RB chief economist on inflation

It was something of a (perhaps minor) landmark event last Thursday when the Reserve Bank’s chief economist Paul Conway gave an on-the-record speech on inflation. It was only Conway’s second on-the-record speech (the first was on housing, something the Bank has little or no responsibility for) and thus only the second speech from a Reserve Bank chief economist for almost five years. Five years in which chief economists have become statutory decisionmakers (members of the MPC), in which monetary policymakers have dealt with a huge and expensive shock, and in which inflation – prime focus of central bank monetary policy – has been let run amok in ways never seen previously (arguably never envisaged) in the first 30 years of inflation targeting. And when (a) external MPC members are barred from research/analysis, and (b) barred from speaking or disinclined to do so, and (c) the chief economist’s own boss has no qualifications/background in economics or monetary policy, we should be able to look to the Bank’s chief economist for incisive and insightful analysis and perspectives on the macroeconomic dimensions of the Bank’s responsibilities. If not him then who?

Sadly, the answer to that seems to be no one at all.

There have been worse things from the Reserve Bank on monetary policy in recent years. The most egregious have been the (apparently) unscripted one-liners from the Governor. One could think of his claims – never backed by any analysis at all – that the economic gains from the LSAP programme were “multiples” of the $10.5bn (Treasury estimate) direct fiscal loss from the LSAP, or the preposterous spin he tried on Parliament’s Finance and Expenditure Committee just a few months ago

Not even arguable, just false.

There is nothing quite so egregious in Conway, mercifully (he is a more earnest, less flamboyant – or worse – character).

But what is there in his speech is far from the sort of standard we should expect from a senior policymaker addressing the biggest monetary policy failure in decades. And it is not as if his speech was delivered to a bunch of high schoolers or the Gisborne U3A (no offence to either) but to an (at least) expert-adjacent group at the ANZ-KangaNews New Zealand Capital Markets Forum.

The Bank’s PR people billed the speech this way

Item 3 is easy. The only thing the Bank can do is raise the OCR and hold it higher for long enough. Although Conway never acknowledges this, it is hard to be very confident in their view (or anyone else’s) on how high or how long might be required, not just because there are always new shocks, but because neither the MPC nor others really yet have a compelling story for why core inflation went so high so quickly.

So much of the speech is made up of plaintive pleas to the public to believe the MPC when they say they are serious, and to act accordingly, without giving us any basis to believe the MPC really knows what it is doing. After all, not much more than 18 months ago Conway’s predecessor was telling the Reserve Bank’s Board there was no hurry and no real need to worry, and their published forecasts were telling us they expected inflation would be almost bang in the middle of the target range by now. It would have been a bad (and costly) idea for people to have based their plans on those forecasts and the contemporaneous rhetoric. You might have hoped that if he really wanted to jawbone us, and have people take seriously his rhetoric, that the Bank’s chief economist (of all people) would be presenting persuasive analysis that they understand what they got wrong and reasons to think they are better now. But there is none of that in the speech, and it refers us to no serious supporting analysis or research either.

Instead there is lots of spin.

One of the most striking things in the speech was something that wasn’t there. Central bankers often, and rightly, pay a lot of attention to measures of core inflation. But in a major (rare) speech about inflation, there is but one (passing) mention of the term (or cognate terms), simply noting in the final few sentences that core inflation is about middle of the pack among OECD countries/economies.

Instead, we get a great deal about “the pandemic, the war, and floods”, which seems to be a slightly more sophisticated attempt at distraction than his boss’s claims quoted above.

No doubt, as Conway notes, the floods will put some pressure on resources over the next few years (particularly to the extent losses are covered by offshore reinsurers, as distinct from being net NZ wealth losses), as the 2010/11 and 2016 events did, and may result in some direct price pressures (some fruit and vegetable prices) in the next couple of quarters. But, thanks to New Zealand’s infrequent and badly lagging CPI, none of that is in the published inflation numbers yet.

What of the pandemic? It is clear that here Conway is not talking about the (with hindsight) gross macroeconomic mismanagement (the RB MPC being the last mover, and thus primarily responsible) that delivered us, several years on, really high core inflation, but the direct price effects of pandemic-driven supply chain disruptions several years ago. Some of those effects may have been material contributors to headline inflation back in 2020 and 2021, but it is now 2023, and if we could do a good decomposition (a good topic for some RB analysis) it seems likely that if anything the unwinding of those disruptions is probably holding headline inflation down a little now (eg global freight costs have fallen a lot). Perhaps he has in mind airfares – where capacity has been slow to return – but that is a good reason to look at, and cite, analytical core inflation measures.

And then there is “the war”. At the Reserve Bank, they are very keen on “the war” as distraction and cover.

We all know world oil prices shot up quite a bit in the immediate wake of Russian’s invasion last February. But not only are world oil prices now lower than they were (real and nominal terms) prior to the invasion, but New Zealand headline annual CPI inflation is still held down artificially at present by the kneejerk petrol excise “temporary” remission put on last March and still in place (strangely, Conway never mentions this). Where else might we find these “war” effects in New Zealand inflation? Wheat prices also rocketed upwards initially, but again they are lower now than they were at the start of last year. I guess fertiliser prices are still higher than they were, but it hardly seems likely to add up to much in NZ CPI inflation. Especially when we know – although Conway never mentions – that core inflation had already risen a lot, to quite unacceptably high levels, well before the invasion.

Conway does acknowledge that monetary policy should have started to tighten earlier (and doesn’t even fall back on the silly line he and Orr have previously used, that a slight difference in timing would have made only a slight difference to inflation – well of course, but the real problem, with hindsight, was not “slight” differences in timing), but engages in a fairly sustained effort to leave readers thinking there really was not an evident problem in 2021, just a few “one-offs”. But this is where analytical measures of core inflation come in. Trimmed mean and weighted median measures are pretty standard parts of many monetary policy analysts’ toolkits.

The big increase in quarterly core inflation took place in 2021.

The sectoral core factor model, like all models of its class, has end-point issues and estimates prone to revision, but the best guess now is that core inflation had already doubled (to in excess of 4 per cent) by the end of 2021.

But none of this mentioned at all in the speech. Nor is the fact that by late 2021 the unemployment rate – best simple measure of changes in excess capacity – was dropping rapidly to below levels anyone regarded as sustainable.

Many of these events took the Reserve Bank (and others by surprise), but they are the ones paid to get these things right. We live with the consequences when they don’t. But nowhere in the speech is there any acceptance of responsibility.

We also get attempts to suggest there is nothing the MPC can do about inflation sourced from abroad…….in a speech where the exchange rate gets no substantive (and only one formal) mention at all.

There is a chart in the speech which purports to illustrate the problem, showing tradables inflation as a share of headline inflation, without any acknowledgement that if tradables tend to average 0% and non-tradables 2.5 per cent (loosely the case pre-Covid) and then tradables average 2% and non-tradables 4.5% tradables would make up a larger share of headline inflation even though nothing about the relationship between tradables and non-tradables had changed at all. Yes, tradables inflation has increased relative to non-tradables but if we look at the core components of each the recent change isn’t unprecedented, tradables didn’t lead non-tradables, and (in any case) the Reserve Bank’s own past analysis has tradables as a typically fairly small component in the overall sectoral core inflation measure.

If – as happened – other countries run high inflation, the job of the Reserve Bank of New Zealand is to tighten monetary policy here to lean against importing that inflation. That will generally occur through a higher-than-otherwise nominal exchange rate.

I’m not going to spend any more time on the jawboning rhetoric. No doubt it feels good inside a central bank – I’ve run plenty of it in my time, in writing and in speeches – but it is really a distraction from the core issues (MPC responsibilities) and less persuasive now – when, with the best will in the world, the central bank has just messed up badly – than perhaps it might have been decades ago when we first trying to transition from high inflation to low inflation, with a newly-independent central bank.

Conway’s speech was made just a month on from the latest Monetary Policy Statement. In that flagship MPC document, there was a substantial four page section on “The International Dimension of Non-Tradables Inflation”. No doubt, the analysis in that section came from Conway’s own Economics Department. But in a flagship speech on inflation just a few weeks later there is no mention, not even a reference, to that analysis at all. In my MPS commentary (last few paras) I briefly identified a number of apparent weaknesses in the analysis. Perhaps on reflection Conway accepted the issues I had raised, but whatever the explanation it seems odd to have such analysis feature prominently one month and simply disappear from consideration the next.

These were two of the last three paragraphs of the speech (emphasis added)

At one level, it is hard to argue. It all sounds good. Except….where is the substance to back up the words? The Bank’s own published research output has slowed to a trickle, there is no serious analysis or insight in the speech, and we know that the Minister of Finance has reaffirmed only last year his commitment (in league with Orr and Quigley) to ban anyone with an active or even future interest in serious research or analysis from serving as external MPC members. Oh, and the Reserve Bank has the least-qualified deputy chief executive responsible for macroeconomic and monetary policy of any advanced country central bank (and probably most emerging and many developing countries as well). Nothing we’ve seen so far suggests any particular reason to treat these words as anything other than spin.

I was mildly hopeful (prone to naive optimism perhaps) when Conway was appointed. Perhaps things are about to change. There is, after all, a position on the MPC that comes vacant next week, currently held by someone who has no relevant subject expertise, who has never explained her views on monetary policy in four years in the job, and who was (so the papers confirm) pretty clearly appointed mostly because she was a woman. Replacing her with a more serious appointee, and overhauling the protocols in a way that encouraged or compelled externals to be individually accountable, would be a small start in the right direction. If Orr, Robertson, and Quigley were serious. I am not, however, holding my breath.

The contrast between Conway’s speech and those of his peers in other advanced central banks once again leaves the New Zealand institution looking well off the pace. Just the slides published for an ECB Board member’s talk yesterday have considerably more substance than Conway’s full speech (and she speaks often). I’ll leave you with this chart, inspired by one of Schnabel’s slides

Terms of trade fluctuations – “direct price effects of the war and the pandemic” – just aren’t a big macroeconomic issue in New Zealand.

New Zealand’s monetary policy mess

The New Zealand Initiative has a new report out this morning, written by Bryce Wilkinson, under the heading “Made by Government: New Zealand’s Monetary Policy Mess”. (Full disclosure: I provided fairly extensive detailed comments on an earlier draft.)

It is a curious report. There is a lot of detail that I agree with (and the report draws quite extensively on various criticisms I have made in recent years) but it ends up having the feel of a bit of a muddle.

(It is perhaps not helped by the Foreword from an Otago academic who seems wedded to a fiscal theory of the price level that doesn’t exactly command widespread support anywhere, and which would appear on the face of it to have predicted that New Zealand would have had one of the lowest inflation rates anywhere. His approach appears to absolve the Reserve Bank of responsibility for the high inflation: “the key reason why we have high inflation rates is fiscal policy and not monetary policy” and “even if the RBNZ had not made mistakes, I doubt that it could have avoided high inflation”.)

The title of the report is clearly supposed to suggest that what has gone on is primarily the government’s responsibility (and specifically that of the Minister of Finance). And there are plenty of things one might reasonably blame the Minister for:

  • changing the Bank’s statutory mandate (if you think this was a mistake, or mattered to macro outcomes, which I don’t)
  • reappointing Orr despite the opposition of the two main opposition political parties, having himself changed the law to explicitly require prior consultation with other parties in Parliament,
  • going along with the Orr/Quigley preference to prevent experts from serving as external MPC members (which still seems incredible, no matter how times one writes it),
  • appointing a weak Board with barely any subject expertise, the same board being primarily responsible for Governor and MPC appointments and for holding the MPC to account,
  • being indifferent to serious conflicts of interest in people he was appointing to the board,
  • prioritising a person’s sex in making key appointments,
  • for bloating the Bank’s budget, and
  • never once have shown any sign of unease about the massive losses the MPC-driven LSAP has run up, about the Orr operating style, or any urgency around better understanding what has gone on (you will search letters of expectation in vain for any suggestions from the Minister that, for example, more/better research capability and output might be appropriate, or that speeches more of the quality seen from other advanced country central banks might be appropriate)

and so on.  Robertson has been both an active and passive party in the serious decline in the quality of our central bank over recent years, and given that Orr has been reappointed and seems disinclined to acknowledge the validity of any criticisms, only the Minister of Finance –  current or future –  can make a start on fixing the institution.  Institutional decline –  and it isn’t just the Reserve Bank –  has been a growing problem in New Zealand, and the current government’s indifference has only seen the situation worsen: one might think too of the Productivity Commission.

But, for better or worse, when most people think of a “monetary mess” at present they probably primarily have in mind inflation.  And the way the report is structured it would seem that both the author and the Foreword writer also put a lot of emphasis on the bad inflation outcomes.  No doubt rightly so.

But there simply isn’t any compelling evidence, or really even any sustained argumentation that would stand scrutiny, that any or all of the many things one can criticise Robertson for really go anywhere towards explaining how badly things have gone with inflation (or even with the massive losses on the LSAP).  I’m not, of course, one of those who believe the Bank should escape blame –  that somehow for example (as per one of the Governor’s ludicrous attempts at distraction) we can blame it all instead on Putin or “supply chain disruptions”, as if they somehow explain the most overheated economy and labour market in decades.

But how confident can we really be that a better Reserve Bank –  on the sorts of dimensions the NZI report rightly draws attention to –  really would have made much macroeconomic difference?   As just a small example (and from a country with a similar pandemic experience) the report rightly draws attention to the better academic qualifications of the Governor and senior figures at the Reserve Bank of Australia.  But nothing about Australian inflation outcomes –  or LSAP losses for that matter –  suggests that the RBA has done even slightly better than the RBNZ in recent years.  If anything, I (the Bank’s “most persistent and prolific” critic, as the report puts it) reckon the RBA has done a little worse, even if there is a better class of people and some more thoughtful speeches.    One could extend the comparisons.  As I’ve highlighted here, New Zealand’s core inflation outcomes have been bad, but about middle of the pack among OECD countries/regions.   Fed Governors do lots of good speeches, the institution does lots of interesting research, experts are allowed to be decisionmakers, but…..core inflation outcomes are little or no better and the Fed was even slower than the RB to get started with serious tightening.  And so on, around most of the OECD.

There is –  as the report notes –  no absolute defence for Orr and the MPC in other countries’ inflation records. We have a floating exchange rate to allow us to set our own path on inflation, and just because other countries’ policymakers messed up should not absolve ours of responsibility.    But to me the evidence very strongly suggests that what happened over the last two to three years was that (a) central banks badly misunderstood what was going on around the macroeconomics of Covid, (b) so did almost all other forecasters, here and abroad, and (c) there isn’t much sign that central banks with better qualified more focused people or more open and contested policy processes did even slightly discernibly better than the others.   I wish it wasn’t so.  With all the many faults in the RBNZ system and personnel, it would be deeply satisfying to be able to tie bad outcomes to those choices (active and passive).  But I just don’t think one really can.    All those governance and style matters etc matter in their own right –  we want well-run, expert, open, engaged, accountable, learning institutions, especially ones so powerful.  And weak institutions are likely over time to produce worse outcomes in some episodes.  But there is little sign yet that this is one of those episodes.

And it is clear when one gets to his conclusion that Wilkinson more or less knows this, as he struggles to connect the very real concerns about the Bank, and what Robertson has initiated or abetted, with the most unfortunate macroeconomic/inflation outcomes.

I was going to say that it isn’t really clear either who the report is written for.  But in fact I think that is wrong, and that the primary intended audience is Nicola Willis, her boss, and her colleagues/advisers.    Thus we find this

Bryce 5

Talk about deferential and accommodating.

And the entire report ends this way

bryce 6

In terms of fixing the institution that seems largely right. It could be fixed, but it will need ministers/governments that care and that are willing to devote sustained attention to using the levers they have to gradually right the ship. As Bryce notes, many of these changes can’t be effected quickly, but mostly because the laws are deliberately (and appropriately) written to make it not easy for new governments of either stripe to make sudden or marked changes. That is helpful when the institution is working well, but quite an obstacle otherwise, and may – if a new government were to care enough – need legislative change.

(I wrote a post here last year with some thoughts on what a new government could and could not do.)

As you watch the interactions between Orr and Nicola Willis at FEC – in which Orr is routinely scornful and dismissive – you wonder how in decency he could possibly continue to serve under a National-led government, But perhaps if he were that sort of person – staying in his lane, acknowledging mistakes, open and engaging etc – the concerns would not exist in the first place. As it is, it would be hard (all but impossible under current law I’d say) to get him out if he wants to stay, and so reform efforts will need to go around him, including progressively replacing the Board with able people and ensuring that the external MPC members are both able and expected to be individually and publicly accountable for their own views and analysis. But do all that and we – and other countries – will still be at risk of really bad macro forecasting errors, and central banks unable to live up to their rhetoric, albeit we might hope for no repeats for another generation or two.

What risks should the state protect people from?

Later yesterday morning, before major international markets opened for the week, the US authorities announced two steps in response to the failure of SVB Bank

  • first, depositors not covered by the FDIC (amounts in excess of US$250000) would in fact be completely covered, with the costs to be covered by levies (taxes) on other US banks,
  • second, a new Fed lending facility was set up, backed by the US Treasury, under which banks could borrow at market rate against securities that for these purposes would be valued at face value not market value.   For most longer-term securities issued in the last decade, market value is currently less than face value.

Legislative changes after 2008/09 were supposed to make bailouts much harder and less likely, but at the first real test – in respect of one failed bank that was 16th largest in the US (and another a bit smaller still) – there were significant elements of a bailout anyway. In respect of a bank that mostly had large deposits (this wasn’t an entity where just a few people had a bit more than $250K on deposit), all depositors were made whole. Most of the commentary suggests that had the assets been liquidated and depositors and other creditors been paid out what was left they’d probably have got back more than 90 cents in the dollar, and the FDIC resolution procedures could readily have allowed those larger depositors access to some portion of their money upfront (this incidentally is/was similar in this respect to the way the Reserve Bank’s Open Bank Resolution model was envisaged as working). The precedent value of this action suggests that in future any depositors at even a moderate-sized US bank are likely to be made whole (“what do you mean you aren’t going to bail out depositors in a failed bank in my district when you bailed out those Silicon Valley tech companies?”)

The main focus of yesterday’s announcement seems to have been to snuff out the risk of further bank runs. Signalling to depositors that they won’t lose their money (no matter how large and otherwise sophisticated they are) is one way of doing that. Another is providing ready access to liquidity for other banks, to signal that such banks would have no problem paying any requests for accelerated withdrawals that did arise. It bears some resemblance to a classic lender of last resort (a function of central banks that few have too much problem with in principle), except that whereas Bagehot counselled that central banks should lend readily on good collateral at a high price, yesterday’s announcement really only met the first element of that test. Much of the collateral has a market value less than the valuation being used to secure these loans (that isn’t good collateral, even if the bond itself is issued by the US government), and the loans are simply at normal market prices. It is, in effect, subsidised lending by the state.

Perhaps some might be inclined to pardon less than ideal policy responses when things have to be done in a rush. And I’m sure the weekend was pretty fraught for many relevant officials and politicians. But the US is a big country with huge bureaucracies and ample time and resources to have robustly war-gamed how failures and potential failures of significant-sized institutions would and should be handled, including thinking hard about the lessons from such exercises for future incentives. If state insurance of all deposits made sense, it made sense a couple of years ago, not just today. But that wasn’t the model adopted. It is hard to believe that lending on collateral using face rather than market value, at normal market rates, would ever make a lot of sense (at least outside some deep and severe systemic crisis where wholesale securities markets had become deeply dysfunctional).

Various people point out that the moral hazard is not complete. After all, SVB’s management will have lost their jobs (but not presumably past salaries and bonuses), shareholders will have lost their money (but not past dividends), and other creditors including any bondholders will not be made whole. But the benefits of yesterday’s bailout will also flow to the management, shareholders, and other creditors of other banks with somewhat similar (albeit typically less extreme) business models. And if the quid pro quo for the heightened moral hazard is supposed to be heightened regulation and supervisory intensity, how much confidence should people really have in that given the evident failure of supervisors and regulators in this case? Perhaps exemplary bank regulation might act as an adequate counter, but in the real world of US banking/regulatory politics?

I’m not one of those opposed to all deposit insurance. Well before the current government decided to introduce deposit insurance to New Zealand I was arguing for it as a second-best response because absent a limited deposit insurance system it seemed all but certain that in a stress event for any major bank (and perhaps some less major ones) in New Zealand, all creditors would end up being bailed out, and no one would have paid the Crown anything for the insurance that was being provided. Even in conjunction with Open Bank Resolution as an option in the toolkit there is still a high risk of a full bailout of creditors of the larger banks – partly because of the pressure that will almost certainly come from the Australian government – and at the margins actions like yesterday’s from the US authorities only increase that likelihood. Perhaps in truth, our deposit insurance scheme will end up only ever being practically relevant should banks like TSB or Heartland be close to failure (in terms of relative size comparisons they are our SVB).

There are people who believe that it is practically desirable, or at least unproblematic, to provide full deposit insurance. My stance is much closer to that of Peter Conti-Brown (professor of financial regulation and author of a stimulating book on various Fed governance issues) than to the former chair of the US Council of Economic Advisers.

And I’m not uninfluenced by having observed, and been involved with, our own NZ retail deposit guarantee scheme in 2008 where once guarantees were in place money flooded towards entities (notably South Canterbury Finance) that offered slightly higher yields. It isn’t a perfect comparison, since prudential supervision of finance companies wasn’t a thing at the time, but it is a useful cautionary experience nonetheless. And my perspective on bank runs is that generally they happen too late and too rarely, rather than seeing them as typically some random or fundamentally unwarranted event. The threat of a run is an important element in market discipline.

But I guess my wider caution is around the question that is the title of this post? What economic risks should the state be offering full protection against?

I can see a reasonable case for retail transactions balances being protected, even guaranteed. In that vein of course, people can choose to use Reserve Bank banknotes. More seriously, one reason why I have always been inclined to favour allowing the general public access to individual Reserve Bank settlement accounts (in modern parlance a CBDC) is precisely to provide such a credit risk-free option (even as, as I noted in my CBDC submission, I do not believe there would be a great deal of demand for such a product). But even then, an overnight Reserve Bank deposit account for transactions purposes might be free of credit risk and market risk, but it is hardly free of inflation risk (any more than a commercial bank deposit).

But if you or I have half a million dollars on deposit with a bank (let alone if an investment fund has $10m or $100m), there is no obvious public interest in the state guaranteeing that you will never lose the nominal value of your deposit. No doubt it would be tough to be substantially hair cut if your bank happened to fail and the assets came well short of covering 100 cents in the dollar but (a) you did have choices (under the proposed NZ system protection will be limited to $100K, so you have a reasonable option of spreading your deposit across five banks and securing full protection), and (b) there are so many other economic risks in life against which the state provides at most limited protection (all while providing a basic welfare system where entitlement in case of need is near universal, in the case of age universal).

I’ve already mentioned inflation. Out of the blue, quite in breach of their published targets, central banks in the last couple of years have delivered a quite unexpected 10 per cent boost to the price level. That is pure windfall gain if you have borrowed money in a conventional nominal loan, and pure windfall loss (not likely to be, or able to be, recouped) to those holding conventional nominal financial assets. Sensibly enough in macro terms, we don’t have price level targets, so no effort will be made to reverse these transfers, but for many the losses are real. For someone with $500000 in the bank, the real loss of purchasing power might be similar to many retail bank failure haircuts. It has surprised me a little – and is useful data after decades of low stable inflation – that more is not made of this arbitrary state set of wealth transfers.

House prices are falling at present in much of New Zealand. For many people – those of us without mortgages, and with a natural position long one (and only one) house – it doesn’t make much difference to anything. But there are plenty of people for whom it does – whether the owners of investment properties, or those who borrowed heavily at the peak of the most recent boom. If you had bought a house in Wellington 2 years ago rather than now you are perhaps 20 per cent worse off for that choice. And there is no state compensation scheme.

Share prices- and market values of Kiwisaver accounts – go up and down and no one proposes compensation (even champions of a capital gains tax are rarely keen on full offsetting of losses, which itself would still only offer partial compensation).

We have a system of accident compensation in New Zealand. I generally support it. It pays income-related compensation for loss of earnings, but only partially (80 per cent) and only up to a threshold (maximum liable income about $130000 per annum). Beyond that even for those risks, you are on your own (albeit with private options). And for many disabling conditions the state provides no specific insurance or compensation at all beyond the basic welfare system (and the health system itself of course). EQC cover is also capped.

Same goes for human capital or the fortunes of particular towns/regions. Or the real economic costs of a failed marriage. Many of these potential economic losses run far beyond the plausible scale of what an individual might have exposure to in a bank failure. And yet while we often sympathise individually, and support having in place a welfare system for basic support, we don’t as a society collectively attempt to compensate individuals for such losses. For most of such losses, no modern state – no matter how socialist in its reach – has ever really attempted to. We have debates at the margin – eg the government’s preferred social insurance scheme – but relative to many of the potential losses such instruments don’t really go very far.

So I struggle to see a strong principled case for treating larger bank depositors more generously. Yes, sometimes bank failures can appear to come from the blue, but they rarely do. Diversification is usually an option (and typically much more readily than you can, say, diversify your human capital or housing or relationship exposures), and so is private insurance. I suspect that few would really disagree as a matter of principle, and much just comes down to “its easier not to let any depositor lose their money” and associated fear of (the minority of ill-founded) bank runs, or “it is too hard to envisage our politicians even being willing to let big banks fail at all”, and living with the third-best consequences of that resigned stance. It isn’t a good place to be – especially when the beneficiaries of these resigned third-best policies will often be among the wealthier parts of society – although even as we try to change the politics, or create better options, there is no point pretending the politics are other than as they are.

UPDATE: Meant to include a mention of the NZ government’s choice – incredibly, on the advice of both the RB and The Treasury – to bail out all policyholders in AMI when that insurer failed after the Christchurch earthquakes. Not only were there no risks of contagious runs – insurance just isn’t like banking – but even if you thought there was a case for bailing out the less-wealthy policyholders, how could it possibly have been a wise, or priority, use of public money to be bailing out people with insurance on a high-end house who, at worst with a severe haircut, might have had to lower their housing sights.

I mean, in this country – as no doubt most – you can be charged by the state for serious offences and a couple of years later acquitted, or wrongfully imprisoned for multiple years and still find it a major hurdle to get serious economic compensation. (To be clear, I do favour erring on the generous side when mistakes are made when the coercive powers of the state are exercised in such ways.)

Bank failure

Sometimes spotting potential bank failures must be hard. One might think of really serious undiscovered fraud, or the weak controls that enabled a rogue trader such as Nick Leeson (who brought down Barings).

But if you were given the following set of facts about a bank:

  • very rapid growth over a short period
  • a heavy reliance on deposits withdrawable on demand,
  • perhaps especially a heavy reliance on uninsured deposits or similar funding,
  • a huge (and unusually large) share of the asset portfolio made up of long-term fixed rate bonds,
  • a position greatly expanded at a time when short and long term interest rates were at record lows.
  • no sign of any extensive use of interest rate risk hedging.

then even if you had reason to believe that the quality of the loans the bank had made were fine, the alarm bells should have been ringing very loudly.   It was a highly risky, nay reckless, way to run a bank.

That was, as I understand it, more or less the picture of SVB Bank, which was closed down by regulators on Friday.  If, like me, you’d never heard of SVB Bank a week ago, it doesn’t really matter.  It was a fairly big bank (second largest actual deposit-taking bank ever to fail in the US, even if small by the standards of JP Morgan or Bank of America) and it seems to have been boringly reckless.  Perhaps when the eventual book is written –  significant US bank failures usually prompt some author into print –  some good stories will emerge, but on the face of it (and there are dozens of articles over the weekend you can look up) the failure was depressingly vanilla in nature.  Chasing yield and coming a cropper,  Since the occasional headline-grabbing bank failure is a useful reminder of risk –  and that people, including very highly paid ones, make bad choices –  perhaps it is not even a bad thing that it happened (and deposits of up to $250000 each are covered by insurance).   Whether one goes that far or not, it is an episode that seems to reflect very poorly on the management and Board of SVB. but also on the bank’s regulators (in this case, primarily the Federal Reserve).    People, perhaps fairly, note limitations in the US regulatory system (and bank accounting standards), and the lobbying SVB Bank itself had engaged in to avoid being covered by some rules that apply (in the US) only to systemically significant banks.   But I am left wondering whether the relevant Fed examiners were asleep at the wheel.  After all, a smart and energetic young Fed analyst who’d never gone beyond publicly available information should have been able to look at the stylised facts above and yell “whoop, whoop, pull up”.    You might have hoped that when the CEO of SVB was (until Friday) on the board of the San Francisco Fed –  boards that from a policy perspective are more ornamental than substantive – that that alone would have meant a more than usual vigilance by Fed staff on risks associated with that bank.  But apparently not.

Anyway, my point wasn’t mainly to add to the oceans of SVB commentary, but to have a look at the big New Zealand banks.  They’ve been under fire lately, and they certainly do seem to be quite profitable businesses (although I’ve always been cautious about that view, including because the NZ subs are not charged for the (considerable) implicit parental support, without which their market funding costs would be higher) but for decades none of them has failed, or even come close.

There is, of course, an old line that part of the general way banks operate is to “borrow short and lend long”.  As the Governor put it in his speech a week or so back, hardly any bank in the world holds enough liquid assets that it could immediately meet all claims if they suddenly came due to today (even the ones that legally could be redeemed today).  Banks hold portfolios of liquid assets –  themselves voluntarily, and under regulatory duress – to limit liquidity risks, and when there is no question about the quality of a bank’s assets, banks also expect liquidity support (at a price) from central banks if they were to face unexpectedly intense liquidity pressures.  The fact that lender of last resort capability is known to exist is one reason why regulatory agencies need to impose liquidity requirements (otherwise holding more higher-yielding less-liquid assets will seem attractive to some bankers).

But bank runs (a) aren’t common, and (b) don’t typically strike out of the blue on innocent well-managed banks, so typically the much more important issue is around risks which threaten to impair a bank’s capital and undermine the prospect of depositors and other creditors being able to get all their money back when it falls due.  And the issue here is not so much what happens to measures of capital as regulators or accountants state them but about the underlying economic value.  Accountants and regulators may not require some assets –  some long-term bonds for example – to be marked to market, but whether the current market value of an asset is in the books or not does not change the facts of a potentially impaired market value.

SVB Bank seems to have been running massive and unhedged interest rate risk.  They had purchased huge volumes of long-term fixed bonds (mostly federal agency mortgage securities) and had, on the other side of their balance sheet, mostly short-term deposits repricing quite frequently.  You could hold a 30 year bond to maturity and know exactly what you will get back for it (assuming the issuer does not default) but it isn’t much comfort to you, or your creditors, if in the meantime your funding costs (deposit rates) have risen very sharply.   SVB seems to have been an extreme example even by US standards, but holding some, reasonably material, interest rate risk position doesn’t appear to be that uncommon in US banks, especially regional ones. 

But not in New Zealand.  Here is the market risk note in ANZ”s latest New Zealand disclosure statement.

ANZ disclosure

In the years shown ANZ took almost no active trading risk (first table) and even the second table (non-traded market risk) is very small for a bank its size.  That is all summarised in the final table.  A 5 percentage point parallel shift upwards in the interest rate yield curve looks as though it would make less than a 5 per cent difference to the bank’s net interest income.  About 6 per cent of ANZ’s capital is held to cover market risk.  

And here is the table summarising the time to reprice for both assets and liabilities

ANZ disclosure 2

On average, liabilities do reprice sooner than assets (check the “up to three months” column as an example) but note too the use of hedging instruments (primarily interest rate swaps): the bank seems to have had a lot of mortgages repricing between 1 and 2 years from balance date and not many liabilities repricing in the same period, but used swaps to substantially reduce the scale of the interest rate risks the bank was exposed to.  

I didn’t check all the other big banks –  although a quick look at ASB’s disclosure statement look very similar –  but I’d be surprised if there was anything very different in any of them.  It is the way banking is done in New Zealand (and a product of some mix of market, self and regulatory discipline).  Consistent with this, neither net interest margins nor returns on equity (with risks properly accounted for) are very sensitive at all to changes in the level of interest rates. 

But if you ever have money with a bank with the sorts of characteristics I listed at the start of this post –  and thus extremely exposed to any material change in the overall level of interest rates – you’d probably be well advised to get it out, very quickly.

But the other lesson from the events of the last few days is probably if you were counting on a public-spirited regulator to spot problems early and act decisively, well….at best that is quite a gamble too.  But if regulators can’t do better than what seems to have been on display in SVB you do wonder quite why we pay their salaries.

Central bank losses and the BIS

The Bank for International Settlements (BIS) is a club of central banks. That isn’t a pejorative label, just a straight factual description. 63 central banks (including the RBNZ) are the shareholders and the institution exists primarily to generate material for, and host meetings of, central bankers. They collate statistics and generate research with a central banking focus. They still provide some financial services to central banks. The chief executive (“General Manager”) is chosen from the ranks of highly-regarded senior central bankers (the current incumbent, Agustin Carstens was (among other things) formerly Governor of the Bank of Mexico and Deputy Managing Director of the International Monetary Fund).

As I mentioned in yesterday’s post, Adrian Orr had been citing material published recently by the BIS in defence of his suggestion that central bank losses from discretionary interventions really don’t matter and are more of an “accounting issue” than an economic one. When that material came out last month I drew attention to it, and (briefly) to the limitations, on Twitter, but since the Governor suggests that the BIS has the answers I thought it might be worth taking another look and unpicking what is, and isn’t, there in the two short BIS pieces. The first is an op-ed from Carstens, published in the Financial Times but the full text of which is on the BIS website and the second is a six page note by several BIS staff “Why are central banks reporting losses? Does it matter?

The Carstens op-ed is short enough I can take it paragraph by paragraph.

It begins with the title “Central banks are not here to make profits”. That is both true and a distraction. First, hardly any aspects of what governments do exist to make money, Second, unlike most arms of government, central banks should typically be at least modestly profitable (as monopoly provider of zero interest banknotes and of residual liquidity to the financial system). Third, when discretionary interventions are being considered the likely profits or losses, and the associated risk to taxpayers, should be at least one part of the full assessment of the pros and cons. And, finally, when interventions are being evaluated ex post, financial outcomes should be at least one part of a full assessment. Costs and benefits both matter.

As context here, one might note that the Reserve Bank of New Zealand, which used to have a low-risk small and stable balance sheet, made a profit each and every year for decades (without support from taxpayer indemnities). It was the normal state of affairs (seignorage earnings, with some volatility up and down as the proceeds of the note issue and the Bank’s equity were typically held in government bonds).

But on to the text

Unlike businesses, central banks are designed to make money only in the most literal sense. They have a mandate to act in the public interest: to safeguard the value of the money they issue so that people can make financial decisions with confidence. The bottom line for central banks is not profit, but the public good.

As noted, this does not mark out central banks from other government entities. Resources used, risks assumed, need to be rigorously evaluated along with programme effectiveness.

Today, following an extraordinary period in economic history, some central banks are facing losses. This is particularly true if they bought assets such as bonds and other securities to stabilise their economies in response to recent crises. Many will not contribute to government coffers for years to come.

“believing that by doing so” they would stabilise their economies. Note that in a formal sense that final sentence is not true of the RBNZ, since the Crown indemnity means losses from their interventions are borne directly by the taxpayer, not via impaired central bank capital. More generally, whatever the formal arrangements – and they differ widely across countries – mark to market accounting reminds us that the best guess is that large losses have already happened.

Does this mean that central banks are unsound? The answer is “no”. Losses do not jeopardise the vital role played by these institutions, which can and have operated effectively with losses and negative equity. And the unique nature of central bank tools means that sometimes losses are the price to pay for meeting their objectives – to support growth and jobs, ensure stable prices and help keep the financial system safe and stable.

In normal times, it is possible for central banks to both fulfil their mandates and earn profits without taking on significant financial risk. Traditionally, being the unique issuer of money provides a reliable revenue stream. But central banks with large foreign exchange reserves, built to cushion external shocks, will often experience ups and downs in income from exchange rate fluctuations. This means they sometimes make losses when pursuing their goal of a stable currency.

Agree entirely with the first two sentences, but they aren’t really the point and I’m not aware of any serious observer arguing to the contrary. The third sentence is much much more arguable, and neither in the brief op-ed nor in the longer Bulletin does the BIS really defend the claim. Most discretionary central bank interventions, if justified at all, should be stabilising and thus profitable (eg the Bank of England bond market interventions late last year). As Carstens notes, for countries with large foreign reserves holdings, exchange rate fluctuations will typically generate substantial year to year gains and losses simply from passive holdings but if that is an issue for Switzerland (where the BIS is based) it isn’t for most of the advanced country central banks we usually compare the Reserve Bank to. And there is likely to be a difference in how one sees passive structural positions and active discretionary interventions.

In times of crisis, central banks may also need to take on additional risks. And they do so with their eyes wide open. One example is the purchases of government bonds, including those made during the great financial crisis and more recently during the Covid-19 pandemic, in order to avert economic disaster by supporting financial stability, keeping credit flowing and boosting economic activity.

All this simply asserts what it does not show. But there is also an important distinction, not drawn here, between interventions to help restore market functioning (the initial QE back in 2008, and the initial bond buying in March 2020) which, support them or not (there are, after all, some moral hazard risks), should typically be expected to be profitable, perhaps even on a risk-adjusted basis, and large scale bond-buying with the goal of influencing the entire level of the yield curve. There is little evidence that many central banks (notably the RBNZ) really did much serious advance analysis on the use of this tool, the financial risks associated with it, the likely effectiveness of it, let alone exit strategies. In a NZ context, we should give no weight to the suggestion in the final sentence that the LSAP was necessary to “avert economic disaster”.

In the last decade, with inflation and interest rates low for a long period, these bond purchases boosted income. In fact, some central banks were able to transfer unusually large profits to governments. But in the wake of the pandemic and given the invasion of Ukraine by Russia, inflation has returned. This requires higher interest rates to contain spiralling prices – and exposes central banks to losses related to assets purchased in past successful rescue efforts.

Here Carstens touches on one of the problems with the 2020 QE interventions: central banks, including our own, seem to have been lulled into a degree of complacency about the risks they were taking on by the fact that QE done in other countries in the wake of the 2008/09 recession had not ended up costing central banks or taxpayers lots of money because the longer-term trend of falling real interest rates had continued. There was, however, no reason to suppose it would do so indefinitely, and a continuation was in any case less likely with bond yields near 1 per cent than with bond yields at, say, 5 per cent.

Central banks should put purpose above profits. Would it make sense for a central bank with large foreign currency reserves to increase their value by haphazardly triggering a devaluation of its own currency just to generate a windfall? Or for a central bank with domestic currency assets to keep interest rates low, even in the face of high inflation, just to preserve low-cost funding and generate profits? Such actions would be wildly inappropriate, violate their mandates and destabilise the economy.

By this point in the article, handwaving and straw men are well and truly to the fore. The issue is much more about the risk analysis – financial and otherwise – undertaken before the initial discretionary intervention (and at each stage of it), not how one clears up the mess afterwards. No one I know has suggested central banks should not allow interest rates to rise simply to protect their own financial positions, but there are serious questions about whether those (known to be) highly risky asset swaps should have been done in the first place.

The soul of money is trust. To operate effectively, business must maintain the trust of investors. And central banks must maintain the trust of the public.

Governments also have a role to play in the face of today’s central banks’ losses. Because these institutions are ultimately backed by the state, trust in money requires sound government finances and good financial management.

Blah, blah, blah. But one might add that maintaining the trust of the public in a modern era typically involves both demonstrated competence, openness and transparency, and acknowledgement of errors – not just patting people on the head and telling them “don’t worry, its complex, we are the experts and we have it in hand” even as staggering real losses are run-up and realised.

And finally

Losses matter because they may inflict a bruise on public finances but a far greater injury would result from central banks neglecting their mandates in order to avoid a loss. The public, via elected officials, have given central banks the job of price and financial stability because of their enormous societal benefits. Now, and in the long term, the costs from central bank losses are insignificant compared to the costs of runaway inflation and prolonged economic crisis.

Perhaps that first phrase is key. Losses matter, they are real. Nowhere does Carstens suggest they are “just an accounting issue”. The rest of that paragraph is really just handwaving and distraction, culminating in that outrageously misleading final sentence which seeks to suggest that there is some inescapable tradeoff between “insignificant” central bank losses and “runaway inflation and prolonged economic crisis”. There simply isn’t – and starkly there clearly wasn’t when central banks like the RBNZ launched and kept up their highly risk bond buying in 2020. With hindsight – and no matter what people might have claimed to believe back then – large scale bond-buying kept on well into 2021 or in some cases 2022 did not keep us from “runaway inflation and prolonged economic crisis”. Instead, overall central bank responses to Covid delivered us a really severe outbreak of (core) inflation, which central banks are now grappling to get back down again.

The Carstens piece is best seen as distractive spin for central banks by the chief executive of their own club. That needn’t necessarily mean there are no useful points their own lobbyist could ever make, but there were almost none relevant to the issues at hand, or the challenges that have been posed to Orr, in this piece.

More generally – and if this is a central bankers’ conceit, they probably aren’t the only interest group to suffer this fault – there is no sense anywhere in the Carstens piece that central banks might ever make mistakes, that some interventions might be worthwhile and appropriate and others not. But when central banks have done even their core job so poorly over the last couple of years – see core inflation rates across much of the world – the absence seems particular notable.

I’m not going to attempt a similar paragraph by paragraph treatment of the longer BIS staff note. It has some useful material in it, particularly for those less familiar with these issues, even if it has a strong focus on “whether losses matter for a central bank” (as they note, losses do not compromise a central bank’s technical ability to fulfil its mandate), rather than whether they matter for taxpayers, citizens, and those wishing to hold a central bank to account. I wanted to pick up briefly just the last couple of paragraphs, on how central banks should respond to losses.

“Effective communication” does not include trying to spin public audiences or MPs with assertions that real economic losses – that leave taxpayers poorer – are “just an accounting issue”. It should not include handwaving assertions about the wider benefits being “multiples” of the losses. It should include careful analysis and research evaluating the actual macroeconomic impact, including by comparison with the gains that less financially risky interventions might have offered. It should include careful ex ante disclosed risk analysis (the case for which was all the stronger for central banks coming late to the QE party, like the RBNZ or RBA). And it should include explicit recognition by central banks that they can, and sometimes do, make mistakes, even substantial ones. None of that has characterised the Reserve Bank of New Zealand through this episode.

And what of that final paragraph? It has the feel of editorial spin. Although it has become common in this field to claim that big financial losses are sometimes the price that has to be paid, there is rarely any rigorous attempt made to demonstrate the truth of that claim in respect of discretionary ad hoc interventions like the LSAP (or peer programmes abroad). Central banking done well should be profitable, from the nature of the institution – not because a central bank sets out to maximise profits (such a beast would be dangerous indeed) but because of its position in the market/economy and the monopolies the state gives it central bank.

Finally, and reverting specifically to New Zealand, one of my consistent criticisms of the LSAP programme is that there is no evidence in any of the material that has been released that the Reserve Bank or Treasury ever conducted or provided a robust analysis of what could go wrong when seeking the approval of the Minister of Finance for such huge punts on the bond market (and punts they were).

As just one example, consider this Treasury report to the Minister dated 1 May 2020 (so six weeks after the LSAP had been launched, and well after the initial US-led disruption to bond markets had settled down), in support of the Reserve Bank’s bid to expand the LSAP programme, and increase the associated financial risks. Here is the relevant bit of the financial risks section

Written in a way to suggest the programme was more likely to make money than lose it (despite the record low interest rates at the time) and with a “large but plausible” downside scenario involving the OCR only getting back to 1 per cent by this year, with no attempt at all to offer tail risk estimates of the extent of the possible loss. It simply isn’t the sort of analysis that should prompt any degree of confidence in either the Reserve Bank or the Treasury.

But this is the sort of stuff that Orr apparently stands by 100 per cent, with no regrets for anything he or the MPC were responsible for.

Central bank inadequacy and spin

Last Friday the Reserve Bank Governor, Adrian Orr, gave a keynote address to the Waikato Economics Forum. This event seems to have become part of the annual economic policy calendar, with Waikato University boasting that

The forum will bring together an outstanding lineup of top economists, business leaders and public sector officials, who will share their expertise on how we can address the major challenges facing our country today.

Sold that way, you might have thought that when a really senior and powerful public official turns up for a keynote address to an assembled economically literate audience he’d have delivered some fresh and interesting insights, going rather deeper than he might to, say, a provincial Rotary Club. Doubly so when in that official’s area of policy responsibility things have proved so challenging in the last few years, when so much taxpayers’ money has been lost, and when core inflation is so far outside the target range the government has set. It was just a couple of weeks after the latest Monetary Policy Statement, so would have been a great opportunity for the Governor to expand on the issues and shed light on how, and how rigorously and insightfully, he sees things .

Instead we got “Promoting economic wellbeing: Te Pūtea Matua optimisation challenges”, a title that held out little or no hope and offered less across a sprawling 12 pages of text. Attendees must have wondered whether it had really been worth getting out of bed early enough to hear the Governor at 7:40am. As for me, I read it twice, just to be sure.

Faced with major policy failures – and the core inflation outcomes cannot really be considered anything else, no matter how many allowances might be made – there is not a single fresh or interesting insight in the entire speech, In fact, it is the sort of address one of Orr’s junior staff could easily have given, as a “functions of the Reserve Bank” talk, to a Stage 2 university economics class.

Perhaps it would be one thing if (a) little or nothing interesting was going on in the economy or with inflation, or (b) if the Governor and other members of the Monetary Policy Committee were giving speeches on monetary policy matters every couple of weeks, although one might still – given the character of the audience – have reasonably expected more, including because good and thoughtful speeches offer insights into the quality and character of decisionmakers and their advisers. As it is, a great deal is going on, a great deal that has taken the Bank (and most others) by surprise, and that is still ill-understood (eg why did almost everyone get it wrong, what did we miss, what do we learn?), and serious speeches by MPC members on things to do with monetary policy, inflation etc are – unlike the situation in most other advanced countries – very rare. As far as I can see, the last serious monetary policy speech the Governor gave was to the Waikato forum a year ago, the chief economist has not given any speeches on monetary policy or inflation (nor, perhaps mercifully, has his boss), none of the external MPC members has ever given a speech on these topics or put their names to specific views or lines of analysis/reasoning/evidence, and the Deputy Governor’s last speech on monetary policy was 18 months ago, when the Bank was barely worried about inflation at all.

It is inexcusable in people who wield so much power, perhaps for good longer term but certainly for ill in the last couple of years. And it seems to speak of some combination of the utter arrogance Orr routinely displays when he does speak, and the probable absence of any fresh or interesting analysis in the entire institution. If they had such insights, such research, such analysis, surely they’d be wanting to impress us with it? But the Bank now publishes hardly any formal research and it is rare to find even an insightful chart in an MPS. If spin seems to be the order of the day, and it so often does (see below) they aren’t even very good at generating supporting material, let alone providing any serious accountability.

There really wasn’t much interesting in this keynote address at all, but I did want to highlight just a few of the spin lines.

On the straight economics there was this

Low and stable inflation is a necessary outcome for economic wellbeing in the longer term

I’m deeply committed to the case for price stability (ideally, an even lower inflation target than we have now) but this is simply overblown nonsense, which discredits the case for low and stable inflation. A more serious Reserve Bank in years gone by might, much more reasonably, have framed the point simply as “tolerating high inflation won’t make us any richer, and will come with all sorts of distortions and costs, and in the longer term if price stability doesn’t determine whether or not we are prosperous and productive, it is still the best limited contribution monetary policy can make.

Then there was the corporate spin

Looking ahead, in striving to be exceptional in our work,

Perhaps it is good to aim to be exceptional (although few people or institutions ever are), but…..the Orr Reserve Bank, when we get speeches like this, and few of his decisionmakers ever expose themselves to any sort of serious scrutiny, and when leading from the top the Governor is reluctant to ever express regret for anything he/they might have done, or failed to do. Great institutions – especially powerful public ones – acknowledge openly and learn from their mistakes.

I’ll skip the empty waffle about climate change (“we have a key part to play”) or the political posturing about the Treaty of Waitangi (which is apparently part of a “move from being a good to a great Central Bank” – who granted them even a rating of “good?)

At the end of the speech there is a section headed “Our research programme”, where Orr asserts

Te Pūtea Matua has a long tradition of pursuing policy-relevant research and as a full service central bank our research programme covers all three strands of work we are tasked to deliver.

It used to be true that the Bank had a strong record of policy-relevant research on things around monetary policy, inflation, and the cyclical behaviour of the economy. But no more – just check out how little research they’ve published in those areas in recent years, It has (sadly) never been true that the Bank has had any sort of sustained tradition in policy-relevant research around either its mushrooming financial regulatory and stability responsibilities (in fact, there were conscious decisions by successive Governors not to invest in such research), or its cash responsibilities, and there is no sign that has changed for the better. Instead, we just get spin like this.

And then in conclusion Orr asserts that

We are a learning institution and we enjoy collaboration.

Learning institutions engage, learning institutions aren’t prickly and defensive, learning institutions don’t just make stuff up, learning institutions don’t claim to regret nothing, learning organisations – especially amid the biggest surprises/policy failures in decades – don’t give keynote addresses like this. And collaborative institutions don’t engage in the sort of defensive abuse Orr is sadly all too well known for.

Learning organisations, agencies that are exceptional in their work, great central banks, don’t just make stuff up. Orr does.

The Herald’s Jenée Tibshraeny had a nice piece yesterday on just the latest example, from the question time after Orr’s Waikato speech. He was asked a question about central bank losses from things like the LSAP bond-buying programme (about 1.03 hrs into the video of the day), specifically citing the (recently newsworthy) losses the German central bank had been recording and disclosing. Instead of responding seriously and substantively, Orr blustered, attempting to imply that these were really just accounting issues (as if good record keeping doesn’t matter), muddying the waters by getting into questions about how much central bank equity matters, and condescendingly suggesting that while such issues “hurt the brain” people need to start exercising their brain, and “calm down”. The questioner himself clearly wasn’t satisfied, and asked a follow-up, but Orr simply talked out the clock, even suggesting (astonishingly) that the BIS – a bunch of technocrats in Basle – had explained it all for the public.

There are two points people like the BIS have made that are of course true, and as general points have never really been disputed by serious commentators and observers.

First, central banks don’t exist to maximise profit. They exist (in their monetary policy functions) to deliver low and stable inflation, and

Second, central banks can in principle function perfectly well with low, zero, or even negative equity (I spent a couple of years working for one that not only had negative equity but wasn’t even able to produce a proper balance sheet for a prolonged period).

But harping on those sorts of points is simply irrelevant in the face of the huge real losses to taxpayers that central banks have sustained in the last couple of years.

In New Zealand’s case, as it happens, the negative (or impaired) equity issue doesn’t even arise, since the Bank in advance wisely sought a government indemnity for any losses the LSAP might lead to. As a technical matter they didn’t need to – they could have run through all the equity the government had given them and recorded huge negative equity. Nothing about the Bank’s ability to function would have changed one iota, but some hard questions no doubt would have been asked, and Orr reasonably enough preferred to have any blame shared.

But none of that changes the fact that the MPC’s choices around the LSAP – signed off on by the Minister of Finance, with Treasury advice – have cost taxpayers in excess of $9 billion: not “just accounting issues” but real losses. That is what happens when a government agency (central bank) does a huge asset swap, transforming much of the government’s long-term fixed rate debt into effectively floating rate debt just before short-term rates rocket upwards. Had the LSAP programme never been launched – or even if it had been halted a few weeks in once bond markets had settled down from the US-led turbulence of March 2020 – taxpayers and the Crown would be that much better off, in real purchasing power terms. And none of Orr’s spin and distraction – and none of the BIS material – ever seriously engages with those real losses. Instead they respond to points that are not those serious critics are making.

And if one happens to think the LSAP made a meaningful economic difference – as Orr still seems to claim – then that only reinforces the point, since it added to the level of stimulus that helped deliver the core inflation, miles outside the target range, that central banks are now struggling to get under control and reverse. Better not to have had the real economic losses, and of course with hindsight we know the level of monetary stimulus was too large for far too long.

(As I’ve argued in numerous posts here over the last 3 years, I don’t believe the LSAP made much meaningful difference to anything – simply added huge risk, without any serious advance risk analysis, culminating in huge losses. I was encouraged to see in Tibshraeny’s article that the former Deputy Governor, Grant Spencer – able economist and former bank treasurer – seems to have the same view

“The main benefit was that it smoothed the disruption to the bond market that occurred in April/May 2020 when there was some real volatility in the bond market and bond rates spiked up,” Spencer said.

“After that, the rest of the purchases, I would say, had very little effect on the term structure of interest rates.”

Well quite. The initial intervention may not have been necessary but could have been highly profitable on a small scale. The latter purchases made no difference to short to medium interest rates (set by the OCR and expectations about it) and little to longer-term rates. Had they wanted short rates lower, the OCR could always have been cut by another 25 basis points, at no financial risk to taxpayers.

Orr seems to have backed away somewhat from a line he gave Tibshraeny in an interview last year, where he claimed that the macro benefits of the LSAP programme were “multiples” of the losses (and the Bank’s five-year monetary policy review last year provided no serious support for such claims) preferring now just to rely on bluster, distraction, and the hope that people will eventually get tired, or confused, and forget.

Orr’s comments on Friday reminded me that I’d heard that Orr had also been trying on the handwaving “it’s just an accounting issue” at FEC after the recent Monetary Policy Statement. I hadn’t listened in at the time and finally did so this morning.

If National Party members don’t always ask very good questions on this issue, at least they show no sign yet of being willing to let it go. In doing so, they bring out Orr at his prickly, blustering, and basically dishonest, worst.

Willis asked if it was not regrettable that there had been a direct fiscal cost from the LSAP programme of about $9bn. Orr’s response was a single word: No.

Willis followed up asking if he was really saying that these losses were justified. This time, she got a three word response “Yes, I do”.

Orr went on to state that he “100% stood by” the LSAP and its losses, getting a bit more expansive and asserting/reminding the Committee that central banks could operate with negative equity – as noted above, this is pure distraction in the NZ context since the Reserve Bank’s capital was not impaired at all (although taxpayers’ “equity interest” in the NZ government was) – and explicitly going on to assert that it was “an accounting issue not an economic one”. As applied to the LSAP, that is simply false, yet another outrageous attempt to mislead Parliament.

And he wasn’t finished. Willis asked if he was saying he had no regrets at all. His response? “Those were your words”, before falling back on his regrets for things he had no responsibility for – regrets Covid, regrets Ukraine, regrets Gabrielle, even passively regrets that New Zealanders are experiencing high inflation – but no regrets for any choices he made might have actually made, not ones that costs taxpayers $9 billion, and certainly not ones that led to core inflation of about 6 per cent and likely “need for” a recession. Spinning again, he repeated the line he is fond of that if they’d tightened one quarter earlier it would have made very little difference. No doubt so, but the big mistakes – perhaps pardonable, perhaps even understandable, but big mistakes nonetheless – weren’t about one quarter, but about fundamental misjudgements in 2020 and early 2021, on things Parliament has delegated Orr and his MPC responsibility for, as supposed technical experts. And yet they refuse to take any real responsibility, falling back on attempts to distract MPs and avoiding serious engagement with anyone else.

There has been a lot of focus in the last week or so on Rob Campbell’s mistakes, for which he has rightly paid a price and no longer hold Crown appointments.

But Orr managed to lose billions – having done no advance risk analysis, having talked rather negatively on bond-buying strategies only a few months prior to Covid – and delivered us very high core inflation, core inflation reflecting largely domestic demand imbalances well under Reserve Bank monetary policy influence, refuses to engage seriously, actively and repeatedly misrepresents things and misleads Parliament, and treats those to whom he is accountable with prickly disdain and no respect whatever, and yet keeps his job, and starts a second term later this month. It is a sad reflection on how degraded New Zealand politics and policymaking has become when accountability now appears to mean so little.

Unpaid debts

More than a decade ago now, I got interested in the sovereign debt defaults in the 1930s. Debt was in the wind, between the severe economic recession and financial crisis and the Reinhart and Rogoff book. And so it was while I was working at The Treasury that I first became aware of New Zealand’s sovereign default in the 1930s. A couple of years later that story ended up written up here and our (quite limited) default joined the published lists of sovereign defaults.

The biggest defaults globally weren’t, and often still aren’t, in such lists. I wrote here a few years ago about the US government’s abrogation of gold clauses in debt instruments, in effect depriving bondholders of a big chunk of their real purchasing power, all as written up in UCLA economist Sebastian Edwards’s accessible book.

But on a global scale the most important series of defaults in the 1930s were those on liabilities arising from World War One. There was German war reparations of course: by the depths of the Great Depression there was little appetite to keep claiming them, and rather less willingness on the German government’s part to keep paying them.

But there were also big debts among the governments of the World War One allies. Once the US entered the war in 1917, Britain and France in particular had borrowed large sums from the US government, and Britain in particular (France to a much lesser extent) throughout the war had lent large amounts to her allies (including New Zealand). Britain had made substantially more intergovernmental loans than she had received (and was a net lender even once the large loans to Russia, never likely to be repaid after the revolution, were set to one side). For the UK, intergovernmental debts alone were about 20 per cent of nominal GDP (the war had also given rise to a lot of market debt, offshore and domestic)

In his new book, University of Nottingham political science and international relations professor David Gill writes about The Long Shadow of Default: Britain’s Unpaid War Debts to the United States 1917-2020. The “long shadow” is, in part, an allusion to the literature which suggests that in practical terms memories of sovereign default often seem quite short, with defaulters often relatively rapid able to re-enter the market.

After World War One there was a considerable strand of thought in Europe – and some in the US – that the intergovernmental war debts should simply be cancelled. The war had, after all, from 1917 become a common project, and if the US had been the net lender to its allies, those allies themselves had paid a much higher prices in lives and physical destruction. To the extent it was not going to be cancelled, pressure for substantial reparations from Germany would be increased (particularly from France, whose combined debts to Britain and the United States, with few offsets, exceeded Britain’s gross debts to the US).

The cost of cancellation would of course have fallen primarily and substantially on the US, and its taxpayers (Britain would have borne some costs, while France and Belgium would have been significant beneficiaries). Gill never points out that the total debts owed to the US government were equal to perhaps only 10 per cent of US GDP (although note that the US federal government share of GDP itself at the time was very small), but he is a political scientist primarily, and anyway what mattered was (much) less the economics and much more the politics. There was little or no appetite in the US, and specifically in Congress, for the Europeans to do anything other than repay the debts their governments had voluntarily taken on. US opinion seemed particularly reluctant to accept any connection between the intergovernmental debts and German reparations.

During the 1920s each European sovereign borrower reached its own agreement with the US government on servicing and repayment terms for the war debts. The main focus here is the UK, and in 1923 Chancellor of the Exchequer Stanley Baldwin had settled with the US on terms that involved payment of the following 62 years (and an effective discount on the debt of 28 per cent of the original total), and provisions which prevented the US government marketising the debt, selling it off to retail and wholesale investors. Signing was controversial (sign now or wait: many states that waited secured more generous US terms a few years later) but was regarded by officials as broadly satisfactory, since the UK negotiated in parallel in respect of its own wartime loans to allies and was left expecting its outgoing would be broadly met by receipts on those loans to allies). At prevailing exchange rates, servicing the US (USD) debt was costing the UK (gross) less than 1 per cent of GDP per annum.

Most European countries that had borrowed from the US during the war defaulted in 1932. European countries had largely agreed among themselves, although the agreement was never ratified, to end both reparations payments and the service of intergovernmental war debts among themselves. After making token payments in 1932 and 1933 (accepted by the US as not formally defaulting), the UK government chose to default in 1934. (Of all the sovereign borrowers, only Finland maintained an unbroken record of payment, making a final payment in 1975 eight years ahead of schedule (to a toast from President Ford at a state banquet in Helsinki)).

As Gill makes clear, the issue for the UK itself was never primarily about ability to pay. Yes, the Great Depression had happened – but it was much less severe in the UK than in the US (or Germany, or New Zealand/Australia) – and going off gold in 1931, and the subsequent exchange rate depreciation, had raised the sterling servicing costs of the US war debt. But even by 1933, UK real GDP is estimated to have been only about 2.5 per cent below the 1929 peak, and by 1934, when the final default decision was made, UK real GDP was hitting new highs. The issue was primarily one of willingness to pay, a willingness that was no longer there (amid a European desire – which would not have benefited the UK financially – to have wiped the war debts/reparations slate clean). From Gill’s account there was little appetite in political circles, government or opposition, or in the wider public to keep on paying (though of course by 1934 impressions will have been influenced by other countries having defaulted in 1932).

The US was another matter, even though it had been President Hoover who had in 1931 initiated a one-year moratorium of all intergovernmental war-related payments. There were attempts to negotiate with the US but they were ultimately futile. Even though there were some prominent figures in the Hoover administration who favoured a more generous settlement, Congress was the main obstacle and in the depths of Depression there was no public mood sympathetic to writing down the debts. In fact, in early 1934, Congress passed, and Roosevelt signed, the Johnson Act, under which no government in default to the US would in future be able to borrow in the United States (enforced via heavy criminal penalties on anyone in the US involved in buying or selling such bonds). Gill notes that there are suggestions that Roosevelt may have been sympathetic to this measure, but whether he was or not, he had other fights he chose to spend his political capital on. The Johnson Act was in place when the UK made the final decision to default.

Much of the book is about the aftermath of default. As Gill notes, the defaults (not just Britain’s) appear to have reinforced the aversion to involvement in European affairs that resulted in the Neutrality Acts. But the most tangible effect, that came increasingly into focus, was the inability of the UK to borrow in US markets, something it would not normally do in peacetime anyway, but which would be likely to be necessary in the event of a new general European war (there had been considerable UK government on-market borrowing in the first couple of years of World War One, while the US was still neutral). Gill cites documentary evidence that in 1938 and 1939 senior British officials, and presumably ministers, were well aware of this emerging constraint (he isn’t writing about France, but it would be interesting to know if French officials were equally well aware). The issue wasn’t likely to arise in the very short-term (foreign reserves and existing holdings of marketable securities could be used to generate USD) but could easily became a binding constraint in any protracted (and British preparations assumed any new conflict with Germany would be protracted).

The issue came to a head by late 1940, as the British had placed defence orders in the US (and taken over some of those placed by France before the fall in June 1940). Its own sharply declining export receipts exacerbated the intensifying pressure on the available foreign reserves (USD and gold holdings) and it was increasingly apparent to both British and American officials in late 1940 that by some point in 1941 Britain would no longer be able to pay for the orders that were being placed.

By this point Roosevelt – whether he envisaged the US eventually entering the war or not – had concluded that Britain’s successful resistance was in the best defence interests of the United States.

And thus the genesis of the Lend-Lease programme under which aid could be granted to other countries, when doing so was judged to be in the defence interests of the US. Huge amounts were to go to the UK and the USSR in particular without any real expectations of post-war repayment (the idea of returning equipment after the war was there at the start). There was, by this time, a real aversion on all sides to a repeat of the entanglement of debts, and tensions post-war, of World War One (although the British – with survival at stake, the continued ability to fight the war – would have borrowed if they could, and did borrow heavily from within the sterling area).

But even with Lend-Lease well underway, and the US itself entering the war in December 1941, as Gill documents the memory of the 1934 default still hang over financial dealings between the UK and the US. In a decision he later regretted (describing it as his worst mistake in office) Truman cut off Lend-Lease assistance as soon as the war ended. The UK’s own export industries were not going to fully rebound overnight, and the UK still had significant foreign currency commitments (including occupation forces in Europe), and without a significant decline in living standards and/or a deep depreciation of the exchange rate (which finally came in 1949), the UK needed a gift or a loan (a large amount either way) from the US. People debate whether the US should have been more generous, but Gill’s book documents the way in which the memory of the past default shaped public and congressional opinion in finally agreeing the onerous terms of the loan (some of which quickly proved unsustainable,and were not sustained). This approach in turn jeopardised Britain’s willingness to proceed to join the IMF and World Bank (the very late British vote to finally proceed – mid-December, less than 3 weeks before the deadline – may have further reduced the prospects of New Zealand joining at the foundation).

You might have supposed to surely by this point, a whole new war having flowed under the bridge, the old debts – and memory of the default(s) would have passed into history, with no ongoing significance. And I think a fair reading of the book would be that that was largely so in the end in substance. But not in law, and – Gill has a book to sell – there have been surprising returns of the issue in the decades since, which have kept officials (and lawyers) busy, even apprehensive, from time to time. The US has never written off the World War One debts and has continued to record them with accrued interest in their own government accounts (Gill reproduces a US Treasury table from 2009, showing US$37.2 billion of debt outstanding, $16.7bn of which is owed by the British government. The British government accepts that the debt has not been written off – although since World War Two got fully underway they have not received six-monthly demands for payment – and has also long had the position that its own loans to World War One allies (including New Zealand) have not been written off either (of the New Zealand loan, Condliffe’s 1959 economic history records that after 1952 New Zealand no longer included its debt – 24.1 million pounds remaining, before any accrued interest – in our public debt statistics, but still recognised it then as a contingent liability). Gill even recounts the story of a court case arising out of a decades-old (1920s) will where, after the death of the life-interest beneficiaries the proceeds (by this time the 1990s) were to go towards Britain’s war debt to the US, in which officials in both countries had to decide what signals might be sent by their stance towards the litigation (to change the terms of the bequest). US courts ruled that there was a valid outstanding debt, which was legally enforceable.

But still the legacy of the default was not exhausted. When the UK first sought sovereign credit ratings in the late 1970s there appears to have been considerable discussion around whether and what to disclose regarding the 1934 default (which did not stop the UK getting AAA ratings.

There was talk in the 1960s, when France had accumulated large reserves, and was threatening to convert them to gold, of suggesting an offset with the French war debt. In the early 70s, a hundred US congressmen signed a resolution on collecting the old debts (at the time, the US was successfully pursuing debt arrears with several other sovereign borrowers). As recently as 25 years ago, then US Treasury Deputy Secretary Lawrence Summers was involved in a controversy within the US government regarding the accounting treatment of these debts and the signals that might be sent by particular choices. In this century there have been occasional questions in the UK Parliament regarding these debts. They sit, it seems, in a limbo in which it is in nobody’s interests to seek to press for payment (no one wants to reawaken the entire chain on other debts and claims, including German reparations) but no mileage in seeking to get the debts formally written off either. Perhaps they will forever.

In case you are wondering, the Johnson Act is still on the statute books – I have a hard copy of this very short piece of legislation in front of me as I type – but it was amended in 1948 to state that the provisions do not apply to any country that was a member of the IMF and World Bank (the UK has done some occasional borrowing in the US). New Zealand, of course, did not join the IMF until 1961, but then we had neither borrowed from the US government nor defaulted to them.

It is a fascinating and well-written book, drawing fairly extensively on archival material. New Zealand pops up surprisingly often: that outstanding debt to the UK still (apparently) not legally written off. There is absolutely no doubt that the default and the Johnson Act constraints mattered a lot over 1939-41, although I can imagine some other scholars perhaps mounting an argument that the post-war story, curious and interesting as it is, is a little over-egged (and I didn’t find his account of NZ’s debt difficulties in 1939 particularly convincing). Gill often raises the “what might have been” (but impossible to answer) questions. That could have been from both sides – whether more courageous political leadership in the mid-late 20s might have lead to a cancellation of all inter-government war debts, or whether (since it was able to pay) the UK continuing to service the debt after 1934, perhaps easing the grounds for finance in the early years of World War Two. It is impossible to tell but, intriguing factoids aside, perhaps what I took away most was the astonishing and courageous nature of the British decision to push towards confronting Hitler in a war knowing that the only international credit market where they might otherwise have raised funds was firmly closed to them. (If you wonder how Hitler got on, having no borrowing markets open to him, think pillage and plunder (“occupation levies”) of three of the most advanced industrial countries under Germany occupation by mid 1940.)

How much debt defaults really matter – especially for on-market debt raising – is primarily an empirical questions. But some years ago at a function I was talking to someone senior in local government finance in New Zealand. Somehow NZ’s credit record came up and I mentioned that in the article (linked to in the first paragraph) about New Zealand’s 1933 default I had noted in passing a couple of NZ local government debt defaults in the 1930s. My interlocutor was somewhat rattled as apparently information memoranda to potential latter day investors in local government securities had reported that no local government in New Zealand had ever defaulted. The defaults of a couple of small local authorities 80 years earlier probably had little useful information on probability of default now, but it still seemed to attract a little attention.

Now I’m almost curious as to what would happen if I sent $50 to the Minister of Finance or Treasury towards settling New Zealand’s outstanding World War One debt to the UK.


In the Sunday Star-Times yesterday there was a double-page spread in which various moderately prominent people (all apparently “leading speakers” at some “annual University of Waikato economic forum” this week were given 100 to 150 words to tell us “How can NZ build back following a string of serious economic and social setbacks”.

Most of the contributions were pretty underwhelming to say the least. To be fair, 150 words isn’t a lot, but real insight tends to shine through and there wasn’t much on offer in this selection. But then, who really cares much what the chief executive of the Criminal Cases Review Commission or the co-founder of an advertising agency think on such issues.

By contrast, Paul Conway is a statutory office-holder in an economic field. He is the (relatively new) chief economist of the Reserve Bank of New Zealand and in that capacity has been appointed by the Minister of Finance as an internal member of the decision-making Monetary Policy Committee. This was his contribution.

It was pretty bad. It is hard to argue with the first sentence, although the previous decades had not been an unbroken record of success and low inflation (check out core inflation measures over 2007 and 2008). But it was when I read the second sentence that I started to get concerned. What possible analytical or empirical basis is there for that claim?

For decades the Reserve Bank has told us (and rightly so) that there are no material long-run trade-offs between inflation and activity/unemployment/”prosperity”. That is so on the upside – you can’t buy sustained prosperity or lower unemployment by pursuing or settling for a higher inflation rate – but it is also largely true on the other side. Not only does lower inflation not create permanent adverse economic outcomes, but it is not a magic path towards materially better economic outcomes either. At best, and this is a line the Bank has also run for years, sustained and predictable low inflation, or price stability, may be conducive to the wider economy functioning a little better than otherwise, but any such effect is typically viewed as very small, and difficult to isolate statistically.

Unfortunately, Conway’s line has the feel of political spin, the sort of thing we might here these days from Luxon or Hipkins amid talk of a “cost of living crisis”. But, as the Reserve Bank MPC members should know only too well, real hits to economywide material living standards are not a consequence of general inflation but of supply shocks that (a) central bank can do nothing about, and (b) which would have been a thing, with adverse consequences for average living standards, even if the central bank’s MPC had done its job better over the last few years (Conway himself was not there when the mistakes were being made). As it happens, the process of actually getting inflation back down again will – on the Bank’s own forecasts – actually, and necessarily, involve some temporary losses of output and “prosperity”.

It was pretty poor from the chief economist of the central bank who (unlike his boss, the deputy chief executive responsible for macro matters and monetary policy) is a qualified and experienced economist.

Then we get the curious claim that monetary policy “is only part of the solution to reducing inflation”. Except that it isn’t. The way things are set, the Reserve Bank Monetary Policy Committee is responsible for keeping (core) inflation at or near the target midpoint, after taking into account all the other stuff that is going on, all the other policy initiatives here or abroad. Monetary policy isn’t the only influence on inflation, but it is given the job of delivering low inflation having factored in all those other influences. Thus, when the Canterbury earthquakes happened and there was a huge stimulus to demand over the next few years, it was still monetary policy (and monetary policy alone) that was responsible for delivering inflation near to target. We wouldn’t have wanted the repair and rebuild process slowed down just to have made the Reserve Bank’s job a bit easier. Same will go, on a smaller scale, for the repairs etc after the recent storms. Perhaps Conway or his colleagues think the government should be running a different fiscal policy, but as monetary policymakers it is really none of their business: fiscal policy and the central bank should normally each do their own jobs. As it is, Conway’s line gives aid and comfort to people talking up things like temporary petrol excise tax cuts as a way of helping ease inflation.

But bad as some of that stuff was it was the last three sentences that really struck me, including because Conway likes to talk about productivity (he was head of research at the Productivity Commission in that agency’s better day, and produced a range of interesting papers). We should all be able to agree that, in general, higher economywide productivity growth would be a good thing. People would be better off and individuals and governments would have more real choices.

But it isn’t a path to lower inflation, let alone lower interest rates, whether in the short or long run. And it isn’t clear why Conway appears to think otherwise.

In the short run, perhaps he has in his mind a model in which the Reserve Bank determines nominal GDP growth. If it did then, all else equal, the higher real economic activity was in any particular period then, mechanically, the lower inflation would be in that period. If higher productivity was an element in that higher real economic activity, and nothing else changed as a result, then higher productivity might be part of such a story. But the Reserve Bank does not control nominal GDP growth in that sort of mechanical sense, and if firms suddenly stumble on paths to higher productivity it is very likely nothing else will change as a result. Over the longer-term, higher rates of real GDP growth – and productivity growth – tend to be associated with higher, not lower, interest rates (a “good thing” in that context, as not only is there typically strong investment demand to take advantage of the productivity shocks and the opportunities they create, but also expected future incomes will be stronger and people will rationally want to lift consumption now in anticipation of those future gains). And if, as it appears may be the case, Conway is more focused on the short-term (“without the need for ongoing interest rate increases”) then it is really just magic fairy stuff, distracting from the (hard) choices the Reserve Bank has been having to make. Productivity growth isn’t just conjured out of the air at short notice to suit the cyclical preferences of central bankers.

It might have been better if Conway had declined to participate in this elite vox pop (after all, monetary policy really hasn’t much to offer, and we shouldn’t want to hear a central banker’s personal views on other policies) but if he was going to participate he really should have produced something better than what actually appeared. Yes, he didn’t have many words to play with, but the basic points aren’t hard to make quite simply. Whatever shocks, positive or negative, the economy experiences the Reserve Bank should be looking to provide a stable macroeconomic backdrop, and nothing monetary policy does can do more than take some of the rough edges off the worst of booms and busts while delivering a stable and predictable general level of prices. After the failures of recent years, that wouldn’t be nothing.

A couple of MPS thoughts

I don’t have very much I want to say about yesterday’s Reserve Bank Monetary Policy Statement – although “welcome back from the long holiday” might be in order. Oh, and I noticed a nice photo from my own neighbourhood on page 6 of the pdf.

As so often, I continue to be a bit surprised by the fairly superficial analysis of inflation itself. Thus, they include a chart of various core inflation measures, but all as annual rates. Surely, surely, surely, a central bank Monetary Policy Committee, ostensibly forward looking, would want to be focused as much as possible on the very latest quarterly data. For example, this chart from my own post last month on inflation data.

It isn’t impossible that the “true” story is less encouraging than this quarterly series might appear to suggest, but I’d have hoped to hear/see the analysis why or why not from the Bank. As just one example, the data aren’t seasonally adjusted, but the RB is big enough and has enough clout with SNZ that they could either redo the series using seasonally adjusted data or get it done for them (or having looked into it concluded any difference was small enough it didn’t matter). As it is, even if there are some seasonality issues the Q4 numbers for both series were lower than for Q4 in 2021. It looks to be a somewhat encouraging story – still some way to go to get back to annual rates around 2 per cent – but better than it was, better than it might have been.

There is still no sign either – in the MPS or any of the other material the Bank has published in recent months – that the Bank has thought any deeper about what and why they (like many other people) got the inflation (and, thus, monetary policy) story so badly wrong over 2020 to 2022. The Governor was reported this morning as telling MPC that he didn’t think the inflation outcomes represented a “failure”. With hindsight, things might be partly understandable, perhaps even somewhat excusable, but against (a) the targets the government set for the Bank, and (b) the promises of central bankers over recent decades as to what they could deliver, it does not help the advancement of knowledge or understanding (although perhaps it helps MPC members sleep at night) to pretend what has happened has been anything other than a failure. I

I’m not taking a strong view on what the inflation outlook is, or even how much additional monetary policy restraint may (or may not) be needed, but the second point from the MPS that struck me was around their own story and how well it held together.

On their numbers, the output gap was estimated to have been 2.1 per cent of (potential) GDP in the June quarter last year, rising to a new peak of 3.2 per cent in the September quarter. Here are the estimates and forecasts

Their forecasts show that they expect the output gap to have averaged 2.7 per cent of (potential) GDP for the Dec and March quarters too. In other words, the period of maximum pressure on resources and of upward pressure on core domestic inflation includes right now (around the middle of the March quarter).

If so, core inflation (quarterly) should have been continuing to rise, something there is no sign of in the data. And a great deal turns on the June quarter, when they expect a sharp fall in the output gap as GDP growth itself turns negative. That is a fairly big call in itself (and of course, actual events will be messed up by post-cyclone repair activity).

But what of inflation? The Bank forecasts that by the December quarter of this year, headline quarterly CPI inflation will be down to only 0.6 per cent. There is some seasonality in the headline CPI numbers, and December inflation tends to be a bit lower as a result. But the difference looks fairly consistently to be only about 0.1 per cent, so that a seasonally adjusted forecast for the December quarter (measured as at mid November, nine months from now) is probably 0.7 per cent. That would be the least bad outcome since 2020, and in annualised terms back inside the target range. (And the December quarter numbers won’t have been thrown around by the end of the petrol excise tax cut or temporary fruit and veg effects of the cyclone). If they deliver that it will be a good, and welcome, outcome. If we apply the eyeballed seasonal factors to their remaining CPI forecasts, by the September quarter of next year, quarterly seasonally adjusted inflation is right back down to 0.5 per cent – slap bang in the middle of the target range.

But I’m left puzzled about two things. The first is that the Bank usually tells us that monetary policy takes 12-24 months to have its full effects on inflation. If so, then why on their story do we need further OCR increases from here when inflation 18 months hence is already back at target midpoint. And then, given that inflation is at the target midpoint 18 months from now, why is policy projected to be set in ways that deliver deeply negative output gaps (not narrowing rapidly at all) all the way out to March 2026? Perhaps there is a good and coherent story, but I can’t see what it is (and I don’t see it articulated in the document). Entrenched inflation expectations can’t really be the story, because as the Bank has often noticed medium to long term expectations have stayed reasonably subdued and shorter term surveys of inflation always tend to move a lot with headline inflation which is expected to be rapidly falling by this time next year.

(My own story would probably put more emphasis on the unemployment rate as an indicator of resource pressures. On the Bank’s (and SNZ”s) numbers, the unemployment rate troughed a year ago.)

The final aspect of the MPS I wanted to comment on was the brief section (4 pages from p30) on “The international dimension of non-tradables inflation”. It is good that they are attempting to include some background analysis in the document, although sometimes one can’t help thinking it might better have been put out first in an Analytical Note where all the i’s could dotted and t’s crossed, and the argumentation tested. We might reasonably wonder what the non-expert members of the MPC make of chapters like this, which they nonetheless own.

The centrepiece of the discussion is this chart, which looks quite eye-catching.

Count me a bit sceptical for three reasons. The first is that I am wary of a picture that starts at the absolute depth of a severe recession and would be interested to know what it would have looked like taken back another three or five years. Perhaps they didn’t do so because the treatment of housing changed (very materially) in 1999, when the dataset they used starts from, but one is left wondering. Second, end-point revisions are a significant issue with the techniques used to derive the global CPI component, and might be particularly so over the last year when headline inflation has been thrown around so differentially depending on (a) exposure to European wholesale gas prices and mitigating government measures. And then there is the question of the countries in the sample. Of the 24, 12 are part of the euro-area (or in Denmark’s case, tightly pegged to the euro) for which there is a single monetary policy. For these purposes, it is like using as half your sample individual US states or Japanese prefectures. I don’t understand why they chose those countries, or why (for example) Hungary is in but the Czech Republic and Poland (all with their own monetary policies) are out. Or why you’d include Luxumbourg – which has the euro as its currency – and not (similar-sized) Iceland with its own monetary policy. And since this is just using headline CPI inflation data why you’d use only these countries anyway and not a range of non-OECD countries with market economies and their own monetary policies. Perhaps it would make little difference, but we don’t know, and the Bank makes no effort to tell us or to explain their choices.

Now, to be honest, if you had asked me before seeing this section I would probably have said ‘yes, well given that a whole bunch of advanced economy central banks made similar mistakes I might expect to see a stronger than usual correlation between New Zealand non-tradables inflation and some sense of “advanced world core inflation”. And thus I wasn’t overly surprised by the right hand side of the chart above.

The Bank attempts to address that question, summarised in this chart, using the same period and same 24 countries as in the earlier one.

But count me a little sceptical. Almost every OECD country – including their 24 (with all the same issues around selection of countries) – had unemployment rates late last year at or very close to cyclical lows. As New Zealand did as well. But whereas the Reserve Bank estimates our output gap late last year was +2.7 per cent of potential GDP (and, by deduction, the Bank must be using their own estimate in this calculation) OECD output gap estimates have 12 of the Bank’s 24 countries running negative output gaps last year (they don’t even think New Zealand’s output gap was positive last year, despite abundant evidence of resource stresses here). Given the choice between fairly hard unemployment rate indicators and output gap estimates which are notorous for revisions, personally I’d be putting a lot more weight on the labour market indicators where (as the Governor himself has emphasised in the past) all his peers say they have the same issue of “labour shortages”. (The OECD no longer publishes “unemployment gap” estimates but they do publish “employment gap” estimates, and of the Bank’s 24 countries only a handful had (small) estimated negative employment gaps in 2022).

They end the special section with a paragraph “What does this mean for monetary policy?”. I didn’t find their story persuasive – that it would mean monetary policy was harder – but given how little confidence we can have in the charts, it isn’t worth spending more time on that discussion.

Harry White, and reconstructing the international financial system

Harry White and the American Creed: How a Federal Bureaucrat Created the Modern Global Economy (and Failed to Get the Credit), a new book by James Boughton, was my weekend reading.

Boughton, now retired, was formerly the official in-house historian of the International Monetary Fund (IMF).   White was a fairly senior official in the US Treasury, a key adviser to Secretary Henry Morgenthau, from the late 1930s to 1945, and has a fair claim to have been the technocratic father of the IMF (and was then for a short time the first US Executive Director of the IMF).  It was a short official career and he died quite young, but has an interesting – and contested – story nonetheless.

What of the book?   Well, ignore most of the title.  I’m still not at all sure what the “American Creed” is supposed to mean in this context, and the bit about “created the modern global economy” is simply laughably wrong (and seriously misleading to the casual bookshop browser).  It is a full biography, but two-thirds of the book is about the last 7 years of White’s life (1941-48), including extensive discussion of the allegations which have dogged his reputation ever since that White may have been a Soviet spy.

By the time White became even moderately senior in the US Treasury, pretty much every country had moved off the Gold Standard (the European “gold bloc” countries not until 1936) and most major exchange rates floated.  In the diminishing number of democratic countries, private capital movements were mostly still free (although in the US for example private holdings of gold were simply outlawed).  Views differed on whether the new exchange rate regimes were a “good thing” or otherwise (in another book on my shelves there is a record of White on an official trip to London in the mid 1930s talking to prominent business figures who had embraced an era of floating exchange rates, but officialdom was often less enthusiastic).  In some circles then – and still today (Boughton seems guided by this story) – there was a narrative that non-fixed exchange rates were a material element causing a backing away from globalisation and multilateral trade in the 1930s (a story that I don’t think stands much scrutiny). It is certainly true that floating exchange rates in peace time were something of a novelty.

Then came the war (the US eventually joining in late 1941) with the attendant debt, disruption, and extensive controls over all manner of aspects in life in pretty every combatant country (and even many neutrals).

White wasn’t heavily involved in the creation of lend-lease, that innovative form of cross-country support initiated by the US (although they too were recipients of lend-lease assistance, New Zealand (for example) being a net provider of assistance to the US) but eventually had oversight responsibility for the administration of the scheme.  The real focus of his efforts as described in the book was on post-war planning, which absorbed a huge amount of resource among (in particular) US and UK officials even as the physical conflict raged.

As is fairly well known, there were rival conceptions of the details of what the post-war international monetary order should look like, exemplified by the ideas of White (for the US) and Keynes (a key adviser to the British).   But what no one seems to have been in much doubt about was that a regime of fixed (but adjustable) exchange rates should be established, and that if current account convertibility (ability to buy, sell and pay for goods and services freely from abroad) was over time to be a goal for many/most, private capital mobility was (at best) looked on with considerable suspicion (neither White nor Keynes were keen).  If you weren’t going to allow private capital mobility, not only were fixed exchange rates were more or less unavoidable but governments had to be sure of their own access to foreign reserves to manage fluctuations in the demand for their respective currencies.  There was no appetite for a return to a classical Gold Standard, but also a surprising attachment to the idea that gold should still have a place in the international monetary system (one presumption being that countries would be reluctant to accumulate substantial foreign reserves simply in the currency of another country without the ability to convert to gold).

If there were different conceptions there were also different interests and contexts.  The US, for example, had been a net provider of assistance to the rest of the world during the war, and so although it would emerge from the war with large domestic debts it had not accumulated an adverse international position.    The US under Roosevelt also came and went a bit on to what extent they sought to undermine the future of the British Empire and British Commonwealth relationships (notably the imperial preference trade arrangements, and the “sterling area” which had developed after Britain went off gold in 1931).  The UK, by contrast, had suffered a real large deterioration in its external financial position (as well as having lots of domestic debt) as a result of the war, and had accumulated huge volumes of blocked sterling liabilities to Commonwealth and Empire countries (goods had been sold to Britain, sellers had been paid in sterling, and the resulting central bank balances were not readily convertible into other currencies –  notably dollars).  New Zealand was among the countries that had accumulated such large claims on the UK.  The overhang of sterling liabilities was to be an issue for decades.   The US was keen on a fairly early move to convertibility, while the UK was wary, to say the least.   (There were, of course, many other countries, including the exiled governments of occupied countries like the Netherlands and Norway, but the bulk of the discussion and negotiation was between US and UK officials –  often led by White and Keynes (both of whom seem to have been awkward characters in different ways).

In institutional terms the US conception won the day. It was almost always going to. The US was by the biggest economy, was not itself dependent on external finance (although had a clear interest in a general post-war economic revival), and of course whatever was agreed between governments had to get through a US Congress that –  as ever – was not generally under the control of the executive.   And, in truth, the basic IMF structure (my focus here although the World Bank –  International Bank for Reconstruction and Development – also emerged, less controversially from this process) was an elegant one.   Countries would fix an exchange rate to the USD, while the USD itself would be convertible (for governments/central banks) into gold at a fixed rate.  Each member country would deposit some portion of their gold or USD reserves with the Fund, which in turn would establish rights for countries to “borrow” from the Fund in times of temporary balance of payments pressures.  Countries could make modest exchange rate adjustments themselves, but larger adjustments – to address structural imbalances – would require the approval of the Fund, itself governed by Executive Directors appointed or elected according to the quotas negotiated for each country.  I put “borrow” in quote marks, as formally the IMF did not do loans, but things that were more like currency swaps –  and obscure currency swaps (partly modelled on what had been done with the US’s own Exchange Stabilisation Fund in the 1930s) were thought easier to get through Congress than loans.  In economic substance there was no difference.

Boughton was, as I noted earlier, the official in-house historian of the IMF. Since the IMF still exists today, it is a perspective that leans him to seeing what was created in 1944/45 as an unquestionably good thing.   I’m much more sceptical.  One could wind up the IMF today and the world would not be worse off.   And one could mount an argument that if negotiated arrangements were almost inevitable in 1945, there is still little reason to suppose that the creation of the Fund was a net positive even then.

It didn’t –  couldn’t –  deal with the really big overhanging issues (including, but not limited to, those blocked sterling balances) and was part of state-led arrangements that enabled for a time some deeply unrealistic post-war exchange rates.  Britain, for example, went through a period of seeking further US financial assistance, was then forced by the US in exchange to allow early convertibility which went badly wrong very quickly, and only finally took the deep exchange rate depreciation that was always needed under pressure in 1949.   It is not hard to think that restoring floating exchange rates pretty much as soon as the war ended might have been a better way (also reducing the pressure later for the Marshall Plan – a point some US sceptics made even at the time).

But whether or not the creation was a good thing, there is little doubt that White was the technocratic father of the Fund – which exists today even if the world it was created for almost wholly doesn’t – and Boughton has written a useful and interesting account of aspects of that period, complementing the range of other books (many on the Bretton Woods conference in 1944 where the final details were negotiated with 40+ allied countries in attendance).

There is lots of other interesting detail in the book (occasionally too much – even as a former Washington resident I did not need every single street address White lived at), including White’s involvement in helping flesh out the madcap Morgenthau Plan that envisaged turning post-war Germany into primarily an agricultural economy. White owed his position to Morgenthau who in in turn owed his position and influence to his friend and neighbour Roosevelt. Once Roosevelt died, White’s hour in the US government system had passed,

One is left with the impression of an influential, extremely hardworking, smart individual, but also an abrasive and not altogether pleasant one.  In an age of great figures –  good and evil – my sense is that no one would today be writing biographies of him if (a) the IMF no longer existed, and (b) it were not for the espionage allegations (the two aren’t unrelated since it was uncomfortable for the Fund to have such allegations about one of its “founders”).

The espionage allegations were not my main interest in buying the book. Not being American I’m probably less interested in any case against White than in, say, the truth about Bill Sutch.   Boughton goes to great lengths to review and rebut in detail many of the claims that have been made ever since the 1940s.  In some cases, he seems very persuasive, and in others a bit less so.   What is now unquestionable is that some of White’s good friends and colleagues were Soviet agents in one form or another (in some cases very active), and even Boughton concedes that at times White may have been indiscreet in his ties with people who, while Soviet officials, were still wartime allies and official interlocutors.  But if Boughton’s is the pro-White case, other serious people (without IMF ties) still seem equally certain of White’s guilt.  Perhaps we will never really know.

New Zealand participated in the Bretton Woods conference where the new international monetary arrangements were settled.  Our key delegate was Walter Nash then (simultaneously) Deputy Prime Minister, Minister of Finance, and resident NZ Ambassador to the United States.  His small delegation including the Secretary to the Treasury, Ashwin, the then Deputy Governor (later Governor) of the Reserve Bank, Fussell, and the highly regarded economist AGB Fisher.   There were two main working groups at the conference –  one on the Fund chaired by White, and another on the World Bank chaired by Keynes.  Nash chaired a less important working group.

Bretton Woods was, in many respects, not a matter of great moment in New Zealand (and it is interesting that neither the war economy  nor political and external affairs volumes of the NZ official history of World War Two seem to have any mention of the conference or the issue).   New Zealand was firmly in the sterling area –  our pound pegged to sterling –  and Nash had a strong aversion to overseas debt.  But there was still an important defensive interest, since Labour has put in place pre-war extensive exchange controls and import licensing restrictions and had no intention of removing those restrictions in peacetime.

Digging around various other books on my shelves, it seems clear that Nash and the NZ delegation did not make a great impression.  Ed Conway’s book, The Summit, has a few comments.  Introducing Marriner Eccles, the then chair of the Fed, he suggests that Eccles’ oratory “would give New Zealand’s dreary Walter Nash a run for his money as the most self-important and tedious delegate”.  The relative size of each country’s quota in the Fund was then, as now, a matter of politicking dressed up behind an apparent technical façade.  New Zealand was among those objecting to the US proposal (not helped by the fact that Nash apparently confused sterling and dollar amounts) “in a ten-minute sermon from the country’s dreary lead negotiator, the Hon Walter Nash”.  Conway quotes from the contemporary diary of UK delegate/economist Lionel Robbins “throughout the conference {Nash] has shown a tendency to be about three bars behind the band”. 

A more recent history of New Zealand diplomacy during the war, by Gerald Hensley, has a more substantive discussion.  He notes that the delegation had a good grasp of the basic New Zealand needs “But not one had been able to do any deeper thinking about the implications of the Fund and on this occasion it showed”.  He goes to quote from a contemporary British delegation report back home which concluded that Nash was simply out of his depth (“He understood comparatively little of the technicalities, but could not restrain himself from intervening in an embarrassing manner on many complicated points which were, moreover, not the least concern to his country”).  The Australian delegation also recorded complaints.

As Hensley notes, however, the government’s (and Nash’s) main focus was on ensuring that nothing in the agreement would interfere with the government’s ability to maintain exchange and import restrictions.   Nash’s official biographer, Keith Sinclair records that “according to the notes he made at this time, he asked the chairman Harry D White whether exchange controls were permissible, provided that exchange was used to pay for all current transactions.  White replied that this was his understanding, and he asked the meeting if there was any dissent. There was none.”

(Which is all very well but it was not be until the early 1980s that New Zealand finally removed all restrictions on even current account transactions)

If Nash himself was content with the final form of the agreement, there was still a significant amount of angst back home.  Instructions came from the Prime Minister that New Zealand was not to sign adhesion to the Final Act from the conference, and in the end the two most junior officials in our delegation were allowed merely to sign a document that certified that it was a true record of the conference proceedings. That Nash himself was persuaded is reflected in a letter to Harry White that was read to the conference by a senior US delegate as the conference was winding up (Nash had had to leave early)

“Owing to the urgency to make a train last night it was not possible to say goodbye before leaving for New Zealand.  In congratulating you and those working with you on the foundation work in connection with the Fund and the Bank I affirm that it can easily be the greatest step in world history with possibilities of removing one of the major causes of war, if not the major cause.”

Talk about overblown political rhetoric.

New Zealand was one of a very small handful of countries that participated in Bretton Woods that did not join the Fund early on (the most prominent of course was the Soviet Union, but even Australia did not join until 1947).  There is an entire article to be written on this strange history one day (I have a big folder of papers I collected a few years ago but cannot immediately find it).  There was significant unease on both sides of parliamentary politics with talk of free votes. It seems to have been one of those issues that few cared much about (either way) but a minority (against) felt very strongly about.   The Labour government failed to take any lead (there was significant dissent in their own caucus), and by the 1946 election campaign the leader of the National Party was openly opposed to joining.   There seem to have been a range of concerns, some reasonable, some not, and it is not as if there was no sensible dissent in other places either (I read one speech from a senior former UK minister in the House of Commons ratification debate expressing concern that the IMF would allow the UK less exchange rate flexibility than the UK had needed in 1931).  Between close ties to the UK, some unease about an emerging US-led system, a commitment to the sterling area and UK trade preferences, all combined with on the one hand the NZ regime of controls and, in the late 40s, New Zealand’s strong external position (we revalued our currency in 1948) there wasn’t much momentum, before the undertones of Social Credit type concerns were mentioned.  When New Zealand did finally sign up in 1961, Hansard still records unease from Labour members that IMF membership might threaten New Zealand’s full employment record.

New Zealand did join.  New Zealand has borrowed from the IMF on a few occasions ( a former colleague recently described to me the gaming of the rules of one particular facility in the 1970s).  It isn’t clear that joining or not really made very much difference then or now – these days we get only not-very-useful advice and a few job opportunities for officials – although it would these days look odd not to be a member.

(Personally I’m quite glad NZ finally did join as four years on the IMF payroll –  two resident in Zambia, two as Alternative Executive Director in Washington – were by far the highest paid of my career, and the only technical assistance mission I ever did for them, in China, was conveniently timed to pay the bills for our wedding.)

UPDATE: Someone inquired about my observation that NZ was a net provider of lend-lease assistance to the US. On checking, I’m reminded that in accounting terms the two sets of flows were roughly even (we received about as much as we provided), however Hensley’s book (p250) notes that this somewhat misrepresented the flow of real value, since much of what New Zealand provided was valued at pre-war prices, while material received from the US was typically accounted for in contemporary price terms. To the extent this was so, NZ was a net provider to the US.