Walking the path?

At 11am the New Zealand Initiative released their latest report, by Bryce Wilkinson and Leonard Hong, under the title “Walking the Path to the Next Financial Crisis”. It comes complete with a Foreword from former Reserve Bank chief economist (and former Board chair) Arthur Grimes, under the title “A short walk?”, foretelling doom and repeating his recent attacks on the Reserve Bank’s conduct of monetary policy over the last 20 months, ending with the ominous – and printed in bold – declaration “This time is not different”.

The Initiative was kind enough to send me an embargoed copy yesterday. Perhaps the first thing that rather surprised me – in a document that is really quite critical of both monetary and fiscal policy and aspects of the way the Bank does other things – is that the acknowledgements include thanks to a Reserve Bank MPC member (Bob Buckle) for “valuable feedback and suggestions”, and to a Reserve Bank economist (Andrew Coleman) for “careful comments on a draft version”. Perhaps it is an encouraging sign. Perhaps one day the Governor will also get MPC members to give speeches and openly account for their own thinking and actions. But more likely not.

It is hard to know quite what to make of the report. It probably won’t surprise the authors that my bottom line is that, amid some interesting material, much of it seems a bit overblown. In a way it was captured best in the final paragraph of the authors’ Executive Summary

The less prudent the government, the more prudent individual New Zealanders will need to be. Borrowing heavily to buy property or shares at current prices is like playing Russian roulette with one’s financial future. Portfolios should be
diversified. There are risks of both deflation and inflation.

As an advertisement for inflation-indexed bonds (eg 19 year ones, yielding a real 0.88 per cent yesterday) that final sentence could hardly be bettered, but isn’t it always so? The future is uncertain, diversification is usually prudent, and hedging (in this case against inflation uncertainty) usually is too. As for borrowing at present, well even if the government was running a balanced budget I’d be pretty hesitant myself about taking on lots of debt secured on assets like New Zealand houses but (a) it is much less risky if you are buying a house you intend to live in for 40+ years (hedging etc) and (b) people like me (including successive Governors) having been saying as much on many occasions over the last 30 years. Those with particularly long memories – and I’m sure Bryce is one of them – will recall Don Brash, newly appointed as Governor, refusing to buy a house in Wellington in 1988 given how expensive they were.

As for the government, just how imprudent is it? Well, I’ve been as critical as anyone (well, more than most) of the large structural deficit they chose to run in this year’s Budget, when there was no obvious macro or Covid need for such deficits, but if it is stocks (of debt) you are worried about – which for Wilkinson’s and Hong’s purposes you are – then here is the OECD’s series of net general government liabilities as a percentage of GDP (including the May 2021 forecasts, so there should be an update shortly).

nzi nov 21

Is it more net debt than I’d like to see? Indeed. But on the OECD numbers we’d have the 6th lowest net debt (per cent of GDP) of all the OECD member countries next year, and an absolute level that poses no risk to anyone or anything, even if we were to get a severe recession/crisis in the next few years (the global risk the authors are most focused on).

There are also curiously anachronistic touches to the report. Again from the Executive Summary

The composition of New Zealand’s official overseas reserves should be reviewed, particularly in respect of gold.

For those who aren’t aware the Reserve Bank is among a small number of advanced country central banks that hold no gold at all in their foreign reserves (New Zealand has not done so for decades). What really clear from the report is why the authors think the Bank should do things differently. It can’t be as an inflation hedge, since most of the Bank’s reserves are already hedged (funded with foreign currency liabilities). And since the reserves are held to enable crisis intervention in the foreign exchange market – and thus immediate access to liquidity has always been a priority – it isn’t obvious why we should want our central bank holding a non foreign exchange asset that has a very volatile price. If we must have a New Zealand Superannuation scheme (and I suspect the authors agree with me that we shouldn’t) perhaps that is the place to think about whether gold – or Bitcoins for that matter – have a place in a diversified investment portfolio.

Of the authors’ other recommendations for New Zealand, I’m with them on the idea of a independent fiscal council – although it is hard to see it making much difference given the degraded state of New Zealand government agencies generally. On monetary policy their call is for

The Reserve Bank should have a clear path for reversing its emergency credit creation and lifting its control interest rate.

And I have some sympathy when it comes to the future of that huge stock of bonds the Bank bought in a fit of “look, we are doing something/anything” frenzy but in fairness to the Bank they have (a) stopped increasing the stock of bonds, and (b) were one of the earlier advanced countries to start raising official interest rates. No one really doubts there are more increases to come, but then no one wise will be pre-committing to a particular path for the OCR because no one, but no one, knows what sort of interest rates (real or nominal) will be required a few years from now.

The authors seem quite enamoured of the thesis advanced in a recent book by economists Charles Goodhart and Manoj Pradhan who argue that demographics will drive interest rates much higher in the coming decade. It is an interesting argument – and I’m open to it (if not yet convinced) – but in the same paragraph in which they mention this thesis they cite Germany and Japan (countries with particularly unfavourable demographics). But surely the problem then is that both Germany and Japan have far lower interest rates than New Zealand (or, say, the United States). Sure, asset-buying programmes may influence those rates to some extent, but there is just no sign the market thinks real rates (or nominal actually) are going to go a lot higher, even on a 20 year view. The market could be quite wrong – it has been known – but so could Goodhart, Pradhan, and the NZI authors.

Without trying to caricature the authors I think it would be fair to represent their views in this stylised way:

  • things haven’t been the same since the world moved to fiat money,
  • fiscal discipline has been breaking down globally, but especially in the big Western countries,
  • moral hazard (around government bailouts of failing financial institutions) is an increasing problem

And that, in combination, the way is set that will lead to crisis (globally, even if our financial system itself were to be fine).

There are aspects of the argument I sympathise with. It wouldn’t surprise me if the next serious recession were to see a major euro crisis, and perhaps even the end of the euro. But then that has been my view for a decade now, and yet life goes on. Fiat money has had its downsides – look at how much prices have risen over the last 100 years compared with the previous 100 – and yet the reality of the decade prior to Covid was one of inflation in most of the advanced world repeatedly undershooting targets. And much as I abhor structural fiscal deficits – of the sort established in places like the US, UK, and Japan – it remains true that real interest rates (servicing burden) are extraordinarily low, and have now been low not for a few months but for really rather a long time. Perhaps 3 per cent real interest rates will return and endure, but for now there is little credible sign of such a development anywhere, and quite a bit of what Wilkinson and Hong worry about seems to rest on such a scenario. If I were advising New Zealand’s Minister of Finance today – or his Opposition counterparts – risks around advanced world fiscal debt would not be high on the list of things I’d be worrying about. And I’m not keen on bailouts either, but surely there is at least as credible argument that in much of the world capital ratios are now so much higher than they were that – to some extent at least – the moral hazard argument is less strong than it might have appeared in 2009.

It is good to be challenged, and there is some interesting material in the report including (at least for those less aware of monetary history) on how the current global system came to be. And I strongly endorse the authors’ scepticism about the self-politicisation of our Reserve Bank (and the tendency of many other central banks to want to weigh on on matters simply not their responsibility). Even that weird new central bank ‘network for indigenous inclusion’ gets a mention (I keep waiting for the day when the Icelandic central bank is signed up, their “indigenous people” having settled Iceland just a few hundred years before Maori first settled New Zealand). And counsels of vigilance rarely go astray when it comes to macro and banking policy. But I wasn’t persuaded we were quite as far along the path to perdition as the author’s fear.

Curiously, there is a launch event going on at present at which former Prime Minister John Key (current chair of the ANZ) is speaking (I didn’t tune in). Aside from the name recognition he offers, it seemed curious to have such an establishment figure, known more for his sunny optimism than for his willingness to make hard calls and choices, to be launching this jeremiad. But if Key is persuaded, I wouldn’t want to be a borrower at the ANZ at the years to come, as presumably materially-tighter lending standards would be a corollary of the Wilkinson/Hong analysis?