Something a bit odd in the data

I haven’t had time to look closely at last week’s GDP data, but as a last post for the year I thought I’d have a very quick look at the productivity (real GDP per hour worked) numbers that the various recent SNZ releases (national accounts and HLFS) suggest.

Over the years, I’ve often used as a proxy – SNZ not publishing an official series – a measure calculated by averaging the two quarterly GDP measures and dividing them by (an index from) an average of hours worked from the HLFS and hours paid from the QES. But in periods of lockdowns you really don’t want to be using hours paid, because things like the wage subsidy schemes were designed to get people paid even if they weren’t able to work, or their firm wasn’t able to generate much output. So in this chart I’ve simply used the average of the two GDP measures and the HLFS measure (self-reporting respondents) of hours worked.

This one starts from back just prior to the 2008/09 recession. As you see, the decade or so leading up to Covid wasn’t a good time for labour productivity growth in New Zealand (something not much more than 0.5 per cent per annum). And then came Covid and all the disruptions (and policy stimulus).

prod dec 21

Here is the same chart starting just prior to Covid (2019Q4).

prod dec 21 2

Perhaps unsurprisingly there has been quite a lot of variability in this measure of productivity, in ways that really don’t make a great of sense (to me).    There is always some variability –  one reason for using average measures –  but you can see from the first chart that the last couple of years look quite different, so far.  That “so far” is important, as there will be revisions to the GDP numbers for several years to come –  although none to the hours numbers (and who really knows how people were answering in lockdowns).

But if you believe these numbers –  and I recommend that you don’t –  we appear to have found the elixir of New Zealand productivity growth.  First take a global pandemic, then shut the borders, ease monetary policy, throw lots of government money at things, mess up the housing market further, compound it all with huge uncertainty from month to month (sometimes week to week).

Something just doesn’t ring true.  Sure, people find smart ways of doing things from home, but generally you’d have to assume that if the new ways were so great as to be better than what went before in 2019 they’d have been done then.  And no doubt macro policy has given a big boost to overall demand, activity, employment and hours….but this is a productivity measure, and whatever the boost was you’d normally think it would lift demand for people who on average were less productive than what went before.

There are always averaging effects –  in lockdowns perhaps some of the least productive people are disproportionately those who can’t work (waiters, motel cleaners etc) –  but….the picture was already looking surprisingly strong in Q2 this year, when there were hardly any domestic restrictions.

I just don’t believe that the picture represents reality, and that somehow productivity growth has –  after all these decades – started to accelerate.  There have been no micro policies working in that direction –  rather the opposite –  and no one really supposes that forcing businesses not to interact with overseas customers and suppliers etc face to face is good for medium-term productivity.  Add to that all the supply chain problems –  even the small weirdness that USPS no longer delivers to New Zealand –  and it suggests we should be pleasantly surprised if the level of labour productivity now is not lower than it was two years ago.  It just doesn’t make sense to think it is so much higher.  All else equal, the GDP estimates –  and that is all they are, in tough times for measurement and estimation –  look too high.

On which note, I will end the blogging year.

It has been a year of many fewer posts than in most since the blog began.  That was largely down to me getting a cold back in May 2020 from which I never fully recovered, graduating into what the doctor eventually diagnosed (labelled as) chronic fatigue syndrome.  By the standards of what one reads or hears of other people I had a mild version, but for long periods that meant I wasn’t good for much beyond the day to day basics, and sitting in front of a screen for even half an hour was at times astonishingly draining.  An attempt to walk much further than round the block could knock me back, sometimes for weeks.  I’m still not 100 per cent –  still need naps most afternoons – but seem to getting close; perhaps 90 per cent of normal, which is a considerable relief all round.

Having said that I don’t suppose I will drift back into a routine of a post each week day. Posts two or three times a week, supplemented with charts/links on Twitter, seems to be a useful and workable model for now.

Reviewing immigration policy

The Productivity Commission has been charged by the government with reviewing immigration policy with a view to identifying “what working-age immigration policy settings would best facilitate New Zealand’s long-term economic growth”, with a specific emphasis on productivity.

The draft report came out in early November, and I wrote a couple of sceptical/critical posts on it (here and here). The Commission invited submissions on the draft report (submissions close on Friday) and I’ve just lodged my submission. The full text is here:

Submission to the Productivity Commission inquiry on NZ immigration policy Dec 21

Most of the material in my submission will be familiar to regular readers, so I’m not going to quote extensively from it here. My overview was as follows:

There are plenty of individually interesting bits of material in the report (and supporting working papers) but overall, I’m left with the impression that the Commission has not yet done adequately what was asked of it. Specifically, in the Terms of Reference for the inquiry, you are invited to “explore what working-age immigration policy settings would best facilitate New Zealand’s long-term economic growth and promote the wellbeing of New Zealanders”, and in the next paragraph the connection to improving productivity is explicitly highlighted. Your draft report seems to touch on many of the more-detailed points listed in the Terms of Reference, but does not sufficiently stand back to evaluate the way in which immigration policy has (or has not) been contributing to productivity growth and material
living standards of New Zealanders.

Doing so well would require at least a pretty comprehensive review of New Zealand’s experience with large-scale non-citizen immigration over recent decades (arguably informed by the earlier post-war large scale immigration experiences that ended in the 1970s), including recognising that our approach to immigration policy has been something of an outlier among advanced countries, occurring against the (also unusual) backdrop of a very large net outflow of our own citizens. Without something of that sort, informed too by relevant overseas experiences and by a detailed engagement with the stylised facts of New Zealand’s dismal productivity record (recognising that the scale of New Zealand’s
immigration policy structural “intervention” has been huge), it is difficult to see how you can reach a view on what future immigration policy would be most suited to maximising, all else equal, New Zealand’s specific economywide productivity prospects. Moreover, nothing at all in the report seriously engages with the literature on economic geography, surely a startling omission when New Zealand immigration policy involves inviting large numbers of people to relocate to the most remote outpost in the advanced economy world, with the policymakers responsible claiming to have had explicit economic motivations for the policy.

Consistent with these omissions, two of the three highlighted Preliminary Recommendations are primarily process oriented, and the third is really a second-tier issue around absorption capacity. Other suggestions, some sensible, some questionable, play around the edges of the issue, perhaps focused simply on refining something like the last decade’s status quo. None gets to the heart of the issue: what sort of immigration policy should New Zealand run in future, if governments were interested in maximising the productivity and income prospects of New Zealanders?

The rest is there for anyone interested.

I had a quick look earlier in the week through the submissions the Commission had already received. The one that most caught my eye was a second submission by someone called Mike Lear (he’d already made a submission prior to the draft report). I don’t know who Lear is, although I deduce from his submission and this footnote that has had some past exposure to economic analysis and economic policy issues.

34 When I started work in the Department of Industries and Commerce in 1972 (in the newly formed
Productivity Centre!) I was told by the most senior person in the department responsible for overall industry policy that New Zealand should aim to be the Switzerland of the Pacific region for machine tools.

It is a very well-written submission, almost certainly easier to read than my own. Much of it represents a fairly trenchant championing of the “Reddell hypothesis” (the idea that our large-scale non-citizen immigration policy has detracted from New Zealand’s productivity performance) and point by point pushback on various points made (or ignored when they should have been made) by the Commission in the draft report. I don’t agree with every line of his submission, even where he is writing about my ideas, but it is a particularly clear and useful articulation of the arguments and identifies numerous issues that the Commission really needs to grapple with before publishing a final report next year.

Here is his Introduction

lear 1

lear 2

It will be interesting to see what the Commission comes up with in the final report. There is an opportunity to do a really valuable report standing back and asking how best this major structural policy intervention can contribute to improving our dismal economic fortunes. Or the Commission can keep to where the draft report got to, and focus mostly on process issues and tweaks (some sensible, some not) to the (pre-Covid) status quo. The former seemed to be what the government invited the Commission to do when it set out the Terms of Reference for the inquiry.

HYEFU bits and bobs

I don’t have too much to say about yesterday’s HYEFU, but two things caught my eye.

The first was a bit of attention on the $6 billion “operating allowance” the government has given itself to increase spending (or, I suppose, cut taxes) at next year’s Budget. It is a big number, but it doesn’t mean a great deal. In principle, the operating allowance covers things where the government has some discretion (whereas, by legislation, tax revenue tends to rise each year as nominal GDP does, and welfare benefits rise each year as inflation/wages do, and without new legislation the government of the day has no choice in the matter).

But governments tend to care about purchasing/delivering real goods and services, and they need actual people to work for them. And when there is inflation, the dollar cost of purchasing goods, services, and labour tends to rise. Governments don’t have to – and tend not to – compensate agencies/votes for inflation each and every year but when inflation is higher, over time more dollars need to be allocated for increased spending just to keep the real volume as the government intended. And since inflation – in principle – just blows up prices and incomes, making us as a whole neither richer nor poorer, they can do so with no particularly ill effects.

To illustrate, suppose the government spends $100 billion a year in an economy with nominal GDP of $330 billion (so roughly 30 per cent of GDP). Now assume that prices generally suddenly rise by 5 per cent, with nothing else changing. The things the government wants to purchase cost more, but its tax revenue also rises by more. In fact, it will now cost $5 billion more than otherwise to purchase the same volume of goods, services, labour (or real transfers). In practice, as noted above, quite a bit of government spending is indexed by legislation (roughly a third of core Crown spending is on welfare) and so not covered by the operating allowance. But in this scenario a 5 per cent lift in prices might require a $3.3 billion operating allowance, just to keep real government purchases unchanged.

I don’t have the time today or the patience to try to reconcile all the numbers, but to illustrate that inflation is a big part of the picture note that in this year’s Budget Treasury forecast that inflation for the year to June 2021 would be 2.4 per cent, for the year to June 2022 1.7 per cent, and for the year to June 2023 1.8 per cent. In the HYEFU, those numbers (2021 now known) are 3.3 per cent, 5.1 per cent, and 3.1 per cent. The total increase in the price level over those three years was expected to be 6.0 per cent, and is now expected to be 11.9 per cent. So of course the government needs to put more money (quite a lot more) in the operating allowance just to maintain real spending at the levels they intended only a few months ago. A lot of it is simply an inflation illusion. In the same way that a very small operating allowance would reveal nothing about the fiscal stance if inflation was to be unexpectedly low (as it was, say, a decade ago).

Don’t take it from me. Here are The Treasury’s forecasts of core Crown operating expenses as a per cent of GDP, including the government’s fiscal plans (those “big” operating allowances) as communicated to them and published yesterday.

core crown expenses hyefu 21

On these plans, core Crown spending as a share of GDP will be around the same share of the economy as it was going into John Key’s final term.

There is plenty to criticise about individual spending items under this government – take $51 million wasted on the aborted, always ludicrous, Auckland walking bridge, let alone $5 billion in Reserve Bank losses – but the bottom line at this stage is one in which total spending ends up much where it was as a share of GDP. One might, of course, worry more about timing. With an overheated economy (on Treasury and Reserve Bank numbers), with high and rising inflation, and with a high terms of trade, the government really should be running a surplus next year (headline surplus consistent with cyclically-adjusted balance. But, in fairness, the forecast deficit for 2022/23 is small.

As noted, there has been – and is expected to be – quite a bit more inflation. Like the Reserve Bank, Treasury now seems to think that even core inflation will move outside the top of the target band the government set for inflation. They expect 3.1 per cent inflation in the year to June 2023 – ages away, and fully within the control of monetary policy now – and won’t be forecasting the sorts of one-off price shocks that often distort near-term headline inflation forecasts.

But, on the Treasury’s numbers it doesn’t seem like anything to worry about because by the end of the forecast period (June 2025) inflation is back to 2.2 per cent, basically the midpoint of the target range.

But how is this being achieved? Sure, they expect the Reserve Bank to raise the OCR, to a peak of 3.2 per cent by June 2023. But raising the OCR above neutral – as the Governor told us they expect to – usually dampens (core) inflation mostly by generating some temporary excess capacity in the economy.

But here is The Treasury’s view on the output gap.

Tsy output gap

They reckon it was deeply negative a decade ago, when core inflation was low and falling (reaching a trough around the end of 2014), but now they reckon it will be positive – quite materially so for the next couple of years – throughout the forecast horizon. All else equal, that should normally be consistent with core inflation rising further.

What about the labour market? The Treasury doesn’t publish an “unemployment gap” number, but comparing their unemployment rate forecasts, and the medium-term trend assumptions they use in their Fiscal Strategy Model makes very clear that they expect the unemployment rate to be below sustainable levels over the next few years.

U gap Tsy

So how is it that they expect (core) inflation to come down?

I can think of two possibilities, neither very convincing. The first is that they are still treating all the current (and forecast over the next 18 months) surge in the inflation rate – including on the core measures – as really just transitory and having nothing to do with excess demand. If so, as (eg) supply chain disruptions dissipate, what now looks like core inflation vanishes like the morning mist. But that certainly doesn’t seem to be the Reserve Bank’s view, just doesn’t square with (eg) forecast positive output gaps, and isn’t really consistent with expecting fairly rapid increases in the OCR.

The second possible story might involve inflation expectations. Perhaps they too stay firmly rooted at 2 per cent and inflation just vanishes, despite the headline pressures, despite the (on Treasury’s own estimates) overheated economy. But it doesn’t make a lot of sense, and isn’t consistent with any of the other swings or slumps we’ve seen in core inflation over the decades.

I don’t know what Treasury thinks the story is. In the end, perhaps it doesn’t matter that much. The Reserve Bank will – we presume – eventually do what needs doing and adjust the OCR to get core inflation credibly heading for the midpoint. But if there is enough inflationary pressure built up that the OCR really needs to be raised more than 200 basis points more from here, it is a little hard to believe that would be consistent with an economy still generating a positive output gap and such low unemployment rates. Medium-term forecasting is a mug’s game – no one is any good at it – so my interest is more in the logic of their model than in what the economic outturns a couple of years hence might be. But if the OCR has to be raised a lot more over the next 18 months, you might normally expect the biggest adverse economic effects (normally needed to get core inflation back down) might well be showing themselves in the second half of 2023. Which might be awkward timing for the government.

But who knows how many shocks – positive, negative, Covid and other – will be along before then.

The Reserve Bank appears underwhelming

First thing this morning the Reserve Bank fronted up at Parliament’s Finance and Expenditure Committee for their Annual Review hearing.

The Governor kicked off with some introductory remarks that were celebratory (the focus of the hearing was notionally on the last financial year) but superficial. In some cases barely even honest. He was “very proud” of all the Bank had achieved, talked up monetary policy as having been “highly effective in preventing deflation”, claimed (wrongly) to have been one of the first central banks to have raised policy interest rates again, and ended with a paean to “diversity and inclusion” talking of having “many plans” and “much action” on that front. There was no mention, for example, of the $5 billion of taxpayers’ money they had lost, or of the continuing churn at the top of the organisation.

Last evening they had had to announce that two more senior managers were leaving, ousted in yet another of Orr’s restructurings. Orr didn’t deny the claim made by National’s Simon Bridges (and various journalists) that the Bank had hoped to keep these departures secret until after the hearing, and had only announced them late yesterday afternoon after the news had seeped out. It can be hard to keep track of all the departures – in several cases Orr can’t even blame his predecessors as at least two of the senior management departures have been of people who Orr had first promoted before changing tack and pushing them out. I’ll take the departure next year of the Bank’s long-serving CFO (who would be over 65) as a genuine retirement, but mostly the departures seem to have been Orr-initiated, such that of the large senior management group in place when he took office only 3.5 years ago, only two will soon be left.

And the departures aren’t simply in peripheral or support positions. Orr has now ousted two chief economists in succession, and we have no idea who will be filling that vacancy on the MPC, at a time when things are scarcely all quiet on the monetary policy front. On the financial stability side – largest part of the Bank and the growing bit – the gaps are even more obvious. The Deputy Governor (who ran that side of the Bank) is leaving, and now the two senior managers (heads of supervision and head of prudential policy/analysis) are leaving – the latter having already accepted a demotion a couple of years ago. Each of these guys has strengths and weaknesses (although I thought Andy Wood was good value), but all will be gone very shortly – and with them huge amounts of experience. In their place, we have a new Deputy Governor who has no background in banking, supervision or financial regulation, and two vacancies. So far at least, Orr has shown no ability to (or interest in doing so?) attract top-notch talent to the Bank at senior levels. And from 1 July next year, the Bank’s new Board is becoming the key decision-making body on prudential matters including policy. The Minister makes those appointments and so far no one whom one might think of as offering exceptional intellectual or practical leadership in these areas had been appointed. The Bank looks incredibly weak on that side of its business, and one wonders what their capable and experienced APRA counterparts make of it all.

But to return to this morning’s hearing, when Simon Bridges suggested that the volume of churn might almost be described as “reckless”, Orr’s only response was to suggest “or planned”. As Bridges noted the Bank was losing a lot of senior and experienced people, likely to be replaced with more junior less experienced people, perhaps “people who agree with you”. Bridges went on to comment on the number of people who had already got in touch with him to express concern at what was going on at the Bank. Orr offered no comment in response.

David Seymour also chipped in on this issue asking about turnover at senior levels. The Bank’s response seemed to be a mix of cute answers (people who had confirmed they were leaving shortly were nonetheless still there and so hadn’t left), obfuscation (emphasising how many more staff in total the Bank had – as if that too should not be a concern), and a bit of outright denial. Seymour asked Orr if he was “absolutely confident” that there was nothing about his (Orr’s) leadership that had led to conflicts resulting in departures”. Orr’s reply: “Absolutely”. I don’t suppose he was ever going to own up – the main who really hates being challenged or disagreed with – but it wasn’t a confidence-inspiring performance. And who is responsible for the Governor? Well, that would be the current ineffectual Board – whose chair has been carried over to the new and (legally) more powerful Board, and of course the Minister of Finance.

The Green Party’s Chloe Swarbrick also asked a couple of useful questions, and was simply fobbed off by Orr. Was there anything about the policy response over the last couple of years, she asked, that the Governor might have done differently with the benefit of hindsight? It was, she was told, a hypothetical that he wasn’t going to answer, but he then went on to say that he was “very confident” that “exactly the right decisions had been made”. With the benefit of hindsight, does any normal reflective human being make such bold claims? Well, Orr certainly does ($5bn of losses, as just one example, notwithstanding). Swarbrick went on to ask if there would be value in a review of Covid fiscal and monetary policy (a good idea, and a suggestion I’d also made to Treasury at a consultation session last week). Orr claimed that such reviews were ongoing and very transparent. If so, there is no evidence of it, and when someone reviews themself such reviews are often not received with total conviction.

David Seymour followed up, noting that the Governor had said earlier that house prices were above a “sustainable” level, employment was above the maximum sustainable level, and inflation was high and/or rising. Might it not be thought that the degree of monetary stimulus had been a bit overcooked?

Orr’s blustering response was that it was better than an alternative of extremely high unemployment and deflation, repeating his line that the Bank had been one of the first in the world to raise rates. Seymour pushed back and suggested some possibility of a middle ground – that, with hindsight, a bit less monetary stimulus might have been warranted, but Orr simply refused to engage.

There were no questions about the LSAP scheme ($5bn of losses notwithstanding) but National’s Andrew Bayly again asked about the Funding for Lending scheme. Crisis conditions have long passed, the OCR is working fine, and being raised, and yet the Bank keeps on for another year with the emergency facility that all else equal holds interest rates DOWN. The Assistant Governor burbled on about the need to provide certainty to banks – as if anything else about the economic (or virus) environment is certain. It is simply bizarre that emergency facilities are still providing stimulus, even as core inflation heads for top of the target range.

Not all the questions from non-Labour members was really to the point. As Orr noted, the MPC has to take the fiscal stance as given and adjust the OCR as required (having said that, National could point out that on occasion Orr has been an open cheerleader for bigger fiscal deficits), and National seems unable to decide whether it dislikes high inflation or a higher OCR more. Personally, I’m with the Governor on that one: high inflation needs to be brought back into check, and monetary policy is the most effective instrument. In fact, it was good to hear Assistant Governor Hawkesby explicitly note that inflation expectations had risen and that monetary policy was oriented towards getting inflation back to around the midpoint of the target range.

But two final questions are worth noting. A government member asked a patsy about the Bank’s climate change crusade, prompting National Andrew Bayly to note that the Federal Reserve of New York had recently published research suggested that climate change posed little threat to financial stability (he could have cited recent Bundesbank stress tests as well). Bayly asked if the Bank had done any modelling of its own. Orr’s response was an unequivocal “yes”. That was interesting because a quick check of the Bank’s climate change page showed that still the only “research” they listed was a single paper from 2018 which (“preliminary analysis”) also concluded that there wasn’t likely to be much to the climate change financial stability risk issue. You might have supposed that the Bank would be keen to get out in the public domain any research they’d done supporting the Governor’s ideological priors and political preferences. I have today lodged an OIA request for the modelling work the Governor was referring to this morning. On past form, we might see something six months from now.

And then Chloe Swarbrick got in one last question. You’ll recall that the Governor had told the Committee that in the Bank’s view house prices were currently higher than “sustainable”. All else equal, Swarbrick asked, how much would house prices need to drop to be considered “sustainable”. Orr’s response was “I don’t have that number” (he had what looked like a dozen staff present in support). It seemed an eminently reasonable question. The Bank has the biggest team of macroeconomists in the country, it has in-house research capability and has claimed – not once but many times – that prices are “unsustainable”. The way places like the Bank work is that there will be a range of model estimates informing the judgement that current prices are unsustainable. It wasn’t that Orr didn’t have a number (or, more likely, a range) it was that he simply refused to answer, and did not suggest he would follow up and get back to the member.

A year ago, one might have said (I would have) that it really wasn’t an issue for the Bank. But the Minister changed the Bank’s Remit, and Orr and the MPC have embraced the change. You may, like me, think that they way they approach “sustainable” is meaningless and often misleading (their concept has nothing at all to do with longer-term fundamental supply characteristics) but…….they are the ones openly opining that prices are “unsustainable”. How much then, even as a range? Orr’s refusal to reply really made a mockery of parliamentary scrutiny.

Overall, it was good to see the Bank and the Governor facing some serious questions. 55 minutes for the whole thing, including government patsys, really wasn’t enough in the circumstances, but what we saw was a weak and unpersuasive central bank. The Reserve Bank is a key economic agency in New Zealand, exercising a great deal of discretionary power, and we (and Parliament) should expect a solid team of really capable and experienced senior people, articulating credible and thoughtful nuanced responses to serious questions and challenges. It wasn’t at all what we saw today. But of course, there is little follow through, and no serious questioning on these issues of either the Bank’s Board or the Minister of Finance. Instead we just see the continued degradation of yet another of New Zealand key public sector institutions. I suppose unserious governments – there is little sign they care much about institutions or medium-term economic performance, let alone getting house prices down – invite increasingly unserious bureaucracies, of which today’s Reserve Bank is one. Perhaps Orr will surprise and he’ll soon announce the appointment of a phalanx really strong capable independent-minded senior managers, who last (perhaps outlast him) but nothing about his tenure to date (or the continued churn) should give us – or Parliament- much confidence.

Price/income ratios

Over the last couple of weeks we’ve had another round of politicians (so-called “leaders”) doing their utmost to deny any interest in seeing house prices much lower. At 60 per cent below current levels – which would be readily achievable with open and competitive land markets, and a genuinely open and competitive building products sector – we’d be looking at something a lot more reasonable. Real rents would probably then be lower than ever before. But our politicians are terrified of the very idea.

The new Leader of the Opposition made clear his opposition to any suggestion of a sustained fall in house prices (while noting that inevitably there would be some ups and downs). HIs new deputy – and National’s housing spokesperson – did suggest that much lower house price/income ratios might be desirable, with something like flat nominal house prices. And while the Prime Minister at the weekend was quoting as suggesting that she wanted lower house prices – quite a change of tone from her, perhaps just getting ahead of what may already be beginning to happen – she too was at pains to deny any interest in much lower house prices.

Of course, in principle, house price/income ratios could be steadily whittled away by some combination of flat nominal house prices and rising wage rate. But when one starts from such an unbalanced situation as New Zealand now does it would be the project of decades, even if anyone took it seriously. The great and good seem to rather like the idea of this “painless” whittling away, presumably as it enables them to sound serious, and not scary to the already-indebted.

Here is a chart of three scenarios, in each of which nominal house prices hold flat from here. In each scenario I’ve assumed 3 per cent annual growth in wage rates (basically inflation at target on average and something like 1 per cent per annum productivity growth). What differentiates the three scenarios is the starting point – a range from 8 times income to 10 times income.

price to income dec 21

At best, it takes 33 years for price/income ratios to get back to three – the sort of ratio seen in large chunks of the US, in cities large and small. At best, it would take almost a quarter of a century to get back to a price/income ratio of four.

In the next chart I’ve assumed a starting point of 10 times income and shown the implications for a range of wage growth assumptions. On these scenarios, my kids would my age before house price to income ratios were again what they were when I was their age.

price to income 2 dec 21

If your idea of political leadership is along the lines of “I must find where the people are going and get out in front of them”, I suppose I understand the apparent political terror at the prospect of much lower house prices, but what a pathetically weak approach, that abdicates any responsibility towards the next generation. These people – “leaders” of our political parties – appear content to get a whole other generation (or two) load up on debt based on house prices they know not to be based on any long-term fundamentals, rather than get to the heart of the issue now.

Of course, some in the media don’t help. I saw last night one journalist suggesting that even getting house prices 25 per cent lower would be reckless, irresponsible, and deeply economically damaging. But politicians put themselves forward, at least notionally, as leaders, people (allegedly) with the best interests of the country at heart. They are supposed to be the communicators, the coalition builders, the persuaders, the people who make things happen…..not those content to sit to the sidelines, idly hoping that well beyond their time in politics things might finally be sorted out.

Take the idea of a 25 per cent fall in house prices. That might take prices back to around where they were at the start of last year. No one who bought before then is put in any particular difficulty. And neither are most of those who bought more recently, as bank lending standards have not been loose, and LVR restrictions have become increasingly onerous. Some would be left temporarily with negative equity, but (a) typically not a large amount, and (b) in a fully-employed economy, modest negative equity isn’t typically a major problem (and to anyone going “easy for you to say”, it was exactly the situation I found myself in a couple of years after buying my first house). But our “leaders” can’t even enthusiastically embrace unwinding the last couple of years’ house price rises.

Of course, the major parties sometimes like to talk about the things they’ve done, up to and including the current amendment to the RMA being rushed through Parliament. But the proof of the pudding is in the prices, and expectations of future prices. Actually, in the political rhetoric as well. Not only have expectations of future house price inflation not gone negative – or even slowed noticeably after the latest “accord” – but the politicians’ own rhetoric reinforces the point: they themselves are scared of embracing lower prices.

Were they actually serious about fixing things, in their own terms of office, some creative thinking (and coalition building) might be required. Big changes in relative prices involve big shifts in wealth. Sharp rises in house prices have skewed the playing field away from the young and the poor. Sharp falls in house prices would skew things sharply away from the very highly-indebted. Of the latter, some don’t (and shouldn’t) command much sympathy at all. If you run a residential rentals business and took on huge amounts of debt to finance your business, well tough. It is a business, in this case built on systematically rigged markets (all that central and local government land-use regulation), and sometimes businesses fail. New entrants will emerge to replace you.

But first home buyers (in particular) command a lot more sympathy, and rightly so in my view. Young families didn’t ask the government to rig the market, or probably even support them doing so. They just want a secure home and backyard to raise their kids, and the only option governments left them for doing so was to pay these absurd price/income ratios, made barely feasible by the sustained decline in neutral interest rates (which in a functioning market should have made purchasing a home easier than ever). For them, some sort of partial compensation scheme might be a fair and necessary path to breaking through the political resistance to much-lower house and land prices. Not a first-best solution perhaps, but a great deal than putting another generation through this quite-unnecessary drama of rigged housing markets. When market prices are miles from the structural fundamentals, there is no merit in trying to foreshadow some very slow and allegedly “painless” adjustment. Better to get the prices (and market regulatory frameworks) sorted out now.

(Oh, and don’t be fooled if prices do fall back a bit over the next 12-18 months. Cyclical fluctuations happen. Falls happen (as over 2008/09). But without fixing the land-use restrictions – and the current RMA amendment does not even come close – the fundamental distortions remain. House prices did fall quite a bit in 2008/09 (even with much lower interest rates), until they rebounded to levels (and price/income ratios) higher than ever.

LSAP losses

The Minister of Finance and The Treasury appeared before Parliament’s Finance and Expenditure Committee yesterday. It was encouraging to see National MPs asking questions about the Reserve Bank’s Large Scale Asset Purchase programme, which was undertaken with the agreement of both the Minister and The Treasury and which has now run up staggering losses for the taxpayer.

A standard way of estimating those losses is the mark-to-market valuation of the Bank’s very large LSAP bond portfolio. As of the latest published Reserve Bank balance sheet, for 31 October, those losses were about $5.7 billion. When the 30 November balance sheet is out, probably next week, the total losses will be lower (bond rates fell over November), but with a very large open bond position still on the books taxpayers are exposed to large fluctuations in the value of the position (up or down), with no good basis for supposing that the expected returns are likely to compensate for the risk involved. If there was a case for putting on a large open bond position early last year – I doubt it, but take that as a given for now – there is no case for one now, in a fully-employed economy with rising inflation, and with the conventional instruments of monetary policy – which expose taxpayers to no financial risk – working normally and effectively.

A post from a few weeks ago set out the issues.

I didn’t watch the whole 2 hours (link to the video above) but from exchanges with various people I think I have seen all the questions and answers relevant to the LSAP issues.

First, at about 43 minutes in, National’s Andrew Bayly asked the Minister of Finance (a) why, when Crown indemnity was approved the Minister did not then require a plan for unwinding the position (the Bank is currently talking about having a plan early next year, almost two years on), and (b) why there was no limit to the indemnity.

I’m not sure either question was that well-targeted, and the Minister had no real trouble responding. As he noted, the LSAP programme had been initiated in the middle of a crisis, time was short etc. And although there isn’t a limit on the indemnity itself there is a limit of how many bonds can be bought, and the government determines which bonds are on issue which amounts to much the same thing. That said, both responses take as more or less given that the idea of an LSAP had never occurred to anyone on any corner of the Terrace/Bowen St triangle until late March 2020. We know the Bank had been (rather idly) talking about the option for several years, including saying they’d prefer not to use it, but it seems they had not done the hard ground work, and neither had The Treasury nor the Minister insisted on it, well in advance. There is no sign any cost-benefit analysis for something like the LSAP was ever done, no analysis of likely Sharpe ratios, no analysis of potential peak taxpayer losses and so on. The Bank should be held accountable for that, but…the Minister is primarily responsible for holding them to account, and The Treasury is the Minister’s principal adviser (and the Secretary is a non-voting member of the MPC).

After the Minister left, Bayly returned to the LSAP (at about 68 minutes), supported by National’s new finance spokesman Simon Bridges. Bayly asked the Secretary to the Treasury whether an increase in the OCR would increase the liability for the Crown for the indemnity. The Secretary responded that the indemnity was net neutral from a whole of Crown perspective. What followed was a slightly confused discussion with Bridges ending up suggesting that the Secretary was “plainly wrong”. I don’t think the Secretary answered well, and she certainly didn’t answer in a way designed to help clarify the issues around the LSAP, but she is correct that the indemnity itself does not affect the overall consolidated Crown financial position (the claim the Bank currently has on its balance sheet is fully offset by an obligation the (narrowly defined) central government has on its balance sheet. It is quite likely that without the indemnity the MPC would have been very reluctant to have run a large-scale LSAP programme (the Bank’s own capital would not support the risk), but once the programme was established what determines the financial gains or losses is, in short, just the movement in market interest rates. The indemnity just reallocates any losses within the wider Crown accounts. In that particular exchange, The Treasury made none of this clear, and Secretary herself seemed a bit confused when the discussion got onto the different ways the bond position might eventually be unwound (there is little or no indemnity if the bonds are held to maturity, but that doesn’t mean there are no costs to the taxpayer). And thus (reverting to Bayly’s initial question) an increase in the OCR – particularly one now expected – doesn’t itself change the Reserve Bank’s claim under the indemnity

About 25 minutes further on, Bridges returned to the fray and a rather more enlightening conversation followed. Bridges asked whether the LSAP did not represent a significant increase in Crown financial risk. The Secretary agreed and both she and one of her colleagues explained – as I have here repeatedly – that what had gone on was that the Bank had bought back long-term fixed rate bonds, effectively swapping them for the issuance of settlement cash, on which the interest rate is the (variable) OCR. Unfortunately some of the discussion still got bogged down in matters of Crown accounting (the difference between the purchase price of the bonds and the face value, which is of no economic significance), and the Secretary was very reluctant to allow herself to be pushed into acknowledging that the position of the LSAP portfolio – implemented with her support – is deeply underwater. As a simple matter of analysis, she was never willing to distinguish between the mark-to-market loss to now, and the potential gains, losses, and risks on continuing to hold a large open position from here on. One is a given – now a sunk cost – and conflating the two (in the hope “something will turn up”) obscures any sense of accountability, including for the choices to keep running the position. She and her staff wouldn’t accept that sort of explanation from any other government agency running large financial risks.

Were the position to be liquidated today – as, at least in principle (crisis having passed, economy full-employed) it should be – a large loss for the taxpayer would be realised. At a narrow financial level it is as simple as that. If the position continues to be run – in the limit through to maturity, finally in 2041 – what will matter is where the OCR averages relative to what is currently priced into bond yields, but it won’t change the fact that the portfolio is starting behind – the OCR is already much higher than was expected at the time most of the bonds were bought. And if the portfolio is let continue to run, taxpayers are exposed to ongoing large risk for no expected return (there is no reason to suppose the Bank is better than the market at guessing where the OCR will need to go over the next 10-20 years).

(The current agreement between the Minister and the Bank requires that if the Bank looks to sell the LSAP bonds it do so only to the Treasury itself. Such a sale, of course, changes nothing of economic substance (purely intra-Crown transactions don’t) – the high level of settlement cash balances would still be there, earning whatever OCR the macro situation requires – but from a political perspective it would be convenient, as there would no longer be monthly updates on the Bank’s website as to the extent of the losses caused by the MPC’s rash choices (backed by The Treasury).

Treasury officials did chip in a couple of caveats. First, the Secretary noted that in assessing the overall LSAP programme one had to look also at the (any) macroeconomic benefits. In principle, of course that is correct, but (as I’ve argued previously) any such gains are unlikely to have been large:

  • the LSAP was designed to lower long-term bond rates, but these are a very small element in the New Zealand transmission mechanism,
  • it is hard to see much evidence here or abroad of sustained effects of LSAP-like programmes on long bond rates (eg movements beyond what changing expectations of future OCR adjustments themselves would simply),
  • the Bank always had the option of cutting the OCR further (on their own telling, to zero last year, and lower still since the end of last year), at no financial risk to the taxpayer, and
  • if there is a macro effect, perhaps it was modestly beneficial last year, but must be unhelpful now (recall that the literature suggests it is the stock of bonds that matters, not the flow of purchases, and we now have an overheated economy with above-target inflation.

And one of her deputies chipped in noting that there might have been some savings to The Treasury from having been able to issue so heavily at such low rates last year, the suggestion being that without the LSAP the Crown might not have been able to get away so many bonds so cheaply. There is probably something to that point, in an overall accounting, but (a) the effect is unlikely to have been large relative to the scale of the subsequent rise in bond yields, and (b) especially with hindsight a better model would have been for the Bank not to have been purchasing bonds and the Crown to have been issuing fewer.

The Select Committee discussion ended with the offer that National MPs could lodge a follow-up question for written response by the The Treasury. I hope they avail themselves of that offer.

The Treasury could be, and should be, much clearer and more upfront about the analytics of the LSAP issues, but it isn’t clear – given their involvement all along – that their incentives are in this case that well-aligned with the interests of the public in scrutiny, transparency, and accountability.

Debt and deficits

The OECD’s latest Economic Outlook came out a few days ago. As always with the OECD, the value is rarely in the analysis or policy prescriptions, but mostly in the vast collection of more-or-less comparable tables, collating data for a wide range of advanced economies (and a few diversity hires).

Take public debt as an example. Next week our Treasury will be out with their HYEFU and more-detailed New Zealand numbers for central government. But there is no easy way of comparing Treasury’s New Zealand numbers with those for other countries. And so I tend to focus most often on the OECD series of “net general government financial liabilities”, which includes all layers of government, and doesn’t exclude things that particular national governments find it convenient to exclude (in New Zealand’s case, all the assets in the Crown’s hedge fund, the NZSF).

The OECD’s forecasts only a couple of years ahead, but that is probably about the most that is useful anyway, Here are their recent forecasts for net general government liabilities as a per cent of GDP (for the 30 countries they do these numbers for).

debt 2023

For New Zealand, the 2023 number is 14.82 per cent of GDP and on these forecasts we’d be 7th lowest of (these) OECD countries. There isn’t a forecast for Norway for 2023, but they have net financial assets of about 350 per cent of GDP, so call it 8th.

Going into the pandemic, our net general government liabilities as a per cent of GDP in 2019 was 0.8 per cent. (Including Norway) we were 8th lowest of these OECD countries.

That is a not-insignificant increase in net debt as a per cent of GDP. Between 2007 and 2012 – serious recession and the earthquakes – net general government financial liabilities were increased by about 12 percentage points of GDP. But, and on the other hand, in five good-times years (from 2002 to 2007) net general government liabilities as a share of GDP dropped by 23 percentage points of GDP.

Here is the cross-country comparison over time

gen govt liabs

I’m not suggesting we should be totally comfortable about that picture, but our net public debt is forecast to remain (a) low, and (b) much lower than the typical advanced country.

What if we break out the countries. Some argue (I’m not really convinced) that big countries, at least those with a history of reasonable government etc, can comfortably ran higher ratios of public debt than smaller countries. And, on the other hand, perhaps the countries most like New Zealand are the fairly-small places with their own central bank and floating exchange rate. Here are the relevant comparisions over time (medians in both cases).

gen govt small and big

The big countries – Germany excepted – really have been on a rising debt path. I’m not one who believes crisis and/or default is looming (generally – Italy remains a wild card) but were I a voter in one of those countries I’d be seriously uneasy. Were I involved in an opposition political party, I hope the high and rising debt would be made a salient political issue.

But – and generally – the small advanced countries have done pretty well (true on this sample of countries, or if one uses all the small countries – including those in the euro – in the database), and there has been (and is) nothing startling or particularly impressive about the New Zealand performance. If anything, one might note the widening gap at the end of the period.

Of course, none of this includes the fiscal challenges imposed by the rising NZS fiscal burden from maintaining the age of eligibility at 65 (although it is now a decade since baby boomers started turning 65) and the expected trend increase in public health expenditure….but I really can’t see public debt itself being a particularly salient issue in 2023.

But what about deficits? No one argues the government should have been running a balanced budget last year, and perhaps not even this year (given the renewed lockdowns and big output losses the government left itself open to), but why not 2023? These are the OECD’s projections – the primary balance excludes financing costs, and a common rule of thumb is that even a small primary surplus is consistent with keeping debt in check. “Underlying” captures cyclical-adjustment.

primary defs

In 2023, with the economy projected to be fully-employed (a reasonably significantly positive output gap), with a strong terms of trade, and (as ever) with some of the highest real interest rates anywhere in the advanced world, the OECD estimates that the government’s fiscal policy will see us in 2023 with a large primary deficit, a bit worse than the median OECD country. (Norway’s primary deficit is much larger, but remember that they have big net earnings (finance receipts) on the government’s huge net asset position.

Were one confident that spending initiatives were being ruthlessly scrutinised to keep waste to an absolute minimum, perhaps one might be a little less worried – although small structural surpluses, where spending is funded by taxes remains a good rule of thumb – but does anyone suppose that describes current New Zealand approaches to public spending.

I don’t suppose Ardern and Robertson are likely to let things get really out of hand. They seem oriented enough towards broad macro stability – in the traditions of all New Zealand governments of recent decades – even as they too watch our real economic performance decline, but at present the structural deficit picture (as the OECD interprets our data and policies) isn’t looking that good.

primary def nz

There should be considerable scrutiny on the government’s plans in the forthcoming Budget Policy Statement, and the Treasury’s HYEFU projections.

Submission on central bank digital currencies

The Reserve Bank has a consultation document out inviting public feedback on the idea – to which they express themselves sympathetic – of the Bank possibly, at some stage in the future, issuing a new central bank digital currency, to which members of the general public would have access (unlike their existing wholesale digital currency – exchange settlement accounts – that only (some) banks currently have).

I wrote a post last week on Barry Eichengreen’s recent seminar for the University of Auckland and some of my own ideas, notably the idea that there is little reason to suppose there would be much demand for such a product (unless subsidised or underpinned by other distorting regulation).

Submissions close on Monday – at the curious hour of 10am. I spent a few hours this afternoon jotting down some thoughts as a submission. No doubt various bankers will make longer, more detailed, and more bureaucratically expressed, submissions on various points (and perhaps some academics might make some more mathematical ones), but I suspect my submission will still offer a reasonably distinctive angle.

The full submission is here

Central Bank Digital Currency submission 4 December 2021

My summary ran as follows:

The case for a possible future central bank digital currency is not persuasively made, and seems to rest on very weak (some simply inaccurate) analytical foundations and characterisations of history, inflated with overblown claims about the role of central bank money. There may be a case, at some point in the future, for a very basic form of digital central bank-issued New Zealand dollar to be available for use by members of the general public. But I would expect that demand for any such product (so long as fairly-priced and not supported by regulatory restrictions on other forms of money) would be quite limited, both in normal times and perhaps even in (extremely rare, by construction of prudential policy) systemic financial crises. This is consistent with the experience with physical central bank money, which is used largely only because private issuance is outlawed. In the shorter-term, and whether or not the Bank ever issues a general purpose CBDC, a much more liberal approach should be taken to allowing
access to the Reserve Bank’s exchange settlement account system.

And here are a few paragraphs

The weaknesses in the consultation document start early. For example, there is the grossly overblown claim on page 6 that “central bank money can be considered systemic in all societal domains [whatever that means] – it underpins people’s …. environmental, social and cultural wellbeing”. There is no analysis presented in support of a claim that seems almost laughably inconsistent with the fact that most countries didn’t have central banks until 100 or so years ago. Central bank money has a useful, indeed important, potential role to play in macroeconomic stabilisation – the reason the Reserve Bank of New Zealand was established – but the implied suggestion that without their new central banks our grandparents (or the greatgrandparents of Americans) somehow had impaired cultural or environmental wellbeing [again, whatever either phrase means] seems, at best, a stretch.


Weaknesses pervade the consultation paper. For example, the Bank claims the issuance of a CBDC would “support the ability of central bank money to act as a fair and equal way to pay and save in our modern and inclusive economy”, and has a lot of handwaving rhetoric around “financial inclusion” without (a) any serious attempt to document the nature and scale of any such issue or (b) any serious analysis of alternative options, if there is an issue.   As far I could see, for example, there was no data in the paper outlining the percentage of the New Zealand resident (and legal) adult population that (a) does not have a bank account, and (b) would like one.  Since even welfare benefits are (almost?) exclusively paid by direct credit to a bank account, it seems hard to believe that – for now anyway – there is a problem in New Zealand.   We are not the United States.  And when the Bank attempts to suggest that a CBDC might help those who are not just unbanked but those who are “underserved by the private sector by offering basic services at low or subsidised prices”, there is no attempt to rigorously analyse who might be “underserved” (or even how that might be defined) let alone why Crown subsidies, via the Reserve Bank, might be desirable.  Similarly weak, in the same section of the paper, is the claim that provision of a general purpose CBDC would be a “public good”.   Being issued by a public agency does not make something a “public good”.


The consultation paper expresses some unease about the possibility that a retail CBDC could either (a) disintermediate banks (or other private deposit-takers), and/or (b) destabilise the banking system in periods of stress by making it (a little) easier for retail depositors to run. The former is unlikely, and if it were to happen would have to revealing something about either (a) public confidence in the soundness of the financial system or (b) the pricing of the product. As the Bank will be well aware, one can generate a demand for almost any instrument if the price is right (or rather, wrong). Retail government inflation-indexed bonds were very popular in New Zealand for several years in the late 1970s and early 1980s, but only because they paid such a high yield (especially after-tax) relative to anything else the market could offer. Pricing of any CBDC instrument could relatively readily be set to keep demand to quite modest levels, if in fact there was revealed to be much demand at all.


There is some discussion of issues around so-called “monetary sovereignty” in the Bank’s papers. Whatever this actually means, there is no serious discussion as to how private payments developments might threaten the ability to conduct an effective monetary policy in New Zealand, or how a CBDC might materially limit any such risk. There was talk of the risk of “global stablecoin” somehow displacing New Zealand dollars, but there was no analysis – grounded in how use of individual national currencies has changed over time – of why such an offering would materially affect anything about the ability of the Reserve Bank to conduct an effective monetary policy. As the Bank will know, much about the usefulness and effectiveness of national monetary policy rests in the stickiness of domestic non-tradables prices and wages. As long as, for example, labour is contracted for in New Zealand dollars, and New Zealand wages are sticky, monetary policy will, in principle, be able to undertake countercyclical stabilisation policy. And if ever that contracting in the real economy changes – as to currency or flexibility – New Zealand monetary policy will no longer be effective (or perhaps necessary). But short of hyperinflations I think the Bank would struggle to identify examples where domestic monetary policy has become so attenuated, or to explain how an offshore stablecoin, backed by some
other national currency, could be likely to displace the NZD for the vast bulk of transactions,
occurring onshore in the same currency as almost all of us earn.

For those who want some more reading on this, I can recommend a thoughtful speech given a few months ago by Federal Reserve Governor Waller, headed CBDC: A Solution in Search of the Problem. Hard to disagree with that sentiment.

Central bank digital currencies

Why have people used Reserve Bank of New Zealand physical notes?

The simplest, and almost entirely complete, answer is that almost 90 years ago Parliament banned any other notes, creating a statutory monopoly for the newly-created central bank. It wasn’t a necessary part of setting up a central bank – although it was a common restriction elsewhere too – but simply a political choice, not to out-compete the note offerings of the trading banks, but simply to outlaw them.

The Reserve Bank is currently consulting on a couple of documents, including one specifically on the possibility of them, at some stage in the future, beginning to issue an additional digital Reserve Bank liability (a “central bank digital currency”) that, in one form or another would be accessible to individual members of the public. Somewhat strangely, in all those many pages there is no discussion at all of how demand for their existing liabilities arose or was sustained.

I’ll come back to the Reserve Bank documents later in the post, but first I wanted to talk about a nice lecture on central bank digital currencies given, at a University of Auckland hosted event a couple of weeks ago by Professor Barry Eichengreen, a prominent US economist based at Berkeley. It was part of a post-APEC conference, so I’m assuming taxpayer cash went to getting Eichengreen – who can’t have come cheap and (surprisingly) didn’t seem (judging by Zoom numbers) to attract a vast audience. Anyway, the recording of his talk is here. (For anyone who wants some more reading, you might also consider Cornell professor Eswar Prasad’s new book, The Future of Money: How the Digital Revolution is Transforming Currencies and Finance.)

[UPDATE: One of the organisers kindly got in touch to tell me that not only was there no public money involved, but that Eichengreen provided his time free, in the interests of encouraging debate on these issues in New Zealand.]

It would be fair to say that Eichengreen is not a fan of central bank digital currencies (CBDC). He structured his task around five arguments sometimes made in favour.

The first is the claim that a CBDC might “be useful for improving the efficiency of payments”

But as Eichengreen noted, there are already lots of digital payments options (he cited Paypal, Visa, Apple Pay, and Venmo – the latter apparently good for peer-to-peer payments, at least if you don’t mind your payments being visible to everyone). Central banks apparently like to claim that they could offer a cheaper service (he cited various numbers for the cost of each the products he mentioned), but he argued that even if central banks charged lower headline prices (a) this would only be a social gain if, over time, they were really more efficient than private providers, and (b) it wasn’t at all obvious that payments technologies of this sort were, or should be, a natural monopoly. Not all payments media are accepted by everyone, or are used for all purposes, and in his view a “diverse eco-system” was likely to be more robust, noting (for example) the recent Facebook outage. It seemed unlikely, he argued, that over time central banks would be at the leading edge of innovation. Even if a CBDC co-existed with private payments media etc – which seemed the most likely scenario – then the savings to consumers would still be much less than was suggested by the headline numbers (he made quite a bit of the fact that a Visa card might involve an annual fee, but also provides a credit line, and the ability to block payments for defective etc merchandise, so a bundled product that can’t just be compared to a basic payments service).

The second argument sometimes advanced was that CBDCs should be issued to help keep control of the payments system, including visibility of payments flows/data etc. He didn’t find this story remotely convincing (and neither do I), pointing out that there are plenty of regulatory oversight and data-gathering powers that either exist already or could be put in place. He wasn’t unsympathetic, for example, to seeing stablecoin products regulated like banks.

Financial inclusion was the third argument Eichengreen addressed (it is one our Reserve Bank seems keen on). As Eichengreen noted, in the UK apparently 2 per cent of the population doesn’t have a bank account, a number rising to 7 per cent in the US. In principle, everyone could have access to a downloadable central bank “wallet”. Such a product might, it is argued, make it easier for things like Covid lump-sum grants to be distributed. He argued, however, that this was a solution in search of a problem, and that other methods are available – including (I suppose) that one might require banks to offer simple deposit/transfer products to all comers. (In a New Zealand context it seems even less likely to be an issue, since one can only get a welfare benefit with a bank account, suggesting that access to a basic bank product is not a major obstacle.

The fourth argument Eichengreen addressed was the idea that a CBDC – or a linked network of them – might enhance the cross-border payments system, which is still typically very expensive at the retail level.

But as he noted, other providers are already experimenting including (he said) SWIFT, and Visa & Mastercard are experimenting with stablecoins. Moreover – and I think was his more important point – it was hard to envisage a global governance (and security) model across 120 or more central banks and their CBDCs. His assertion was that “it won’t happen in our lifetimes” (he is 69).

The final argument that Eichengreen addressed in his talk was that CBDCs – presumably some international linked model – could be a vehicle for reforming the international monetary system (itself typically a shorthand for “reducing the dominance of the US dollar – itself with at least two dimensions (the denomination of foreign reserves, and the use by the US of the dominant position of the dollar to impose and maintain sanctions). The model being addressed here seemed to be some very ambitious international model – and thus not very relevant to the New Zealand discussion – in which the IMF might issues something akin to the SDR, backed by a basket of national CBDCs with similar weights to those for the SDR). Some have argued that such an instrument might be attractive for holding foreign reserves.

He noted that the US Congress would be unlikely to agree to such issuance, but even if it did it simply wasn’t obvious there was the demand. The SDR itself never lived up to expectations and serves now as little more than a disguised system of foreign aid from time to time. There are few SDR-denominated products and the SDR is no one’s natural habitat. As he noted, the initial Facebook proposal for LIbra had been based on the idea of a basket of currencies, but that had now been scrapped and the current proposal is for a dollar-linked stablecoin.

At the end of his talk, Eichengreen’s summary observation was that “the case for CBDCs remains to be made”.

An interesting q&a session followed. Former Reserve Bank Deputy Governor Grant Spencer asked Eichengreen if he saw any arguments for a CBDC. Eichengreen’s response was that there were no strong arguments in favour, that the financial inclusion arguments were “all specious”, and that a range of private payments options already provided a superior mix of services. Spencer followed up asking about a scenario in which private and CBDC solutions co-existed. Eichengreen’s response was that one would need a proper cost-benefit analysis, but that he still wasn’t convinced of the case, noting risks such as botched software updates, hacking of central bank systems, and concerns about disintermediating commercial banks and increasing the risk of bank runs.

Another questioner asked about Eichengreen’s preference for regulation over direct central bank provision, noting “repeated failures of bank regulation”. In response, Eichengreen noted the concentration risks if a CBDC became a dominant product [as central bank notes did], but did note that there was no ideal solution and inevitably regulators would struggle to keep up.

A questioner asked about the US sanctions issue. Eichengreen repeated his scepticism that CBDC could make much difference any time soon, and noted that there were other innovations that were perhaps more likely to reduce the salience of this issue (apparently China is currently developing an alternative to SWIFT.

There followed a private roundtable session. I won’t write much about it because the Chatham House rules were so tight that I can’t even tell you who was speaking. But one speaker did take the opportunity to push back on the notion that CBDCs would increase the risk of bank runs, and should not be adopted for that reason. This speaker made a point (I have long shared) particularly vividly that the way to deal with the risk of a panicked rush out of a crowded theatre was not to bolt the doors, adding that avenues for runs had in any case increased enormously in recent decades and (for example) much about the 2008/09 crisis was wholesale runs. Perhaps the most I can say is that people closest to government agencies seemed most upbeat about what value a government product might add.

What of my own position? It is probably a bit more open to the possibility of a CBDC than you might expect, even as I don’t regard it as a high priority, and am a bit surprised at the resources the Reserve Bank is putting into the issue, even as it has done nothing about dealing with the effective lower bound o nominal interest rates that arises (at present) solely because of (a) the Reserve Bank’s monopoly on the note issue, and (b) its standing offer to convert settlement cash to physical currency at par. That still looks likely to be a big problem in the next serious economic downturn brought on by a persistent or sustained slump in demand.

But, for what it is worth (and I will try to flesh some of this out in a submission in the next few days, which I will post here in due course), my approach is that if banks have access a central bank (risk-free) digital form of the New Zealand dollar (as they do, through exchange settlement accounts), the public should have access to something similar. When I was a central banker, I used to strongly favour open access to exchange settlement account services, and although that wasn’t quite the same thing, it was consistent with this philosophy that we should not be privileging banks (or financial services providers or large players). It is also the only reason I favour the Reserve Bank being open to offering a CBDC. They will never have a technological advantage. Financial inclusion arguments don’t wash (in New Zealand). So-called monetary sovereignty arguments also don’t wash – the issues there are much more about what currency people contract labour in than what products payments are made with. But there is a reasonable case for a barebones safe digital store of value.

But – and here we come back my introductory remarks about why we have used Reserve Bank notes for decades – I don’t believe there would be much demand for such a product. Why would there be? Most people are clearly content to take a modest amount of credit risk and deal in bank liabilities. Most of us give little thought to the modest risk in holding bank account deposits and using those accounts to make most of our payments. Moreover, banks often market bundled products that no central bank would or should be competing with. For particularly risk-averse savers the government has long offered Kiwi Bonds, but very few people buy them. So whether as store of value or means of payment I see no reasons to suppose that a New Zealand CBDC – issued in a country with one of the best-capitalised banking systems on earth – would find many takers. Perhaps I might get myself an account as a curiosity, but I couldn’t imagine using it at all (actually in days one by the Reserve Bank used to offer cheque accounts to its staff, and I kept that account mainly as a curiousity and talking point).

What of the risk of runs? Well, as already noted there are lots of ways to run, and it isn’t obvious we should make it harder for ordinary people than for large investors. More to the point, runs are often quite rational, and the potential to run can be a valuable market discipline. In fact, signs that people were beginning to move into a CBDC might offer some (small) further useful information for bank supervisors. We can’t worry endlessly about moral hazard and assumptions around too-big-to-fail, and still lament products that might enable people to better respond to changing perceptions of individual bank risk.

There is no real analysis of the likely demand for a CBDC in the Reserve Bank material (and not much discussion elsewhere that I’ve seen), assuming governments didn’t try to corner the market for a new central bank product. But if I’m right about the limited demand, it would enable us to set aside one of the real concerns some have raised about a marked increase in the size of central bank balance sheets: we do not want central banks in the business of allocating credit in the economy, by their choices about what assets to invest proceeds of their currency issuance in. If there were no additional demand, it wouldn’t be an issue.

Were I a central banker, however, one concern I might still have – and again the Bank doesn’t appear to treat it – Is the potential for the central bank to be caught up in questions of who should be allowed an account.  Cash is anonymous.  Central bank bank accounts are not. When “the mob” looks askance on some person or group, it isn’t hard to envisage demands coming from some quarters for this that or the other group to be denied access to a CBDC. Even if the Bank successfully resisted – in an open society surely accounts would have to be open to all – it is the sort of controversy they might well prefer to avoid.

That is probably enough for now. I hadn’t thought much about these issues for a few years, but was pleasantly surprised to find that the views expressed in this 2017 post seem fairly consistent with those in this post today.

UPDATE: My submission

Central Bank Digital Currency submission 4 December 2021

Not really up to the job

I was tempted to head-up this belated MPS post “Je ne regrette rien”, as that – I regret nothing (about last year’s monetary policy) – was what Orr told yesterday’s press conference as he was getting rattled towards the end. He should regret quite a bit – notably the $5.7 billion of taxpayer losses on the LSAP, and the ongoing huge risks (neither were points he was willing to engage on, whether in the MPS, in the press conference, or at FEC this morning – indeed he actively played distraction). But that isn’t really where I want to focus my thoughts on the Monetary Policy Statement.

I thought the MPC should have raised the OCR by 50 points. The MPC disagreed, and moved by only 25 points. That is their choice of course, but – once again – I was struck by just how lacking and inadequate the supporting analysis and argumentation were, on their own terms (ie relative to their own published forecasts). No informed reader – and there won’t be many other readers of their 56 pages – will have come away feeling persuaded by the insights and analysis the Bank’s big team of macroeconomists had generated. There was nothing new or insightful, at least that I could see. And much that wasn’t convincing.

As I’ve noted on various previous occasions, when there are big starting point surprises, surely we expect to hear from the MPC (a) why they think they got things wrong, and (b) what that mistake – and mistakes are inevitable in such areas – has taught them about how the economy is behaving and how, if at all, it changes their view about the road ahead. But once again, there was none of that (in fact, in the press conference again played distraction suggesting that the surprise was the lockdowns after August, whereas the September quarter unemployment and (core) inflation surprises really had nothing much to do with those lockdowns (which will, of course, have a big impact on September and December GDP). Their August projections/discussion had suggested something fairly unproblematic on core inflation, and instead they suddenly found themselves with outcomes near the very top of the range, and so on.

Their discussion of inflation expectations also lacked structure, consistency, and any sense of authority. In the minutes of the MPC meeting we were told

The Committee noted that near-term inflation expectations tend to move with actual inflation. Medium-term measures provide a better gauge of whether inflation expectations remain anchored, and these remain close to the target midpoint.

The message seems to be one of nothing to worry about at all. But even the story is misleading, at best. It is certainly true that year-ahead survey measures of inflation expectations seem to be very driven by fluctuations in headline inflation, but here is the two year ahead measure (from the Bank’s own survey) lined up against their (historically) preferred – and most stable – measure of core inflation. Inflation expectations – over almost 30 years – have typically fluctuated through materially narrower ranges than core inflation itself. The exception – potentially important exception – has been the last two years. If anything, the two year ahead expectation could be disconcertingly high already, given the extent of the rise in core inflation itself.

core and expecs

Then there is that claim that all is fine because long-term inflation expectations haven’t changed much. The Bank asks about expectations five and ten years ahead, and outcomes are not far from 2 per cent – as you would hope, given the target, but only because respondents presumably expect the MPC to act sufficiently aggressive to keep inflation near the centre of the target range. If those five and ten year expectations started moving up sharply there really would be cause for concern, but the fact they are still near 2 per cent shouldn’t be telling MPC anything about the appropriate policy stance now.

At the press conference one offshore questioner asked the Governor about the MPC’s response to the big increase in inflation expectations, given the Risk Appetite Statement included in the MPC in which they asserted that “they had a low appetite for policies or decisions that could cause inflation expectations to become unanchored”. This was greeted with a glib and dismissive response from Orr along the lines of “we have reacted and raised the OCR”, not even engaging with the fact that (for example) two year ahead expectations are now a full per cent higher than they were in February, and yet the OCR has been increased by only 50 basis points over that time, there isn’t another review until February, and the MPC has stated that they prefer to move in 25 point bites. At best, it will be the end of March before the OCR will have been raised by 100 basis points, but even that won’t have raised real interest rates at all relative to the start of this year (let alone relative to the start of last year). Perhaps expectations will have moved even higher – outside the target range in the meantime. Perhaps not, but surely we should have expected a more thoughtful nuanced and engaged treatment of the issues and risks? Core inflation has, after all, already increased a lot (and – which we will come to – even they seem to expect it to increase further).

Similarly, we are told that the Bank’s projections have the OCR rising to above (the Bank’s estimate of) the neutral OCR. They seem to base that on this portrayal of neutral.

neutral nov 21

But this chart seems not to have taken any account at all of a jump in inflation expectations. The Governor said they mattered – and that the Bank had responded – but there is no sign they do so in this estimate of neutral. Given the Bank’s inflation forecasts it seems unlikely that medium-term inflation expectations will be dropping any time soon, and if those survey numbers are capturing something real, doesn’t that mean the OCR needs to go (quite a bit) higher than they might otherwise have thought. Now personally I’m very sceptical of the value of medium-term projections, but it is the Bank that uses them as a storytelling device and yet quite a material (and identifiable) part of the story seems to be have been left out.

And so it goes on. The best question I’ve heard about yesterday’s MPS was from a first year economics student, who wanted to know how the Bank could claim to be fulfilling its mandate when it projects that inflation next year will be 3.3 per cent. I haven’t seen any attention paid to what that number means. Recall that it is now November 2021. Nothing about the year to December 2022 has happened yet. So the Bank’s forecasts for inflation next year must be very close to a forecast of core inflation (they don’t know the inevitable one-off shocks – up or down – and they assume the exchange rate is fairly stable). Core inflation is currently about 2.7 per cent and the Bank is quite content to see it rise to 3.3 per cent – outside the target range. When a press conference questioner asked a similar question, she again got a dismissive (and obfuscatory answer). It might be one thing to take things slowly if the unemployment rate was still lingering high, but the Bank is quite open that at present the unemployment rate is below a sustainable level. So raising the OCR more and more quickly wouldn’t be kicking the economy into recession – the Governor’s claim – but would just get both dimensions of their dual mandate back towards desired levels sooner (and with less risk to those pesky inflation expectations). As it is, the Bank’s forecast for the unemployment rate in March 2022 is a tough lower than it was in the latest official release. This is an economy that – on their numbers – has been overheating, and they can’t even manage of Taylor principle scale of response, not even when the unemployment rate is – on their telling -unsustainably low. Perhaps there is a case to be made for their choice, but neither the MPC nor the Governor made it.

I could go on at some length on other matters, but just a few bullet points instead:

  • it is sobering to see how pessimistic the Bank now is about productivity prospects  (0.5 to 0.6 per cent for annum across the forecast horizon).  The Bank has no particular expertise in productivity, but they just now take for granted our woeful performance
  • it was curious to see a lengthy Risk Appetite Statement in the document.  Doubly curious in that more space was given to (for example) the risk of an MPC member missing a meeting than to (nothing at all) the huge financial risks decisions like the LSAP programme expose the taxpayer too,
  • the Bank is all over the place on the LSAP (all while refusing to seriously address the losses, just waving the hands about “overall gains).  They seem oblivious to the international research that suggests the stock of bonds held is what makes any useful macro difference, asserting that the programme was previously making a big difference, but now makes only a small difference.  And once again they refused any serious answers about the future of the LSAP, claiming that a document is coming in February.   Similarly, they make laughable claims about why the Funding for Lending Programme needs to be kept open, Orr even suggesting to FEC that were they to close this crisis tool now (a year or more after the crisis) it might pose a future financial stability threat,
  • there were pages and pages on climate change.  As far as I could tell, all they seemed to focus on was direct price effects, and even then had nothing to say other than “some relative prices will rise”.  No doubt and –  by definition –  others will fall.  Orr claimed there was going to be unusual volality in headline inflation relative to core, but offered not a shred of analysis in support of his claim (we’ve had lots of shocks and policy reforms in decades past).  And, somewhat surprisingly, they didn’t even touch on any effects on the neutral interest rates –  if there is any effect (and I suspect that any effect will be vanishingly small) it is likely to lower neutral rates a bit.
  • remarkably, there was almost nothing in the document offering insights based on the experiences of other countries.  Again, with a big team of economists and access to overseas central banks you’d hope that the Bank’s thinking would be informed by the diverse experiences other central banks are observing.  But there was nothing.   

All in all, it was a fairly typically poor Reserve Bank performance, perhaps undershooting even my low expectations.  It was good that some questions were asked –  at the press conference and at FEC –  about the high turnover at the top of the Bank, even if Orr was allowed to get away much too easily with ludicrous claims about what a desirable place the Bank was to work, what an abundance of talent they had available etc etc.  It certainly wasn’t on display in this document.   

(On the turnover question, one almost had to feel sorry for the Chief Economist who has been restructured out:  asked by MPs about what was going on Orr rashly talked about how Yuong Ha “has chosen to go into a far more challenging role. What are you going to be doing?”  There was a noticeable, whereupon Ha lamely responded “Coaching my son’s cricket team. Taking a break”.   Orr seemed to display all the sensitivity and personnel management skill of, say, a Judith Collins.)