A couple of articles in last weekend’s newspapers got me thinking again about retirement income.

Diana Clements’ personal finance column in the Herald traversed the question of annuities. She begins:

There’s a gaping hole in the KiwiSaver concept: What happens to the money when people turn 65.

There is no need for people to do anything active with the accumulated Kiwisaver funds at 65, and in most cases the amounts involved are still quite small.  But when people have been in Kiwisaver for 20 or 30 years the amounts will be much larger.  And whether or not people do anything active with the funds at 65 they still face the question of how much of their wealth they can afford to spend each year when they do retire.

Clements reports that one company is launching a new hybrid annuity product: put your lump sum with the Retirement Income Group and you will receive an annuity for life, with the twist that if at death the total amount that has been paid out is less than the initial capital sum, the balance goes to the estate.  Of course, that additional insurance isn’t free: without it, the initial capital could afford to pay a higher annuity.

Annuities generally appeal to those with some reasonable level of wealth who think – or worry – that they will live longer than average (and to those without much of a bequest motive).  Actuarially fair annuities can be a great product for an older risk-averse person, especially if they come inflation-indexed.  They convert accumulated savings into a certain real income for life, and the recipient doesn’t have to worry about market investment risk or inflation for the rest of their life.  In that respect, they have some similarities to the best old defined benefit pension schemes.

But defined benefit pension schemes are now almost entirely a thing of the past – schemes have typically had no new contributors for decades –  and (as far as I’m aware) only government-associated schemes ever offered proper and full inflation indexing.  And annuities are hardly seen on the open market at all, and when they are offered they are not inflation-indexed.

The absence of inflation-indexing probably reflects the inability of markets to properly hedge against inflation risk.  That risk is particularly severe in a TTE tax system: when nominal interest is fully taxed at the time it is earned, an unexpected bout of inflation can do very nasty things to real returns.  Capital gains taxes also only rarely adjust for inflation in calculating the taxable gain.

Just recently, the British government announced it intended to scrap a requirement that accumulated funds in private defined contribution schemes be taken as annuities, a move described by one industry participant as “the final nail in the coffin of annuities”.  If so, that won’t be surprising.  Annuities fall foul of two things: adverse selection (when people can choose whether or not to take an annuity), and sharp falls in real long-term interest rates.

A couple of hundred years ago, annuities – and tontines – probably worked quite well (apparently the first known life tables for annuities date back to the third century AD).  Diagnostic medicine barely existed, and many people died from infections or illnesses with a random component.  An annuity provider could attract a pool for customers to whom it could provide reasonably actuarially fair annuities.  No one had the information to select into the pool in a way that would skew its long-term returns away from the provider.  (And expected inflation, and the interaction with the tax system, wasn’t a problem).

Now that is much less so.  Of course, there is still a random element to life expectancy, but it is the systematic element that creates problems for the provision of annuities.  People who come from long-lived families will be more inclined to like the idea of an annuity, but each $1m of capital will support a much lower annuity for them than it would for someone with a much shorter life expectancy.  If providers don’t, or can’t, differentiate by individual life expectancy, and instead set common annuity rates it will mostly be people who think (or fear) they will live for a long time will opt in, which will drive down the sustainable annuity rates, until fewer and fewer people opt for an annuity.    There will always be some, limited, market for the very risk averse, but it isn’t likely to be a very substantial market when people are free to make their own choices.  And even the risk-averse have to worry about the creditworthiness of the annuity provider – one reason why annuities and related products were often sold by governments (at least those with a pretty good track record of not defaulting on general creditors).

And, of course, the other problem is variable – but in trend decline over recent decades – real investment returns and real bond yields. As they have fallen, annuity rates (per $1m of capital) have fallen substantially.   In some respects, it is an inescapable problem. If real returns are low, there are no free lunches, and one can’t escape the constraint simply by not purchasing an annuity.  But timing can matter, potentially a lot.  With advanced country long-term bond yields so low, anyone forced by a government to take an annuity today risks having their purchasing power for the rest of their lives determined by today’s annuity prices.    That might be fine –  no better or worse than the alternative – if yields stay this low for the next 20 years (and who is to say confidently that they won’t)  but what if in three years’ time economies have snapped back and G7 long-term bond yields are averaging 3.5 per cent rather than something like 1 per cent at present?    A government that would force you to take an annuity now, just because you happen to turn 65 this year, would seem to be over-reaching itself.  Of course, real yields could fall further yet, but governments are no better-positioned than you or me to tell whether, and if so for how long, that will happen.

Probably none of us wants to see people in deep poverty in old age.  But the state is already providing an excellent product to cover that risk.  In New Zealand’s case, we have NZS, a modest and near-universal state welfare payment to those 65 and over, which is indexed to wages.  It is, in effect, a real indexed annuity, provided by a government with a pretty strong financial position, which has not defaulted its credit obligations for over 80 years.  NZS is not a particularly comfortable level of income, but it has been enough to ensure that New Zealand has one of the lowest levels of elderly poverty among OECD countries.  If one thinks of the role of the state as partly being a residual insurer, then NZS (combined with a public provision of health services, and resthome subsidies) pretty much has that role covered for the old.

It will be interesting to see how Ralph Stewart’s product goes. I wouldn’t be optimistic, but entrepreneurialism is partly about taking products to market and seeing if they work.  But we should resist the calls that will probably come, in various guises over the next few years as Kiwisaver matures, for anything like compulsory annuitisation of accumulated Kiwisaver balances at age 65.   Unlike the Australian compulsory private scheme, Kiwisaver was explicitly not envisaged as a replacement for the state pension, but as a top-up.  The complex Australian scheme needs all sorts of rules to avoid the state being rorted (probably more rules than it has).  Kiwisaver is just a moderately expensive, moderately distortionary, top-up to what is a pretty cheap and efficient state scheme, which serves what must surely be the main goal –  as it has been since 1898 – of avoiding the indignity of extreme poverty among our old citizens.  And it is a scheme that costs less, as a share of GDP, than most advanced country governments spend.  It isn’t perfect, but I’ll come back to that another day.

Some people might later regret blowing their lump sum Kiwisaver balance in a year or two after they turn 65, but people make choices that can look unwise  –  and that they might themselves regret later – at all sorts of phases of their lives.  Frankly, spending accumulated savings on a good time while they are still young enough to enjoy it, rather than spreading spending cautiously and evenly over decades (as I’m sure I will –  thank goodness for legacy DB pension schemes) seems like one of the less damaging choices people can make, and not really something for the state to concern itself with.

While on the subject of retirement, I noticed that the Retirement Commissioner is running a competition to come up with “catchy names” for different phases of retirement.  Why are we spending scarce public money on this patronising nonsense?  The amounts involved are no doubt small, but it is the mind-set that is concerning.   “Take care of the pennies…” was the old maxim.

Come to think of it, why do we need a Retirement Commissioner at all?   The Commissioner operates under the ambit of something now called the Commission for Financial Capability (costing almost $6m per annum).  But history suggests that governments themselves don’t have that much financial capability and are often worse  than the general public at making good financial choices –  which shouldn’t surprise us, since the people involved have less on the line.  In New Zealand, Think Big, Kiwirail, and a mismanaged Deposit Guarantee Scheme are just the first three central government activities to spring to mind.  And the Treasury is constantly warning us of what it regards as the somewhat perilous long-term position of even New Zealand government finances.  Individuals typically do less badly.

I’ve mentioned on a few occasions that the Reserve Bank is much less transparent about monetary policy, and especially the process behind the final outcomes, than it likes to represent.

A good example is the email below that I just received.  I  requested copies of papers relating to the March 2005 Monetary Policy Statement.  To be clear, that is documents relating to a monetary policy report from 10 years ago.  It is hard to conceive of what specific or general ground under the Official Information Act the Reserve Bank could have for wanting to withhold anything from that long ago, or for why it would have taken more than 20 working days to gather and look through the material  (or, indeed, why they would realise this difficulty on the very last day on which they could respond to the first request).

No doubt, the Reserve Bank is no worse in this area than many other government agencies.  Fortunately, the Ombudsman is currently looking into the operation of the Official Information Act.

The key principle of the OIA is that information shall be made available unless there is good reason for withholding it.  The purpose of the Act is really nicely expressed as follows:

The purposes of this Act are, consistently with the principle of the Executive Government’s responsibility to Parliament,—

(a) to increase progressively the availability of official information to the people of New Zealand in order—

(I) to enable their more effective participation in the making and administration of laws and policies; and

(ii) to promote the accountability of Ministers of the Crown and officials,—

and thereby to enhance respect for the law and to promote the good government of New Zealand:

(b) to provide for proper access by each person to official information relating to that person:

(c) to protect official information to the extent consistent with the public interest and the preservation of personal privacy.

And here is the email:

Dear Michael

On 2 April 2015, you made a request under the provisions of Official Information Act section 12 seeking:  All papers provided to the Bank’s Monetary Policy Committee, and Official Cash Rate Advisory Group, in preparation for the March 2005 Monetary Policy Statement.

Meeting the original 20-day time limit would unreasonably interfere with the operations of the Reserve Bank. Accordingly, and under the provisions of section 15A(1)(a) of the Official information Act, the Reserve Bank is extending by 20 working days the timeframe for a substantive response to your request.

You have the right, under section 28(3), to make a complaint to an Ombudsman about the Reserve Bank’s decision.

Yours sincerely

Angus Barclay

External Communications Advisor | Reserve Bank of New Zealand

2 The Terrace, Wellington 6011 | P O Box 2498, Wellington 6140

1. +64 4 471 3698 | M. +64 27 337 1102

www.rbnz.govt.nz

The Reserve Bank of Australia yesterday put out a Research Discussion Paper containing some discussion of the nature, and estimates of the size, of the social costs of counterfeiting of Australian banknotes.

It is good to see a central bank producing research in this area, and opening it to public scrutiny.  But I question the starting point.  I wonder how confident the Reserve Bank of Australia (and perhaps more importantly, the Australian Treasury as advisers to the Treasurer) can be that the statutory monopoly on physical currency  – which is what the anti-counterfeit measures are protecting –  is itself socially beneficial?

Without that statutory monopoly (on notes in section 44 of the RBA Act, and on notes and coins in section 25 of the Reserve Bank of New Zealand Act) banks would have been likely to have gone on issuing their own notes (and perhaps coins).  New Zealand banks issued their own notes until 1934, when the first Reserve Bank of New Zealand Act prohibited them from offering that payments medium, as part of (but not a necessary part of) the establishment of a central bank in New Zealand.

If the monopoly were removed today, it is likely that private issuance would resume, and central bank notes would revert to being issued/used primarily in quite extreme crises, when there was a generalised loss of confidence in liabilities of the banks.    There is no obvious reason why, in normal times, people would be any more reluctant to hold, say, ANZ banknotes delivered from an ANZ ATM than they would be to hold an ANZ demand deposit (as they were doing just prior to withdrawing the notes through the ATM).  People happily hold notes from the (legally limited) private issuance in Scotland and Northern Ireland.

Actual and potential dishonesty poses major and pervasive costs to society.  A society in which all people were angels would be unrecognisable to us mere flawed mortals. So private note issuers would, of course, have to spend money to protect the integrity of their notes, in just the same sort of way they need to spend to ensure the integrity of both physical (eg cheques) and electronic payments media (credit and debit cards, for example).  Banks must make judgements about how much to spend, and what balance to strike between imposing liability on customers, and assuming responsibility themselves.  It isn’t obvious ex ante what balance should be struck, but they face market tests in making those choices (unlike central bank issuers).  And in a competitive market for physical currency issue we would normally expect a much greater degree of product innovation, including perhaps around security features.

The market for physical currency is highly distorted.  The RBA paper focuses on the extent to which counterfeiting discourages use of physical currency, but currency is probably already under-held and underused even if there were no counterfeiting at all.   At least two factors drive that.  First, using legislation to prohibit use of any notes other than Reserve Bank ones imposes considerable private holding and transportation costs on banks, and customers  (some portion of which probably amounts to deadweight social costs).  By contrast, own-bank notes have no material holding costs to banks.  And second, central banks choose (legislation does not force them) to offer no return on their monopoly note issue[1].

Sometimes it is argued – usually by central bankers – that the zero interest nature of monopoly central bank currency issuance represents an efficient tax (since demand appears to be fairly interest- inelastic).  But, whatever the merits of the argument might be on certain textbook assumptions, it isn’t an approach countries take in the practical design of modern tax system.  Using state-granted monopolies as a source of revenue has been somewhat frowned on in advanced economies for several centuries.

Nothing about monetary control would be jeopardised if the note monopolies were repealed.  So perhaps the RBA could be asked to have its researchers go back to their desks and start a new study on the social costs and benefits of a state currency monopoly.   It might be a small regulatory issue in its own right, but regulatory restrictions should remain on the statute books only when there is a clear continuing case for them. I doubt there is such a case for the physical currency monopolies.  Perhaps repeal of these monopoly provisions could be added to the list for the Australia government’s next “Repeal Day”?

[1] Various authors noted years ago that lotteries based on serial numbers offered one way of providing a positive expected return.

UPDATE:  Just to be clear that what is proposed here is not what is described as “free banking”.  Free banking would involve the abolition of the central bank and a shift to a model in which banks’ issuance of credit etc was constrained only by market forces.  Simply abolishing the bank note monopoly does not change how current monetary policy works, operating on the marginal cost of/return to central bank electronic liabilities  (settlement account balances).  I might come back and explore some of the free banking ideas at some stage.

Reading the Herald over lunch I found Audrey Young’s interview with Labour’s finance spokesperson Grant Robertson.

I was interested in his praise of the former Minister of Finance, Michael Cullen.   No doubt he has to say some positive things about his predecessor, but his comments seem quite genuine – Cullen is his “finance hero”.  It isn’t an overly partisan interview –  he describes both Michael Cullen and Bill English as people “who are seen to be good Finance Ministers”.

There is no single way to evaluate the success of a Minister of Finance; it is such a multi-faceted job.  Labour ran large surpluses for much of its term, but then left a Budget  –  with Treasury’s explicit imprimatur –  that meant large deficits when the unexpectedly severe recession hit.  The current government has run deficits, despite record terms of trade, but then they had a tough starting point.  The economy was buoyant in the years up to 2008, and has shown little (per capita) growth since then, but neither Minister of Finance had much hand in those outcomes.

One the most disappointing aspects of my adult life has been the failure of any government (two Labour-led, two National-led) to make any real progress in turning round the gaps in living standards between New Zealand and other advanced economies.

People can debate how to measure living standards , but perhaps the best test is what choice New Zealanders are making.  Are they coming, going, or staying?

A successful economy isn’t one in which no New Zealander ever leaves.  Individuals will come and go at different stages of their lives, for professional opportunities, for adventure, or just to see the world.  And a few will always go permanently –  whether it is marriage to someone overseas, or a particular professional niche.  I’ve been in and out three times in thirty years, and we actually produced a PLT inflow by having two kids abroad.   But a reasonable benchmark for the success of a country is likely to be whether, on average over time, the net outflows of its own citizens roughly match the net inflows of people returning.  If so, it suggests that people, on average, reckon they can have just as good a life here  –  near home and family, in the culture they know – as in other advanced economies.

How have the different governments, and Ministers of Finance, done since 1984?

These data are based on what people say on their arrival/departure cards.  They aren’t perfect: some people say they are going short-term and end up staying away for good.  Others go planning never to return and are back a few months later.  But the general picture in the multi-year averages isn’t likely to be that far off.

There just isn’t much sign of the net outflow slowing down much.  It ebbs and flows with the differences between the cyclical health of Australia’s economy and ours.  And when the world is in a particularly bad way people tend to stay close to home too.  Perhaps the 1990s period stands out as better than most, but I wouldn’t make very much of that.  Right now the net outflow is quite small, but the series is very volatile, and this trough is no shallower than others we’ve seen over the years.  It is unlikely to last, let alone turn into a net inflow.

I’ve shown the average annual net outflow as a percentage of the population.  Those can look small  –  year by year they don’t make much difference.  But over the 31 years, a net 676000 people have left New Zealand, from a country that had only 3.3m people in 1984.   And many of them will have had children and grandchildren who are also now not growing up as New Zealanders.

Does it matter?  Perhaps not to some – each individual is making his or her own best choices –  but it has changed New Zealand, and if nations mean anything then it matters. To me, it marks the failure of our governments.

John Key certainly thought so[1].  This extract was from a speech he delivered just before the 2008 election.  I had a copy pinned above my desk for several years; first in (perhaps rather naïve) hope, and then, if not in despair, at least in resignation.  What changes?

I came into politics because I believed New Zealand was underperforming economically as a country. I don’t think it’s good enough that so many New Zealanders feel forced to leave our country each year to seek higher wages in Australia. I don’t think it’s good enough that our average incomes lag so far behind the rest of the world. And I think it’s unforgivable that the Labour Party has done so little to address these fundamental challenges. I believe that a very big step change is needed in our economic performance to ensure New Zealand can make the most of its considerable potential.

[1] And I’m sure his predecessors of both parties did too. This isn’t intended as a particularly partisan comment.

Last week I wrote

In their recent book House of Debt, the US academics Atif Mian and Amir Sufi, argued that equity-sharing contracts should become the norm for housing finance.  They argue that such contracts would materially reduce the risk of financial crises, and that the main reason such contracts aren’t common is because of the tax system and the role of US government agencies.  I’m very sceptical of both claims

And here is why.

In the final chapter of their book (so it isn’t the focus of their analysis) Mian and Sufi advocate the introduction of what they label “shared-responsibility mortgages”.  Under these contracts, when house prices in the borrowers’ locality fall the borrower gets an automatic reduction in the principal amount of the mortgage.   The cost of this (what is, in effect, a) put option is covered by providing that five per cent of any nominal capital gain would go the lender (either when the house is sold, or when the loan is refinanced).  In some cases, that payment would go to the lender in just a year or two, but in other cases it might take many decades.

If such residential mortgages were widespread, no mortgage borrower would ever have negative equity in their house as a result of movements in the general level of houses  (severe neglect of maintenance, or specific issues in, say, the street your house was located in could still result in a small number of cases of negative equity).  Whenever general house prices (in your part of the city) fall, the loss is shared with the mortgage lender, and your equity share in the house does not change.

Mian and Sufi argue that this feature would have greatly reduced the severity of the 2008/09 Great Recession in the United States.  In their story –  the thrust of their book –  the severity of the recession was mostly due to the negative equity so many borrowers had once house prices fell, and the impact of those wealth losses on consumption.  I find that story unconvincing.  I’ll skip the detail here, but the paths taken by the New Zealand and the United States economies have been so similar since the mid 2000s, and yet New Zealand had very little sustained fall in nominal house prices, and few cases of material negative equity.  Given that, it is difficult to be confident that falling house prices, and associated wealth losses, are a key causal factor explaining why economies are still lagging so far behind pre-recession trend GDP levels.   For example, fluctuations in house-building activity –  booms and busts –  are much more important than Mian and Sufi recognise.

But I wanted to focus on the suggestions that shared-responsibility mortgages (SRMs) would materially reduce the risk of financial crises, and that the main reason they don’t exist is the role of various government interventions.

Why might the risk of future financial crises be reduced?   They argue that

the downside protection in SRMs would lead lenders to worry about future movements in house prices.  If house prices plummet in the near future, then more recently issued mortgages would generate the greatest loss for the lender.  The lender would have to be very mindful about potential “froth” in local housing markets, especially for newly-originated mortgages.  If lenders fear that the market might be in a bubble, they would raise interest rates for new mortgages in order to cover the cost of the increased likelihood of loss.  SRMs would therefore provide an automatic market-based “lean against the wind”.

To which I would make a few points in response:

• Newly-issued mortgages have always been the ones at most risk of loss to the lender (borrowers borrow to the hilt, especially to get into a first house, and then typically see their economic position improve over time, through rising nominal wages and house prices, and gradual principal repayments).
• The nature of very frothy markets is that no one pays much attention to downside risk (or at least, they pay rather less attention to it than in more normal times).  Recall Ben Bernanke’s pre-recession scepticism about the idea of any widespread house price overshooting in the United States.   In periods of extreme optimism and persistent rises in house prices, there may be at least as much lender focus on booking the 5 per cent capital gain as on the possibility of a future loss.
• Risk isn’t changed by the introduction of an SRM, it is just reallocated.  In principal, lenders should be somewhat more wary about the downside risk, but borrowers have less reason to be concerned about things going wrong.  If house prices fall, their equity will be impaired but- by design – by nowhere near as much as under a conventional mortgage.  There is at least an arguable case that lenders are better placed to bear risk than borrowers, since they can diversify across individual borrowers and geographically.  Mian and Sufi offer no reason to think that the net effect of the reallocation of risk would be to reduce overall risk-taking in the house finance market in boom times.

Mian and Sufi outline one other argument that might act as a modest dragging anchor.  Any  refinancing would trigger the need to make the 5 per cent capital gain payment to the lender, so any cash-out refinancing (drawing more on the mortgages to buy a boat or finance a fancy holiday) would involve meeting the 5 per cent payment.  I suspect that (a) any benefits would be small, and (b) that if such SRMs ever came to market the option premium would probably end up built into the initial value of the loan (you need $300000 to purchase your house, but the loan is booked as $304200[1], and serviced over time on that basis).

The second element of the Mian-Sufi argument is that such  products have not emerged mainly because of mortgage interest deductibility for owner-occupied houses, and because of the dominant role of the agencies in influencing the structure of US mortgage contracts.  The authors report that interest deductibility is available in the US only when the home owner bears the first losses when house prices fall.

These may well be factors that impede the emergence of such contracts in the United States, and no doubt the tax laws could be revised in ways that would bear less heavily on the prospects for SRMs.  But Mian and Sufi’s argument is a very US-centric perspective.  We do not see such contracts having emerged in other advanced economies in which the state has little or no direct role in the housing finance market, and where interest on mortgages on owner-occupied properties is not tax deductible.  New Zealand (in particular) and Australia and the United Kingdom spring to mind.  Bank regulators might not like such products greatly, but capital adequacy frameworks cope with options in other markets, and products like SRMs did not exist either in the decades before risk-weighting and capital adequacy frameworks assumed a key place in the bank regulatory framework.

Robert Shiller has long argued for the emergence of a fuller range economic derivative contracts (house price futures, nominal GDP indexed bonds, and so on), but few of them have emerged.  Revealed preference is a powerful insight.

The Mian and Sufi  SRM is in this tradition – an interesting idea, which seems to have some appeal for some borrowers, few or no regulatory/tax obstacles in many countries, and yet they just have not emerged.  It is interesting to think about why?  Personally, I suspect SRMs have not emerged because conventional mortgages are not “horrible instruments” (Mian’s and Sufi’s term) at all but very attractive and effective instruments.     They have proved to be only moderately risky over many decades, at least  in systems (unlike the US in the 90s and 00s) where government mandates don’t try to override market judgements on credit quality.  In market system the risk around conventional mortgages is managed through lender decisions around initial LVRs and servicing capacity (and, of course, overall capital holdings.  Conventional mortgages also require limited amounts of ongoing monitoring.    Borrowers typically have the most to lose: on any individual loan a new borrower may have only 10% equity in the house so the lender can lose more dollars, but the potential loss for a borrower (in New Zealand or other with-recourse markets) is everything (all their assets).  The system has worked well for many decades, so what would be the impetus for change?  In some ways this comes back to Calomiris and Haber, and the suggestion that the US financial system was made fragile by design.  As they document, the situation in other countries is rather different.

Revealed preference is a powerful insight, but….as an analyst I’m still a bit puzzled why inflation-indexed mortgages haven’t emerged (in countries like New Zealand or Australia).   That might be a topic for another day.

Finally, and harking back to Islamic banking, I presume that SRMs would not be sharia-compliant.  They add some additional uncertainty regarding the future value of the loan but an interest rate is still a key feature of the structure.   Proper equity-finance structures for residential properties still look expensive to establish and monitor, and unlikely to emerge on any scale.

[1] Mian and Sufi estimate that the upfront option premium for the protection the SRM offers would cost 1.4 per cent of the initial value of the loan, on historical US house price performance

Vernon Small’s politics column in today’s Dominion-Post had this paragraph:

English has not overtly disciplined the central bank over its persistent failure to keep inflation close to the 2 per cent target, though he noted yesterday there was a mechanism in his policy targets agreement with the bank governor to address that.  There had been “ongoing discussions” over the bank’s performance and it was a question of how long it went on  –  currently more than two years (or “a wee while” as English archly put it).

It isn’t entirely clear how much of this is accurately reported, and how much is Small’s interpretation/translation of what he thought English said.  That isn’t my concern here. I want to focus on what options are open to the Minister of Finance if he was concerned.

The first is that there is no such procedure in the Policy Targets Agreement.  The PTA sets out the target, and how the Bank is supposed to respond, and report to the public, when inflation moves materially away from target.  The agreement also notes that

The Bank shall be fully accountable for its judgements and actions in implementing monetary policy.

but this adds nothing to the provisions of the Reserve Bank of New Zealand Act, which contain both the accountability provisions and remedies open to the government.

The Act is quite an elegant structure. The Minister takes the lead in setting the [inflation] target and the Governor has sole personal responsibility for implementing monetary policy in pursuit of the target.  The Minister also appoints the Bank’s Board, whose primary responsibility is to act as monitoring agents for the Minister – and, to a lesser extent, the public.  The Minister also has The Treasury, who have no formal institutional role in the monetary policy governance process, but act as the Minister’s own professional advisers and these (and many other) issues.

The Board can recommend that the Minister dismiss the Governor, and the Minister can seek the removal of the Governor with or without a recommendation from the Board.  The Governor can’t, of course, be dismissed on a whim, but only on the grounds laid out in the Act.  The essence of the framework is that the Minister appointed the Governor to do a job –  in respect of monetary policy, as specified in the Policy Targets Agreement –  and if the Governor isn’t doing his job satisfactorily he can be dismissed.  That was one of the ideas at the heart of New Zealand’s far-reaching public sector reforms in the 1980s –  operational independence for chief executives, but the loss of the sort of “tenure until retirement” such chief executives had previously had.  It was why, unlike the situation in most other countries, our Governor is the sole decision-maker on monetary policy: Ministers responsible for the legislation in the 1980s thought it wasn’t credible to fire a whole committee, but it was quite credible to dismiss a single individual[1].

But dismissal is an extreme option.  I’ve long argued that it is not a particularly credible threat either.   A Governor’s failure would probably never be black and white, and he has large institutional resources to defend his position, as well as the threat of seeking judicial remedies (interim injunctions, and/or overturning the decision).  Given how disruptive (including in international financial markets) and uncertain all that would be, all but the very worst Governors have effective tenure to the end of their terms. And that is probably how it should be.   The option of non-reappointment at the end of a five year term is another matter.

If perhaps there is some buyer’s remorse, I’m sure no one is talking of such options at present.

But what other options does the Minister of Finance have?

He could simply pick up the phone or arrange a meeting with the Governor.  No doubt the two of them talk about various things.  But while the Minister of Finance is quite within his rights to want to be sure that the Governor is operating monetary policy consistent with the Policy Targets Agreement, he wouldn’t (or shouldn’t) want to be seen to be putting pressure on the Governor in respect of a particular OCR decision.  Operational decisions around the OCR are the Governor’s alone (with plenty of advice of course).  Maintaining that distance, and respecting appearances, is one reason why it was most unfortunate that the Governor recently appointed the Minister’s brother as one of his monetary policy advisers.

The Minister could seek a report from The Treasury on their view of how well the Governor was doing consistent with the Policy Targets Agreement, could let it be known such work was underway, and could arrange for such a report to be published.  The New Zealand Treasury offers independent professional advice to the Minister of Finance and would have to take seriously such an exercise.  It might be expected to consult externally (but confidentially) to canvass opinion.   At present, for example, most financial market economists –  not the only relevant observers but not unimportant either –  in New Zealand seem quite comfortable with the Governor’s handling of monetary policy.

The Minister could also seek formal advice from the Bank’s Board, and let it be known that he was doing so.  This would be a totally orthodox approach – the Board exists as a monitoring agent for the Minister – and it was, for example, the approach taken in the mid-1990s when inflation first went outside the target range.   The Board has a number of able people on it, but as an effective agent for accountability risks being too close to management.   The Governor sits on the Board, the Board meets on Bank premises, it has no independent resources, and it has been chaired exclusively by former senior managers of the Reserve Bank.    It was striking that last year’s Board Annual Report (which is just embedded in the Bank’s Annual Report document) had nothing substantive on the deviation of inflation from the policy target.

Although it has no formal status, the practice has grown up of Ministers writing to chief executives, in this case the Governor, in an annual “letter of expectation”.  If the Minister has had concerns one assumes that he has used his letter to pose questions to the Governor around the deviation of inflation trends from the midpoint of the inflation target.  under the Official Information Act I have requested copies of such letters (I requested them  from the Reserve Bank, who have now transferred my request to the Minister of Finance).

The Minister also has reserve powers to act directly.  Section 12 of the Act allows the Minister, transparently and for a fixed term, to impose another “economic objective” than the “stability in the general level of prices”.  These powers have never been used, although the previous Minister of Finance talked openly of the possibility of doing so (at that time, discontent with the Reserve Bank resulted in a select committee inquiry into the future of monetary policy).  Using the section 12 powers does not technically alter the governance structure.  A new Policy Targets Agreement needs to be put in place, and the Governor then has responsibility for operating with that.  I’ve previously argued that the section 12 powers might be able to be used to direct the Bank to put short-term rates at a particular level, but there are other ways of skinning the cat that could, in effect, require the Bank to cut the OCR if the government were really concerned that the Bank was not operating consistently with the current Policy Targets Agreement.

I’ve been quite open that I don’t think the Reserve Bank –  the Governor –  has been making the right calls on monetary policy.    Interest rates have been too high now for some considerable time, and it is beginning to get beyond the point where reasonable people just see things differently.  I do think there is an onus on the Board to be asking some particularly searching questions, and to be letting the Minister –  and the public –  know the conclusions they reach, and any reasoning behind those conclusions. The Board is required to satisfy itself that each Monetary Policy Statement is consistent with the Policy Targets Agreement, and there is another Statement coming out next month.    There must now be some question as to whether they could do so if the current policy stance is maintained.

I don’t think it is time for the Minister of Finance to act, but he probably doesn’t need to.  Even garbled newspaper stories that talk of the Minister of Finance disciplining the Governor will no doubt have caught the Bank’s attention.

[1] Experience suggests that dismissing whole committees is perhaps less difficult than was then thought.  The Hawkes Bay DHB and Environment Canterbury examples spring to mind.

Media reported yesterday on a local Muslim woman who had sought to interest New Zealand banks in offering mortgage products that met Islamic restrictions on the payment of interest.  The article suggested that a Kiwisaver provider was interested in offering such products.  There were some small lenders offering such products prior to the 2008/09 recession but they did not seem to survive.

I’ve long been intrigued by the ideas and practice of interest-free finance.  My own Christian tradition for centuries banned, or regarded with intense disfavour, lending at interest.  That drew first on Old Testament provisions, which prohibited Israelites from lending to fellow Israelites in need at interest (while allowing loans at interest to outsiders).  The stance was reinforced by perspectives from Aristotle, rediscovered in the Middle Ages, arguing for the inherent sterility of money.  Prohibitions on lending at interest were eventually removed but  it remains a powerful vision for some (for me).   Within the Christian community, outfits like the Kingdom Resources Trust in Christchurch try to put it into practice.

The injunctions against interest are apparently much stronger and more pervasive in the Koran. In his recent book, Beggar Thy Neighbour, Charles Geisst reports that “of all the prohibitions against undesirable activities in the Koran, usury is mentioned the most.  Interest, or riba, is considered usury and no distinction is made between them”.   This was a distinctly counter-cultural stance, as compound interest had apparently been common among Arabs before the coming of Islam.

If interest is prohibited, profit-sharing arrangements –  equity finance, in effect – are not frowned on at all.  They have a element of uncertain return – economic risk –  for which some reward is appropriate. Predominantly-Muslim countries, and individual Muslims. have grappled with how to apply the prohibitions on interest in today’s world.  The large Muslim minority in the UK and the large financial sector with global connections has led to considerable interest there.  In his pre-crisis heyday, Gordon Brown wanted London to become the global centre of Islamic banking.

My interest in interest-free finance once got me a trip to Iran, as a member of an IMF technical assistance mission. This was shortly after the Iran-Iraq War and the death of the Ayatollah Khomeini, in an earlier phase of opening to the West.  I got on the mission because of my (innocuous, non-US, non-UK) New Zealand passport.  From my perspective, two weeks in Iran was made easier by the fact that I didn’t then drink alcohol at all.

I was (am?) a bit of an idealist, and went in fascinated to learn more about trying to apply the interest-free teaching in practice.  And I like to think we offered them some helpful advice –  monetary policy without interest isn’t particularly intellectually or practically difficult.  But I came away somewhat disillusioned.  We met a variety of people – bureaucrats, bankers, and even some theologians (we wanted to better understand what the permissible limits were).  Some were more earnest than others, but the overwhelming impression I came away with was of people trying to devise instruments to the limits of the letter of the law (Koran), with little regard for the spirit.   I’m not, for a moment, suggesting that that was the approach of individual devout Muslims across the country, but among the groups we engaged with the focus was on products that had the economic substance of interest, but not the legal or exegetical label of interest.

I’m not sure that that was, or is, unrepresentative of many Islamic banking products.  Take mortgages as an example.  A widely-used UK website , Islamic Mortgages, covers a wide range of sharia-compliant mortgage products.

In a nut shell how does an Islamic mortgage work for different types of purchases?

Buying/selling:

• you choose property, agree price, undertake survey
• bank enters into contract to buy the property from vendor
• bank sells property to you at higher price
• the higher price is paid by you in equal instalments over a fixed term, irrespective of what happens to Bank of England base rate
• Leasing:

• choose property, agree price
• bank undertakes survey, buys property and sells it to you for the same price, in return for payments spread over fixed period up to 25 years
• in addition to monthly payments, you pay a sum for ‘rent’ – assessed annually in line with market trends
• you can overpay (as with a conventional flexible mortgage) to buy the house more rapidly

These are interesting products in their own right, but the first is simply economically equivalent to a mortgage with a fixed interest rate for the entire life of the loan.    Neither the purchaser nor the lender will necessarily regard themselves as paying or receiving interest, but the payment streams over the life of the contract (“fixed term”) will be the same as those on a conventional table mortgage with a fixed interest rate for the same term.  And the risks  – credit, market, counterparty –  seem very much the same.

An alternative type of product might be an equity-based housing finance product.  In conventional housing finance markets, the purchaser puts up some equity, and a lender provides the balance.  The lender receives an interest-rate and is exposed to the (hopefully small) risk that the borrower defaults and that the house can’t be sold for enough to cover all the outstanding debt.  Any increases in the value of the house – whether changes in market prices generally, or as a result of improvements/extensions – accrue to the owner.

But it would be technically quite feasible to envisage a model in which the person wanting a house to live in, and the financier, became equity partners in a joint business venture to own the house.  You, the, resident would presumably pay rent to the joint venture, some portion of which would be passed to the equity finance partner, and when the house was eventually sold gains and losses would be shared, proportionately, between you and the equity partner.  You have risk, the equity financier has risk, and no one is paying or receiving interest –  in form or in substance.  It would be simple enough, technically, to structure the contract to allow the resident’s equity share to rise over time (instead of “principal repayments”, one uses the funds for equity repurchases from the JV partner).

I’m not sure if such contracts exist anywhere in the Islamic world.  In the West, without the theological concerns about interest, there is good reason why they don’t exist.

If I’m a young person in the West buying a first house, a bank might lend me 90 per cent of the value of the house.  Most mortgages are table mortgages and are repaid gradually, so that in time the owner’s equity share is large, heading for 100 per cent.  All the Bank cares about after that is my ability to service the debt.  And that depends largely on avoiding prolonged periods of unemployment.  If house prices fall that poses a risk –  banks can call in a mortgage if the value of the collateral drops below the value of the mortgage –  but it typically only crystallises if the flow debt service isn’t being met, and if house prices fall so far that not all the debt can be repaid when the house is sold up.   Within limits – quite wide limits – banks don’t care about or monitor the maintenance you do on your house.  If you don’t do the maintenance, mostly it is your loss.  And they don’t care at all about changes in market rentals in your neighbourhood, or for your specific type of house.  Conventional mortgages are simple, easy, and cheap to monitor.

But equity-sharing contracts would be enormously costly to monitor and manage, especially in a country with such a variegated housing stock (rather than lots of high-rise uniform apartments).  If you are only an equity partner in a house, your incentive to do maintenance is attenuated –  and likely to weaken especially in periods of personal financial stress.  So a financier providing a large equity stake would probably want to pre-specify maintenance obligations and standards (and would then need to monitor compliance).  You’d need to negotiate all alterations and extensions.  Rental rates vary, as do market values.  Perhaps a real rental yield could be pre-specified in the initial contract, but any arrangement for the resident to gradually buy out the outside equity partner requires an agreement on market value at the time of the transaction.  Transactions costs rapidly start to mount.  They might work within a relatively closed community – say, a local church community where effective monitoring costs might be reduced, or a small mosque-based credit union  –  but it is difficult to see them being effective, and economic, more generally.

In their recent book House of Debt, the US academics Atif Mian and Amir Sufi, argued that equity-sharing contracts should become the norm for housing finance.  They argue that such contracts would materially reduce the risk of financial crises, and that the main reason such contracts aren’t common is because of the tax system and the role of US government agencies.  I’m very sceptical of both claims, and would post the note I wrote on why –  but it would take 20 working days to get OIA clearance.  This post is quite long enough, but if anyone is interested I can explain my scepticism in a later post.

UPDATE: The later post on equity-sharing mortgages.

One line sometimes heard in the current New Zealand economic discussion is a suggestion that New Zealand has. or has had, a “robust” recovery.  I reckon “robust” is generally a good word to avoid, since it has connotations of something well-founded and sustainable which, in a sense, only time will tell.  But just how strong has our recovery been?

Official quarterly GDP data go back only to 1987 [surely, surely, we need rather better funding for core official economic statistics] but Viv Hall and John McDermott have generated a series, using earlier annual estimates by SNZ and other authors, all the way back to 1947.

The chart below shows the annual percentage change in real quarterly GDP (seasonally adjusted, since that is how Hall and McDermott present their estimates).  There are some oddities around the estimates for the first few years (if I recall rightly, having to do with the level of aggregation in export prices used in generating the original annual real series) so here I’ve shown the data only from the year to December 1952 (a version showing the data all the way back to 1948 is shown at the end of the post).  It is a long time series by New Zealand standards.

On these estimates, real GDP has been quite volatile over the years.  We’ve had five episodes in which GDP has fallen by 2 per cent or more between one quarter and the same quarter the following year.  The recession in 2008/09 was almost as deep as the deepest of these five contractions.  But what is noteworthy is just how subdued the recent recovery has been.  Annual growth has inched up to around 3.5 per cent, and few, if any, forecasters seems to be picking it to go any higher.  In past cycles, growth peaks in excess of 6 per cent have not been uncommon and periods of growth in excess of 4 per cent per annum have been the norm.

Of course, there is no doubt something to be said for some stability to growth rates. But there is probably more to be said – perhaps especially for those who became unemployed  –  for a quick rebound from a serious recession.  We haven’t had that sort of rebound.  Of course, most other advanced economies have not either but many of them have policy interest rates around zero and have largely exhausted the limits of conventional monetary policy.    Sometimes inflation doesn’t provide any leeway for an inflation targeting central bank to accommodate a strong recovery, but that hasn’t been a problem here.

One could mount an argument – reasonable people would differ on the point – that faced with a location-specific demand shock such as the Christchurch repair and rebuild process, it might have been quite reasonable to have expected a particularly strong rebound in GDP for a time, and perhaps even some overshooting in headline CPI inflation (since medium-term trends are what the Bank is instructed to focus on).

But whatever your view on that particular point, given the depth of the recession, how far below pre-recession trends GDP still is, and how low core inflation has drifted, peak GDP growth of 3.5 per cent should be counted more as a failure than as a success.  An economy firing on two, faltering, cylinders might be a better description than “strong” or “robust”.

One other argument I have heard against cutting the OCR now is the risk of a repeat of what is loosely characterised by my old colleague Rodney Dickens as “Alan Bollard’s go-for-growth experiment” of 2003/04.  That there was such an “experiment” is hard to disagree with –  the government had given Alan a higher inflation target, and he (and the then government) seemed to have a sense that the old-school Reserve Bank hardliners had been holding back New Zealand’s growth potential.  I think the characterisation is a little unfair on Alan, but even he later admitted that the policy approach in 2003 had been a mistake.

I could discuss the similarities and differences between 2003 and the current situation at some length (and I don’t feel defensive about 2003, as I working overseas that year), but the stark and simple contrast is captured in this chart, which I’ve run already this week.

In 2003 and 2004, core inflation was well above the target midpoint, had increased materally over the previous year or so, and was increasing further.  Of course, the PTA at the time made no mention of the midpoint, but no one ever thought the top part of the target range was something to actively aim for.  This particular analytical series did not exist then, but it captures trends that were apparent in other ways of slicing and dicing the CPI.   Even allowing for the uncertainties (SARS etc), to have cut the OCR then and to have been so slow to move it back up when the initial scare passed, is hard to defend.  As Alan later said, it was a mistake.

What is the situation now?  The Bank has, as much by accident as by good planning, achieved something worthwhile in the last few years in finally demonstrating that core inflation will not always be in the top half of the target range.  But this is not a price level target regime, and the PTA is clear that the focus now needs to be on keeping future inflation near the 2 per cent midpoint.  Actual measures of core inflation have been falling for years, and are now well below the target midpoint.  A material increase in the (core) inflation rate would be highly desirable, given the target the Minister and the Governor have agreed.  It has been forecast for several years, but it has simply not arrived.  Perhaps it is just a “not yet”, but the case for OCR cuts now is very very different from the case in 2003.

Appendix:

The first chart above for the full period since 1948.