Disagreeing with Don Brash on monetary policy

August 25, 2017August 25, 2017 Michael Reddell labour party, Monetary policy

The Labour Party is campaigning on a couple of changes to the Reserve Bank Act. One would make a statutory committee, rather than the Governor alone, legally responsble for monetary policy decisions, and would require the minutes of that committee to be published fairly shortly after the relevant meeting. I don’t think that change goes far enough – and it doesn’t deal at all with the extensive (and much less constrained) decisionmaking powers the Bank has around financial institution regulation – but if not everyone actively favours change, there aren’t now that many defenders of the (single decisionmaker, secretive) status quo. Even Steven Joyce got The Treasury to commission some advice on possible changes, although his officials now refuse to release that report.

There is more dispute around the other limb of Labour’s proposed changes, in which they proposed to amend the statutory goal of monetary policy from “stability in the general level of prices” only “to also include a commitment to full employment”.

Earlier this week, so NBR reports, Grant Robertson and former longserving Governor Don Brash came head to head at BusinessNZ election conference. Don thinks the proposed change is wrong and was reported as pointing to two reviews undertaken during the term of the previous Labour government, both of which saw no reason to change the statutory objective for monetary policy.

My initial reaction to the proposed Labour change was also sceptical, and I initially went as far as to describe it as “virtue signalling”. I was discussant at an Victoria University event a few months ago where Robertson launched his policy, and this is how I summarised my view in a post written the following day.

I was (and am) much more sceptical, and nothing that was said in response to questions really clarified things much. I get that full employment is an historical aspiration of the labour movement, and one that the Labour Party wants to make quite a lot of this year. In many respects I applaud that. I’m often surprised by how little outrage there is that one in 20 of our labour force, ready to start work straight away, is unemployed. That is about two years per person over a 45 year working life. Two years…… How many readers of this blog envisage anything like that for themselves or their kids?

But still the question is one of what the role of monetary policy is in all this, over and above what is already implied by inflation targeting (ie when core inflation is persistently below target then even on its own current terms monetary policy hasn’t been well run, and a looser monetary policy would have brought the unemployment rate closer to the NAIRU (probably now not much above 4 per cent)).

I noted that I’m sceptical that the wording of section 8 of the RB Act is much to blame. After all, for several years prior to the recession, our unemployment rate was not just one of the lowest in the OECD, it was also below any NAIRU estimates. And when I checked this morning, I found that our unemployment rate this century has averaged lower than those of Australia, Canada, the US and the UK, and our legislation hasn’t changed in that times. Robertson often cites Australia and the US.

The last few years haven’t been so good relatively speaking. But if the legislation hasn’t changed and the (relative) outcomes have, that suggests it is the people in the institution who made a mistake – they used the wrong mental model and were slow to recognise their error and respond to it. Getting the right people, and a well-functioning organisation, is probably more important than tweaking section 8.

I stand by most of those individual comments. But as I thought about things further, I’ve come to conclude that the direction Labour is wanting to go is the right one (although details matter, and there are few/no details). If anything, one could mount an argument that defence of the current statutory formulation risks being “virtue signalling”.

Don Brash relies in part on the two enquiries undertaken in the term of the previous Labour government. The second, conducted by Parliament’s Finance and Expenditure Committee, can largely be discounted. It was set up in 2007 at time when there was quite a bit of caucus (and ministerial) discontent with the Reserve Bank – the OCR had been raised again, and the exchange rate was again strong. A lot of work went into the inquiry, and it reported in 2008, just weeks before the 2008 election. But however much grumpiness there had been, a government-dominated committee was never going to come out a few weeks before an election their party looked like losing arguing that a key aspect of macroeconomic policy had been done badly throughout their term in office.

The earlier inquiry, conducted by Swedish economist, Lars Svensson at the request of the incoming Minister of Finance in 2000/01 would normally be a more potent argument. Svensson was an academic expert in matters around inflation targeting and he was content to recommend retaining the statutory goal for monetary policy as it was.

So what has changed? Robertson is quoted in the NBR article as saying that monetary policy has “enormously changed” since the international crises of 2008/09. Here I simply disagree with him, and find myself (I think) strongly agreeing with the outgoing Governor of the Reserve Bank, who notes that for all the talk it is remarkable how little change there has been in monetary policy anywhere. Sure, interest rates are a lot lower, and various major central banks resorted to unconventional quantity-based measures to supplement their toolkit. But there is no sign of any material change in any of those countries in how the goals of monetary policy have been specified (whether in statute or in more-operational documents). As the Governor often notes, no one has abandoned inflation targeting, and no one has lowered (or raised) their inflation target.

Of course, if there was once in some circles a degree of hubris around quite how much good stuff central banks can deliver, much of that has now dissipated. And the use of unconventional tools has raised questions about accountability, given that some of those tools can verge quite close to fiscal policy, for which legislatures are typically responsible.

But perhaps two relevant things have changed. The first is Lars Svensson, who – having had several years experience as a senior policymaker – now quite openly argues that flexible inflation targeting should involve a clear and explicit specification of an inflation target and the identification of a sustainable long-run unemployment rate, with explicit weights assigned to deviations from these two variables. I wrote at some length about Svensson’s view of these things in a post in April. As I noted then

I don’t know specifically what Svensson would make of the current debate in New Zealand, or of what the Labour Party (at quite a high level of generality) is proposing. What we do know is that Labour is proposing nothing nearly as specific or formal as Svensson argues for: there would be no numerical unemployment target or an official external assessment of the NAIRU (or LSRU). My impression would be that his reaction would be along the lines of “well, of course the unemployment rate – and short to medium term deviations from the long-run level, determined by non-monetary factors – should be a key consideration for monetary policymakers; in fact it is more or less intrinsic to what flexible inflation targeting is”. He might suggest there are already elements of that in the PTA, but that making it a little more high profile, with an explicit reference to unemployment, might be helpful.

At the time, I suggested they might find it useful to get in touch with Svensson, who retains an interest in New Zealand. Should they form the government after the election next month, he would be someone that they would be wise to consult, both in making their proposed legislative change, and in articulating a social-democratic vision of what should be looked for from a central bank.

The other thing that has changed over the last 15 years or so is our own central bank. It is striking how little public attention they ever pay to unemployment, even though it is the most tangible measure of excess capacity – and one directly involving people’s lives and livelihoods. But perhaps more striking still is the way in which they have conducted monetary policy in a way that has left the unemployment rate above any reasonable estimates of the NAIRU for eight years. That would have seemed staggering to us when we were looking at getting inflation under control in the late 1980s – when we knew that temporarily higher unemployment was a price of getting inflation down. It is pretty inexcusable in today’s climate – which doesn’t stop people making excuses.

And so I come back to the point I made in the remarks quoted above. Getting the right person – and people – into the senior positions responsible for the conduct of monetary policy probably matters more than changing the statutory objective. At the moment, an incoming Minister of Finance has no way of putting his or her preferred types of people in those roles – all that power rests with the Board (the company directors and the like appointed by the outgoing government, with almost no accountability). That needs to be tackled directly, and quickly.

But the way the statutory goal is expressed should affect expectations on the new Governor (and any committee that is established as part of governance reforms). Over recent years, fear of booms seems to have driven the Governor (and his staff) – with no statutory mandate at all – and there has been no pressure on them to focus on delivering low and sustainable rates of unemployment. Changing the Act – in the generalised way Labour seems to be talking of – and not changing the sort of people making the decisions won’t have much impact at all. But changing the Act in this area, can be one part of an array of changes that lead the Reserve Bank in future to put much more emphasis on unemployment, in public and in private, in the way that many other advanced country central banks do. Policy is, after all, supposed to be about people.

What array of changes should any new government make?

a move to a decisionmaking committee, appointed by the Minister, and subject to parliamentary hearings before taking up the appointment,
making a low sustainable rate of unemployment (“full employment” if you must) a part of the statutory goal of monetary policy,
require the Reserve Bank to publish estimates of the NAIRU and, in the Monetary Policy Statement, require them to explain reasons for any material deviations from those NAIRU estimates,
require the timely publication of minutes of the decisionmaking committee and (with a longer lag) of the background analysis papers provided to the committee, and
in the immediate future, change the Act to allow the Minister and Cabinet to appoint the new Governor directly (this is the normal way such appointments are made in other countries). Getting the right person to lead these reforms is vital and there is no reason to think people like the current Board would deliver that person.

And just briefly on the substantive issue: the reason we have active discretionary monetary policy is because people have judged, over decades, that, were we not to do so, output and employment would be much more variable, and in particular recessions – and periods of high unemployment – would be more more savage and sustained than they need to be. That is not a novel proposition now, and it isn’t even a particular controversial one (although some free bankers will point out that, say, the worst US recessions have been since the central bank was set up) – it is a standard insight of modern macroeconomics. Greeece is a particularly nasty example of the alternative approach. That’s why I’m uneasy about those defending a single price stability goal for monetary policy: it may well be the medium-term constraint on what else monetary policy can do, it is one of desired outcomes we want to preserve (I say preserve because sustained inflation is a phenomenon of the central banking era, whereas longer-term price stability was a feature of earlier centuries), but it isn’t the main reason why we have active discretionary central banks. We have such institutions primarily because we care about minimising the bad times – sustained periods of excess capacity and high unemployment. We aren’t – or shouldn’t be – averse to booms (except to the extent they portend busts) but we should be, and mostly are, very averse to significant deviations from “full employment”. Keeping unemployment as low as the other labour market institutions (welfare systems, minimum wages etc) allow could reasonably be seen as the primary goal of monetary policy. Rising inflation would then be an indicator that the central bank had overdone things, and thus price stability represents a useful constraint or check on over-optimism about how low the unemployment rate can be got at any particular point in time. At present however, defenders of the current specification of the goal can almost come across as if it is a point of virtue not to care, let alone to mention, about those who are unemployed.

Things were a little different in 1989 when Parliament was first debating the Reserve Bank legislation. Arguably it made a lot of sense then to put in a single goal of price stability – because having lost sight of the constraint (price stability) in earlier decades, it was important to establish confidence that inflation would in future be taken very seriously. That isn’t the main message we, the markets, or the Reserve Bank need to hear after years of below-target inflation, and even more years of above-NAIRU unemployment rates.

So although I have a great deal of respect for Don Brash, and these days count him as a friend, on this occasion I think he’s wrong and Grant Robertson is much closer to right.

Wage inflation: surprisingly high

August 24, 2017September 1, 2017 Michael Reddell New Zealand economic performance, Productivity

There is plenty of talk about weak wage inflation, here and abroad.

Mostly, I have tried not to put too much weight on New Zealand wages data. I’m not always consistent, and higher nominal wage inflation is probably one of things we should normally be expecting to see if core inflation was really heading back to 2 per cent. But, one can’t really bang on about how there has been no labour productivity growth (reported by SNZ) for almost five years now, and expect much in the way of wage inflation. And I’m not one of those who thinks that immigration surprises tend to dampen wages (relative to GDP per capita, or productivity, that is): they may do so in certain specific occupational areas where there is a particular large presence of migrants, but generally – as New Zealand economists have believed for decades – immigration surprises add more to demand (including demand for labour) than they do to supply, at least over the first few years following a migration influx. With the unemployment rate still somewhat above most estimates of the NAIRU, one probably shouldn’t really expect much acceleration of wage inflation, but there isn’t any obvious reason why workers should be doing particularly poorly relative to the rest of the economy. Overall, of course, the economy isn’t doing that well; weak per capita GDP growth, and no productivity growth.

But listening to Steven Joyce talking about wages on Morning Report this morning prompted me to dig out and play with some relevant data.

My preferred measure of wage inflation is taken from the Labour Cost Index. The LCI series that get lots of coverage purport to adjust for changes in productivity etc. I don’t have a great deal of confidence in the adjustment (mostly because it is a bit of a black box to outsiders), and so I prefer to use the Analytical Unadjusted Index of private sector wages (ie the data before the productivity adjustments).

analy unadj wages

It is a relatively smooth series. Wage inflation picked up a lot during the 2000s boom, slumped in the recession and after an initial recovery seems to have been tailing off somewhat since then.

But this is a measure of nominal wages. And inflation is a lot lower than it was. Here is the same series adjusted for the Reserve Bank’s sectoral core factor model measure of inflation.

real wages

It is a noisier series (suggesting that perhaps parties bargain in nominal terms, rather than having reals in mind), although it is pretty unmistakeable that the average rate of real wage increases has been lower in recent years than in most of the earlier period. I could have done that chart with some smoothed moving average of CPI inflation but (a) lots of the short-term fluctuations in the CPI aren’t things that should affect wages (eg changes in ACC levies or tobacco taxes) and (b) doing so would actually only make the gap shown in the next chart larger and more striking.

Over time, one might expect real wage inflation to roughly equal the rate of growth in labour productivity. Productivity growth is, by and large, the way living standards improve, and for most people real wages rates are an important element in their potential living standards.

One wouldn’t expect those relationships to hold in the very short-term. There are measurement problems in each of the series (wages, inflation, and productivity). There is also a great of short-term volat5ility in the published series that are used to generate the productivity estimates. And if labour is particularly scarce, or abundant, bargaining outcomes can easily differ for a time from what a productivity growth benchmark might suggest. Finally, a sustained lift in the terms of trade can also lead to real wages rising faster than real productivity measures.

In this chart I’ve shown real wages (same measure as above) and smoothed growth in labour productivity (real GDP per hour worked). I’ve taken the quarterly observations for the last two years, compared them to the quarterly observations for the previous two years (and so on) and then converted the result back into an annualised growth rate. There are plenty of other ways of smoothing the series, but none is going to change the fact that we have had no (reported) productivity growth for a number of years now. My particular measure provides a reasonably smooth series for productivity growth, consistent with my prior that to the extent inflation and productivity affect wage bargaining they are likely to do so in a smoothed or trend sense. Anyway, here is the resulting chart.

real wages and productivity growth

It hasn’t been a particularly close relationship over the (relatively short) history of the data. On average, real wage inflation (on this measure, although it is also true using a smoothed CPI measure of inflation) has grown faster than measured productivity over much of the period, perhaps consistent with the step up in the terms of trade from around 2004. (The remaining small upward biases in the CPI work in the other direction, understating real wage growth).

But the gap between the two lines at the end of the period is strikingly large and seems to have become quite persistent. Real wage inflation – although quite a bit slower than it was – still appears to be running much faster than productivity growth in recent years looks able to have supported.

If so, that represents a real exchange rate appreciation, representing a deterioration in the competitiveness of many of our producers. Looking ahead, and since we can’t count on the terms of trade appreciating for ever (for all their ups and downs, over 100 years they’ve been basically flat) we need to see some material acceleration in productivity growth or we are likely to see real wage growth falling away further still. For all the talk of moderate wage inflation in countries such as the US, not many countries (and certainly not the US and Australia) have had no productivity growth at all in the last five years. The puzzle in other countries may be why real wage inflation is so low, but here the focus should probably be on why it is still so high.

Capital gains tax: quite a few reasons for scepticism

August 24, 2017August 24, 2017 Michael Reddell Housing, Taxation

Going through some old papers to refresh my memory on capital gains tax (CGT) debates, I found reference to a note I’d written back in 2011 headed “A Capital Gains Tax for New Zealand: Ten reasons to be sceptical”. Unfortunately, I couldn’t find the note itself, so you won’t get all 10 reasons today. But here are some of the reasons why I’m sceptical of the sort of real world CGTs that could follow from this year’s election. Mostly, repeated calls for CGTs – whether from political parties, or from bodies like the IMF and OECD – seem to be about some misplaced rhetorical sense of “fairness” or are cover for a failure to confront and deal directly with the real problems in the regulation of the housing and urban land markets.

Anyway, here are some of the points I make:

in a well-functioning efficient market, there are typically no real (ie inflation adjusted) expected capital gains. An individual participant might expect an asset price to rise for some reason, but that participant will be balanced by others expecting it to fall. If it were not so then, typically, the price would already have adjusted. In well-functioning markets, there aren’t free lunches. It also means that, on average, capital losses will be pretty common too, and thus a tax system that treated capital gains and losses symmetrically wouldn’t raise much money on average over time. A CGT is no magic money tree. And there is no strong efficiency argument for taxing windfalls.
if you thought, for some reason, that people were inefficiently reluctant to take risk, there might be some argument for a properly symmetrical CGT. In such a system, the government would take, say, a third of your gains, but would also remit a third of your losses (the overall risks being pooled by the state). The variance of an individual’s private after-tax returns would be reduced, and they might be more willing to take risk. But, in fact, no CGT system I’m aware of is properly symmetrical – there are typically tough restrictions on claiming refunds in respect of capital losses (one might only be able to do so by offsetting them against future gains). There are some reasonable base-protection arguments for these restrictions, but they undermine the case for a CGT itself.
All real world CGTs are based on realised gains (and losses to an extent). That makes it not a pure CGT, but in significant part a turnover tax – if you never trade, you never pay (“never” isn’t literal, but tax deferred for decades discounts to a very small present value). And that creates lock-in problems, where people are very reluctant to sell, even if their circumstances change or if a new potential owner could make much more of the asset, for fear of crystallising a CGT liability. In other words, introducing a CGT introduces a new inefficiency to asset markets, making it less likely that over time assets will be owned by the parties best able to utilise them.
Basing a CGT on realised gains will also, over time, bias the ownership of assets subject to CGT to those most able to avoid realising the gains. A long-lived pension fund, or even a very wealthy family, will typically be better able to count on not having to sell than, say, an individual starting out with one or two rental properties, or some other small business, where changed circumstances (eg a recesssion or a divorce) might compel early liquidation. Large funds are also typically better able to take advantage of loss-offsetting provisions. The democratisation of finance and asset holding it certainly isn’t.
CGTs in many countries exclude “the family home” altogether. In other countries, they provide “rollover relief”, enabling any tax liability to be deferred. Most advocates of a CGT here seem to favour the exclusion of the family home, even though unleveraged owners of family homes already have the most favourable tax treatment in our system. Again, a CGT applied to investment properties but not owner-occupied ones would simply trade one (possible) distortion for another.
In practice, most of the arguments made for a CGT in New Zealand have to do with the housing market. But, on the one hand, all major (and minor?) parties claim that they have the fix for the housing market (various combinations of RMA reform, infrastructure reforms, changes to immigration, restrictions on foreign ownership, state building programmes or whatever). If they are right, there is no reason to expect significant systematic real capital gains in houses. If anything, real house prices should be falling – a long way, for a long time. Of course, prices in some localities might still rise at some point, if unexpected new opportunities appear. But “unexpected” is the operative word. Enthusiasm for a CGT, at least at a political level, seems to involve a concession that the parties don’t believe, or aren’t really serious about their housing reform policies.
Oh, and no one I’m aware of anywhere argues that a realisation-based CGT applied to (a minority of) housing has made any very material difference to the level of house prices, or indeed to cycles in house prices.
In general, capital gains taxes amount to double-taxation. Think of a business or a farm. If the owner makes a success of the business, or product selling prices improve, expected profits will increase. If and when those profits are achieved, they would, in the normal course of affairs, be subject to income tax. The value of the business is the discounted value of the expected future profits. It will rise when the expected profits rise. Tax that gain and you will be taxing twice the same increase in profits – only with a CGT you tax it before it has even happened. Of course, at least in principle, there is a double deduction for losses, but as noted above utilising losses (whether of income, or capital) is a lot more difficult. If you think that New Zealand has had less business investment than might, in some sense, have been desirable, you might want to be cautious about applauding a new tax that would fall heavily on those who took business risks and succeeded.
Perhaps double taxation of expected business profits doesn’t bother you. But trying reasoning by analogy with wages. If the market value of your particular skills has gone up, your wages would be expected to rise. When they do you will pay taxes on those higher wages. But by the logic of a CGT, we should capitalise the value of your expected future labour income and tax your on both that “capital gain” and on the later actual earnings. Fortunately, we abolished slavery long ago, but in principle the two cases aren’t much different: if there is a case for a CGT on the value of a business, it isn’t obvious why one shouldn’t have one on the value of a person’s human capital.
(I should note here, for the purists, that there are other concepts of double-taxation often referred to in tax literature, none of which invalidate the point I’m making here.)
Real world CGTs also tend to complicate fiscal management? Why? Because CGT revenue tends to peak when asset markets and the economy are doing well, and when other government revenue sources are performing well. CGT revenue doesn’t increase a little as the economy improves and asset markets increase, it increases multiplicatively. And then dries up almost completely. Think of a simple example in which real asset prices had been increasing at 1 per cent per annum, and then some shock boost asset prices by 10 per cent. CGT revenue might easily rise by 100 per cent in that year (setting aside issues around the timing of realisations). And then in a period of falling asset prices there will be almost no CGT revenue at all. Strongly pro-cyclical revenue sources create serious fiscal management problems, because in the good times they create a pot of money that invites politicians to (compete to) spend it. If asset booms run for several years, politicians start to treat the revenue gains as permanent, and increase spending accordingly. And if/when asset markets correct – often associated with recession and downturns in other revenue sources- the drying up of CGT revenue increases the pressure on the budget in already tough times. It is easy to talk about ringfencing such revenue (mentally, if not legally) but such devices rarely seem to work.

None of this means that I think there is no case for changes in elements of our tax system as they affect housing. The ability for business borrowers to deduct the full amount of nominal interest, even though a significant portion of that interest is simply compensation for inflation (rather than a real cost), is a systematic bias. It doesn’t really benefit new buyers of investment properties (the benefit is, in principle, already priced into the market) but it is a systematic distortion for which there is no good economic justification Inflation-indexing key elements of our tax system is highly desirable – at least if we can’t prudently lower the medium-term inflation target – and might be a good topic for a tax working group. In the process, it would also ease the tax burden on people reliant on fixed interest earnings (much of which is also just inflation compensation, not a real income).

Of course, at the same time it would be desirable to look again at a couple of systematic distortions that work against owners of investment properties. Houses are normal goods and (physically) depreciate. And yet depreciation is no longer deductible. Perhaps there was a half-defensible case for that when prices were rising seemingly inexorably – but even then most of the increase was in land value, not in value of the structures on the land – but there is no justification if land reform and (eg) new state building is going to fix the housing market. Similarly, when the PIE system was introduced a decade or so ago, it gave systematic tax advantages to entities with 20 or more unrelated investors. Most New Zealand rental properties historically haven’t been held in such entities. There is no good economic justification for this distinction, which in practice both puts residential investment at a relative tax disadvantage as a saving option, and creates a bias towards institutional vehicles for holding such assets. Institutional vehicles have their own fundamental advantages – greater opportunities for diversification and liquidity – but it isn’t obvious why the tax system should be skewing people towards such vehicles rather than self–managed options. As noted above, any CGT will only reinforce that bias. Funds managers, and associated lawyers and accountants, would welcome that. It isn’t obvious why New Zealand savers should do so.

I see that there are more than 10 bullet points in the list above. I’m not sure it covers all the issues I raised in my paper a few years ago, but it is enough to be going on with.

And in all this in a country where we systematically over-tax capital income already. I commend to readers a comment on yesterday’s tax post by Andrew Coleman, of Otago University (and formerly Treasury). As Andrew noted:

Somehow, New Zealand’s policy advising community decided it would restrict most of its attention to the ways income tax could be perfected rather than question whether income taxes (which are particularly distortionary when applied to capital incomes) should be replaced by other taxes. It is almost as if we have the Stockholm Tax Syndrome – fallen in love with a system that abuses us.

A broad-based capital gains tax would just reinforce that problem.

Treasury not convinced about the economic strategy?

August 23, 2017August 23, 2017 Michael Reddell Exports, Treasury

Or so it would seem from looking at the forecast tables accompanying today’s PREFU.

Recall that the government has long had a goal of materially increasing the share of New Zealand’s GDP accounted for by exports (with, presumably, a more or less matching increase in imports). As I’ve highlighted on various occasions – yesterday most recently – if anything the actual export share of GDP has been shrinking.

Here is the share of exports in GDP, showing actuals for the last decade or so, and Treasury’s projections for the next few years.

x to gdp

By the end of that forecast period, there will only be four more years until the goal of a much-increased export share of GDP was to be met. On these numbers, exports as a share of GDP would by then be at their lowest since 1989, 32 years earlier. So much for a more open globalising economy.

(The government actually specifies their target as the ratio of real exports to real GDP, while this chart is nominal exports to nominal GDP. Statisticians generally advise against using the real formulation. But on this occasion, it doesn’t make much difference either way. Over the five forecast years, the volume of exports is forecast to rise by 10.8 per cent, and real GDP is forecast to rise by 15.6 per cent. Whichever way you look at it, The Treasury expects the export share of the economy to carry on shrinking over the next few years.)

In many respects that isn’t very surprising. Treasury expects no fall in the exchange rate at all over the period, and they expect rapid increases in the OCR from around the end of next year. And they expect continued rapid population growth.

It is a non-tradables skewed economy, and while there is nothing intrinsically wrong with non-tradables, it isn’t usually a successful path for countries seeking to achieve higher productivity and sustained national prosperity. (Although Treasury does forecast that six years of zero productivity growth will finally come to an end, and we’ll have respectable productivity growth from 2019 onwards. What this is based on, who knows. We can hope I suppose.)

Taxing business

August 23, 2017February 22, 2019 Michael Reddell Taxation

One subject that seems destined to get little attention in the current election campaign is the appropriate tax rate to be applied to business income. As I’ve noted previously, our company tax rate is now in the upper third of those in OECD countries. And if there is any discussion at all in this campaign, it seems more likely to centre on plans to raise more money from companies – foreign companies anyway. The government has just announced measures designed to have that effect, and parties on the left seem keen on doing even more, under the cover of OECD-coordinated moves in that direction.

I was talking to some tax people yesterday, which prompted me to dig out the OECD data on company tax rates and company tax revenue. Both matter. A country can have quite a high statutory headline company tax rate but also have so many exemptions, deductions etc, that the company tax doesn’t actually raise that much money. The United States is a good example – the general government corporate tax rate is 38.9 per cent, the highest in any OECD country, and yet corporate income tax receipts are only 2.2 per cent of GDP, well below the median OECD country. Corporate tax reform is well overdue in the United States (although my money is on nothing very fundamental happening in the current presidential term).

What about New Zealand?

Here is a chart, using OECD data, showing company tax receipts as a share of GDP for New Zealand (blue) and for the median OECD country (orange), all the way back to 1965.

corporate tax revenue

We take a much larger share of GDP in company tax revenue than most OECD countries do. In fact, in recent years, the only countries that have taken a larger share have been Australia, Chile, Norway, and Luxembourg. Given the importance of minerals in the first three of those countries, the company tax receipts may include a large chunk of what might be better described as resource rentals (and in addition production processes in those extractive sectors tend to be quite capital intensive).

But several other things struck me:

the rising trend in company tax receipts as a share of GDP over the last 30+ years. It probably isn’t the impression most people have when you hear all the talk about taxing (or not taxing) multinationals. Presumably part of the increase will have been accounted for by the larger share in overall national income now accounted for by returns to capital in many countries.
just how large the gap was between the New Zealand line and the OECD line at the start of the period (and, hence, how much of a convergence happened during the period when Sir Robert Muldoon was our Minister of Finance – most of the time from 1967 to 1984).
and the substantial rewidening of the gap since the reforms of the late 1980s. The broad-base low(er) rate strategy seems to have raised a great deal of revenue.

But it does leave me with at least two questions:

why has New Zealand typically raised so much more (per cent of GDP) in company tax revenue than most other OECD countries?
is this a sensible approach to tax policy, particularly in the context of our long-term structural economic underperformance.

In the earlier decades, a heavily protected economy probably meant a business sector that was ripe for the (headlines of) plucking. Between the non-tradable service sectors and the highly-protected manufacturing sector, there was plenty of scope to pass increased business costs, in the form of high headline business taxes, on to domestic consumers. The export sector was mostly based around family farms – and probably didn’t pay much company tax. But bear in mind that exports as a share of GDP were shrinking through this period – high internal domestic costs (including business taxes) also help to erode competitiveness.

These days the economy is much less protected, but we are still back to taking a much larger share of GDP in company tax than most other countries do. Many of our biggest tax paying firms are foreign-owned (apparently around 40 per cent of all company tax revenue is paid by foreign-controlled firms), which command little public sympathy or support. The Australian banks are perhaps the most prominent example. Perhaps it looks like a “free lunch” to tax heavily such operations?

(In principle, our dividend imputation system – also adopted in Australia – may act to make people more relaxed about conducting business through a corporate vehicle, since for domestic shareholders there is no double-taxation of dividends. I don’t know whether this will be part of the explanation, although I’d be surprised if it explained much, given the other advantages of limited liability.)

And our large share of company tax revenue as a share of GDP isn’t just because New Zealand taxes everyone heavily – in fact, our tax revenue as a share of GDP doesn’t stand out as being high. Here is the chart showing company tax revenue as a share of total tax revenue (NZ in blue, OECD median in orange).

coy tax revenue

Our heavy reliance on company tax revenue looks to be a deliberate choice to favour that soource of revenue.

Whatever the reason for why we take such a large share in company tax, it seems unlikely to be a sensible element of a successful economic strategy. It is well-known that business investment as a share of GDP has been quite low in New Zealand for many decades. It is one of the more obvious symptoms of our economic underperformance. We also now have a quite moderate level of inward foreign investment. It seems at least plausible that the tax regime might be one part of the explanation – after all, particularly for foreign investors, the choice to operate here (or not) is purely an economic one, influenced largely by the expected after-tax returns, and the risk around those returns. For foreign investors (who can’t take advantage of imputation credits) the New Zealand company tax rate should matter a lot. Partly for that reason, the estimated deadweight costs of business taxation are far higher than those for most other taxes. You get less of what you tax, and foreign investment is likely to be particularly sensitive to taxes.

The OECD data on company tax rates does not go back as far. But here is how our rates have compared to those of:

the median OECD country, and
the median “poor” OECD country (ie those who’ve had consistently lower GDP per capita or productivity than New Zealand).

corporate tax rates Of the “poor” OECD countries, only Mexico and Portugal now have higher company tax rates than we do. Whereas most of the “poor” countries are closing the income/productivity gaps to the richer OECD countries, Mexico and Portugal (and New Zealand) aren’t. I’m not suggesting it is the only factor by any means, just highlighting the choice that the more successful converging countries have been making.

In much of the debate around these issues, all the focus is one who writes the cheque, not on who actually bears the burden of the tax (the incidence). Foreign investors, for example, will have target after-tax rates of return. Higher tax rates discourage reinvestment in the business, discourage new investment, and in time result in lower average productivity and lower wage rates. By contrast, lowering business taxation is a pro-growth, pro working people, policy.

Again, there is a tendency to discount this point with a response along the lines of “look at all the existing investment; cut taxes on the profits on those businesses and it is just a windfall transfer to existing owners”. That often seems particularly unappealing if the owners are foreign – as if it was a pure welfare loss to New Zealanders. The banks are good example of what bothers people – mostly owned by big Australian operations. But actually, the banks are a sector where lower tax rates offer the prospect of genuine savings across the board, for all users of financial services in New Zealand, even if the size of the banking sector itself doesn’t change much. Cut taxes on banks’ profits and, over time, you’ll find fees and interest margins falling. Not from the goodness of a bank’s heart, but from the competitive process at work, as each competes for market share and finds they can discount their pricing a bit more and still deliver on Sydney or Melbourne’s after-tax return expectations.

I don’t think we should be making tax policy specifically to favour foreign investors over domestic ones – which would be the effect of simply cutting the company tax rate – but I do think there is a good case for materially lower taxes on business income. I’ve argued prevously for a Nordic system, in which capital income is taxed at a lower rate than labour income. A more ambitious approach still would be to work towards the development of a progressive consumption tax. Whatever the precise solution, the current arrangements – high rates of company tax, high shares of GDP taken in company tax – don’t look like the right answer if we serious about lifting economic performance in New Zealand, and with it raising the capital intensity of production in New Zealand.

(Commenters on previous posts have asked whether I’m being consistent, in calling for lower business tax rates and at the same time noting the serious limitations of our remoteness. I certainly accept that if we were adopt the Irish company tax policy it would not have the scale of benefits for us it has had for Ireland. But an integrated economic strategy for New Zealand would also involve lower real interest rates and a lower real exchange rate, and in conjunction with lower business tax rates, that would be likely to bring forth quite a range of new business investment – in some cases in new sectors (or retaining firms in New Zealand that might otherwise relocate), and in other cases, adopting more capital intensive (ie higher labour productivity) modes of production in existing sectors, including agriculture.)

The Labour Party is campaigning on establishing a tax working group if it forms the next government. I hope they envisage something more than just a tidy-up and a recommendation for a capital gains tax, and that in thinking now about the possible terms of reference for the proposed tax working group – which they will presumably want to move quickly on once in office – they are willing to cast the net rather wider, and invite the proposed group to consider connnections between the design and balance of our tax system and our overall economic performance. Higher taxes on business – especially the dreaded multinationals – might be some sort of “progressive” shibboleth, but in fact lower business taxes should be an option that any seriously progressive government, concerned to lift living standards for all, takes very seriously.

Economic performance

August 22, 2017 Michael Reddell Exports, New Zealand economic performance, Productivity

The second half of the Grant Robertson/Steven Joyce debate on Sunday was around things to do with overall economic performance and management.

On one thing they agreed: Winston Peters’ proposal that New Zealand should adopt a Singapore-style approach to monetary policy and the exchange rate isn’t an option for New Zealand. I agree with them, and explained why in a post a few months ago.

Grant Robertson reminded viewers that John Key had promised to close the gaps between New Zealand incomes and productivity and those in Australia, noting that no progress has actually been made. Steven Joyce likes to push-back by citing numbers that suggest that after-tax real wages have been rising faster here than in Australia. When I’ve looked at that claim previously, a lot appeared to depend on which exchange rate one used to convert wages in the two countries into a common currency. Using PPP exchange rates, the gap has actually widened a bit further. Comparing wage series across countries isn’t that easy – countries measure things differently, and things that are effectively part of remuneration (eg employer superannuation contributions) often aren’t included.

Personally, I prefer to focus on economywide measures, which are compiled in a consistent manner across countries. Here is real GDP per capita for the two countries, indexed to 2007q4, just before the global downturn/recession began.

real gdp pc nz and aus

I could have started the chart a few quarters later, to coincide with the change of government. Either way, no progress at all has been made in closing the gap to Australia.

Things look worse if we focus on labour productivity (real GDP per hour worked).

real gdp phw nz and aus aug 16

Best summary? We haven’t lost much ground against Australia when we focus on GDP per capita, but since relative productivity has dropped away badly we’ve only maintained even that mediocre real GDP per capita record by working even longer hours on average.

But if the government’s record is pretty poor, it isn’t clear that the Labour Party is offering anything much different. It is all very well to criticise the current government for making no progress in closing the gaps, but Labour doesn’t even seem to be talking about doing so. Robertson did highlight the four or five years now of zero productivity growth, and talked of needing a plan for something different. But it wasn’t obvious from anything he said, or anything I’ve read, quite what the plan is, that might be equal to the challenge. There is plenty of talk of lifting skills – but the OECD data already suggest New Zealand skills levels are among the very highest among advanced countries. There is talk of a tax working group, with an apparent presumption that that is likely to lead to a capital gains tax. And there is talk of R&D tax credits. But I doubt anyone – even those who support such measures – believes that they are remotely enough to make the sort of difference closing the gaps to Australia might involve.

Of course, the National Party’s position seems no better. The Minister’s rhetoric is that people are voting with their feet and realising that the jobs and incomes are now here. Sure, the annual outflow of New Zealanders to Australia has dropped, but it is still an outflow each and every year. And no one seriously thinks other than that average incomes in Australia remain much higher than those here. But it is tougher to get established in Australia at present – that’s a bad thing for New Zealanders, not a good one.

Steven Joyce was touting the success of certain subsets of firms exporting from New Zealand. It is perhaps easy to forget that the government has long had a goal of substantially increasing the export share of GDP (and, presumably, the import share, since we export to import – sell stuff to other people so that we can consume ourselves).

Here are exports as a share of GDP.

exports joyce It is easy for one’s eye to go to those peaks in 2000 – at a time when the exchange rate had fallen sharply – but even much more recently the trends haven’t been favourable. Even the vaunted services exports are lower now as a share of GDP than they were 10 years ago, or than when the government came to power. The Minister talked of “high-tech value-added manufacturing” as the future, but then overall goods exports are lower as a share of GDP now than at any time in the last 30 years.

Mr Joyce talked of a slump in global trade, as if our experience was just something like everyone else had experienced. But even that isn’t true. The share of exports in GDP for the median OECD country has increased by around 5 percentage points in the last decade. In that decade before that, it increased by about 6 percentage points.

And for all the talk of services exports, here are exports of services as a per cent of GDP for New Zealand and the other small OECD countries.

services x small countries

Grant Robertson was prepared to go as far as to say that the exchange rate is “too high”. Artificially lowering it wasn’t, we were told, the answer (and I’d agree, if by that he meant eg a Singapore-style monetary policy). But there was no hint of how Labour thought a lower exchange rate might be brought about in a more sustainable manner.

New Zealand has faced some obstacles to growing the tradables sector of our economy in the last decade. The earthquakes meant that real resources had to be used for other things – repair and rebuild – and other activities had to make room. Policymakers have known this since the very days after the earthquakes occurrred. The substantial amount of offshore reinsurance just reinforced the way in which the earthquakes represented a large shock skewing the economy for a time more towards the non-tradables sectors.

But what was extraordinary is that the same policymakers allowed, and cheered on, another even bigger non-tradables-skewing shock.

Here is a chart showing cumulative population growth since National took office, and the cumulative inflow of non-citizens (the PLT data, with all their pitfalls).

popn and immigration

We’ve had a 510000 increase in population over the term of this government, 421000 of which is accounted for by the net inflow of non-citizens. The fertility and migration choices of New Zealanders would, all else equal, have given us only around 2 per cent population growth over the eight and half years, putting a great deal less pressure on

housing markets
other infrastructure
the physical environment, and
the tradables sector as a whole.

Remember that each new arrival need a lot more physical capital stock than is accounted for by the labour those people supply early on. Policy has been deliberately skewing our economy away from the tradables sector. We’ve had a net non-citizen migration inflow of almost exactly 300000 people in just the last five years. With no productivity growth at all in that time, and an export (and import) sector shrinking as a share of GDP, and business investment pretty subdued too, one might reasonably ask ‘to what end?’ for New Zealanders.

We should be left wondering why, if we vote for them, either main party expects anything different than the mediocre economic performance of the last few years. Gareth Morgan criticised Labour’s apparent lack of much policy substance as “putting lipstick on a pig”. It isn’t obvious that the National Party is even offering the lipstick.

And all this is without even repeating for the umpteenth time that the unemployment rate now is still higher than it was at any time in the last five years of the previous Labour government, at a time when demographics appear to be lowering the natural rate of unemployment. Or the underutilisation rate of almost 12 per cent. We should be able to do a great deal better for New Zealanders.

Debating housing

August 21, 2017August 21, 2017 Michael Reddell Housing, labour party, Uncategorized

The centrepieces of the two weekend TV current affairs shows were political debates: The Nation had Phil Twyford and Amy Adams on housing, and Q&A had Grant Robertson and Steven Joyce on the economy more generally (but with a large chunk on housing). I only saw the Q&A debate, but I have glanced through the transcript of Twyford/Adams.

In the course of his debate, Phil Twyford was asked how much house prices should be relative to income. His response was excellent

Twyford: Ideally, they should be three times. If we had a housing market that was working properly, your housing would be— the median price would be about three to four times the median household income.

Grant Robertson repeated those sorts of numbers in his exchange with Steven Joyce. It was good, clear, encouraging stuff. A reminder of just how totally out of whack things are in the New Zealand house and urban land market. And a suggestion that the main opposition party wants things to be materially different and better.

But I can’t help wondering in which decade they expect things to be more or less okay again. In time for, say, my children – perhaps 10 to 15 years from now – or will it only be the grandchildren?

Don’t get me wrong. Watching the Robertson/Joyce debate, as someone who has no idea who he will vote for, I thought Robertson had much the better of the housing side of the debate. The current government seems reduced to some mix of lamenting that it is “a global problem”, reluctantly conceding that Auckland prices are a bit too high, and claiming that just over the horizon there is a wave of supply that will substantially address the problems. So if I’m critical of Labour here, take for granted that almost all the criticisms apply with more force to National.

Here is Phil Twyford avoiding suggesting that Labour wants house prices to come down

So is it Labour’s goal to get it down to that – about four times?
Twyford: We want to stabilise the housing market and stop these ridiculous, year on year, capital gains that have made housing unaffordable for a whole generation of young Kiwis.
But in essence, you’re going to drop the value of houses, if you want them to be four times the price of the average income.
Twyford: Well, we’re going to build through KiwiBuild. We’re going to 100,000 affordable homes.
I want to come to KiwiBuild in a moment. I just want to talk to you about the price.
Twyford: That will make housing affordable for young Kiwi families. That’s our policy.

Stabilising the housing market, and ending rapid house price appreciation, isn’t a recipe for fixing up the housing market for the current generation of young people.

Grant Robertson was much the same – reiterating the goal of house prices of 3 to 4 times income, but he couldn’t or wouldn’t say how long it would take. There was plenty of talk about building “affordable houses” (around $600000?) and “cracking down on speculators” and beyond that it all seemed to be down to growing incomes. But there wasn’t even a mention of freeing up land supply – a topic where formal Labour policy looks better than anything else on offer from major parties. Even though, the largest single component in the increase in New Zealand (especially Auckland) house prices has been the land component.

On the other side of the exchange Steven Joyce was taunting Robertson with the suggestion that “Labour wants to crash house prices with a punitive capital gains tax” – as if, whatever the (de)merits of a CGT, much lower house prices would be the worst thing in the world.

Lifting growth in productivity and real incomes is highly desirable. All else equal, flat nominal house prices and faster income growth is a recipe for improved housing affordability. But how long might it take on reasonable assumptions?

I’ve shown similar charts on this point previously. Here I assume a starting point of a price to income ratio of 10 (around current Auckland levels) and that (a) nominal house prices hold at current levels for the indefinite future, and (b) incomes grow at a rate equal to 2 per cent (midpoint inflation target) plus the rate of economywide productivity growth. I’m just going to assume that the 2 per cent average inflation could be achieved quite easily if the government wanted to. Productivity is the harder issue. Here I’m showing four lines using:

actual productivity growth (GDP per hour worked) over the last decade (just under 0.6 per cent per annum),
actual productivity growth over the last thirty years (for which we have quarterly real GDP and hours data), of just under 1.2 per cent per annum,
productivity growth of 1.5 per cent per annum, and
productivity growth of 2 per cent per annum.

The straight line on the chart is at a price to income ratio of 3.5 (ie the midpoint of the 3 to 4 times income Labour is talking of).

house price to income ratio with flat nominal house prices

On the best of these scenarios, price to income ratios get to 3.5 in about 27 years time. If we manage productivity growth equal to that for the last 30 years – which itself would be quite an achievement at present – we’d be waiting almost 35 years.

Affordable housing, and a functional housing market, for the current generation simply requires a fall in nominal house prices. And yet no major party politicians seems to have the courage, or the self-belief (in their ability to communicate and take people with them), to make that simple point.

For most existing home-owners, the market value of their house does not matter a great deal. A large proportion of home-owners have a modest mortgage or none at all, so negative equity isn’t a risk. And since most people retire in the same city they’ve spent their working lives in, their house price doesn’t even affect very materially their own expected future purchasing power.

Fear of falling house prices seems to reduce to two particular dimensions:

people who, having bought in perhaps the last five years, would find themselves with negative equity if house prices fell markedly (in turn divisible between new owner-occupiers and purchasers of additional rental properties), and
some generalised fear that a fall in house prices goes hand in hand with economic disaster, serious recessions and the sort of experience the US or Ireland had.

The latter is mostly a category error. In both the US and Ireland, there was material overbuilding (excess stocks of actual houses). There is no prospect of that situation in New Zealand on any of the policies of the major parties. In Ireland, the situation had been compounded by joining the euro, which gave Ireland interest rates set in Frankfurt that bore no relationship to the needs of the Irish economy. In the US, there had been persistent official efforts – from Congress, the Fed, and successive Administrations – to encourage, or compel, the financial system to take on housing lending risk that the private sector would be unlikely to have assumed willingly. None of that resembles New Zealand. Not only do we set our own interest rates, but to the extent there is state involvement in the housing finance market it is reducing the supply of credit.

A severe recession could, at least for a time, lower New Zealand house prices. Recessions – severe or otherwise – aren’t things to welcome. But the sort of land market liberalisation (with associated infrastructure rules) that might, as a matter of policy, set out to materially lower New Zealand house and land prices would be most unlikely to materially dampen demand or economic activity. If anything, it could represent a material boost to demand, as building became more affordable. (And if some people would find themselves with negative equity, whole swathes of younger generations would suddenly face new opportunities and less of a desperate need to save.)

What about the people facing negative equity? I don’t have any particular sympathy with those who’ve purchased investment properties in recent years and might face being wiped out. They’d have taken a business and investment risk – in this case on the regulatory distortions never being fixed – and lost. That happens in all sorts of market – think of the people with exposures to shares after 1987, or in finance companies 10 years ago. Or those with businesses based in import licenses in earlier decades. It is tough for them individually, and almost all of them have votes. But it was a business risk, and a conscious voluntary choice.

I’m much more sympathetic to those who bought a first house and could face a large chunk of negative equity. I touched on this in a post a few weeks ago

No one will much care about rental property owners who might lose in this transition – they bought a business, took a risk, and it didn’t pay off. That is what happens when regulated industries are reformed and freed up. It isn’t credible – and arguably isn’t fair – that existing owner-occupiers (especially those who just happened to buy in the last five years) should bear all the losses. Compensation isn’t ideal but even the libertarians at the New Zealand Initiative recognise that sometimes it can be the path to enabling vital reforms to occur. So promise a scheme in which, say, owner-occupiers selling within 10 years of purchase at less than, say, 75 per cent of what they paid for a house, could claim half of any additional losses back from the government (up to a maximum of say $100000). It would be expensive but (a) the costs would spread over multiple years, and (b) who wants to pretend that the current disastrous housing market isn’t costly in all sorts of fiscal (accommodation supplements) and non-fiscal ways.

Those numbers were made up on the the fly, but even on later reflection they look like a reasonable basis for something that might not be unreasonable, and also might not be unbearably expensive. It would recognise that people need to bear some material risk themselves (a 25 per cent fall in nominal house prices is not small). But it is also designed in recognition of the fact that since 2013, it has been hard for first home buyers to get a mortgage above an initial LVR of 80 per cent, so that not many would be in negative equity now even if house prices fell by 25 per cent from here.

Since many people will stay in their existing house for a long time if they have to, and the scheme only compensates if the house is sold, that also limits the potential fiscal cost. In fact, the biggest pool of owner-occupiers who would sell at a material loss would be those forced in the event of new severe recession (unemployment is typically the biggest threat to the ability to service mortgage debt) and (a) those people would naturally command a degree of public sympathy and (b) land liberalisation would be a stimulatory policy, reducing the chances of a near-term future recession. There would be some voluntary sellers, to capture the compensation, but the cost of selling and buying a house, and of moving house, is not trivial. If 100000 households were to claim the maximum compensation of $100000 that would be total additional government expenditure of around $1 billion, spread over a considerable period of time. And to claim $100000, you’d have to have bought say a $1 million first house and seen house prices fall 45 per cent from your entry price.

It isn’t a perfect scheme by any means, and lots of details would need to be fleshed out. One could relatively easily restrict it to apply only to those in a first owner-occupied house, again the people who will naturally command the most sympathy anyway. But if something of this sort could be done for, say $1 billion, and it helped the pave the way for a genuine structural fix in the housing market – a willingness to actively embrace lower house prices – it would seem likely to offer more value than, say, the least valuable of the proposed 10 new “roads of national significance”, which are estimated to cost on average just over $1 billion each. How much congestion is there on the existing road from Levin to Sanson?

And three final points on housing:

it was depressing to read the housing section of Jacinda Ardern’s campaign opening speech. It wasn’t the focus of her speech, but – just like Andrew Little at his conference speech earlier in the year – there was reference to dealing to “speculators”, barring foreign purchasers, and to the state building more houses, but not a word – not even hint – about freeing up the land market in a way that might make those price to income aspirations achievable,
it was slightly strange listening to Robertson and Joyce debating the possibilities of a capital gains tax, focused on housing. Weirdly Robertson didn’t take the opportunity to rule out applying a CGT to unrealised gains – even though he surely really realises that, whatever the theoretical appeal, there is no way anyone is going apply a CGT to anything other than realisations. But it was even more strange to hear this debate going on after both sides were insisting they “had a plan” to fix housing. If they really did then surely there would be few/no systematic capital gains in the housing market for decades to come?
and finally, Steven Joyce ran his line that house prices are a global problem. This seemed to be a variant of the sort of “problems of success” line John Key often ran. Out of curiosity, I dug out the OECD’s real house prices series this morning. They don’t have data for quite every country, but here is the change in real house prices from 2007 to 2016 (annual data) for the countries they have the data for. There are a few countries that have done worse, but not many. In the median OECD country, real house prices have fallen over the last decade.

house prices last decade

Mostly, the countries that have been about as bad as us have also had quite rapid population growth (Israel, Australia and Luxembourg in the lead on that count) – not, of course, that either Finance spokesperson suggested doing anything about that.

What about a longer-term comparison. There are lots of gaps in the OECD data for earlier decades, but here are real house prices increases for the countries they have data for over the three decades to 2016.

house prices since 86

Worst of them all, without even the income growth to match.

We need to face up to the importance of lowering house prices, of adopting policies likely to sustainably make that happen, and – if necessary – consider compensation packages for some to help make that transition possible.

Submission on the DTI proposals

August 18, 2017August 18, 2017 Michael Reddell Financial stability, Housing

Submissions close today on the Reserve Bank’s consultation on its proposal to add a debt to income limit tool to the approved list of possible direct controls on bank housing lending.

Despite the Prime Minister’s comments the other day, I don’t regard this as a “dead duck” at all. The Reserve Bank won’t be coming back to the Minister of Finance with its recommendation, in light of the consultation, until after the election, and who knows what the political or housing market climate will be like by then. Graeme Wheeler will be gone by then, and so the Reserve Bank’s decision will be in the hands of the (illegally appointed) acting Governor, Grant Spencer, and new Head of Financial Stability (and presumed Governor-aspirant) Geoff Bascand. Perhaps they will have less appetite for controls than Wheeler has had – both come from backgrounds that were not particularly keen on direct interventions – but for now we have to assume that the proposal will continue to move ahead.

As I noted earlier in the week, there is a lot of useful and detailed material in Ian Harrison’s paper on the DTIs, which I gather he is putting in as a submission.

I ummed and aahed about whether to make a submission. In one sense, it is a pure waste of time, since the Bank is unlikely to grapple very seriously with any points I make. But, on other hand, it is good to have alternative perspectives, and questions, on the issue out there, and just possibly it might provide some angles for people with a bit more influence than I have.

So I did write a fairly brief submission. My overview and summary is here

Overview

I am firmly against adding any sort of serviceability restriction (henceforward “DTI”) to the list of possible controls. The Reserve Bank has failed to mount a convincing case, and has not demonstrated that it (or anyone) has the level of knowledge required for such restrictions to operate in a way likely to make New Zealanders as a whole better off. Such restrictions would appear to go well beyond the Reserve Bank’s statutory mandate (contributing little or nothing to soundness and eroding the efficiency of the financial system), and a better cost-benefit analysis would in any case suggest that such controls would probably be welfare-detracting.   Other instruments (such as capital requirements and associated risk weights) that do not impinge directly on the borrowing and lending options open to individuals and firms remain a superior way to manage any future risks to the soundness of the financial system. Serious microeconomic reform remains the best route to fix the serious housing affordability/land price problems.

As a reminder, the Reserve Bank has no statutory mandate to target house prices or the level (or growth rates) of credit in the New Zealand economy.   It also has no “house purchaser or borrower protection” mandate. Restrictions of the sort proposed in the consultative document would represent serious regulatory over-reach.

The fact that a handful of advanced economies have deployed somewhat similar tools is little comfort or basis for support for the Reserve Bank’s own proposals. Bad policy elsewhere isn’t a good reason to adopt bad policy here. But more specifically, the interests of regulators themselves and of citizens are not necessarily, or naturally, well-aligned, a point that Reserve Bank material rarely if ever addresses. For example, the Reserve Bank makes much of the British and Irish DTI limits (which do not apply to investment properties, where the consultative document says the Reserve Bank would want to focus), but never addresses the institutional incentives facing regulators in those countries following the financial crises each experienced in 2008/09 (the typical regulator incentive in the wake of a crisis to overdo caution – and “to be seen to be doing something”, in the regulator’s own bureau-protection interests).     On the flip side, neither in the current consultative document nor in past Reserve Bank material has the Bank seriously engaged with the experience of housing loan portfolios in floating exchange rate countries during the 2008/09 crisis. In countries like ours – including Australia, Canada, the UK, Norway, Sweden, as well as New Zealand – residential loan books emerged largely unscathed, despite big credit and housing booms in the prior years, and the subsequent nasty recession and, in most of these countries, a sustained period of surprisingly low income growth.

There has also been no evidence presented that banks have been systematically poor at making and managing portfolios of loans secured by residential mortgage, let alone that citizens should have any confidence in the ability of (and incentives on) regulators to do the job better.   Anyone can suppress overall credit creation with tough enough controls, but to what end, at what cost, to whom?     Controls of the sort now proposed, and the sorts of LVR restrictions already extensively used, seem to represent ill-targeted measures, based on an inadequate model of house and land prices. They temporarily paper over symptoms – house prices driven high by the failures of regulation elsewhere require high levels of credit – rather than address the structural causes of the housing market problems.     And because they seem to be premised on a model that wrongly treats credit as a leading factor in the housing market problems, they also do little to address any (limited) financial stability risks. And in the process, they systematically favour some groups in society over others – the sorts of distributional choices that, if made at all, should be made only by elected politicians, not by an unelected official.

A reasonable starting proposition would be that in the 25 years prior to the imposition of LVR restrictions the New Zealand housing finance market had been efficient and well-functioning. Lenders lost little money, more borrowers could get better access to credit than in the earlier regulated decades, borrowers had no need to concern themselves with the changing details of Reserve Bank regulatory restrictions, there were no rewards to special interest group lobbying and rent-seeking, and competitive neutrality among different classes of lending institutions prevailed. Perhaps the Reserve Bank would disagree with that characterisation of the market, but if so then, in proposing still further extensions of its regulatory intervention powers, surely the onus should be on you to make your case, not simply to ignore the past, apparently successful, experience?

Anyone interested can read the whole document here

Submission to RBNZ consultation on DTI proposal Aug 2017

The DTI proposal is a tool to address, inefficiently, a problem that isn’t there (threats to the soundness of the financial system), while appearing to try to do something about an actual serious problem (house and urban land prices), of successive governments’ making, about which the DTI tool can do little or nothing useful. It won’t help, and if anything it distracts attention from the real issues, and from those really responsible, for the disaster that is the New Zealand housing “market”.

Virtue signalling, with your money

August 17, 2017August 17, 2017 Michael Reddell NZSF, Uncategorized

I haven’t written about the New Zealand Superannuation Fund (NZSF) for a while, and a well-informed reader has been encouraging me to get back to the economics of the Fund (and some of the important issues raised in a recent review paper). I will, but for now I remain of the view that the Fund is serving no useful purpose and should be wound up.

But while we have it, it needs to be run well.

One of the annoying aspects of the Fund is the way in which the Board and management get to take your tax money and mine, and invest (or not) in causes which they happen to find appealing. Of course, the Act isn’t written that way, but that is what it boils down to. I’m not too keen on my money being invested in abortion providers or private prison operators – just to span the ideological spectrum – but obviously Adrian Orr and his Board don’t have a problem with such exposures. They, on the other hand, object to tobacco companies and whaling, which don’t greatly bother me.

But the other day, they announced a big new policy shift that has substantially reduced the carbon exposure of the Fund (somewhat puzzlingly, I saw no mention in any of their documents of methane exposures, and as we know in New Zealand at least methane exposures make up a very large chunk of greenhouse gases).

To their credit, NZSF pro-actively released several background and Board papers relevant to this move, as well as several pages of question and answer material (all at the link in the previous paragraph).

This shift is dressed up as a simple matter of economic and financial management. Indeed, they are at pains to assert that ethical (or presumably political) considerations played no part in the shift. But, on the material they have presented it just doesn’t ring very true.

For example, they released a presentation to the Board from a few months ago. In it, the chief investment officer and the “head of responsible investment” told the Board that

We believe climate change is a material long-term risk for which the Fund will not be rewarded.

What they appear to mean is the market prices of shares with (adverse) exposure to climate change and any associated policy responses do not adequately reflect those risks.

It is an arguable proposition, for which you might expect that evidence would be marshalled. But the Board appears to have been presented with no evidence whatever, just assertions, and questionable economic reasoning. Thus, on the next page

Climate change is a market and policy failure: markets are producing too many emissions and are over-invested in fossil fuels. We believe carbon risk is under-priced partly because the time horizon over which the effects will manifest is too long for most market analysts – but it is relevant to the time horizon that matters for the Fund.

This is a hodge-podge paragraph. For a start, climate change itself isn’t a market failure, but may well arise from market failures (costs aren’t properly internalised etc). But the fact of climate change – whatever role past policy or market failures may have played – tells one nothing about whether shares in companies exposed to carbon are now fairly priced or not. They are just two completely different things.

And there is still no evidence presented for the proposition (“belief”) that markets have overpriced these companies (such that expected future risk-adjusted returns on them won’t match those available elsewhere). Other market participants know as much (or as little) as NZSF staff know.

There was a more detailed Board paper in April containing the final recommendations. It has more text, but no more analysis of the risks or of why the Board (or we) should believe that NZSF is better placed than the market to appropriately value climate change related risk. Instead, we get a repeat of the same assertions,

NZSF quote

followed by a sentence which is best summarised as “but we really don’t know”.

There are repeated references to lines such as “ignoring Climate Change presents an undue risk”, but that isn’t even remotely the issue. The issue is whether (a) the market on average is mispricing that risk, and (b) whether NZSF staff, management, and Board are better placed to evaluate the complex mix of scientific, economic, technological, and political factors that determine how things will play out (and thus what fair value pricing will prove to have been). Thus, it is quite likely that the market on average has the appropriate pricing of these risks wrong, because much of what is relevant is inherently unknowable. But if it is likely that the market is wrong, there is no particular reason to be confident which side the error lies on. And it isn’t obvious why it is easier for NZSF to be confident it is right about this, than about any of the other very long-term risks embedded in many sectors, or in the market as a whole.

There are also hints that really this has little to do with a careful evaluation of financial investment risk and a lot more about politics and “good causes” – virtue signalling.

NZSF 2

Consistent with this political focus, the very first item in the proposed communications strategy reads

“Recommend engaging with the Greens to explain to them the approach we have taken”

(And, sure enough, they were lauded by the Greens – although not for the quality of their financial analysis – when the new policy was finally announced the other day.)

NZSF’s detailed public story is contained in the Q&A document they released. This is text that they will have had months to refine, the Board having made this decision in April.

But again, there is no analysis presented or summarised to indicate why the Board is confident the market has it wrong. Instead they seem reduced to lines like this

We believe that now is the right time to act. Even if there remains some uncertainty about global policy, its general direction is consistent with meaningful carbon reductions.

This is the basis for a major strategic investment choice by the Board managing taxpayers’ money?? “General directions” are one thing, assessing market pricing and demonstrating with a high degree of confidence that market prices are wrong is quite another.

Or lines like this

The Mercer climate change study that we participated in during 2015 found that the biggest risk to investors from climate change was to be on the wrong side of strengthening global policy and/or technological disruption. Mercer found that investors who got ahead of the curve could mitigate the potential downside.

Well, of course. If you read markets well, and judge policy correctly, there is plenty of money to be made. But doing so is hard…..very hard, and NZSF provides no evidence that they are able to beat the market uniquely well is this particular area of their global exposures.

There is further evidence that this move is about politics and virtue signalling, rather than robust financial analysis.

Will your active managers be allowed to hold stocks that have been sold from the passive portfolio on the Fund’s behalf?
Our active NZ equity managers (who may also from time to time invest in Australia) will not invest in these stocks.

If this were just a strategic view that markets were systematically mispricing this risk, there would be no reason to bar active managers from holding such stocks from time to time (after all, even if one average the market is mispricing this risks, it doesn’t mean there won’t occasionally be opportunities in individual stocks that are exposed to such risks.)

There is very strong sense that NZSF decided to reduce its climate change exposures, and then back-filled the (rather weak) argumentation in support of that. As it is put early on in the April Board paper, setting the scene for the recommendation.

“a reduction of climate-change related risks for the Fund is a key goal of the CCIS [Climate Change Investment Strategy]”

Perhaps there is some other economic and financial analysis, that they haven’t yet released, to support that strategic preference (I’ve lodged an OIA request to that end) but at the moment it looks like a political choice not a financial one.

The NZSF has implemented this strategic choice by the Board and management by altering their so-called Reference Portfolio benchmark. They have long argued that the reference portfolio is what their performance should be benchmarked against (the numbers scream out at one, in large type, when one goes onto their website). I’ve long argued that is the wrong benchmark for citizens and taxpayers to focus on (useful as it might be for the Board to judge staff active management choices against). In this case, the Board itself has taken what amounts to a punt (an active call) that the market is underpricing risk in a particular sector. They need to be evaluated on the results of that call over time, not avoid accountability by burying the implications of their policy decision in what looks like a passive benchmark that is beyond their control.

Perhaps the NZSF choice will be widely popular. But that isn’t their job. In fact, it has always been one of the dangers of the Fund. It isn’t their job to be playing politics by tilting the portfolio towards trendy causes. If anything, long-term investors (the advantage they constantly assert) might be better positioned to take somewhat contrarian stances, leaning against the tide of opinion at times (but only when backed up with sound analysis). And if they really believed that the market was underpricing climate change risk, why not be rather more open about the resulting investment choices – leave the reference portfolio unchanged, and implement the market call through active management positions?

And you do have to wonder how, in a country where policy is still aimed at opening up further oil and gas deposits, a New Zealand government agency now has an official ban on buying shares in companies that might be developing those resources. Will an NZSF ban on dairy exposures be next?

We have elections to choose the people who will make policy decisions. If the public want to ban dairying, or oil and gas exploration, then elect the politicians to make those calls, and hold them to account. But lets not have bureaucrats and unaccountable Board members pursuing personal agendas (even popular ones) with our money. If the economic and financial case is really there – and remember that active management calls of this sort don’t have a great track record globally – then lay it out for us to see. On what they’ve released to date, this look much more like a virtue-signalling call than one consistent with the NZSF’s statutory mandate, or with the sort of professional expertise we should hope for from well-remunerated investment managers.

LVR restrictions

August 16, 2017August 16, 2017 Michael Reddell Financial stability, Housing, Uncategorized

The successive waves of LVR controls that the Reserve Bank Governor has imposed on banks’ housing lending in recent years are back in the headlines, with comments from both the Prime Minister and the Leader of the Opposition (here and here).

As readers know, I’m no defender of LVR restrictions. The other day I summarised my position this way

I never favoured putting the successive waves of LVR restrictions on in the first place. They are discrimatory – across classes of borrowers, classes of borrowing, and classes of lending institutions – they aren’t based on any robust analysis, as a tool to protect the financial system they are inferior to higher capital requirements, they penalise the marginal in favour of the established (or lucky), and generally undermine an efficient and well-functioning housing finance market, for little evident end. Oh, and among types of housing lending, they deliberately carve-out an unrestricted space for the most risky class of housing lending – that on new builds.

You’d never know, from listening to the Governor or reading the Bank’s material, that New Zealand banks – like those in most other floating exchange rate countries – appear to have done quite a good job over the decades in providing housing finance and managing the associated credit risks. We had a huge credit boom last decade, followed by a nasty recession, and our banks’ housing loan book – and those in other similar countries – came through just fine.

The Bank’s statutory mandate is to promote the soundness and efficiency of the financial system. On soundness, successive (very demanding) stress tests suggest that there is no credible threat to soundness, while the efficiency of the system is compromised at almost every turn by these controls.

At a more micro level, this comment (from my post yesterday) about the Bank’s debt to income limit proposals is just as relevant to the actual LVR controls they’ve put on in successive waves.

Much of the case the Reserve Bank seeks to make for having the ability to use a debt to income limit rests on the assumption that banks don’t do risk management and credit assessment well and that, inevitably crude, central bank interventions will do better. The Bank’s consultation paper makes little or no effort to engage on that point at all. It provides no evidence, for example, that the Reserve Bank has looked carefully at banks’ loan origination and management standards, and identified specific – empirically validated – failings in those standards. Neither has it attempted to demonstrate that over time it and its staff have an – empirically validated – superior ability to identify and manage risks appropriately.

For all that, in partial defence of the LVR controls right now, many of those who are calling for the controls to be lifted or eased seem to be giving all the credit (or blame) for the current pause in housing market activity to the LVR controls. That seems unlikely. Other factors that are probably relevant include rising interest rates, self-chosen tightening in banks’ credit standards, pressure from Australian regulators on the Australian banking groups’ housing lending, a marked slowdown in Chinese capital outflows, and perhaps some election uncertainty (Labour is proposing various tax changes affecting housing). I don’t know how much of the current slowdown is explained by each factor, but then neither do those focusing on the LVR controls. Neither does the Reserve Bank.

And the backdrop remains one in which house price problems haven’t been caused mostly by credit conditions, but by the toxic brew of continuing tight land use restrictions (and associated infrastructure issues) and continuing rapid population growth. Those two factors haven’t changed, so neither has the medium-term outlook for house and land prices. Political parties talk about improving affordability, but neither main party leader will openly commit to a goal of falling house prices, and neither main party’s policies will make much sustained difference to the population pressures. A brave person might bet on some combination of (a) a recovering Australian economy easing population pressure, and (b) talk of abolishing limits around Auckland actually translating into action and much more readily useable land. It’s a possibility, but so is the alternative – continued cyclical swings around a persistently uptrend in the price of an artificially scarce asset.

And thus, in a sense, the Reserve Bank has a tiger by the tail. House prices are primarily a reflection of serious structural and regulatory failures, and the problem won’t just be fixed by cutting off access to credit for some, or even by just buying a few months breathing space until a few more houses are built (before even more people need even more houses). This isn’t a “bubble”, it is a regulatorily-induced severely distorted market.

So I strongly agree with the Prime Minister that, having repeatedly sold the LVR controls as temporary, the Reserve Bank Governor really needs to lay down clear and explicit markers that would see the controls be wound back and, eventually, removed completely. And yet how can the Governor do that in any sensible way? After all, the underlying problem wasn’t credit standards, or even overall credit growth. It appeared to be simply that the Governor thought that he should “do something” to try and have some influence on house prices, even though he (a) had no good model of house prices in the first place, and (b) his tool didn’t address causes at all, and bore no relationship to those causes – it was simply a rather arbitrary symptom-suppression tool. And the Reserve Bank knew that all along – they never claimed LVR controls would do much to house prices for long.

Because the interventions weren’t well-designed, any easing or removal of the controls will inevitably be rather arbitrary, with a considerable element of luck around how the removal would go. What sort of criteria might they lay out?

a pause in house prices for a couple of years? Well, perhaps, but as everyone knows no one is good at forecasting cyclical fluctuations in immigration. Take off the LVR controls and, for unrelated reasons, house price pressures could still return very quickly,
housing credit growth down to, say, the rate of growth of nominal GDP for a couple of years. But there isn’t much information in such a measure, as the stock of housing credit is mostly endogenous to house prices (high house prices require a higher stock of credit).

The latest set of restrictions seemed to be motivated as much by a distaste for investor buyers as by any sort of credit or systemic risk analysis, so it isn’t clear what indicators they could use to provide markers for winding back the investor-lending controls. And since the Bank has never documented the specific concerns about banks’ lending standards that might have motivated the controls in the first place, it isn’t obvious that they could easily lay out markers in that area either. Since the controls were never well-aligned with the underlying issues or risks, it seems likely that any easing won’t be able to be much better grounded – almost inevitably it will be as much about “whim” and “taste” as anything robust. Unless, that is, the incoming Governor simply decides they are the wrong tool for the job, and decides to (gradually) lift them as a matter of policy. Doing so would put the responsibility for the house price debacle where it belongs: with politicians and bureaucrats who keep land artificially scarce, and at the same time keep driving up the population.

Some have also taken the Prime Minister’s comments as ruling out any chance of the Reserve Bank’s debt to income tool getting approval from the government. I didn’t read it that way at all.

But he [English] explicitly ruled out giving the bank the added tool of DTIs, which it had requested earlier in the year.

“We don’t see the need for the further tools, Those are being examined. If there was a need for it then we’re open to it, but we don’t see the need at the moment. We won’t be looking at it before the election.”

As even the Governor isn’t seeking to use a DTI limit at present (only add it to the approved tool kit), and as submissions on the Bank’s proposal haven’t yet closed, of course the government won’t be looking at it before the election (little more than a month away). It will take at least that long for the Reserve Bank to review submissions and go through its own internal processes. In fact, at his press conference last week Graeme Wheeler was explicitly asked about the DTI proposal, and responded that it would be a matter for his (acting) successor and the new Minister of Finance to look at after the election. Perhaps the Prime Minister isn’t keen, but his actual comments yesterday were much less clear cut on the DTI proposal than they might have looked.

In many ways, the thing that interested me most in yesterday’s comments was the way both the Prime Minister and the Leader of the Opposition seemed to treat decisions on direct interventions like LVR or DTI controls as naturally a matter for the Reserve Bank to decide.

The Prime Minister’s stance was described by interest.co.nz as

However, he again reiterated that relaxing LVR restrictions was a matter for the Reserve Bank. “I’m not here to tell them what to do.” English said government was not going to make the decision for them and that he did not want to give the public the impression that politicians could decide to remove them. “The Reserve Bank decides that.”

The Leader of Opposition similarly

“But we’ve not proposed removing their ability to set those…use those tools,” Ardern said. “We’re not taking away their discretion and independence.”

Both of them accurately describe the law as it stands. The Reserve Bank – well, the Governor personally – has the power to impose such controls. But there isn’t any particularly good reason why the Reserve Bank Act should be written that way.

The case for central bank independence mostly relates to monetary policy. In monetary policy, there is a pretty clearly specified objective set by the politicians, for which (at least in principle) the Governor can be held to account. In our legislation, the Governor can only use indirect instruments (eg the OCR) to influence things – he has not direct regulatory powers that he is able to use.

Banking regulation and supervision are quite different matters. I think there is a clear-cut argument for keeping politicians out of banking supervision as it relates to any individual bank – we don’t want politicians favouring one bank over another, and we want whatever rules are in place applied without fear and favour. In the same way, we don’t want politicians making decisions that person x gets a welfare benefit and person y doesn’t. But the rules of the welfare system itself are rightly a matter for Parliamant and for ministers.

There isn’t compelling reason why things should be different for banking controls (and, in fact, things aren’t different for non-bank controls, where the Governor does not have the same freedom). As my former colleague Kirdan Lees pointed out on Morning Report this morning, when it comes to financial stability and efficiency, there are no well-articulated specific statutory goals the Reserve Bank Governor is charged with pursuing. That gives the holder of that office a huge amount of policy discretion – a lot more so than is typical for public sector agencies and their chief executives – and very little effective accountability. So when Ms Ardern says that she doesn’t propose to take away the Bank’s discretion or independence, the appropriate response really should be “why not?”.

We need expert advisers in these areas, and we need expert people implementing the controls and ensuring that different banks are treated equitably, but policy is (or should be) a matter for politicians. It is why we have elections. We get to choose, and toss out, those who make the rules. It is how the system is supposed to work – just not, apparently, when it comes to the housing finance market.

I’ve welcomed the broad direction of the Labour Party’s proposal to shift to a committee-based decisionmaking model for monetary policy. But, as I noted at the time of the release, their proposals were too timid, involved too much deference to the Governor (whoever he or she may be), and simply didn’t even address this financial stability and regulatory aspects of the Bank’s powers. There is a useful place for experts but – especially where the goals are vague, and the associated controls bear heavily on ordinary citizens – it should be in advising and implementing, not in making policy. Decisions to impose, or lift, LVR controls or DTI controls should – if we must have them at all – be made by politicians whom we’ve elected, not by a single official who faces almost no effective accountability.

croaking cassandra

Economics, public policy, monetary policy, financial regulation, with a New Zealand perspective

Author: Michael Reddell