As we approach the OCR decision this afternoon and as some market economists are now talking about the possibility that the OCR could be below 1 per cent before too long, there has been more and more talk about whether fiscal policy should be brought to bear, to stimulate demand and (in some sense) assist monetary policy in its macroeconomic stabilisation role. Just this morning there was an editorial in the Herald, a column on Stuff, and a comment from Bernard Hickey at Newsroom. Some of the discussion is about what should be done now, and the rest is about contingency planning – what happens when the next serious recession happens if the OCR is still constrained.
Much of the discussion seems to stem from people on the left who aren’t that happy with the government’s fiscal policy. As someone not on the left, it has always seemed strange to me that Labour and the Greens pledged themselves to keep much the same size of government (and much the same debt) as National – especially when, at the same time, you were running round the country talking about severe underspending on this, that, and the other thing. I’m also of the view that structural budget surpluses are a bad thing, in principle, when net government debt is already acceptably low (on the OECD measure of net general government financial liabilities, New Zealand is now about 0 per cent of GDP, which seems like a nice round number – an anchor – to target). There is an argument there – whether from left or right – for some fiscal adjustment (taxes or spending), which might have the effect of a bit more of a boost to demand.
But those arguments really have almost nothing to do with the situation facing monetary policy. They are fiscal and political arguments that should be made, and scrutinised, on their own merits: the arguments would be as good (or not) if the OCR was still 2.5 per cent as they are now, and you can be pretty sure that people on the left would have been making them then anyway? The Governor of the Reserve Bank, for example, (a pretty staunch representative of the centre left) seemed keen on more infrastructure spending a year ago. I guess he is a voter to so is entitled to his opinion, but it really doesn’t have much to do with monetary policy.
The general arguments that led countries around the world to adopt monetary policy more exclusively as the primary stabilisation policy tool have not changed. Monetary policy can be adjusted quickly (to ease or tighten), operates pervasively (gets in all the cracks, without making specific distributional calls), is transparent, and so on. If we had a fixed exchange rate – as individual euro area countries largely do – it would be a bit different (individual countries don’t have the monetary policy option any longer) but we have a floating exchange rate system which, mostly, works well for New Zealand.
To the extent that there is a monetary policy connection to the current calls for fiscal policy to be used (or the ground prepared to use it), it has to do with the looming floor on nominal interest rates. International experience suggests that, on current laws and technologies, short-term nominal interest rates can’t be reduced below about -0.75 per cent without becoming ineffective (as more and more people shifted from other financial instruments into physical cash). We don’t know quite where that floor is, as no central banks has been willing to take the risk of going further, but there is a fair degree of consensus (and it has long been my view too).
But that still means that in a New Zealand context there is 200 basis points of OCR cuts that could be used if required. That isn’t enough for a typical New Zealand recession (rates have often been cut by 500bps), but is still quite a degree of leeway if what we are entering were to turn out to be a fairly mild slowdown in New Zealand. It could (I’m not hedging here). That capacity should be used energetically, not timorously. So the issue – monetary policy needing “mates” deployed now – is not immediate. It is about preparing the ground.
And there, the best macro stabilisation option remains the one the Reserve Bank – and other central banks – have done nothing active about, but really should. Authorities (and it probably needs political support to do so) should be moving to make the effective floor on short-term nominal interest rates much less binding than it is. It binds because the practice of central banks – perhaps backed by law – has been to sell banknotes, in unlimited quantities, at par. That practice can be changed. It could be as simple as putting an (adjustable) cap on the volume of notes in circulation (quite a bit above the current level, but not at a level that would be transformative) and then, say, auctioning the right to buy additional tranches of bank notes from the Reserve Bank. In normal times – with the OCR at, say, current levels – the auction price would be at par. If the OCR were cut to, say, -3 per cent (and be expected to stay there for some time) the auction price would move well above par, acting as a disincentive on people to attempt to make the switch from deposits to cash. There is a variety of other ideas in the literature, as well (no doubt) as much less efficient regulatory interventions that could prevent really large-scale conversions happening.
Unusual as such options may sound, this is where the authorities – here and abroad – should really be concentrating their energies: giving monetary policy more leeway, in ways that will buttress market confidence that monetary policy will do the job when it is required. At present, by contrast, when market participants contemplate a severe downturn they look into an abyss wondering what, if anything, will eventually be done, by whom, and for how long. In a serious downturn that will just worsen the problem, driving down inflation expectations as economies slow (note that in the RB survey out yesterday, medium-term inflation expectations fell away quite noticeably – and this while we still have conventional monetary policy to use). And if there are objections that all this is somehow “unnatural”, bear in mind that had the inflation target been set at zero (rather than 2 per cent), as was the normal average inflation rate for centuries, we’d already have run into these practical limits, and been unable to get real interest rates even as low as they are now.
So there is plenty to be done with monetary policy, and the work programme to do it should be something open and active, drawing in the Bank, the Treasury, the Minister, and other interested parties. The time to do preparation is now, not in the middle of a surprisingly severe downturn.
I have a few other reasons – than “it shouldn’t be necessary” – to be wary of calls for large scale fiscal stimulus now. Just briefly:
- there would be little agreement on what should be done – these are inherently intensely political issues. There is lots of talk of infrastructure gaps etc, but no agreement on what those are, let alone recognition of the twin facts that (a) the best projects, with the highest economic returns, have probably already been done, and (b) New Zealand government project evaluation is not such as to inspire confidence that new projects would add economic value. And suppose there were attractive roading projects – perhaps central Wellington and the second Mt Vic tunnel? – we know the attitude of the government’s support partner to new major roads. Not a thing. So what should we then spend on? Uneconomic new railway lines? Or what? Perhaps some just favour more consumption or transfers spending – which might be fine if you are a lefty who believes in permanently bigger government, but if you aren’t the issue has to be addressed of how programmes once put in place are unwound later.
- I don’t rule out the possible case for discretionary fiscal stimulus in the event of a new severe recession (especially if the authorities refuse to address the monetary policy issues above) but my prediction is that (in many ways fortunately) the political appetite for large deficits would not last very long, and that therefore we should preserve the option for when it might really be needed. It isn’t now. I take much of the rest of the world after 2008 as illustrations of my point: in late 2008 all the talk was of fiscal stimulus, but within two or three years all the political pressure was to pull deficits back again. I don’t see why New Zealand would be any different (and that is to our credit, since low and stable debt has become established as a desirable baseline).
- And thirdly, a point we don’t often hear from champions of more fiscal stimulus, relying more on fiscal policy and less on monetary policy to support economic activity and demand will, all else equal, put more upward pressure on the real exchange rate, further unbalancing an already severely-unbalanced economy (see yesterday’s long-term chart of the real exchange rate). In a severe recession – when the NZD tends to plummet – that isn’t a particular problem, but it should be a worry now (when the TWI is still a bit higher than it was a year ago, let alone thinking about the longer-term imbalances.
Perhaps the Governor and the (experts-excluded) Monetary Policy Committee will proactively address some of these issues this afternoon. I do hope so. If not, I hope some journalists take the opportunity to push the Governor on why he (and the Minister and Treasury) aren’t actively pursuing work to make the lower bound on nominal interest rates much less binding, in turn instilling confidence in the capacity of New Zealand policy to cope conventionally with a severe downturn if/when it happens.
Oh, and I do hope some journalists might also ask the Governor this afternoon about the justification for ruling out from consideration for appointment to the Monetary Policy Committee
“any individuals who are engaged, or who are likely to engage in future, in active research on monetary policy or macroeconomics”
The Governor is, after all, a Board member and was one of the three person interview panel. What was it that he – or the Board generally – were afraid of? Expertise? An independent cast of mind? Of course, it isn’t only active researchers who have such qualities – indeed, not all of them do either – but it simply seems weird, and without precedent in serious central banks elsewhere in the advanced world, to simply disqualify from consideration for the (part-time) MPC anyone with the sort of background that many other central banks (Australia, the UK, the euro area, Sweden, the United States, and so on) have found useful, as one part of a diverse committee.