Time to reform Reserve Bank goverance – international perspectives

On Saturday evening I put out my paper Time to reform the governance of the Reserve Bank.  It was slightly odd timing in some ways, but the Sunday Star Times had expressed interest in giving the issue some coverage.

Many people won’t read an 18 page paper, so I’m going to highlight some of the key aspects of the paper in a series of posts this week.  The essence of my argument is that decisions around monetary policy and financial regulatory policy should not be exercised by a single unelected official, no matter how good the official.  No other advanced democracy does it that way, and New Zealand runs no other aspects of policy that way.

But I should first repeat one point.  Decisions around the governance of the Reserve Bank are a matter for the Minister of Finance and, ultimately, for Parliament, so my arguments for change are not criticisms of the Bank, but of the choices Parliament and successive ministers have made (most recently, through decisions not to change the system).    Officials operate within structures that politicians establish.  And contrary to the headline in print version of the Sunday Star Times, I am not arguing that the “RBNZ wields too much power”, rather that, given the responsibilities Parliament has assigned to the Bank, the Governor himself (any Governor) exercises too many of those powers.  What powers the Bank should, or should not have, is a topic for another day.

The Reserve Bank operates under an Act that was initially passed in 1989.  The Act has been amended quite a few times since then, mostly to add new powers and responsibilities.  The governance structure, however, has not materially changed since 1989.  In the paper, I highlighted four strands of thinking or data that influenced choices made a quarter of a century ago, and how differently things look on each of those counts today.  The governance structure chosen in 1989 was unusual, but there was a logic to it.  Things are different now.

The first of my four aspects was international experience.  In 1989, not many other central banks had effective and statutory independence in monetary policy (and not much attention was paid to financial regulation).  In 2015, there are plenty of countries to look at.  Only one other allows (as a matter of law) the central bank Governor to make interest rate decisions himself (rather than by legislated committee, with the associated checks and balances).  No other country allows a single unelected official to make decisions on both monetary policy and supervision/regulation himself.

Here is what I said, quite briefly, about international experience.

As things looked in 1989:

First, at the time only a few other central banks had (both statutory and effective) operational independence.  The ones New Zealand officials tended to be interested in were the central banks of the United States, West Germany, and Switzerland, and none of those were from the the British-based tradition of parliamentary and public sector governance.  In other words, there were few international models that could readily be adopted in New Zealand[1].   The Reserve Bank of New Zealand legislation was the first in what was a whole wave of new central banking legislation around the world over the following 10-20 years.

[1] The Reserve Bank’s own initial proposal to the Minister of Finance was based around the Australian statutory model. In that (1959) model the Reserve Bank of Australia’s Board was formally the decision-making body, but the Federal Treasurer could override the Bank so long as this was done openly (tabled in Parliament).  Appealing as the model may have looked on paper, it was a curious recommendation since, in practice, the RBA  participated actively in the public sector policy debate but ultimately did as it was told from Canberra, and the formal override powers were never –  and have never been – used.

For some discussion of this and some of the other historical material see my 1999 Reserve Bank Bulletin article “Origins and early development of the inflation target”


And as things stand today

The fourth aspect where events have unfolded differently has been in what other countries have done in reforming their central banks and financial regulatory institutions.

Take monetary policy first.  Since 1989, there has been a substantial global shift, in both legislation and practice, to provide many more central banks with operational autonomy for monetary policy:  Among the G7 countries, central banks in the UK, Japan, and France have been given independence, and the (new) ECB has the highest level of monetary policy autonomy of any modern central bank.  Across eastern Europe (still mostly communist in 1989), and other parts of the emerging world, there have been similar trends.  But not a single advanced country, of the many to have reformed their central bank legislation, has moved to a model with a single unelected individual as decision-maker for monetary policy[2].    Despite all the attention paid to the New Zealand reforms, no country has adopted the New Zealand governance model[3].

Governance models for banking regulation/supervision in other countries are quite diverse.  In some countries many or all of these activities occur within central banks, and in other cases most of the regulatory functions occur in separate agencies.  However, I am also not aware of any advanced economy in which Parliament has delegated the major policy decisions in respect of financial supervision/regulation to a single unelected official.  A decision-making Board, advised by technical experts, is a much more common model, and in some cases many more of the policymaking powers (than in New Zealand) are reserved for ministers.

In sum, in no other advanced democratic country does a single unelected official exercise so much power in matters of monetary policy and financial regulatory policy.  Only in Canada’s case, with rather old legislation, does a single official exercise final legal power (in respect of monetary policy), and the Bank of Canada has very much more limited functions than the Reserve Bank of New Zealand.

[2] I am not aware of any developing countries having done so either, but have looked less deeply into the range of reforms in those countries.

[3] A few years ago Israel amended its central banking legislation to shift from a single decision-making Governor, to a decision-making monetary policy committee.  For a useful survey of monetary policy governance in a range of advanced countries see http://www.rbnz.govt.nz/research_and_publications/reserve_bank_bulletin/2014/2014mar77_1aldridgewood.pdf

More on why our interest rates have been so high

Last week I illustrated how much higher our long-term interest rates have been (and are) than those in other advanced countries, and set out my argument that investor concerns about the large New Zealand negative NIIP position (loosely, “the large external debt”) don’t look to have been the culprit.

In this post, I’m going to show another couple of charts, and then briefly respond to a commenter’s question.

One possible reason why New Zealand’s interest rates might sensibly have been higher than those abroad would have been if New Zealand’s rate of productivity growth had been so strong that returns to large amounts of new investment in New Zealand were very high.  Profitable business opportunities might have abounded, and businesses had been rushing to invest to take advantage of those opportunities, while households might have been rationally anticipating future much higher incomes.

That doesn’t sound like New Zealand over the last 25 years.  In fact, our rate of business investment (as a share of GDP) has been one of the lower among OECD countries.   In recent days, I’ve shown a couple of charts drawn from the Conference Board’s TFP data.   Here is another.  For the advanced countries for which the Conference Board has estimates all the way back, it shows total estimated growth in TFP since 1989 (when the public data start). New Zealand hasn’t been the worst of these countries, but the record is pretty underwhelming.   And Greece, Spain and Portugal each look a bit worse than they deserve because there is so much excess capacity in those economies right now.

tfp since 89

My other chart this morning is about the slope of the interest rate yield curve.  Very broadly speaking, yield curves are generally upward sloping.  That is, short-term interest rates tend to average a bit lower than long-term interest rates.  But New Zealand has been different.

As I showed the other day, long-term interest rates in New Zealand have been higher than those in other advanced countries.  But short-term interest rates have been even higher.   That is what this chart captures.  It uses OECD interest rate data,  The data aren’t ideal: the long-term interest rates are government bond rates, and the short-term rates are those on private sector securities.  But as that is so for each of the countries it shouldn’t materially complicate cross-country comparisons.

I’ve deliberately only drawn the chart to the end of 2008.  Since the near-zero lower bound on short-term nominal interest rates became an issue for an increasing range of countries, looking at the slope of the yield curve has not had the same meaning (since short-term rates can’t be cut as low as they otherwise would).

yield curve

Over that 17 year period –  in which each country had several interest rate cycles – New Zealand stood out.  If foreign investor concerns were at the heart of why interest rates were so high, long-term rates would be high relative to short-term rates (relative to what is seen in other countries).  That is the situation in Greece now.  But as the chart illustrates, in New Zealand it the other way round.  Our short-term interest rates averaged much higher relative to long-term interest rates than was the case in the other countries shown.  It suggests that we should be looking for things that drive short-term rates for our explanation as to why New Zealand interest rates have been persistently so high (again, relative to other countries’ rates).  It also nicely illustrates my observation the other day that New Zealand interest rates have long been regarded as unsustainably high, and not just by government officials and other pointy-headed analysts.  The slope of the yield curve is set in the market.   Private investors have expected our short-term interest rates to fall relative to long-term interest rates (whereas in these other countries there was no such expectation).  But those expectations have been wrong.  Persistent surprises in how long our interest rates have stayed up relative to those abroad can help explain why the exchange rate has been so persistently strong.  My former colleague, Anella Munro, covered some of this ground, in rather more technical terms, here.

And finally, some brief answers to a commenter’s question.  On Friday a commenter asked:

Michael, your analysis seems to make sense – that it’s more pressure on resources than risk premium that explains persistently high NZD interest rates
But it also raises, for me, some further questions.

My understanding is that when the NZ Government used to borrow in USD, back in the 1970s and 1980s,(when NZ was probably a worse credit risk than it is today), it did so at a rate only a small margin above the rate at which the US government borrowed. And I imagine that, today, NZ banks borrow USD at much the same rate as that at which US banks borrow. So if the only difference is in the currency of denomination (ie, the counterparties and the countries are the same) doesn’t that suggest that the explanation for the persistently high NZ interest rate has to have something to do with the currency?

Second, if there has been persistent pressure on resources, why would that not have been been closed by net imports?

Grateful for any responses you may be able to offer.

On the first question,  yes New Zealand credits borrow internationally in USD at much the same interest rates as similarly-rated borrowers from other countries do.  A AA-rated New Zealand bank is likely to pay much the same US interest rate on a bond issue as, say, a AA-rated Swedish bank might.  That certainly helps make the point that, whatever, is accounting for the differences between, say, New Zealand dollar and Swedish krone interest rates it is not the credit quality of the borrowers.    The credit ratings of our banks are as good as those anywhere.

But does that mean that it is all to do with the exchange rate?  Well, yes and no.  I would argue that it is the ability of the exchange rate to move that makes the material cross-country differences in interest rates possible[1].  Since expected risk-adjusted returns should be roughly equal across advanced countries, interest rates on New Zealand dollar assets  can only be higher than those on assets denominated in another currency (for similar quality borrowes) for any length of time, if the New Zealand dollar is expected to depreciate against that currency over time.  When the interest rate gap opens up, the New Zealand dollar tends to rise until it reaches a level that is not regarded as sustainable. At that point, the expected future deprecation more or less offsets the yield advantages.  There is an alternative story, in which the NZD is such a volatile currency that we have to pay premium interest rates to attract the foreign capital we need.  But again, if such  premia exist, and are material, they should result in a surprisingly weak exchange rate.  That hasn’t been the New Zealand story –  indeed, the only sustained period of weakness in the New Zealand exchange rate was around the turn of the century when our policy rate was quite low relative to those abroad (our OCR briefly matched the Fed funds target rate in 2000).   Such premia –  whether to do with the NIIP or a volatile exchange rate –  should tend to encourage resource-switching towards the tradables sector, in a (self-stabilising) manner that reduces future perceived vulnerability and any risk premia.   I scarcely need to point out that we’ve seen nothing of that sort over 25 years.

And just briefly, the second question was whether, if there has been persistent pressure on resources, why that would not have been closed by (net) imports.  The simple answer to that is because the economy can be thought of as made up of tradable bits and non-tradable bits.  If everything in the economy were fully tradable, then any excess demand in New Zealand could be expected to be fully met through imports.  Since tradables prices are set largely in world markets,  there would be no sustained domestic pressures on the inflation rate (and no real need for a domestic monetary policy, or our own currency).  Most of the interesting stuff arises from the fact that much of the economy is not freely tradable across borders, and tradables and non-tradables aren’t fully substitutable (I need a haircut, my mother needs rest-home care, and so on).  So when we see persistent incipient excess demand pressures, some of the pressure shows up in the current account, and some in interest rates.  As a result, despite a pretty strong government balance sheet, New Zealanders’ have run large current account deficits over the last 25 years, and we have had high interest rates relative to those in other advanced countries.  Excess demand pressures, arising domestically, largely explain both phenomena.

[1] As I illustrated in one of my very early posts, back in the 1890s, when the New Zealand government was very heavily indebted, but the exchange rate was fixed, the gaps between New Zealand and UK government bond yields were much smaller than those in recent decades.