Financing the government

In normal circumstances governments finance themselves primarily with visible legislated taxes, with a bit of additional debt on the side.

In New Zealand, over the last complete 10 years, core Crown revenue was $715 billion (mostly taxes) and debt contributed between $10 and $40 billion –  depending which gross or net measure you prefer.    That borrowing was almost all from the private sector, again as one would expect.  The Reserve Bank’s holdings of government bonds. for example, hardly changed at all (nor did bank settlement cash balances at the Reserve Bank).   And the government mostly had credit balances in its account at the Reserve Bank.

In the last couple of months, everything has been thrown up in the air.   On the Budget numbers I mentioned in Friday’s post, almost a quarter of government spending over the five years (including 2019/20) is expected to be financed by increased debt.   And on the Reserve Bank’s own numbers we could easily see at least half of that increase in debt take the form of Reserve Bank lending to the Crown (the forecast rise in net debt is $134 billion, and the Governor has talked of the possibility of raising further the current $60 billion limit on the LSAP programme).

That the Bank is buying those bonds on the secondary market, rather than getting some or all direct from the government (as some advanced country secondary banks are now doing to an extent), is a second or third order issue, making little or no macroeconomic difference.   The important point at present is that (a) the Bank is buying the bonds, and (b) the Bank is sterilising the liquidity effect on those purchases by paying an at-or-above market rate on the resulting settlement cash balances.

Oh, and the most important points of all were that the decision to buy bonds at all is (a) wholly a decision for the Monetary Policy Committee, and (b) working with an unchanged (from pre-crisis) mandate: delivering inflation near 2 per cent and, as much as it can consistent with that, supporting employment.  The government has given the Bank an indemnity, which makes the Bank feel more comfortable taking the associated interest rate risk, but if the government had not done so, it need not have stopped the Bank making the purchases if the MPC felt that was what the monetary policy mandate required.

I wrote about all this a month ago when there was first a flurry of concern about reported comments suggesting that at some point the Bank might buy bonds direct from the Crown, in a post intended to be basically supportive of the Bank.

Now, as you know, I don’t think the LSAP is making much difference at all now to anything that matters much to macroecononomic outcomes.  It is slightly perverse in that it involves shifting the duration of the Crown’s effective debt portfolio much shorter –  swapping long-dated government bonds for on-demand instantly repriceable settlement cash liabilities –  but if you believe interest rates are going to be low for quite some time, you might even downplay that.  Other than that, it probably does little harm –  and adds to our database of monetary experiments for future analysis – if little good.

But in the last couple of weeks there have been a number of comments from the Governor that suggest that something much more troubling is afoot.

The first hint I heard of it was when the Bank turned up to Parliament’s Finance and Expenditure Committee on the day after the Monetary Policy Statement.  This is an extract from the post I wrote then.

Goldsmith asked the Governor about those comments a few weeks ago that the Bank could consider buying government bonds directly from the Crown, rather than (as at present) in the secondary market.  He seemed to just be wanting to close off the issue, but the Governor opened it up all over again, in a way that seems to have attracted no attention.

The expected answer would probably have been along the lines that there were no plans at present, the secondary market was working well, but if there ever were dysfunction there was really no macro difference in the Bank buying direct, so long as the decision rested with the Bank, consistent with the inflation target.   In backing the Governor on this point previously, that is what I have said.

Instead, the Governor launched into a discussion noting that while the Bank did not rule out lending direct to the Crown, that was really fiscal policy not monetary policy, that the central bank can always lend as much as fiscal policy requires, but that that would be a matter for the government to decide, not the Bank.

Goldsmith then challenged him on that, asking whether he was really saying that the Minister could decide whether the Bank would lend direct.  Orr reiterated the possibility of market dysfunction, while noting that at present markets were functioning well, but then repeated that what he called “pure monetary financing” would be a matter for the Minister of Finance to decide.

At this point, the Governor invited the Deputy Governor Geoff Bascand –  usually the safe pair of hands in that senior management cohort –  to comment.  He indicated that it would be a matter of ministerial direction, but which would involve a substantial process including looking at whether what the minister might be directing would still be consistent with the existing price stability etc target.  And then he tried to close things down by suggesting that this was all just an “esoteric discussion”.

Reasonably enough ACT’s David Seymour reacted to that, suggesting that if the Bank was seriously saying the Minister of Finance could direct them to lend to the government, in any amount he chose, it was “anything but esoteric”.

I went on to articulate the (possibly) relevant provisions of the Act as I saw them, concluding

But……there is no hint in this provision [section 12 override powers], or anywhere else in the Act, suggesting that the Minister of Finance can direct the Bank to lend to the government.  Perhaps the Bank and its lawyers think/worry that “lend to the government at zero interest up to $…billion” is an alternative “economic objective” within the meaning of section 12 of the Act.   But, at very least, it would be a stretch –  it isn’t an “economic objective”, but an instrument,  and favouring one specific party in the economy.    And note that if a government did attempt to impose such an “economic objective” there would still be nothing to stop the Bank setting interest rates for the rest of the economy at a sufficiently high level to counter the inflationary effects of this coerced lending.

I’m at a loss to know what the Governor and Deputy Governor mean.   I’m tempted to lodge an OIA request, but am not sure I’ll bother, as they would find myriad ways to refuse to release anything.  But journalists could directly ask the Bank what the Governor/Deputy Governor were on about?   MPs could use parliamentary questions to ask the Minister of Finance whether (a) he has received any advice as regard his direction powers over the Reserve Bank, and (b) whether he or Treasury believe he has the statutory power to compel the Bank to lend to the Crown.  Most everyone I’m aware of has always assumed they can’t –  and took great reassurance in that –  so if the powers that be now believe differently we deserve to know?    (Of course, if the government just wants more inflation, it can always raise the inflation target, but that is a rather different issue).

And there I left it, a bit puzzled, none the wiser, and even wondering whether Orr had perhaps confused some details and there really wasn’t anything to worry about.

At least until over this last weekend.  Then I happened to listen to a post-MPS presentation Orr had given to clients of Jardens (on 15 May), in which he touched on the issue and noted that (paraphrasing from my notes) “if we were to take a direction from the government to finance it directly – as distinct from what monetary policy needs might imply – we would have to have different legislation”

I then read an interesting interest.co.nz article reporting comments the Governor had given to their journalist Jenee Tibshraeny late last week in which this topic was addressed at some length.

Orr said it was up to government to decide if it wanted to go further and give the RBNZ the mandate to buy bonds for fiscal policy purposes, rather than monetary policy purposes – IE buy bonds to help pay for government spending initiatives rather than to keep inflation and employment in check.

“There’s no right or wrong,” Orr said.

“It’s just that it is different and you would need legislative and/or institutional instructions, because when I last looked at my job description, I’m not allowed to go off and buy whatever I feel like because I’ve got the ATM…

“That would take some significant transparency as well as operational structures to ensure everyone knew who was doing what, why, how, where, when.”

Asked whether he would be hesitant to go down this path if Robertson asked him to, Orr responded: “Yes, I mean, it really depends to what purpose… and under what conditions is this managed.

“Because you could take it to the extreme immediately and you’ve gone back in time 30, 40 years and the central bank is being used as the ATM for a government and it’s unclear whether we can control inflation anymore, and it’s back in the hands of the elected officials…

“It’s not for me to choose the policy. I would implement the policy, but I would be extremely cautious about making sure the risks are understood, managed and mitigated wherever they could be.

“And I imagine I would be surrounded by many many people with free and often unsolicited advice around whether it did or didn’t work… which is good…

“People are very passionate about the structures that have been built and you don’t muck around with them lightly.

“These things are achievable; they’re just different.”

On the one hand, it is good to know that the Governor seems to think that under current law he can’t just go and buy anything he likes (he probably can, but it has to be consistent with the Bank’s statutory functions, including the monetary policy Remit the Minister has given him, which in turn is subordinate to the Act).   But then note those Bascand comments earlier suggesting the Bank thinks it could be directed under existing legislation, even if that might involve overriding or changing the Remit.

The Bank has clearly been giving such radical options quite a bit of thought, not just as extreme contingency plans (Parliament, being sovereign, can empower almost anything) but as something they are quite openly talking about.    That suggests something that they are either keen on themselves, or which the Minister and/or Treasury has raised fairly seriously as a possibility.

Given the Governor’s longstanding belief in a bigger government and a more aggresssive use of fiscal policy, it wouldn’t be entirely surprising if this were something he was championing (indeed, it would be the best explanation for why (a) he is the only one talking about it, and (b) doing so in a non-negative sort of way).

Going down such a path would, however, be a seriously retrograde step. Perhaps it might lift inflation expectations a bit –  governments acting to direct the central bank to lend to them will create some concern – but in a quite undesirable sort of way (even if Social Credit and the more rabid MMT enthusiasts might be salivating at the prospect).

For a start, there is no obvious need for such a mandate.  The New Zealand government is a highly creditworthy borrower which, on current government plans, will remain one of the least-indebted of all the advanced countries.   One can never rule out a new extreme global crisis that might seize up markets for a few days, but the prospects of the New Zealand government not being able to issue on market the quantity of debt believes it requires is slim indeed.   And the Crown already has an overdraft facility at the Reserve Bank that it can draw on to smooths ups and downs.

More disconcertingly, although technically the Reserve Bank could be required to lend to the government –  beyond anything consistent with the Remit –  and that wouldn’t immediately tip us into serious inflationary problems, it would be a highly distortionary policy.  In principle, the Bank could lend lots of money to the Crown at zero interest, and the government then further increases its spending beyond what would normally be consistent with the inflation target. If that happened, you would expect the MPC to start raising the OCR, to keep overall demand in check.  And then we’d be in the bizarre throwback world in which the government was borrowing for zero and the rest of the economy faced really quite high interest rates, squeezing out private sector activity to favour the government.

I’m not going to allow myself to be drawn into an inconsistency here.  At present, if anything, the presenting issue is that the Reserve Bank is not doing its core monetary policy job sufficiently well that either the market, survey respondents, or the Bank itself believe that inflation will be consistent with the target set for them.  If they persist in that stance, amid a really savage recession, I believe the Minister of Finance should act, using existing powers either to replace the key individuals (to ensure the current Remit is being followed) or to explicitly direct the Bank to adopt an easier monetary policy (consistent with the current Remit over the medium term).  Those powers are in the Act for a reason, to protect citizens.   There is no such power to direct the Bank to lend to the government and there has long been an international consensus that it would be quite unwise to provide for such a power.  It would be to step away from any sense that monetary policy operates in a neutral way, not setting out to favour or disadvantage any particular party or sector (private or public), and into a world where governments could regard control of the “printing press” as an acceptable way for them to finance their spending (or reluctance to tax) preferences.  With reasonable people, it isn’t some immediate path to hyperinflation, but it would be undesirable on numerous counts and further increase the politicisation of the Reserve Bank.

One can make an argument against central bank operational autonomy –  I sometimes come and go and whether there are real advantages that justify the costs and lack of accountability (part of the reason why I keep on about enhancing real central bank transparency) – but giving the government reason to think control of the printing press is a legitimate tool has nothing going for it at all.

We need some answers as to just what is going on.   When I tweeted about this on Saturday, Tibshraeny responded

That is encouraging, and I will look forward to her story.  But if Robertson –  who always seem conservative and risk averse (sometimes beyond what is warranted) – is not interested, then what cause is Orr championing, to what end, and why?

If he thinks more macroeconomic stimulus is required, try conventional monetary policy (would have helped, of course, if he’d sorted out those alleged “operational issues” some banks are claimed to have, but even those obstacles exist they can be overcome).  If the governments thinks it needs to spend more, the conventional options are still open to them –  higher taxes (probably not a great idea at present) or tapping the global market for public debt.  Maintaining that borrowing capability was, as you’ll recall, one of the main reasons why successive governments kept net debt low and stable.  (Of course. it also has a $40 billion fund –  which it insists on putting more money into, even as its new borrowings are large, to speculate on world markets –  much of which could be quite readily liquidated.)

 

 

Still avoiding scrutiny and accountability

I’m not one of those inclined to join the new Leader of the Opposition in describing the government’s handling of the coronavirus situation as “impressive”, but sometimes other people are just determined the make the Cabinet and core government departments (notably Health, Treasury, DPMC) look not bad at all.

Transparency is one of those issues.  I was critical –  and still am –  about how slowly the government released key official documents relevant to the crucial decisions taken at various stages in March and April.    Difficult decisions made, inevitably, with partial information, and with consequences (either way) that are huge by the standards of any typical government decision should have been accompanied by the near-immediate release of all the significant relevant analysis and advice.

Nonetheless, and to their credit, the government is slowly getting there.  There was a big proactive release a couple of weeks ago of all sorts of central government documents (mostly advice to ministers and Cabinet papers) – individually important or not – on the coronavirus situation from the start of the year until mid-April, and there is a promise of another batch presumbly sometime next month.   What is done is now done, but the release of those papers –  many of them written to very short deadlines and in the fog of war – helps us, as citizens and voters, assess the quality of the central government advice and decisionmaking process.  And since Covid hasn’t gone away, it may even help clarify where improvements might be made –  even demanded –  in government contingency planning against the risks of further problems.

But, of course, there are other public sector agencies operating at arms-length from ministers, exercising a great deal of discretionary power (including through the Covid crisis), and not covered by the government’s own pro-active release.   I’m thinking most notably of the Reserve Bank and, these day, the Monetary Policy Committee, a statutory body –  members each appointed by the Minister of Finance –  charged with the conduct of monetary policy.

Without any great optimism about a positive response, and fully expecting the request would simply be the first step on the path to an appeal to the Ombudsman I lodged an Official Information Act request on 20 April.

I am writing to request copies all papers prepared by or for staff or
management of the Reserve Bank for the Monetary Policy Committee in
2020.

I am, of course, well aware of the Bank’s typically obstructive
approach to releasing such official information in normal times.
However, given the scale of the events the Committee has been
grappling with this year, the magnitude and unusual/unprecedented
nature of many of the interventions (and decisions on occasion not to
act), the scale of the economic and financial risks the wider public
and the taxpayers are being exposed to, there is a clear and strong
public interest in the release of these particular papers, without
necessarily creating a precedent for more-general release of MPC
papers.  In addition, I would note that the succession of meetings
this year, and the fast-moving nature of events, means that papers
written even a month ago are already likely to have aged beyond the
point of immediate market sensitivity much more quickly than would
normally be the case.

Public accountability demands much greater transparency.

“Typically obstructive approach” refers to the Bank’s adamant refusal to release any papers relating to monetary policy decisions, at least unless they are perhaps 10 years old (they did once release a set of those, and I haven’t tested whether the effective threshold is 3, 5, 7 or 10 years past).

“Public interest” is in reference to the provision of the Official Information Act which states that for many of the possible withholding grounds

Where this section applies, good reason for withholding official information exists, for the purpose of section 5, unless, in the circumstances of the particular case, the withholding of that information is outweighed by other considerations which render it desirable, in the public interest, to make that information available.

I had a reply on Thursday. In fairness, at least it was only a day or two beyond the 20 working day deadline, although I doubt it took the Bank any time at all to decide its response.  The substance didn’t really surprise me at all, even if it was a disappointing reflection on the continued refusal of the Reserve Bank to accept that the principles of open government, the principles of the Official Information Act, apply to them and to the Monetary Policy Committee as well.

They pointed to the various press releases and Monetary Policy Statements (which, personally, I wouldn’t have thought were in scope, although that is beside the point) and went on

We are withholding all remaining information within scope of your request under the following grounds:
 section 9 (2)(d) – in order to “avoid prejudice to the substantial economic interests of New Zealand.”
 section 9 (2)(g)(i) – to “maintain the effective conduct of public affairs through the free and frank expression of opinions by…members of an organisation or officers and employees of [an] organisation in the course of their duty.”

We have considered your views regarding the need for the information to be released including, the scale of the events the Monetary Policy Committee has been grappling with this year and potentially, strong public interest in the release of these particular papers.

The Reserve Bank is currently conducting monetary policy in an environment of great uncertainty and market volatility. In these circumstances it is especially important that the MPC has the space to assess all the available information, select monetary policy tools, convey clear messaging through its Monetary Policy Statements, and evaluate its actions as it proceeds. The release of such recent MPC papers would be likely to interfere with the effective implementation of monetary policy.

As you are aware the Reserve Bank has a statutory duty to make official information
available unless there is good reason for withholding it. In this instance the Reserve Bank believes that there is good reason for withholding the requested information and that the public interest in releasing it does not outweigh the reasons for withholding we have listed above.

Note that the request was not for every casual email staff and management might have loosely exchanged over the months, it was for the papers prepared for the Monetary Policy Committee, a statutory body that the Governor (who also sits on the Committee) and staff advise and service.

There is a close parallel to the way (a) government departments advise individual ministers, and (b) the way an individual Minister’s Cabinet paper seeks the approval of his/her colleagues.  Advice and recommendations and analysis flow to decisionmakers, and decisionmakers decide.  Sometimes that advice is poor, sometimes good, sometimes necessarily rushed, sometimes not.  But to their credit, the government has released the significant bits of advice/recommendations –  whether or not each of those pieces of advice make advisers or decisionmakers look good, whether or not decisionmakers accepted that advice or not, whether or not the advisers might now wish they’d advised something different?

What make the Reserve Bank –  the Governor as chief executive, or the statutory MPC he chairs –  think it should be exempt from that sort of scrutiny and transparency, through one of the most dramatic periods of modern times (including as regards monetary policy)?

One of the excuses the Bank has sometimes advanced for withholding monetary policy materials is that releasing them might give away information about future strategy.  Even if that were true, it is really grounds for selective redaction, not broadbrush refusal, but at present it is a particularly absurd argument.  For example, my request encompassed papers relevant to the February MPS –  you’ll recall that that was the one in which they played down coronavirus and were rather optimistic about the rest of the year, adopting a very slight tightening bias.  Whether or not those were reasonable views at the time, they were long since overtaken by events. Nothing in the advice and analysis provided to the MPC for that MPS has any possible bearing on actions the Bank or market is taking now.

But take more recent events.  The MPC issued, and has since reaffirmed, their pledge to not cut the OCR for a year.  They provided no supporting argumentation or analysis for that stance, but presumably there must have been some analysis and advice, perhaps around these mysteroius “operational obstacles” that the Governor, as the MPC’s spokesman, keeps referring to.

Or the LSAP programme?  Surely there must be staff analysis and advice, provided to MPC under the imprimatur of the Governor, on the likely effects of such a programme?  What possible grounds can there be for simply refusing to release any of it (as distinct perhaps from withholding specific paragraphs touching on the implementation plans for example)?

All the excuses about

In these circumstances it is especially important that the MPC has the space to assess all the available information, select monetary policy tools, convey clear messaging through its Monetary Policy Statements, and evaluate its actions as it proceeds. The release of such recent MPC papers would be likely to interfere with the effective implementation of monetary policy.

could no doubt equally be argued by officials in Health and Treasury etc, or by Ministers.  But to their credit, ministers have recognised the importance of openness and put the advice out there – rushed and perhaps inadequate, rapidly overtaken by events, as sometimes it inevitably was.   And at least Ministers have to face the electorate in September, but the only effective accountability for the Governor and his MPC (many of whom refuse even to be interviewed) is the sort of openness and transparency that the OIA has long envisaged.

The Bank likes to claim that it is very transparent, but solely on its own terms and its own definitions. Transparency does not mean telling people what you want them to hear when you want them to hear it –  everyone does that, in their own self-interest.  Transparency is about the stuff you sometimes find uncomfortable, even embarrassing, or just very detailed, but which you put out anyway.   Had she wanted to the Prime Minister could have run the sorts of excuses the Bank did –  claiming that she held a press conference every day and ran full page adverts in newspapers every day telling people what she thought they needed to know then –  but to her credit she is better than that, and recognised the very strong public interest in much greater transparency –  some of which might put her or her officials in a good light, some not.  It is what open government is about.

I’ll be referring this to the Ombudsman, and perhaps seeking from the Bank all material relevant to their consideration of this particular request, but if the government is serious about its commitment to openness and transparency, it is past time for the Minister of FInance to have a word with the Governor and with the others he himself appointed to the MPC, and with the chair of the Bank’s Board –  whom he appointed –  and strongly urge, come as close to insisting as he can, that extraordinary times, extraordinary monetary experiments, call for a much greater degree of openness that the Bank has, hitherto, been willing to display.

If The Treasury’s advice to the Minster of Finance on these matters is open to scrutiny in these exceptional fast-moving circumstances, why not the Reserve Bank’s advice to their decisionmaking body?  As it happens, the Secretary to the Treasury is now a non-voting member of the MPC, so perhaps she might have a word with her colleagues and draw attention to what transparency and accountability are supposed to mean in New Zealand.

 

 

 

Losing $128 billion

I don’t usually pay much attention to forecasts of nominal GDP.  Not many people in New Zealand really seem to.  But The Treasury takes nominal GDP forecasts more seriously than most, since nominal GDP (in aggregate) is, more or less, the tax base.

Out of little more than idle curiosity I dug out the numbers from last December’s HYEFU forecasts –  the last before the coronavirus –  and compared them to the numbers published in last week’s BEFU, accompanying the Budget.  And this was what I found.

Nominal GDP ($bn)
HYEFU BEFU Difference
2019/20 319.8 294.2 -25.6
2020/21 336.4 294.2 -42.2
2021/22 354.1 328.3 -25.8
2022/23 371.5 352.3 -19.2
2023/24 389.2 374.3 -14.9
Total 1771 1643.3 -127.7

Over the full five years, New Zealand’s nominal GDP is projected to be $128 billion less than The Treasury thought only a few months ago.

Recall that changes in nominal GDP can be broken down into three broad components:

  • the change in real GDP  (the volume of stuff produced here),
  • the change in the general price level (inflation), and
  • the terms of trade

On this occasion, changes in the terms of trade make only a tiny difference over the five years taken together.

General (CPI) inflation is expected to be lower than previously thought.    On average over the five years, the price level in the BEFU forecasts is about 1.8 per cent lower than in the HYEFU forecasts.  That accounts for about $33 billion in lost nominal GDP.

The balance –  the overwhelming bulk of the loss –  is real GDP.

I haven’t written anything much about The Treasury’s forecasts, which were done quite a while ago, and could not fully incorporate the final fiscal decisions the government made.  But for what it is worth, I reckon Treasury’s numbers were on the optimistic side –  quite possibly on all three components of nominal GDP.  On inflation, for example, they are more optimistic than the Reserve Bank (which finished its forecasts later), even as they assume tighter monetary conditions than the Bank does.

But the point I really wanted to make was that these forecast GDP losses will never be made back (in the sense that some future year will be higher to compensate –  resources not used this year mostly represents a permanent loss of wealth).  And that these losses occur despite all the fiscal support (and rather limited monetary support).   And fiscal here includes both the effects of the automatic stabilisers (mainly lower tax revenue as the economy shrinks) and the discretionary policy initiatives (temporary and permanent).

How large are those fiscal numbers?  Well, here is core Crown revenue (more than 90 per cent of which is tax)

Core Crown revenue ($bn)
HYEFU BEFU Difference
2019/20 95.8 89.5 -6.3
2020/21 101.6 87 -14.6
2021/22 106.5 94.6 -11.9
2022/23 112.7 104 -8.7
2023/24 117.7 109.9 -7.8
534.3 485 -49.3

Almost $50 billion the Crown was expecting but which it won’t now receive.  Some of that will be the result of discretionary initiatives –  the corporate tax clawback scheme, much of which will result in permanent losses, and the business tax changes announced in the 17 March package –  but the bulk of the loss will be the automatic stabilisers at work.

And on the expenditure side?

Core Crown expenses ($bn)
HYEFU BEFU Difference
2019/20 93.8 114 20.2
2020/21 98.8 113.5 14.7
2021/22 102 119.8 17.8
2022/23 106.3 118.6 12.3
2023/24 109.2 113 3.8
Total 510.1 578.9 68.8

Almost $70 billion of current spending the Crown didn’t expect to make only a few months ago.  A small amount of this will be the automatic stabilisers at work (the unemployment benefit), but The Treasury is pretty optimistic about unemployment.  Most of the change is discretionary policy initiatives (announced or provided for).

And here is the change in net debt

Net core Crown debt (incl NZSF) as at year end  ($bn)
HYEFU BEFU
2018/19 14.1 14.1
2019/20 14.6 47.6
2020/21 17.6 82.8
2021/22 17.1 111.7
2022/23 12.3 131.7
2023/24 3.9 138.2 134.3

That will be almost $135 billion higher than expected.

As I’ve noted in earlier posts, I don’t have too much problem with the extent of overall fiscal support (although I would have structured it differently and made it more frontloaded –  consistent with the “pandemic insurance” model).

But even on this scale, fiscal policy is nowhere near enough to stop the losses.  Some of those losses are now unavoidable.  It is only five weeks until the end of 2019/2020, so we can treat $26 billion of nominal GDP losses (see first table) as water under the bridge now.   As it happens, fiscal policy looks to have more than fully “replaced” the income loss in aggregate (whether $27 billion from operating revenue and expenses in combination, or the $33 billion increase in net debt) –  not as windfall, but as borrowing (narrowing future choices).   (UPDATE: Even in quote marks “replaced” isn’t really quite right there, as without the fiscal initiatives it is near-certain that actual nominal GDP would have been at least a bit lower than The Treasury now forecasts, even for 19/20.)

But there is a great deal of lost income/output ahead of us, even on these (relatively optimistic) Treasury numbers.

Which is really where monetary policy should be coming in.   The Treasury assumes that monetary policy does almost nothing: there is no further fall in the 90 day rate (the variable they forecast), and as they will recognise as well as anyone inflation expectations have fallen, so real rates are little changed from where they were at the start of the year.  And although the exchange rate is lower throughout than they assumed in the HYEFU, the difference is less than 5 per cent –  better than nothing of course, but tiny by comparison with exchange rate adjustments that have been part of previous recoveries.  It isn’t entirely clear how The Treasury has allowed for the LSAP bond purchase programme, but whatever effect they are assuming…….there is still a great deal of lost output.

The Governor has often been heard calling for banks –  private businesses – to be “courageous”.  It is never quite clear what he means, but he apparently wants to risk other peoples’ money.  But the central bank is ours –  a public institution.   A courageous central bank, that had really grasped the likely severity of this slump, could have begun to make a real difference.  If they’d cut the OCR back in February, and taken steps to ensure that large amounts of deposits couldn’t be converted to physical cash, and then cut the OCR to deeply negative levels (perhaps – 5 per cent) as the full horror dawned, we’d be in a much better position now looking ahead.     Wholesale lending and deposit rates would be substantially negative at the short end, and even real rates on longer-term assets might be as low as they now, without much need for bond purchases.   Retail rates might also in many case be modestly negative –  perhaps for small depositors achieved through fees.   And, almost certainly, the exchange rate would have fallen a long way, assisting in the stabilisation and recovery goal.  There are winners and losers from such steps –  as there are from any interventions, or from choices just to sit to the sidelines –  but it is really just conventional macroeconomics: in a time of serious excess capacity and falling inflation expectations, act to seek to bring domestic demand forward, and net demand towards New Zealand producers.    Working hand in hand with the substantial fiscal support (see above), we’d be hugely better positioned to minimise those large future nominal GDP losses –  losses that at present, we risk never making back.

But neither the Governor nor, apparently, the Minister of Finance seem bothered.

Finally, if nominal GDP appears to be a slightly abstract thing, it is worth recalling that almost all debt is nominal and it is nominal incomes that support outstanding debt.  There is about $500 billion of (intermediated) Private Sector Credit at present (and some other private credit on top of that).  Most likely that stock won’t grow much over the next few years. But government debt will –  on Treasury’s numbers net debt rises by $134 billion.   Against those stocks, a cumulative loss of nominal GDP of $128 billion over five years is no small loss.  As noted earlier, amid all the uncertainties, the precise numbers are only illustrative, but the broad magnitude of the likely losses (on current policies) are what –  and that magnitude is large, if anything perhaps understated on The Treasury’s numbers.

 

A practical suggestion for the Governor

A commenter on a recent post left the reasonable question

if the RBNZ is flooding banks with deposits/reserves to pay for its QE, why are the banks still paying 2.5% to raise term deposits from the public ? Surely the banks have more cash than they know what to do with ?

Well might she ask.  And her question prompted me to think a bit harder about useful steps that could be taken in response to what looks like quite a glaring anomaly.    At present, the Reserve Bank pays 0.25 per cent on settlement balances banks hold at the Reserve Bank, banks are paying much the same rate on (wholesale) 90 day bank bills, but when I checked this morning the average retail rate on offer for a six month term from our five largest banks was about 2.15 per cent.

It wasn’t always so.  Here is a chart showing the 90 day bank bill rate and the 6 month term deposit rate (the one the Reserve Bank provides a long time series for) back almost 30 years.

retail and wholesale

Short-term wholesale rates used to be a bit higher than comparable maturity retail rates.  That made sense.   The marketing and admin costs associated with one $20 million bank bill are going to be a lot lower than those associated with 400 retail deposits of $50000 each.  The margin ebbed and flowed a bit, but it was rare for retail rates to be below wholesale.  All that changed at the time of the 2008/09 recession and financial crisis, and the old relationships have never resumed.

In this chart I’ve taken a shorter period –  since the start of 2007 –  and have also shown the rate on a 1 year interest rate swap (for which the Bank has only published data since mid 2010).

retail and wholesale 2

The maturities differ a bit, but despite that you can see how similar the two wholesale rates have mostly been and how different they’ve been to retail rates.    And here, for the same period, are the margins between the 6 month retail rate and the 1 year swap rate respectively and the 90 day bank bill rate (itself usually moving very similarly to the OCR).

retail and wholesale margins

The gaps that sometimes open up for a while between the swap and bill rate just reflect the maturity differences – eg in 2013 and 2014 the Bank was strongly expected to raise the OCR so swaps yields rose in anticipation.  Over time, the differences have been small and non-persistent.    By contrast, the margin between retail and wholesale rates has typically been large and somewhat variable.

What accounts for this weird situation in which Michael Reddell private saver can get, pretty consistently, 150 basis points more for my smaller deposit than Michael Reddell trustee of the Reserve Bank staff pension scheme can get for the much larger amounts of money he (and other trustees) formally own (on behalf of the members)?

(Totally parenthetically, hasn’t policy been pushing people into collective savings vehicles –  where they can only get the lower rates – ever since Kiwisaver was set up?)

It has a great deal to do with the 2008/09 crisis conditions, and perceptions and regulatory responses thereto.    In New Zealand in the run-up to 2008/09 banks had had a very large share of their funding in the form of very short-term foreign wholesale instruments.  That funding was cheap and easy to raise –  times were good, money was easy, the mood was exuberant – and banks simply did not believe those markets could ever seize up  (I’ve told the story previously of one very senior risk manager of one of the big banks who when we were doing pandemic planning in about 2006 asserted that very strongly).  They did.  More generally, wholesale runs were the catalyst for the failure of various major institutions abroad.

And so, perhaps understandably, there was a quite a reaction, by banks themselves (scares change behaviour, for a time at least), rating agencies, investors in bank debt, and regulators.  In this post I will be focusing on the New Zealand regulatory intervention, but I don’t want to be read as suggesting it was the whole story (in fact, some readers may have memories long enough to recall my arguing 10 years ago that the regulatory effect then was probably small, relative to the private market response in those early post-crisis days).

Prior to 2008/09, the Reserve Bank had never had minimum liquidity requirements for banks.  It was talked about from time to time –  we used to worry, some more than others, about the macro risks associated with very high levels of short-term foreign debt –  but in a small organisation it had never been a top priority, and there was Basle II to implement.

The Reserve Bank, The Treasury, and the banks got a fright in late 2008.  It generally wasn’t totally impossible for our banks to borrow abroad but for a time it was very difficult to borrow (including on terms that didn’t send an atrocious signal) for much longer than overnight.  Even with their prior fondness for fairly short-term debt, that was troubling for banks.  (None of this, of course, was about the health of our banks or their parents; it was all about global markets seizing up.)

There were immediate policy responses to get through that episode –  Reserve Bank liquidity provision, Crown guarantees for new wholesale borrowing – but also a fairly quick Reserve Bank policy response to try to reduce or substantiallly eliminate the risk of finding ourselves in that situation again.   For a bank with a sound asset base, it is almost a given that a central bank will eventually lend if necessary, but the idea was to put buffers in place that meant we weren’t the port of first resort if things got tough, and (since banks’ board never like relying on central bank funding) to reduce the extent of pro-cyclical shocks to credit availability.

There are a number of strands to Reserve Bank liquidity policy but the bit I want to focus on is the one-year Core Funding Ratio (CFR) requirement: now that “core funding” must equal at least 75 per cent of each bank’s total loans and advances.  In practice, as banks do with capital buffers, they typically hold a considerable margin above the regulatory minimum.     Here are systemwide numbers since 2013, when the minimum ratio was raised to 75 per cent.

CFR data

And what counts as “core funding”?

Well, here is the summary from the policy document

CFR defn

Simplifying a bit, core (Tier 1) capital counts, as does all funding with a residual maturity in excess of one year, half of any long-term securities in the period between six months and one year to maturity, and (per the table) “short-term non-market funding”.

There is quite a lot of other detail defining “market funding”, but suffice to say that long-term wholesale (market) funding is attractive for these purposes (sell a 7 year bond, and the bank can count it as core funding fully for six year, and half for six months), but so is money from the little person –  you and me.  Anything we hold, so long as it less in total than $5 million per bank, counts at 90 per cent as term funding, even if the relevant account is fully liquid and the deposit are withdrawable on demand without question.  It isn’t just individuals; corporate cash holdings are treated the same (not on an instrument by instrument basis but based on the total holdings of that firms and all its related parties).  And other financial institutions – even small and passive ones (like the Reserve Bank superannuation one) – are explicitly excluded.

It is just great if you are an individual depositor.  But it is really rather anomalous, and not based on any terribly-robust analysis.

Now the missing bit in all this is the cost of that long-term wholesale funding, which is more or less as valuable as a retail term deposit for CFR purposes.  It is hard for outsiders to get a reliable fix over time on those costs, but from time to time the Reserve Bank includes a chart like this in the MPS, as it did last week.

fundingcosts

Quite how they put it together isn’t that clear (and the underlying data aren’t disclosed), but the line to focus on is really the grey one –  the estimated all-in cost of long-term foreign funding (issuing the debt in foreign currency and hedging it back into NZD for the term of the loan).  The margin between the grey line and the OCR is both large and variable.  Much of that typically has to do with the hedging costs –  again not something easy for outsiders to track routinely, but which have typically been more adverse, and more variable, over the last decade or so than was typically the case in the years prior to 2007.     If the hedging costs were consistently low, the grey line would be a lot closer to the OCR and the cost of domestic wholesale short-term funding, which in turn would mean banks would price term deposits much closer to the OCR/bank bill or to those domestic interest rate swaps.

Perhaps the other relevant consideration here is that the New Zealand economy as a whole is still quite heavily dependent on foreign capital, and in particular on foreign debt intermediated through the banking system.    If our net international investment position was different, there would be a larger stock of domestic retail/corporate deposits, and the relevance of the offshore funding costs (including hedging) might be a lot less.

But as it is, the banks are compelled to have –  in total – a lot of funding from retail and long-term wholesale sources.  A rational bank will price term deposits so that the cost of that form of core funding is typically and roughly equivalent to the cost of equivalently-useful long-term wholesale funding (the latter mostly from abroad).

When the CFR was put in place there was a recognition that core funding would be a bit more expensive that other funding, and that was a price judged worth paying. By the time of the increase in the minimum ratio to 75 per cent, this huge margin between the cost of “core funding” and the cost of other liabilities seems –  from the relevant RIS –  to have come to be accepted as some sort of new-normal, perhaps even desirable.  At the time, the Bank even toyed with the idea of the CFR as a so-called macroprudential tool (it appears in the MOU on such things agreed in 2013), and there was a view afoot that a higher CFR might enable us to tighten overall conditions without pushing up the exchange rate.

But, frankly, it all looks a bit daft at present.    The policy is premised on the notion not only that Michael Reddell as personal depositor is less likely to run on his bank than Michael Reddell the super fund trustee and that – even if granted that that was true –  that stickiness (possibly not even rational, since I might just be slacker about my finances than about my fiduciary responsibilities) was so valuable from a financial stability perspective to be worth driving such a massive wedge between the rates available on two products with absolutely the same credit risk.    More generally, if you were around in 2007/08 you may recall (a) the retail runs on domestic finance companies,  and (b) Northern Rock and the queues down the streets in the UK.     There probably is some value in encouraging banks to have a reasonable volume of longer-term funding, that can’t be encashed on demand by the holder, but there is little obvious basis for distinguishing deposits of the same maturity held by individuals, by companies, by other small financial institutions and so on.    A cost-benefit analysis simply could not support the sorts of –  inefficient –  wedges we have come to see.   I emphasis the “inefficient” because (a) the Governor likes now to refer to efficiency, and (b) more importantly, because the provisions of the Reserve Bank Act governing the exercise of prudential powers still do, as an important constraint on what the Bank does.

From a macroeconomic perspective, none of this much mattered when the Bank was freely able and willing to adjust the OCR as required, to more or less keep inflation towards target.  If term deposit rates were going to be a little high, the OCR would be lowered, and although there would still be much the same wedge between retail and wholesale rates, the level of retail lending and borrowing rates could be more or less managed to what the Bank regarded as consistent with the inflation target.

These days, however, the Bank seems to regard itself as bound to an exceptionally rash commitment it made in a hurry on 16 March, not to reduce the OCR further.  And the Governor and Deputy Governor are reduced to asking really really nicely (or not so) for the banks to lower lending rates, even as they say they can ‘rationalise’ –  in terms of those funding costs –  why they don’t.  To me the answer is straightforward: if as a central bank you think retail rates need to be lower, consistent with your inflation target, then cut the OCR until retail rates get there.  Simple as that.

But if the Governor really does regard himself as honour-bound –  like some teenager’s promise to a dying parent that he’d never ever partake of the demon drink – there are still options, and ones that might make a real difference where it matters to depositors/borrowers.   Specifically, the CFR.

For example, the Governor –  and this is his decision, not the MPC’s –  could lower the minimum CFR to, say, 65 per cent (and commit to keep it no higher than that for, say, the next five years).  Do that and the pressure would come off term deposit rates very quickly and the relevance of those marginal foreign term funding costs would abate.  He could do more complicated things as well – options we looked at a decade ago –  of imposing a minimum requirement only on the share of foreign funding that is long-term (recognising that we don’t have largely repo-funded investment banks as they had in the US). I wouldn’t recommend the more complex changes in the short-term –  action is what is called for, and not things that take lots of careful drafting and consultation.

You might  –  perhaps especially if you were a bank supervisor –  think it strange to propose such a relaxation in the middle of a very troubled period.     But bear in mind several points:

  • we aren’t in the exuberant phase of the cycle (unlike, say, 2005 to 2007), where banks are just pursuing whatever is cheapest regardless of rollover risk,
  • we’ve already got to the point where the Bank is happy to provide almost limitless funding to the banks.  They are running term loan liquidity auctions, and for now getting no takers.  And although the wholesale deposits that arise through the bond purchase are technically pretty short-term, I heard the Governor on the radio yesterday stating that he thought the Bank would be holding the bonds to maturity (in which case the funding will also be there for years).  None of this funding counts as ‘core funding” for CFR purposes,
  • there was no robust cost-benefit analysis of just what was being gained from the CFR, let alone the specific parameter settings (nothing even to match what was done for capital last year). In other words, the current 75 per cent is no less or more ad hoc than a 65 per cent ratio for a few years would be.
  • the Bank has already wound back its capital requirements (delayed the start of the increase in required capital), so there would be no particular inconsistency in doing the same for liquidity, given the anomalous pricing the Bank’s rules are producing.

The Reserve Bank was a fairly early adopter of a core funding requirement after the last recession.  Many other countries now have something called a net stable funding requirement as part of their bank supervision arrangements.   The rules are a bit different, and no doubt each country has its own specific calibrations (and I’m not that familiar with the details of any of them).  This post is not an argument for getting rid of a funding requirement rule –  although in the end it is the quality of bank assets that matters mostly –  but for recognising how large a wedge our specific rules have driven, and the way that now (with the self-imposed OCR floor) contributes to holding our retail lending rates up.

I’ve noted in a couple of posts, including yesterday’s, that even though the New Zealand and Australian policy rates are essentially the same, retail term deposit rates in Australia are much lower than those –  offered by the same banking groups –  in New Zealand (and by much more than any slight differences in credit quality might explain).  As I noted earlier, it isn’t just regulatory provisions that explain the wedge between core and non-core funding of the same term and credit, but it seems likely that the specification of the NZ rules explains the bulk of the difference between New Zealand and Australian term deposit rates.

If the Governor is determined to stick to his crazy OCR promise for now, action on the CFR offers the fastest surest mechanism to materially lower domestic retail interest rates.  The Governor says that is a priority for him.  This decision is entirely his.

It is fair here to point out that the Governor’s prudential regulatory powers have to be used for prudential regulatory purposes –  soundness and efficiency of the financial system –  and can’t just be used as a monetary policy tool (any more than LVRs could).    But on this occasion that should not act as a constraint: after all, that large wedge between returns on instruments of the same maturity and credit, dependent solely on who holds the instrument, doesn’t look good on any sort of efficiency test, and I’m sure I’ve heard in recent weeks the Governor suggest –  quite credibly –  that lower retail lending rates were likely to be, at the margin, a positive contribution to financial stability.   When efficiency and soundness ends are both served it really should be an easy call.  There is a Bank Financial Stability Report due next week, which would be a good opportunity to announce such a change –  or for MPs and journalists to grill the Governor on why he would continue to oversee a policy that drives such a wedge into the interest rate structure.

UPDATE:   Shows how many initiatives there have been that one can lose track of.  A reader draws my attention to the fact that the Reserve Bank had already cut the CFR in late March.   I must have read that at the time and then forgotten it.  Will have to reflect further then on why term deposit rates are still so high relative to wholesale rates.  One possibility might be uncertainty about how long the relief will last.

 

Monetary policy again

One way of looking at developments in New Zealand’s monetary policy is to compare what has been done, and how that has affected market prices, in the country that is in many respects most similar to New Zealand, Australia.

There are no perfect comparators –  and in many ways everyone is flying a bit blind at present – but the two economies do have many of the same banks, similar institutions (variable or short-term fixed mortgages) and a fairly similar experience of the virus.   Sceptic that I am of the Reserve Bank of New Zealand, I am not starting from a view that the Reserve Bank of Australia’s monetary management is some sort of standard to which we should aspire.  Coming into this crisis, for example, both central banks have presided over core inflation undershooting the midpoint of their respective inflation targets, the RBA by more than the RBNZ.      And for reasons that are not very clear (at least to me), the Reserve Bank of Australia is more resolved not to adopt a negative policy rate than our own central bank.

What was the starting point at the end of last year (a time when no one in either country had the coronavirus in focus)?  Recall that Australia’s inflation target (centred on 2.5 per cent) is a bit higher than ours (centred on 2 per cent).  Here are the interest rates I could find, all from the respective central bank websites, except the Australian interest rate swaps yields.

31 dec 2019 int rates

Every single one of the New Zealand rates was higher than the comparable Australian rates –  the smallest gap of all being in the two policy rates, and by far the largest being in term deposit rates.   Note that at the end of last year, markets were looking to the prospect of a cut in the RBA cash rate later this year, while in New Zealand attention was beginning to turn to the possibility of an OCR increase at some point.

So what has happened since then?

  • the RBA cuts its cash rate by 50 basis points to 0.25 per cent, while the RBA cuts its OCR by 75 basis points to 0.25 per cent,
  • both central banks have massively increased the volume of settlement cash in the respective systems.  At the RBNZ, all those balances (currently around $28bn) are remunerated at 0.25 per cent, while at the RBA balances are remunerated at 0.10 per cent (both central banks changed their rules for remunerating large balances),
  • the RBNZ announced its large-scale asset purchase programme, concentrated on government bonds, currently with a limit of $60 billion,
  • the RBA announced a target rate of 0.25 per cent for the yield on three year government bonds, indicating that they would operate in the market (primarily that for government securities) to maintain market rates at or near that target.

And here is how much those rates have changed to now (latest available data)

int rate changes

Tracking down old mortgage rates for Australia is beyond me, but note that both variable and fixed mortgage rates in New Zealand are well above those in Australia.    But so are term deposit rates: averaging across the big four banks, in Australia for AUD six month term deposits the banks are paying about 0.8 per cent, and in New Zealand for NZD six month term deposits the banks are paying about 2.2 per cent.

As you can see from the table, wholesale rates (bills, bonds, swaps) have fallen by more in New Zealand than in Australia.  That is not inconsistent with the fact that the Reserve Bank of New Zealand cut its effective policy rate by more than the RBA cut its effective rate.  Here are the current wholesale rates (Australia in the second column)

wholesale 3

It is notable that longer-term rates are now lower in New Zealand than in Australia –  quite a contrast to the situation at the end of last year.

Consistent with all that, incidentially, the NZD/AUD exchange rate fell by about 4 per cent over this period.

What might explain these developments?

On the one hand, quite possibly people trading the markets in the two countries may reckon the New Zealand recession will be more severe and/or longer-lasting than Australia’s.    It is certainly true that forecasts of the decline in June quarter GDP are much steeper for New Zealand than for Australia, although beyond that –  looking ahead a year or two –  it isn’t obvious at this stage why things might be so very different at the sort of horizon more relevant to longer-term rates.  So for now I’ll just note that possibility and pass on.

What about central bank words and choices?

The Reserve Bank of Australia has apparently been pretty clear that it will not lower than cash rate from here.   The market seems to more or less believe them (the OIS rates on the RBA website are consistent with the current effective cash rate).  By contrast, the Reserve Bank of New Zealand has opened the door to the possibility of a negative OCR next year. I don’t have access to New Zealand OIS data, but I did notice this chart in a Westpac market report, dated yesterday, that someone sent me.

NZ OIS

Markets here are pricing a negative OCR throughout next year.  In other words, our longer-term interest rates price in even more conventional monetary policy easing.  Consistent with that, a reasonable chunk of the fall in the exchange rate has occurred since the Reserve Bank’s MPS last week.

All of which then leaves the question of quite what difference the Reserve Bank’s vaunted long-term asset purchase (LSAP) programme is making.  The Reserve Bank repeatedly tries to suggest the answer is “a lot”.  But there is reason to be more than a little sceptical that it is making much difference where it matters.

As I noted above, both central banks launched novel asset purchase programmes.  The RBA’s approach involved purchasing whatever it took to keep the three year government bond rate around 0.25 per cent.   In the early days –  amid the global bond market liquidation –  achieving that goal took a lot of purchases.  But here are the RBA’s total bond purchases

A$mn
Total 51348
March 27000
1st half Apr 17500
2nd half Apr 5748
May 1100

You’ll recall that the Australian economy is quite a lot bigger than New Zealand’s.  A$51 billion in bond purchases there might be akin to perhaps NZ$7-8 billion purchases here.

But note what has happened: after heavy purchases in late March and early April, the RBA’s bond purchases have almost completely dried up.  Despite the heavy expected federal government bond issuance, expectations about short-term rates are now sufficiently subdued that the three year government bond rate is holding at the target rate with no material bond purchases at all.  And the purchases the RBA has been doing have been heavily concentrated in relatively short-dated government bonds, consistent with reinforcing monetary policy signalling and with the fact that, as in New Zealand, most private sector borrowing tends to be on variable or short-term fixed terms.

What about the Reserve Bank of New Zealand?    Here is the same table for them (government bonds only –  there is a small amount of LGFA purchases also).

NZ$m
Total 11,228
March (from 26th) 950
1st half April 3,833
2nd half April 2,845
May 3,600

Relative to the size of the economy, total purchases here have been somewhat larger, but the real difference is that the Bank is buying just as heavily as ever.  And as I noted in my post on Monday more than two-thirds of all their purchases have been for maturity dates from 2027 and beyond –  and virtually no one I’m aware of, other than the government itself, takes funding exposed to rates that long.

In other words, it seems plausible that the LSAP programme might be knocking 20-30 basis points off long-term government bond yields and swaps rates, while making almost no difference at the short-end (where the RBA would seem now to provide a reasonable benchmark).  And yet it is the short-end that influences borrowing costs for most households and corporates.  At the long end……well, there is the government.    It all looks quite a lot like a programme designed to do two things:

  • by waving around very big numbers to suggest that monetary policy is doing a lot when it actually isn’t really doing that much at all, and
  • to lower the marginal borrowing costs of the Crown, at a time when the Crown has a very big borrowing programme.  At very least, that is a questionable use of monetary policy – not at all consistent with the MPC’s Remit (since fiscal policy will be what it will be whether or not bond yields are 20 points higher or lower) –  and all while exposing the Crown to a really high degree of unnecessary degree of interest rate risk (if the authorities really believe interest rates are extraordinarily low they should be markedly lengthening the duration of the Crown’s debt to the private sector, not skewing it dramatically shorter by buying in government bonds and issuing variable rate settlement cash in exchange).

And, on the other hand, if the Bank were really serious about getting retail interest rates down –  rather than anguishing in public and suggesting that commercial banks aren’t doing their job –  it would just get on and cut the OCR quite a lot further.  As it is, go back briefly to the changes table (the second one from top): nominal rates have fallen to a moderate extent this year, but survey and market measures of inflation expectations suggest that expectations of future inflation have fallen by probably 0.7 percentage points.  Real rates generally haven’t fallen much at all, while retail deposit rates –  held up by the combination of the Bank’s core funding requirement regulation (their choice) and the continuing relatively high cost of offshore terms finance (illustrated in the MPS last week) –  have actually risen in real terms.

Quite a claim to fame that: to be the central bank, in a country with a highly safe banking system (as the Governor now repeatedly avers), that presided over a rise in real deposit rates in the face of the biggest economic slump in decades.  Extraordinary.

Meanwhile, in the last 24 hours we’ve had the Deputy Governor offering interviews to both Stuff and the Herald reaffirming the MPC’s commitment to stick to its bizarre promise on 16 March not to cut the OCR further before next March, come what may.   Apart from anything else, it has the objective effect of tightening monetary conditions relative to where they were –  in effect, urging markets to price out those early negative OIS prices and, all else equal, push up the exchange rate.

There is, of course, something to be said for sticking to one’s word.  But rash promises generally should not be followed through on.  I suppose we should be thankful that the MPC in February –  recall, they were upbeat about the rest of the year then –  had not offered “forward guidance” committing not to cut the OCR this year, come what may.  Perhaps they’d have felt obliged to stick to that rash pledge as well?  As it is, this was a pledge made on 16 March, at a time when the Governor was reluctant to even concede that a recession was happening, at a time when the Secretary to the Treasury (observer on the MPC) was telling the PM that things might be not much worse than the 2008/09 recession.   Perhaps (or not) those were pardonable calls at the time, but they were clearly mistakes, and not small ones.   Sticking to a rash pledge made in some highly uncertain and fast-moving circumstances is almost akin to the suicidal person talked down from the edge, but still averring that “I promised I’d jump, I even left a note, I need to stick to my word”.  Among the sick, such misperceptions might be pardonable.  From highly-paid public figures charged with conducting a nation’s monetary policy, it is simply stubborn, verging on the crazy –  the more so if the MPC thinks that sticking to that pledge in any way enhances the sort of credility that matters.  After all, it was the MPC last week that published projections showing inflation below the bottom of the target range for two years, and unemployment unacceptably high.  Those were supposed to be the considerations people judged the Bank on.

Finally, I see that Stuff’s Thomas Coughlan in his column this morning has picked up my call that if the MPC won’t move –  won’t do the job that is really needed, to provide a lot more stimulus, to get us on the path back to full employment and price stability –  that the Minister of Finance should use the override powers Parliament has long provided him with.  They aren’t powers that should be exercised lightly, but these are exceptional times, and the Bank seems to be content to do little of substance, while pretending otherwise.  Of course, the Act was initially written primarily to protect us from inflation-happy politicians, but also has to protect us from central bankers just not doing their job –  in this case, on either the employment or inflation dimensions.  If he fails to act –  as surely, risk averse as he is, the Minister of Finance will fully share responsibility for the unncessarily slow recovery that he and his MPC seem set to risk.   To what end?

Debt jubilees revisited

The last of my three kids went back to school this morning and so life returns to (more or less) weekday normal.  It was something of an unexpected bonus to have them around for eight weeks –  for at least two of them it was probably slightly net positive educationally – but it is also nice to have the house to myself again during the day.  So to mark the moment, it might be a day for a post with not very much to do with the coronavirus economic issues.

A few weeks ago I did a post on the notion of a “debt jubilee”.  It was sparked by a column from the Australian economist Steve Keen calling for widespread government-funded debt forgiveness as part of the response to the coronavirus slump, and in preparation for my RNZ discussion with Keen (although that debate never got onto that specific).   What he was proposing seemed likely to dissolve into hyperinflation (and although I don’t suppose he believes that, I’ve not seen any clear articulation as to why/how).    I ended that post this way

When I think of debt writeoffs, I think of explicitly recognising that someone has to bear those costs –  on any very substantial scale there are few/no free lunches.  Banks will have to write off some debt –  perhaps quite a lot –  over the next few years, and their shareholders will bear that cost.  That is the business they went into.  Writing off mortgage debt more generally on the sort of scale Keen seems to envisage can only be done by imposing fearsome losses on others.  It is so utterly different from that Old Testament conception (which, in effect, limited the scale of liabilities anyone could run up in the first place).

I have some sympathy with the view that requiring young –  and now not so young –  people to take on multiple hundreds of thousands of dollars of debt to get into a basic house in our cities is pretty unconscionable and deeply unjust. But, frankly, that isn’t fault of the banks but of the central and governments that make land –  a resource we have in abundance – artificially scarce.  In fact, I’ve even gone so far as to argue that if ever we managed a government with the courage to fix the land market, it might be both opportune (building coalitions) and just to offer some compensation to the losers –  those more or less compelled to take on very high debt in recent years just to get a foot on the ladder.   But there would be an explicit, shared, cost to that.

And more generally I’m not persuaded that current debt levels –  public, private or total –  in New Zealand pose any vast threat of economic or financial collapse.  Keen likes to highlight how much debt has risen since, say, 1990, but it isn’t obvious why that is the most relevant benchmark.  In a speech I wrote with Alan Bollard a few years ago, I included a chart showing that mortgage debt (house and farm) was materially lower then  as a per cent of GDP than it had been in 1920s New Zealand,  I rechecked the numbers this morning and the picture today is the same as it was in 2011.  Contrary to Keen, our banking system looks pretty robust, not ricketty.

I also take the view that there is plenty that can and should be done to assist individuals and firms through the next few months.  There is a strong case for income support (broadly defined) or even income insurance (of the sort I’ve championed here) but that is very different proposition than somehow looking to wipe out debt without identifying whose claims to real resources will be wiped out to pay the economic cost of that (as distinct from the “which account to write the cheque on” issue that Keen deals with).

Anyway, a commenter on that post mentioned a recent book on the jubilee issue and in so doing reminded me that I had bought Michael Hudson’s ...and forgive them their debts  a while ago, so I dug it out and read it.   The subtitle is “Lending, Foreclosure and Redemption From Bronze Age Finance to the Jubilee Year”.   Hudson is/was an economist and economic historian who has devoted much of his effort in the last couple of decades to making the case for different approaches to money and banking.  His book has blurbs from a fairly predictable range of left-wing writers in the area (Graeber, Pettifor, and Keen himself) but was also selected as one of the economics books of the year by the Financial Times, and the book has drawn praise from the FT’s chief economics columnist Martin Wolf

The American economist Michael Hudson has written a fascinating book,  . . . and forgive them their debts: Lending, Foreclosure and Redemption From Bronze Age Finance to the Jubilee Year on the historical antecedents of the Mosaic debt jubilee. The work of Assyriologists has shown that by the third millennium BC, the rulers of the ancient Near East understood the necessity of repeated debt forgiveness. The alternative was, he writes, “economic polarisation, bondage and collapse”. The relevance of this history to the world of today seems clear: debt is necessary; too much debt is disastrous.

Set aside the final sentence for now and I’d largely agree.    It is a fascinating book, although I would recommend it only guardedly: read it and you will learn a great great deal more detail about ancient Mesopotamia –  and not a little about debt, property etc, in late first millennium Byzantium –  than you probably ever wanted to know.   My tastes are fairly geeky, and I have quite a large collection of books on all sorts of dimensions of Byzantium, but to be strictly honest I could probably have done with a 70 page version rather than the 300 page one.

The core of the book is about the debt forgiveness practiced by kings in ancient Mesopotamia, where (typically) the debts owed by the peasantry were, it appears fairly conclusively, remitted each time a new king came to the throne.   This wasn’t typically commercial debt –  which was not covered by the debt remission –  but that of peasants in an economy with little or no productivity growth and very high effective interest rates.   The borrowers hadn’t borrowed to increase the commercial potential of their land, but had fallen into debt often as result of crop failures.  Often the debt was tax debt itself –  in other words owed directly to the central state.    And why did kings decide to remit debts –  not just once, but numerous times over the centuries?    The essence of it seems to have been to maintain a free landholding peasantry, available for military service (the alternative for many being flight).   What, after all, was the alternative in what was, for most, a near-subsistence economy?  It was path that would have led to landlessness and enslavement.   It wasn’t just money debts that were remitted. Hudson records that by Babylonian times, the jubilee release also encompassed the return of those who’d become indentured servants in response to debt, and the restoration of cropping rights that debtors had pledged to creditors.

Here a couple of short excerpts from Hudson

“The common policy denominator spanning Bronze Age Mesopotamia and the Byzantine Empire in the 9th and 10th centuries was the conflict between rulers acting to restore land to smallholders so as to maintain royal tax revenue and a land-tenured military force, and powerful families seeking to deny its usufruct to the palace. Rulers sought to check the power of wealthy creditors, military leaders or local administrators from concentrating land in their own hands and taking the crop surplus for themselves at the expense of the tax collector.

‘By clearing the slate of personal agrarian debts that had built up during the crop year, these royal proclamations preserved a land-tenured citizenry free from bondage.

‘Babylonian scribes were taught the basiv mathematical  principle of compound interest, whereby the volume of debt increases exponentially, much faster than the rural economy’s ability to pay.  That is the basic dynamic of debt: to accrue and intrude increasingly into the economy, absorbing surplus and transferring land and even the personal liberty of debtors to creditors.   Debt jubilees were designed to make such losses of liberty only temporary.

As I noted in the earlier post, very similar ideas and prescriptions are found in the Old Testament.

In the Western tradition, the idea of the year of jubilee comes to us from the Old Testament.    The idea was to avoid permanent alienation of people from their ancestral land –  in effect, land transfers were term-limited leases, and if by recklessness or bad luck or whatever people lost their land it was for no more than fifty years. In the fiftieth year –  the Year of Jubilee –  all would be restored: land to the original owners and hired workers could return to their land.   It wasn’t a recipe for absolute equality –  the income earned wasn’t returned etc –  but about secure long-term economic and social foundations.

Hudson’s book is partly about filling out the antecedents for the Old Testament model, but also for addressing directly the idea that idealistic as the Levitical provisions may have been there wasn’t much evidence they had ever been applied in practice in ancient Israel.  As Hudson demonstrates, they clearly were applied in practice –  in the essence –  elsewhere in the ancient world.

Hudson’s argument –  and I hope I am not unfairly caricaturing him here –  is that what was good for the ancient world is directly applicable today: that escalating debt poses much the same sort of threat now that it did in Mesopotamia, and that in one form or another debt-write-offs are inevitable.  In fact, here is a line from his introduction

“In all epochs a basic maxim applies: Debts that can’t be paid, won’t be paid. What is at issue is just  how they won’t be paid. If they are not written down, they will become a lever for creditors to pry away property and income from debtors – in practice from the economy and community at large.”

And this is where I really part company from Hudson.

Again as I noted in the earlier post, as a Christian the vision of the year of jubilee has a certain appeal. But what is less clear how it might be relevant today –  a point I recall debating with a discussant on the first paper I ever wrote on Christianity and economic issues.  In passing, I’d note how curious it seems just at present to be worrying about the effects of compound interest as even nominal interest rates head rapidly towards zero, even for quite long-terms.

More generally, as I noted

For many –  for me –  it has an appeal, although one could argue that in many respects modern society already reflects some of the vision underlying the original near-eastern ideas: after all, we prohibit slavery, we allow personal bankruptcy (and discharge from bankruptcy without paying all the original debts), we provide education free at the point of use, and a welfare system for those who might otherwise fall through the cracks.

To which one could add, “and we generally have an economic environment in which people live at above subsistence, in an economy that (generally) has positive productivity growth and positive real income growth.  Economists, for example, debate the long-term relationship between the real rate of interest and the real rate of productivity growth, but if there are gaps between the two they are nothing as compared to those between, say, the 30 or 40 per cent interest rate of the Bronze Age and barely any productivity or real income growth at all.

If we value a participatory democracy in which all are able to feel that they have a part in the economic fortunes of the community more generally (and, to be clear, I do) it isn’t obvious that debt or debt remission is a key element.  And, of course –  and quite contrary to the Mesopotomian situation –  most debt is now not owed to the Crown (hardly any in fact) and it is much more common for the Crown to owe us, even the relatively less well-off among us, through such mechanisms as Kiwisaver accounts.

Keen, for example, emphasises the high level of housing debt in countries like New Zealand and Australia.  But it is mostly a symptom not of hard-hearted banks but of governments (central and local) that keep on rendering urban land artificially scarce, and then –  in effect –  compelling the young to borrow heavily from, in effect, the old to get on the ladder of home ownership.   I count that deeply unconscionable and unjust.  But the primary solution isn’t debt forgiveness –   never clear who is going to pay for this –  but fixing the problem at source, freeing up land use law.  The domestic-oriented elites of our society might not like it –  any more than their peers in ancient Mesopotomia were too keen on the remission –  but that is the source of the problem.  Fix that and then there might be a case for some sort of compensation scheme for those who had got so highly-indebted, but at present –  distorted market and all –  the highly indebted mostly have an asset still worth materially more (a very different situation from a near-subsistence peasant borrowing in the face of extreme crop failure).

Is personal debt –  not secured by mortgage –  a different issue?  Quite possibly, but it is also not the large scale problem that Hudson, Keen etc highlight.  At an individual level I think the case for interest-free lending to people in real need, and perhaps forgiveness of the debt later, is quite strong. But in a society like ours, it seems like a peripheral issue. One might debate the appropriate generosity of the welfare systems, but ours is designed so that people don’t get heavily into debt just to feed their families.  And we rightly do not allow debt bondage, let alone slavery.

So, fascinating as the book was, I came away thinking it of largely antiquarian interest, with some value to Jews and Christians in shedding light on the Old Testament texts.  Obviously other read it and view it differently.   I suspect the call last week from Bernie Sanders and a large number of mostly fairly far-left politicians (including our own Golriz Ghahraman) for the remission of the debt owed by developing countries to the World Bank and IMF can be read in that light.

Having got to the end of the post, I realised I hadn’t mentioned moral hazard –  the way borrowers would respond if they thought there was a credible prospect of a write-off –  and, in turn, how lenders would respond to that.   It probably wasn’t that much of an issue back in Bronze Age Mesopotomia where, as Hudson notes, debts mostly arose from things like crop failure. It is, or would be, these days where credit can be, and is, used to support all sort of lifestyle options – and borrowers might be even more keen to finance a new car or overseas holiday as well if they thought they realistically might never have to pay back the cost, with few or no adverse consequences from failing to do so.

 

LSAP scepticism

The Governor of the Reserve Bank is always keen to tell us what an important contribution the Reserve Bank is making through its large-scale asset purchase programme (LSAP).  Recall that the Bank cut the OCR by 75 basis points and then gave up on using conventional monetary policy –  promising (in one of the weirdest pledges in the history of modern monetary policy) to do no more for 12 months, come what may – in favour of buying lots of (mostly) government bonds.  At present, the MPC has authorised the Bank to buy up to $60 billion of bonds, and there is speculation from some banks that that total may even be raised further at the next  Monetary Policy Statement in August.   The Bank claims –  as it did in the MPS last week and at its appearance at FEC the next day –  to be making a big difference, but it is mostly a smoke and mirrors show.  There are big numbers involved, but the differences being made to things that might matter economically are really rather small.

Sadly, it seems to suit our very conservative and risk-averse Minister of Finance to believe –  or acts as if he believes –  the Bank’s story, even if by doing so he aids and abets an insuffficient macro policy response to the savage recession that is upon us.  The macro consequences of his indifference probably won’t show up before the election, but even beyond that horizon in his entire term in office he has been remarkably deferential towards the Bank. It is if he is scared of doing what the economy needs.

It is fair to say that there has been an active debate over quite what these asset purchase programmes have achieved ever since they were launched.   While I was still at the Reserve Bank I recall a couple of visits from Dan Thornton, then a senior researcher from the St Louis Fed, who presented versions of papers arguing that the Fed’s various asset purchase programmes really hadn’t made much sustained difference to anything.    I was never fully convinced but if you’d asked me a year ago I’d have said that my summary impression was that earliest Fed programme –  in the midst of the financial crisis –  probably added some value, but that the later ones didn’t achieve much at all, perhaps beyond some announcement signalling.  (The issues in Europe were a bit different, since breakup risk was in play).  Long-term interest rates in the US, for example, hadn’t seemed to have fallen more, relative to the change in the policy rate, than we’d seen in New Zealand or Australia (which, to then, had not resorted to asset purchase programmes).

In truth that didn’t seem very different to the approach being taken by the Reserve Bank’s chief economist only two months ago.  This was reported in the Herald on 13 March

yuong ha

That sounded –  sounds in fact –  about right to me.   It isn’t, of course, the line that either Ha or his boss are running now.  Instead, we get repeated suggestions – never quite pinned down with hard estimates or illustrations –  that what the Bank is doing with the LSAP is some sort of fully adequate substitute for the sort of scale of OCR adjustment we’ve had in past serious recession (recessions which, it might be added, it has often taken years for the unenemployment rate to drop back acceptably).

Strangely, the Governor has found some supporters among the local bank economists.  I presume they really believe what they are saying, but I still don’t find it very persuasive at all.

Much has been made of the claimed impact of the bond purchase programme on wholesale interest rates.  But even there, the story isn’t particularly persuasive.

Typically, the biggest influence on longer-term interest rates is the expected future path of short-term interest rates.  Why?   Because, in principle at least, someone holding a 10 year bond has as an alternative investing in a series of 40 day 90 day bills.  If the market thinks the short-term rates wil rise or fall materially over the life of the bond, that will influence bond yields themselves.

Sometimes, there is a serious recession, involving significant cuts in the OCR, but where the effect is expected to be quite shortlived; before long it is expected that the Reserve Bank will be raising the OCR again.   If so, bond yields might not fall much, and in particular the implied forward interest rates (eg the second five years of a 10 year bond, backed out using yields for five and ten year maturities).   That was more or less exactly how markets reacted in 2008/09.

5 yr forward rate

It took a couple of years for markets to really begin to appreciate that future policy rates were likely to be low for some considerable time.  This New Zealand experience wasn’t that unusual.  In fact, it took a while for the Reserve Bank to learn –  they’d actually started tightening in mid 2010.

But what about this recession?  I’ve not seen a single serious commentator here or abroad –  I’ll set aside the columnists who reckon we are now on an inexorable path towards Venezuela –  who think there is any material chance of policy rates being raised any time in the foreseeable future (several years at least).  By contrast, just a few months ago people were beginning about the possibility of OCR increases perhaps later this year or next year.

And yet even with all that Reserve Bank bond buying –  actual and promised –  the implied five year forward government bond rate hasn’t really fallen that much at all.  It is down 80-90 since the middle of last year and 60 points since January.  It just isn’t very much –  look at the size of some of the past movements even just in the period of this chart –  and all this against a backdrop of a 70-80 basis point fall in medium-term inflation expectations (whether one uses survey measures or market prices).  Unfortunately, long-term historical swaps data isn’t readily available, but for the more recent period the picture is much the same: implied forward rates haven’t fallen very much relative to history, relative to the scale of the economic shock, or relative to the fall in inflation expectations.  And yet it was this fall in swaps rates on which the Bank seems to pin its claims.

Ah, but what about the counterfactual?  What would have happened if the Reserve Bank had not launched and then expanded the Large Scale Asset Purchase programme?    The only fully honest answer of course is that we do not know.

The Bank likes to run the charts showing how bond yields surged upwards in late March, and then fell after it intervened with the LSAP.

10 yr yield may 2020

The global rush to cash and liquidation panic was well-recognised.  Quite probably, central bank interventions helped to stabilise things.  But that is a different proposition from a claim –  which is the one the Bank and its supporters are making –  that the current level of yields, six weeks on, is being very materially influenced by central bank purchases.  One could mount a counterargument that where yields are now isn’t much different than where they might have been anyway given (a) the OCR being stuck at 0.25 per cent for now, and (b) the economic situation having got a whole lot worse than it was, say, on 16 March, and (c) medium-term inflation expectations having fallen quite a bit further.

One might say the same looking at this chart of the swaps yield curve on various dates.

swaps curves

The grey line was the peak in rates amid that flight to cash that most severely affected te bond market.  But again, compare the 16 March line (the day the Bank cut the OCR) with the latest observation last Thursday.  It has the feel of the sort of fall –  concentrated over the front five years –  you might have expected if you’d been told that in the interim the economic situation had got so much worse and inflation expectations had fallen materially.

But, again, the counter-argument will come: what about all those fiscal deficit and the big volume of debt issuance coming down the track?  To a first approximation, my response is “what of it?”.

First, recall what else is going on.  Investment demand has slumped and is likely to remain lower than it was for several years.  And private savings preferences also appear to have risen. So if we are thinking about what might be expected to happen to interest rates  – even if the Reserve Bank were buying nothing –  we have to think not just about what the government is doing but about the private sector.  Money is, after all, fungible.  Absorption, frankly, seems unlikely to have been an issue, in a very lightly-indebted sovereign –  even if the Reserve Bank had not done any LSAP.

Gross public debt as a share of GDP is now projected to rise by 30 percentage points between last year and 2023/24.  But it isn’t as if big increases in public debt have never been seen before.  In fact, the last time was only a decade or so ago, when gross public debt as a share of GDP rose by 20 percentage points between 2008 and 2012.   There was no asset purchase programme then and –  as illustrated above –  once markets became convinced that the OCR would have to stay down for a while, it wasn’t enough to stop implied forward rates falling a long way.

And how much would we expect changes in government debt to affect interest rates, absent central bank intervention?   Views will differ on that, but the Governor did write about exactly that issue in his relative youth, publishing empirical estimates drawing on work he’d previously been part of at the OECD.  Perhaps the Governor has changed his view since 2002, but then he estimated that 30 percentage points on net debt might have been worth perhaps 15 basis points on bond yields, all else equal (which it decidedly isn’t right now, with very high levels of excess capacity).

Another point worth bearing in mind is that even the Reserve Bank will, I think, concede, that very long-term interest rates just don’t make that much difference to many people in New Zealand, other than just lowering the government’s own financing costs.  The marginal activity in the residential mortgage market, for example, is typically around one and two year fixed rates.  And yet the data on the Bank’s LSAP shows that more than two-thirds of all the Bank’s government bond purchases have been for maturities of 2027 and later.   So even if those purchases are having a material impact on those very long-term rates, so what?  To what end?  As it is, we know that shorter-term fixed rates have hardly fallen at all in real terms –  what one might have expected with a small, badly lagging, OCR response, not with all the power the Bank asserts its balance sheet purchases can have.

Perhaps also the Bank is right that there has been some helpful exchange rate effect, and we do not know the counterfactual. But we do know how much the TWI has often fallen in past serious recessions, and it is much more than anything we’ve seen to date this time.  The LSAP might be a little better than nothing, but it is no substitute for the OCR the Bank is now so reluctant to use.

Are there other possible channels where there might have been an impact?    A commenter last week noted that perhaps equity markets were higher as a result?  Perhaps, although the effect must surely be small, but equity markets have always been seen as much less important a part of the transmission process here than in, notably, the US.  The Bank and its supporters have also been talking up portfolio balance effects –  in other words, the people selling bonds to the Bank have to do something with the money that is freed up.  Again, perhaps there is some small effect, but it is difficult to see where such material tangible effects might be.    For example, I’ve seen this chart a couple of times in ANZ publications

corp bonds

It is a useful chart (altho perhaps with a line missing?), with data on corporate bond yields that those of without a Bloomberg terminal can’t otherwise easily track.  The Reserve Bank doesn’t buy the corporate bonds, but purchasing government bonds may displace some holders into corporate debt.  But, again, count me fairly sceptical that the ongoing LSAP programme is explaining much about the current level of these yields, given (a) weakening OCR expectations, and (b) the weakening economic environment.  It is hard to be sure, but it is hard to believe that any effect is very large.

We don’t have real-time inflation data, but we do have near real-time proxies for inflation expectations –  and especially changes in them –  from the inflation-indexed government debt market.   When implied inflation expectations for the next five years on average have fallen by about 80 basis points (measured imprecisely, so call it anything from 70 to 90 points) in just a couple of months

IIBs mAY 20

it is not a sign of a central bank that is doing its job well, of a central bank whose instrument is doing what needs to be done, even allowing for all the fiscal support as well.   If we had a Minister of Finance who really cared about macroeconomic stabilisation he’d insist on change.

A deeply negative OCR, generating retail rates near-zero (consistent with what the governments is lending to SMEs at) is more like the sort of monetary policy stance we need, one that might make a real and sustantive difference to inflation, inflation expectations, output and (un)employment.    What we have at present is theatre –  arguably doing little harm and perhaps a modicum of good, but successfully (it appears) from the Bank’s perspective distracting from where the real gains might be had.