’s act) of regulatory action? The relevant section of the Act says if I remember correctly that the Bank must use these powers for the purpose of ensuring the soundness and efficiency of the financial system. While the stress test results are one potential indicator they are not a necessary condition to justify regulatory action. Indeed I suspect that very little prudential regulation might be justified if this were the case. Stress tests are indicators of what might happen given a number of important assumptions any of which may not be true in real life. Also stress tests almost always are calibrated to ensure banks pass them ( or else additional capital should be added by failed institutions). History shows that stress tests have a poor record at predicting financial crisis. I think many reasonable people would consider a large fall in Auckland house prices might challenge the stability of the financial system in NZ. It’s true that in some circumstances it might not but would you expect the Bank to bank on being that lucky? The spillovers to the rest of the country would potentially be great.

The Bank’s actions in this area are in step with the generally successful international experience with regional LVR type measures. I think that this alone makes it difficult to argue the Bank is acting in an ultra vires manner. The IMF’s advice in this area is that macro prudential measures can be employed assuming key macro policy settings are also supportive. Your stance on monetary policy settings thus seem further supportive of the Bank’s stance. Although I am sure that the government could be doing more to help as you point out.

I’ve always enjoyed debates with Kelly, and I thought it might be worth addressing a few of the points he makes:

  • The Reserve Bank Act (sec 68) requires that the regulatory powers in Part V of the Act be used (by the Governor General, the Minister, and the Bank, but here the Bank’s discretionary action is in focus) “for promoting the maintenance of a sound and efficient financial system”.  Note that it is not about “ensuring” such an outcome, and neither has a “sound” financial system ever been regarded as one in which no bank failed.
  • Kelly suggests that very little prudential regulation might be justified if stress tests were to be used a key indicator.  I don’t think that is right.  After all, the risks that the Reserve Bank and APRA assessed last year were those that existed given the current panoply of regulatory controls, including the earlier LVR restrictions.  In other words, some mix of market disciplines and regulatory measures had produced loan books which appeared to be pretty robust to some pretty severe shocks.  The issue here now is whether a case can be made, in terms of the Reserve Bank Act, for further, quite intrusive and quite unconventional, controls.   That case would have seemed much easier to make if the stress tests had produced results which appeared more threatening to the soundness of the financial system.
  • Kelly alludes to widespread scepticism about the use of stress tests by some regulatory and supervisory agencies.  It is certainly true that one would not expect a regulator to publish stress test results, particularly those undertaken in the midst of a financial crisis, suggesting that the financial system was in great danger without having first taken remedial action.    But context matters.  Clearly New Zealand and Australian banks are not in crisis now.  Moreover, the timing of the recent NZ stress test was determined by APRA, not by the Reserve Bank of New Zealand, and occurred at a time last year when, if anything, the Reserve Bank seemed to be looking at the possibility of winding back, or lifting, the avowedly “temporary” LVR restrictions.  When the results of the stress tests were published in the November 2014 FSR there was no hint of any undue concern about risky lending practices or region-specific controls.  In other words, even from outside, I think we can acquit the Reserve Bank of any suggestion that it undertook the stress tests with a particular end in mind.  Instead, they really wanted to assess the health of the New Zealand system, posed some deliberately searching test scenarios, and were pleasantly surprised by the results.
  • Stress tests aren’t the only possible measure of financial strength.  Indeed, in the day-to-day activity of prudential supervision they play a much less important role than regulatory capital requirements.  In fact, it is unease about the use of not-very-transparent, hard to evaluate, internal ratings-based models for calculating capital requirements that has encouraged many to put more weight on stress tests in recent years.   But in any case recall that New Zealand banks have high capital ratios by international standards, and that is so even when higher risk weights are applied to housing exposures than in is done by banks in many other advanced countries.
  • Kelly notes that “many reasonable people would consider a large fall in Auckland house prices might challenge the stability of the financial system in NZ”.  As a matter of description that is certainly true, but that is why, for example, stress tests are done and why, for example, Parliament mandated the publication of Financial Stability Reports. Those reports are supposed to enable us to better understand, and to assess, the risks and the Bank’s regulatory activities.   And I’m certainly not suggesting that New Zealand should rely on luck to get through an eventual house price adjustment (rather, high capital ratios, and slow growing balance sheets are what suggest pretty moderate risks)   Indeed, I was one of those who was a bit surprised when we saw the first stress test results.  I pushed and prodded, and wondered if they were missing something important.  Sunny optimism is not in my nature, but in the end I was persuaded.  There are no doubt some things the stress tests don’t fully capture –  the possibility of sustained deflation is one of those risks, but that can’t be the concern the Bank is relying on (since the word does not even appear in the FSR).  And frankly nor would I expect it to be at this stage.    It seems likely that the Governor does not really believe the stress tests, or the capital ratios.  There might well be a good reason for his doubts, but he owes it to us, and to Parliament (through FEC), to explain the nature of those doubts, and allow them to be scrutinised and challenged.  It isn’t enough –  given his Act –  simply to worry that Auckland prices are too high and might come down one day.   We particularly need to be able to scrutinise the Bank’s analysis given that it is a unelected single individual  –  with, frankly, not that much experience or background in these policy areas –  who is making these regulatory calls.
  • Finally, Kelly notes that “the Bank’s actions in this area are in step with the generally successful international experience with regional LVR type measures. I think that this alone makes it difficult to argue the Bank is acting in an ultra vires manner.”   There are at least two separate points here.  First, as a matter of law I’m not arguing that the Bank’s proposed new controls would necessarily be ultra vires.  Some others might.  I would argue simply that they are using the legislation for purposes Parliament never envisaged, which is not good for the legitimacy of policymaking, and that – at present – they have not met any sort of burden of proof regarding why such arbitrary restrictions on investment property lending (of the sort never before used in New Zealand, even under the Nash to Muldoon years) are either necessary or desirable to further enhance the soundness of the financial system, especially in face of the inevitable efficiency costs.  It is important to remember that whatever the preferences of the Governor, the Reserve Bank has been given powers by Parliament for the promotion of the “soundness and efficiency of the financial system”.  That is different from the mandates regulatory agencies in many other countries have.    Whatever other countries have done, the Reserve Bank must look primarily to its own legislation.   Second, Kelly suggests that Auckland-specific restrictions are in step with “generally successful international experience”.  I think that is wrong, at least in the sort of countries, market-based economies, and systems of government we typically like to compare ourselves with.  I’m not aware of regional-based banking regulatory controls in any of the other Anglo countries for example, or in the Nordic countries.

Perhaps all will become clear when the Reserve Bank releases its consultative document on the proposed new controls.  I certainly hope so.     But there is a lot to clarify.