Has monetary policy run its course?

In one of the world’s most prominent economics platforms, the economics columnist for the Financial Times, Martin Wolf uses this week’s column for a piece headed “Monetary policy has run its course”, with a subheading “It has made secular stagnation worse.  Fiscal alternatives look a safer bet.”.    That headline was guaranteed to get my attention, disagreeing as I do with all three limbs of the apparent argument.

Wolf draws on various other papers, but doesn’t really make his case in a compelling way.  Take secular stagnation first.  There are various definitions: Wolf uses one of “chronically weak demand relative to potential output”, while the FT’s own lexicon uses a materially diferent version

Secular stagnation is a condition of negligible or no economic growth in a market-based economy.

On the former definition, most of the OECD is estimated to be back somewhere near a zero output gap, and the unemployment rate now in several major economies (but not New Zealand) is lower than it was going into the last recession (and there is a striking fact that the worst performers are all in the euro common currency, a system Wolf tends to be keen on).  That has happened without big new surges in overall ratios of private debt to GDP.

On the latter definition, even in countries with high starting levels of productivity, productivity growth has slowed but not stopped.  Per capita GDP across the OECD is now about 10 per cent higher in real terms than it was in 2007.  Not stellar, but it means that 10 per cent of all the output growth managed in the last several hundred years (since the Industrial Revolution) has been in the last decade alone.

I think there are credible stories under which monetary policy wasn’t used sufficiently aggressively in, and following, the last recession –  partly because both markets and central banks misjudged things and expected a strong rebound, so were always looking towards the first (or subsequent) tightenings.  But is very difficult to construct a story, in which monetary policy has made any material (adverse) difference to population growth, productivity growth, actual innovation opportunities or the like.    And even if, for argument’s sake, there was some effect in the frontier economies, most OECD economies (including large ones like the UK, Japan, Italy, Spain, Canada, South Korea) are nowhere near the frontier.

Having said that, there is little doubt that neutral real interest rates have fallen away very substantially over the last 15 years or more.  They are now at levels that are pretty much without historical precedent.  This is the first chart in the article.

ft chart

That means there are issues.  There is an effective lower bound, at present, on short-term nominal interest rates.  No one knows precisely where that bound is, but there is a degree of consensus that taking your policy interest rate much below -0.75 per cent will lead to fairly large scale conversion of deposit balances into physical cash (not, primarily, transactions balances –  where the inconvenience would dominate – but large wholesale balances).  The limit now exists wholly and solely because (a) governments monopolise physical currency issue, and (b) pay zero interest on physical currency.  Zero might not be much, but for a multi-million dollar fund, it is a lot more than -3 per cent (for the same credit risk).

Quite a few countries (including the euro area) are at or very near that floor already.  Other countries, including New Zealand, Australia, and the United States are not.   But even in those countries, a severe recession in the next few years would be likely to exhaust conventional monetary policy capacity (our Reserve Bank could cut by perhaps 2.5 percentage points, but it has often needed to cut by more than 5 percentage points in previous downturns).

Wolf isn’t apparently keen on doing anything about that, observing that a need for materially negative nominal official interest rates

would, to put in mildly, create a wasps’ nest of technical, financial and political problems.

Not nearly as many problems as doing nothing, and allowing persistently high unemployment for multiple years might create.

There are two broad options for creating more monetary policy space.   The first is to raise the inflation target (and reading a central banking magazine yesterday I noticed that a Swedish Deputy Governor is calling for exactly that), and the second –  and more reliable –  is to remove, or markedly ease, that near-zero effective lower bound.   No government or central bank has done so (and there are not overly complex ways of doing so), and that passivity –  apparently endorsed by Wolf – is increasing the risk of problems when the next serious downturn gets underway.  If interest rates can’t, for now, be cut far, people will quickly recognise that, not expect it, and adjust their behaviour, and asset holdings, accordingly.

Is there reason for unease about some of these options?  Perhaps.  If we were to allow short-term interest rates to go materially negative, no one knows how far they might eventually go.  There are good theoretical reasons to think not too far (human innovation hasn’t died, there are naturally productive (positive returns) assets (land or fruit trees) but no one knows with certainty.  Would it matter if interest rates went, and stayed, materially negative?  I’m not convinced it would, allow it would certainly be a symptom of something odd.   But such philosophising shouldn’t get in the way of actively preparing to handle the next serious downturn.  Neither central banks nor governments seem to be doing what they could on that score (and although the issue is a bit less immediately pressing in New Zealand, it is true here too).

Which brings me to the third limb of Wolf’s argument: “Fiscal alternatives look a safer bet”.   “We need more policy instruments he argues”.  In many respects, the rest of the article is a teaser for a conclusion around more aggressive use of fiscal policy.   (“More aggressive? perhaps Antipodean readers wonder, but as a chart in the article illustrates OECD net government debt as a share of GDP has trended quite strongly upwards in the last fifty years as, generally, has government spending.).  He asserts boldly:

If the private sector does not wish to invest, the government should decide to do so.

And yet who is “the government”, except a collective representation of the voters, themselves “the private sector” in one form or another.  There is no sense of trying to understand why the private sector might not choose to invest more heavily and then, if those things are in the gift of governments (tax, regulation, policy uncertainty or whatever), fix them.

And nothing at all on the near-certain “political problems” and constraints around the large scale and persistent (for it is something structural he is championing, not just a short-term cyclical response) aggressive use of fiscal policy, whether for consumption or investment.  Monetary policy has its problems, but if central bankers and politicians got on and fixed some of the regulatory (lower bound) obstacles, it would be a much more reliable tool to deploy.   At worse, even left-wingers (such as Wolf, and the Democratic economists he cites –  Laurence Summers, Olivier Blanchard, and Jason Furman) should want to have monetary instruments to hand, rather than some all-or-nothing wager on fiscal policy, when there is no political consensus at all (anywhere) on using fiscal policy in the ambitious way they suggest.

Wolf is right that central banks can’t deal with structural secular stagnation –  although they can do the important job of leaning against serious cyclical downturns, as they did in 2008/09. But even on the most optimistic of readings, it seems unlikely that aggregate fiscal policy is going to be able to either, whether for technical or political reasons.  And so-called secular stagnation should simply not be regarded as an acceptable excuse for poor productivity growth and weak investment in countries that are far from the productivity frontier, New Zealand pre-eminent (for how far it has drifted behind) among them.

In defence of capital charges (and higher public sector discount rates)

I don’t usually see the National Business Review but a copy of the latest issue turned up at home and I flicked through it on Saturday afternoon.  On page 2, I found a very strange article, in a column called (Tim) “Hunter’s Corner”, about health funding and (in particular) the application of the “capital charge” to DHBs.  It is, we are told, a “knuckleheaded approach” and should, in Tim Hunter’s view, be abolished.

Capital charges have been around for a long time now, since 1991 in fact.  Here is one description

The charge is levied on the net worth (assets minus liabilities) of departments and some Crown entities. The assets are assessed on the basis that they are valued in financial statements and may include buildings and other fixed assets, cash appropriated for depreciation or held as working capital, inventory, or receivables. The capital charge represents the opportunity cost of money – what the government can expect to earn in alternative investments entailing similar risk. It may be thought of as an internal rate of return on the government’s investment in its own entities.

and here is one articulation of the point of the charge

The capital charge has a dual purpose: it signals that capital is not costless and should be managed as would any other cost of production, and it spurs managers to include the cost of capital in comparing the cost of outputs produced by government entities with the cost of obtaining the outputs from outside suppliers. The charge puts internal contracting on the same footing as contracting out and encourages full cost recovery of outputs sold to governmental or private users.

It has always seemed eminently sensible to me.  Don’t charge for the cost of capital and government agencies will be incentivised to use lots of it, and to do things themselves that might be more efficiently provided by private sector firms (whose owners will, reasonably enough, expect to cover the cost of capital).   Without a capital charge, any hope of limiting those tendencies requires (even) more centralised adminstrative edicts.

I couldn’t see any information on The Treasury’s website about the current rate of captial charge, so I’ll take Mr Hunter’s word for the fact that it is “typically about 6-8%”.    Eight per cent (nominal) is the standard discount rate Treasury recommends for project evaluation.

So what bothers Mr Hunter?  His article seems to imply that capital charges squeeze the funds available to deliver health services to the public.  Waive them and suddenly DHBs will have more money.  Except that, were capital charges to be scrapped, one would expect to see an entirely-commensurate drop in central government funding to DHBs.  Of course, the Crown could decide it wanted to spend more on health service delivery but logically that is a quite different decision.  One can increase health spending with or without the capital charge.  All else equal, just scrapping the capital charge would increase the overall government deficit, and it would weaken the incentives in government agencies for capital to be used wisely and abstemiously.  Crown capital costs –  and that costs fall on citizens and taxpayers.

Hunter also seems worried about incentives

“…charging 6-8% on net assers provides an incentive to sell property and lease it back where the rental cost is below the capital charge”

Indeed, and so long as the capital charge is designed reasonably well, that is a feature not a bug.  Recall that the purpose was to help efficiently allocate resources and not artifically favour in-house solutions.

Getting still more specific, he goes on to argue that

“However, the actual cost to the Crown of the capital is more like 2% (the latest bond tender achieved a weighted average yield of 1.8%) and the chances of a DHB achieving a lease cost at or below that level are zero.  This means the capital charge incentivises the DHB to increase the actual cost to the Crown.”

It has to be pretty worrying that a senior business journalist thinks an appropriate measure of the Crown’s cost of capital is the rate it can raise debt at.

Just as for any private sector entity (businesses most obviously, but the concept applies more broadly), the cost of capital is better represented by some weighted some of the cost of debt and the cost of equity.    That is what The Treasury is trying to mimic in its recommended discount rates (and, I assume, in calculating rates of capital charge).  You can see the various assumptions (including the equity risk premium and leverage) laid out at the link.

The fact that the Crown doesn’t pay dividends and isn’t listed on the stock exchange doesn’t change the fact that equity capital has a cost.   When the government takes our money – and that is how the government raises equity, coercively through the tax system –  we can’t use that money for other things.   As citizens we, presumably, expect them to use that money wisely, and at least as well (for things at least as valuable) as the alternative options we have open to us.  Opportunity cost matters.    And, of course, the Crown’s cost of issuing debt isn’t just kept modest by the actual equity the Crown has accumulated, but by the ability of the Crown to raise our taxes whenever necessary to service the debt.   Lenders know that; in fact, they count on it.   And yet in evaluating state projects that option cost (to citizens) isn’t internalised.

I wrote a post a few years ago on the question of what price we should put on government projects.  Here are a couple of key paragraphs.

The Reserve Bank of Australia recently ran an interesting and accessible Bulletin article on the required hurdle rates of return that businesses use in Australia.  They report survey results suggesting that most firms in Australia use pre-tax nominal hurdle rates of return in a range of 10-16 per cent (the largest group fell in the range10-13 per cent, and the second largest in a 13-16 per cent band). Recall that nominal interest rates in Australia are typically a little lower than those in New Zealand, and their inflation target is a little higher than ours.   In other words, it would surprising if New Zealand firms didn’t use hurdle rates at least as high in nominal terms as those used by their Australia peers.     The RBA reports a standard finding that required rates of return were typically a little above the firms’ estimated weighted average cost of capital. The literature suggests a variety of reasons why firms might adopt that approach, including as a buffer against potential biases in the estimated benefits used in evaluating projects.

As a citizen, it is not clear why I would want to government to use scarce capital much more profligately than private businesses might do. I use the word “profligately” advisedly – using a lower required rate of return puts less value on citizens’ capital than they do themselves in running businesses that they themselves control.  And if the disciplines of the market are imperfect for private businesses (as they are), the disciplines on public sector decision-makers to use resources wisely and effectively are far far weaker. Fletcher Challenge took some pretty bad investment decisions in the 1980s and 1990s: its shareholders and managers paid the price and the firm disappeared from the scene (along with many more reckless “investment companies”). The New Zealand government, architect of Think Big debacle, lives on – citizens were the poorer, but ministers and officials paid no price.

And here was a chart from J P Morgan that I used in a recent post

hurdle rates

I also noted

If anything, there are several reason why governments should be using higher discount rates than private citizens would do:

  • Governments raise equity (“power to tax”) coercively rather voluntarily, and effectively impose near unlimited liability on citizens.
  • Governments are subject to fewer competitive pressures and market disciplines to minimise the risk of resources being misapplied.
  • Many government investment projects exaggerate the exposure of citizens to the economic cycles (the projects go bad when the economy goes bad)

The last of those isn’t really relevant to use of capital in the health sector, but the other two certainly are.  They represent what looks like a pretty good case for requiring something well above 8 per cent to used in evaluating public sector capital projects, both when seeking new funding from the government, and when making ongoing management choices within organisations.

Note that none of this is about taking a view on the appropriate level of health services the public sector should provide, it is simply (but importantly) about helping to get closer to recognising the true costs and risks associated with the capital devoted to funding these services.

There is no perfect system for allocating capital, whether within a private multinational company, or within a government.  “Perfect” is never the relevant benchmark.  But if the capital charge regime isn’t perfect –  and that is almost inevitable –  we are materially better off with it than without it.   I hope the Minister of Health pays no attention to the siren call from Tim Hunter to scrap capital charges, at least as they apply in the health system.    There is probably a stronger case to scrap DHBs themselves, but even if that were done much the same challenges around the efficient use of capital, getting the best mix of labour and capital, would still face health system managers and those funding them.   Capital costs, and those (true) costs are quite high, especially when politicians and public officials are making the decisions, and rarely face sufficiently strong incentives to utilise capital as efficiently as possible.

Highly productive countries tend to do more social spending

Earlier in the week I saw somewhere some charts drawn from the OECD’s Social Expenditure database, so I went to have a look.  In this database, and an associated report, the OECD attempts to gather reasonably consistent cross-country estimates of (what they describe as) social expenditure.  In this case, the numbers exclude spending on education (other than early childhood spending).

This is the first chart,

socex1

This is direct government spending on such things (health, unemployment and disability benefits, active labour market policies, age pensions and the like).   There probably isn’t much very surprising in the 2018 ranking themselves, although a few things caught my eye:

  • in among the European countries with above-median spending Japan now appears.  Not that long ago Japan had relatively low rates of government spending (share of GDP) but now it is higher than all the English-speaking countries,
  • among those English-speaking countries the Irish numbers are very misleadingly low because of the way features of the corporate tax regime have led measured GDP in Ireland to far outstrip the “true” level of economic activity occurring in Ireland, let alone the income accruing to Irish residents.
  • New Zealand was very close to being the median country in 2018.
  • and, whether or not one approves of such high levels of social spending (and I’m pretty uneasy) it should not be overlooked that among the nine largest spenders (share of GDP), seven are in the top-tier OECD group for average labour productivity (exceptions being Finland and Italy).       I’m not offering any thoughts about causation (and other very high productivity countries – US, Ireland, and the Netherlands –  below the median), but it remains a data point one has to take seriously.

And, of course, the other thing that is striking is how much social spending as a share of GDP has increased.  Perhaps 20 per cent of OECD countries have such spending a bit lower or much the same as in 1990 (New Zealand is one of them –  in 1990 the NZS eligibility age was still 60 and the unemployment rate was rising rapidly in the midst of our disinflation and restructuring), but in most countries there has been an increase even since 1990.   For the countries for which 1960 data were available, the increases have been very large in every single country –  although Japan (still pretty poor in 1960) stands out.

Interesting as these charts of direct public outlays are, they can be only part of the picture.  If the government compels you to save, or compels you to buy medical insurance, or offers tax treatments that incentivise such private spending, the differences between public and private spending can quickly get rather blurry.  Switzerland, for example, has a low share of public social spending but requires everyone to take out medical insurance.  That might, or might not, be a better system, but it means that low-ish direct public spending numbers don’t always tell a simple small-government (or self-reliant) story.   This isn’t a big issue for New Zealand, but here is the OECD’s attempt to reflect some of these different institutional arrangements and produce some bottom line estimates of net social expenditures (apologies that it is a little hard to read –  you can click here for a more legible version).  The orange dots are the ones to focus on.

socexp3

On this measure, the Netherlands and the US move a long way to the left (on the chart), only just behind France.  Switzerland (and Australia) also move a long way to the left.  Of the English-speaking countries, only Ireland now ranks below New Zealand, and that is just because of the tax-system distortion to the GDP numbers (done as a share of net national income, Ireland would spend more on social expenditure than New Zealand).

There are all sorts of quibbles possible about these numbers, including how safe it is to simply add them up (to what extent are the components really apples and oranges?), but it is probably salutary to note that there is now a stronger alignment between income/productivity levels and net social expenditure as a share of GDP than was evident in the first chart.  Countries towards the right of the chart are (almost entirely) the poorer and less productive OECD countries, and countries to the left of the chart tend to be the richer/more productive OECD countries (the outliers being Greece and Portugal).    Whether or not one approves of high rates of social spending, it is at least consistent with the story that much higher productivity gives countries, and individuals, options (practical and political) that poorer and less productive countries don’t have.   That might be something for our political officeholders –  increasingly indifferent to New Zealand’s productivity failure –  to reflect on.

And don’t think you can put the cart before the horse – in general, raising social expenditure won’t do anything much to raise (and may even lower) medium-term average economywide productivity.

Planning for the next recession

In a post earlier this week, I made passing reference to a new opinion piece on Newsroom headed “Why we need a recession plan”.  The article is written by another former Reserve Banker, Kirdan Lees, who these days divides his time between the University of Canterbury and economic consulting.  His article is organised around a list of five reasons, although it combines his arguments about the form any such plan should take.

I strongly agree that we need some serious, credible and open planning for the next recession (whenever it comes, but it is now eight or nine years since the last one and neither the foreign nor domestic outlooks are looking particularly rosy).  Indeed, in respect of monetary policy, it is a case I’ve been making for about as long as this blog has been running.    The case might have seemed a bit abstract four years ago –  especially to anyone who paid much attention to the Reserve Bank’s pronouncements (that interest rates were rising, and inflation would soon be getting back to target).  It should be much more pressing now, as the growth phase has got old and yet (New Zealand) interest rates are at record lows and inflation still isn’t back to target.  But, unfortunately, there has been nothing serious from the Bank –  under Wheeler, (unlawful) Spencer, or Orr.  They claim to believe there just isn’t a problem; that monetary policy can do as much as ever.

This is, more or less, Kirdan’s first reason.

Reason 1: The outlook now points to recession risk with little room for interest rates to do much

But interest rates have never been so low, leaving little headroom for monetary policy to kick in. Mortgage and lending rates can’t fall by much if the big banks are to retain margins. 

As a reminder, the real obstacle is around wholesale deposit interest rates. By common consensus, official interest rates could be lowered to perhaps -0.75 per cent, but any lower and the strong incentives are for people (including particularly wholesale investors) to convert their assets into physical cash and use safe-deposit boxes and strongrooms.  Conventional monetary policy no longer works then.     That means our Reserve Bank could cut the OCR by up to around 250 basis points –  more than many advanced country central banks could –  but in typical recessions they’ve needed to cut interest rates by 500 basis points (575 basis points last time, and the recovery then was very muted).

There are ways around this lower bound constraint, but the Reserve Bank and the government have shown no signs of any action (or even any serious analysis).  In principle, things could be done in a rush in the middle of the next recession, but that is almost always a bad way to make good policy, and by failing to clearly signal in advance that the authorities have credible responses in hand they are likely to worsen the problem (see below).

Kirdan doesn’t seem to see much scope for doing anything to increase the flexibility of monetary policy.  His focus is on fiscal alternatives.

Reason 2: By the time Treasury calls a recession it’s too late to trigger a fiscal stimulus plan

Not just Treasury of course.  Economic forecasters and analysts are hopeless at recognising recessions until they are well upon us (among the reasons why no one at all should take any comfort from the latest IMF update –  international agencies are among the worst in recognising things before they break).

It would always be better to have good forecasts, even so-called nowcasting (where is the economy right now –  given that our most recent national accounts data relates to the July to September period last year, and even that is subject to revision).      Kirdan is an optimist and believes we can do (materially) better than just waiting for the GDP data.

Today, a myriad of timely data exists: across transport movements, customs data, privately held data on small businesses (such as Xero) and consumption (such as Paymark). A small panel of experts could use that data to gauge recession risk and tell us when to pull the trigger.

In principle, of course, all these data are available to Statistics New Zealand (which could require them to be provided under the Statistics Act), and if the data could be available to “a small panel of experts” it could presumably be available to the Treasury and the Reserve Bank.

But even if these data can provide a few weeks advance notice of negative GDP quarters, there are bigger questions which more-timely data can’t answer.   The first is how long any downturn will last.  That matters quite a lot.   A couple of weak quarters might sensibly lead the Reserve Bank to consider a cut to the OCR, and probably the exchange rate would be weakening anyway.   But that is very different from a couple of weak quarters foreshadowing a deep and prolonged recession.   Telling the difference isn’t easy.  And who seriously supposes that –  in a democracy –  we are going to hand over to a panel of experts (self-appointed or otherwise) decisions about when to trigger big fiscal stimulus programmes which –  whatever their composition –  have huge distributional consequences.  These are inherently political choices, which will benefit from technical input, but the accountability needs to rest with those we elect (and can eject).

On which note

Reason 3: Economic theory can help: a fiscal plan needs to follow three principles
When it comes to fiscal stimulus principles, macroeconomists have their own triple-T: stimulus needs to be timely, targeted and temporary.

Which looks fine on paper, but is much less help in practice.  If you want “timely”. monetary policy can typically be adjusted faster than fiscal policy –  exchange rates, for example, adjust almost instantly to monetary policy surprises, and often in anticipation of monetary policy actions.   And monetary policy moves are designed to be temporary, but without tying anyone’s hands: you raise the OCR again when you are pretty sure inflation is going to back to target.

In the UK they tried what looked like a clever fiscal wheeze in the last recession: cutting the rate of VAT for a year, and only a year.  It looked like a fairly sensible move at the time it was announced –  encouraging people to bring forward consumption.  And it probably would have been if the downturn had been short and sharp, but it wasn’t.  More generally, people like the IMF championed fiscal stimulus in 2008/09, but again implicitly on the view that economies could rebound quickly.  When they didn’t, the mix of economic and political arguments about “austerity” took hold and only complicated the handling of the economy.

Of course, if you get can get your legislation through Parliament you can write cheques (electronic equivalent) quite quickly –  Kirdan is keen on focusing temporary additional spending on “poorer families” –  but you can’t do the same for the sort of infrastructure spending that those keen on fiscal stimulus often champion.

Kirdan’s reason 4 had me puzzled.

Reason 4: Trotting out the same tired approach will provide the same tired results 

One of the enduring traits of fiscal policy is tacking on extra spending in good times and taking away spending just when it is needed.

Hard to disagree too much with that second sentence –  pro-cyclical fiscal policy is a problem.

But even if you think there is a role for some active counter-cyclical fiscal policy, I wasn’t clear on the connection to what came next

Governments seeking a labour boost need a better targeted fiscal stimulus. That means targeting labour-intensive industries such as such as health and education, construction, horticulture, accommodation and retail industries. ….

But identifying labour-intensive industries is not enough. Maximum effectiveness comes from targeting the labour-intensity of the entire supply chain: labour-intensive industries that in turn use labour intensive inputs from other industries are the best bets for fiscal stimulus.

It seems to be an argument for, in effect, targeting reductions in average labour productivity –  by focusing on boosting industries that are (directly or indirectly) more labour-intensive.  Perhaps –  just possibly –  there is a case for something of the sort, as a pure short-term palliative, in a very deep economic depression, but in an economy where lack of productivity growth has been a decades-long problem (and particularly evident in the most recent growth phase) targeting low productivity industries doesn’t seem a particularly sensible medium-term approach.

Which brings us to the last point in Kirdan’s article

Reason 5: Articulating a trigger for the fiscal plan shapes the expectations of Kiwi businesses

I don’t think ministers can articulate a highly-specific trigger for action –  so much will depend on context (what is going on here and abroad) –  and attempting to do so is only likely to create a rod for the government’s back.  But where I do agree is that there needs to be a clear and credible commitment from both the government and the Reserve Bank that prompt and firm action will be taken if the economy turns down substantially, and particularly if that is in the context of a serious global event.

Kirdan’s focus is fiscal, and I have no problem with his points that (for example) debt to GDP should be expected to rise in a severe downturn, without threatening the medium-term commitment to moderate debt levels.  In fact, we would probably agree that there should be some public debate now about how the next downturn should be handled, as there is a risk that we get a serious downturn and the government is still fixated on its medium-term debt target (and avoiding leaving a target for National to attack them), even if that isn’t what is needed in the short-term.

But in my view, the argument generalises.  One of the problems we face going into the next severe downturn –  whenever it occurs –  is that (a) every serious observers knows that monetary policy has limited capacity, even in New Zealand and much more so in many other places (in the euro-area for example, the policy rate is still negative), and (b) that there are real political/social constraints on the flexibility of fiscal policy in many places (partly because debt levels are often high, partly because of distributional considerations, partly memories of post-stimulus austerity).  I’m not necessarily defending these constraints, just attempting to identify and describe them.

Faced with these limitations, the quite-rational response to a downturn will be to assume that there isn’t that much authorities will be able to do about it.  That, in turn, will deepen any downturn, and be likely (for example) to lower inflation expectations, making the recovery job even harder (it is going to be even harder to generate inflation in the next recession than it was in the last one).   Perhaps the general public don’t yet recognise these constraints, but many more-expert observers already do, and the news will rapidly spreads if and when a serious downturn gets underway.  What, people in Europe would reasonably ask, can the ECB do?  How much, Americans will reasonably ask, will the Fed be able to do?  And what appetite will there be for much large scale on the fiscal front.   These things matter to us, even if our government has more fiscal leeway than most, precisely because recoveries from serious recessions often result from the combined efforts of many authorities at home and abroad.  Many engines are likely to be missing in (in)action next time round.

I’m critical of our own government and Reserve Bank on these issues.  It isn’t clear that other countries’ authorities are doing anything much more –  there seems too much of simply hoping the situation will never arise and interest rates will get back to “normal” first.   But we can’t do anything about other countries, and we can get ready –  and have the open conversations – ourselves, taking account of the probable constraints other countries will face.     There may well be a place for some fiscal action in the next serious domestic recession, but monetary policy is better-designed for stabilisation purposes and we could be taking action now that would give people and markets much greater confidence that the lower bound won’t bind.      To the extent there is a role for fiscal policy, it is more likely to be used well if there is open debate and contingency planning now –  although my expectation is that, however much advance discussion there is, political constraints (community tolerance) will bite quite quickly.  We shouldn’t need discretionary fiscal policy in a short sharp recession, and it is unlikely to be there long enough in a deep and prolonged recession.

Finally, to anticipate comments about quantitative easing programmes.  Reasonable people can interpret the evidence about those programmes differently (I tend towards the sceptical, once we got out of the midst of the immediate crisis) but I’m not aware of anyone who regards even large scale QE programmes as more than pallid supplements to what conventional monetary policy could usually be able to do.

A serious Reserve Bank would be engaging –  indeed leading, given its role in stabilisation policy –  this sort of discussion and debate.  At our Reserve Bank the Governor has now been in office for 10 months and we’ve had not a single speech on monetary policy issues.  Quite extraordinary really.

(UPDATE: In my post last Friday about stress tests and the Reserve Bank’s plans to increase bank capital requirements, I referred to a letter the Governor had sent to a journalist who had written a critical article.  I noted then that I had lodged an OIA request for the letter, and that the Bank is legally required to respond as soon as reasonably possible.  Given that the letter was already in the public domain (the recipient being a private citizen) there were no obvious grounds for any deletions, except perhaps the name of the recipient.  The letter had been written only a couple of weeks ago, so there were no search problems, and no good “holiday period” grounds for delay.  That request was lodged nine days ago and I’ve still not had a response (and we also still haven’t seen the background papers the Governor promised in the letter that he was just about to release).     As it happens, the recipient of the letter –  Business Desk’s Jenny Ruth –  has now sent me a copy, which I appreciate, but that doesn’t justify this small scale Reserve Bank obstructionism around a major public initiative –  capital requirements –  in which the Governor will act as a one-man prosecutor, judge and jury in his own case –  at potentially large cost to the rest of us.)

 

Looking at some fiscal data

With the US partial government shutdown dragging on, I was digging around in the OECD’s fiscal data, with a particular emphasis on the US.  Of course, the shutdown itself has nothing to do with disquiet at the US fiscal position, or competing visions of the pace of adjustment back to budget balance.  There were once US politicians –  probably on both sides of the aisle –  who cared about balancing the budget, but if there are any such people left they are either inconsequential or keeping very quiet.   To the extent that fiscal issues play any role in next year’s presidential election –  probably unlikely –  they seem set to be conflicting visions of recklessness.

Here is a chart from the OECD comparing the core fiscal balances of the United States and New Zealand.   This measure is cyclically-adjusted, covers all levels of government, and is for the primary balance (ie excluding servicing costs).    There are various reasons for focusing on the primary balance, including the fact that interest costs can be heavily influenced by the rate of inflation (high in the 80s, low now), without telling one very much about the sustainability of the overall position.

us and nz fiscal

It is a striking chart.  Over 30 years there have only been two years when the US primary balance was higher (more positive) than New Zealand’s.   All else equal, New Zealand cannot run primary deficits quite as large as those of the US, as our real interest rates are typically higher than those in the United States.

But what of public debt?  In the early 1990s, when this particular debt series starts, the net government debts (per cent of GDP) in New Zealand and the United States were very similar.  But not now.

us and nz debt

And the US situation is seriously understated in this chart, because of the large unfunded public service pension liabilities that aren’t included in the debt numbers.   There is nothing remotely similar (small GSF liabilities only) in New Zealand.

The US isn’t alone (and one could mount an argument that the US is better placed to cope with higher public debt than many advanced countries as it still has a faster population growth rate than most).  Here are some of the G7 countries for the same period

g7 debt

Germany is little changed (point to point) and Canada has managed a large reduction.

I don’t take much comfort from the current low level of interest rates –  either they are low for a reason (eg lower productivity growth, lower population growth) or they will eventually “return to normal”, resulting in a heavy servicing burden.

Perhaps the thing I found most interesting was this chart, using OECD data for net government liabilities as a per cent of GDP and the OECD cyclically-adjusted primary balances.  One might have hoped that there would be some relationship between the two –  countries with very high debts, now running decent primary surpluses, and perhaps countries with very low debts running modest deficits.

net debt and primary bal

But, in fact, on this simple bivariate chart there is no relationship at all  (the US is the dot at the very bottom of the chart, while Greece –  surpluses – and Japan –  deficits –  are the two countries furthest to the right).

I wouldn’t read too much into the relationship.   What is captured in the debt numbers does vary across countries (see, eg, the pension point I noted earlier), as do the demographics (eg Japan now has a falling population), and the external constraints (eg Greece), but I found it a little sobering nonetheless.   There is a sense that, at least in some countries, the old self-correcting disciplines appear to have weakened considerably.

But they probably haven’t disappeared altogether, which brings us to what should be the biggest area of concern in the next few years.   When the next serious recession comes, there is little conventional monetary policy leeway in most countries (even in the US, 300 basis points less than going into the last recession), and not one of those G7 countries in the chart above has made any significant progress in rebuilding the public sector balance sheet. In fact, the two largest OECD economies – the US and Japan –  not only have high debt, but are also running some of the largest structural deficits, at a time when in both countries the unemployment rate is near record lows.

 

 

HYEFU bits and pieces

This is getting to be a bit of a half-yearly ritual, but politicians’ words are one thing, and the best professional judgements of our Treasury forecasters are another.   The latter aren’t necessarily very accurate at all, but as their website blares

The Treasury is New Zealand’s lead advisor to the Government on economic and financial policy

Heaven help New Zealand you might think, given that both Treasury and the government seem lost in the nebulous alternative reality of the living standards framework, wellbeing budgets, and a grab bag of alternative indicators that may –  or may not –  matter to anyone much other than them.

But they are the official advisors, charged by law with producing independent forecasts twice a year.   And the forecasts I’ve been particularly interested in for a while have been those for the export (and import) share of GDP.  The previous government, somewhat unwisely set themselves numerical targets for the export share of GDP –  reality bore no relationship to the targets.  The current government avoided that particular mistake, but senior ministers –  all the way up to the Minister of Finance and the Prime Minister –  talk regularly about rebalancing the economy and gettings the signals right in ways that lead to more exports and higher productivity.

But here are the numbers, for exports as a share of GDP, from last week’s economic and fiscal update.

exports hyefu 18

You can read the earlier decades in various ways.   If you wanted to be particularly negative you could note that we got to an export share of GDP in 1980 which we haven’t sustainably exceeded since then.  But if you were of a more charitable disposition you might suggest that, broadly speaking, things were still getting better until about 2001 (although you shouldn’t put much weight on that peak –  it was an unusual combination of a year of a very weak exchange rate and very high dairy prices).  But this century hasn’t been good, and this decade has been bad.

As a reminder it isn’t that exports are in some sense special, but that successful economies typically have plenty of growing firms that are producing goods and services that are making inroads in the very big market of the rest of world.  That, in turn, enables us to enjoy for of what the rest of the world produces.   For small economies in particular, exports are typically a very important marker.

If you were of a generous disposition you might note that a temporary dip in the export share of GDP might not have been unexpected, or even inappropriate, for much of this decade.  After all, the Canterbury earthquakes meant that resources had to be diverted to repairs and rebuilding, and resources used for one thing can’t be used for other things.  The exchange rate is part of the reallocative mechanism.  And the unexpected surge in the population, as a result of high net immigration (a good chunk of it changing behaviour of New Zealanders), arguably had the same sort of effect.

But the largest effects of the earthquake are now well behind us, and even net immigration inflows are also dropping back.   And yet the Treasury forecasts –  the orange line in the chart –  show no sustained rebound in forecast export performance at all.   In fact, by the final forecast year (to June 2023) the export share of GDP will be so low than only one year in the previous thirty will have been lower.  Not only is there no sign of a structural improvement –  a step change that might one day see New Zealand exports matching or exceeding turn of the century levels –  there isn’t even a reversal of the decline this decade, which might plausibly be attributable to unavoidable pressures (eg the earthquakes).

For anyone concerned about the long-term performance of the New Zealand economy –  which appears to exclude our political officeholders, who could actually do something about it, but choose not to –  it is a pretty dismal picture.  Something like the current level of the real exchange rate seems to be Treasury’s “new normal”, and absent huge positive productivity shocks that is a recipe for continued structural underperformance.

Still on the HYEFU, I’ve long been intrigued by the Labour-Greens pre-election budget responsibility commitment around government spending (which continues to guide fiscal policy).

Rule 4: The Government will take a prudent approach to ensure expenditure is phased, controlled, and directed to maximise its benefits. The Government will maintain its expenditure to within the recent historical range of spending to GDP ratio.

During the global financial crisis Core Crown spending rose to 34% of GDP. However, for the last 20 years, Core Crown spending has been around 30% of GDP and we will manage our expenditure carefully to continue this trend.

As someone who thinks that there is plenty the government spends money on that just isn’t needed (and eliminating which would, in turn, leave room for some of the areas where more spending probably is needed), this commitment has never really worried me. But then I’m not a typical Labour/Greens voter.

But if it didn’t bother me, it did puzzle me.  Why would the parties of the left, evincing (otherwise) no conversion to the cause of smaller governments, (a) commit themselves to such a relatively moderate share of GDP in govermment spending, and then (b) aim to undershoot that?

Here is what I mean.  In the chart I’ve shown Treasury’s core Crown expenses series as a share of GDP, including the projections from last week’s HYEFU.  I’ve also shown averages for the periods each of the previous three governments were responsible for (thus the former National-led government mainly determined fiscal outcomes for the year to June 2018).

core crown expenses hyefu 18

On the government;s own numbers (and these are pure choices, made by ministers), core Crown spending in the coming five fiscal years (including 2018/19) will be lower every single year than the average in each of the three previous governments, two of which were led by National.   Sure, there was a severe recession in 2008/09 –  not that fault of either main party here –  and then a severe and costly sequence of earthquakes (ditto), but on these numbers government operating expenditure as a share of GDP in 2022/23 will be so moderate that in only two years of the previous fifty (Treasury has some not 100% comparable numbers back to the early 70s) was spending even slightly lower (those were the last two years of the previous government).

It seems extraordinary.

It isn’t as if the economy is grossly overheated (which might suggest a need for considerable caution, since GDP might soon go pop).  Treasury estimates that the output gap is barely positive over the entire projection perion (the numbers so small we might as well just call them zero).   Of course, Treasury (and other forecasters) never forecast recessions, and it seems quite likely that some time in the next five years we will have one.  All else equal, a recession would raise government spending as a share of GDP, but even a 4 per cent loss of GDP in a recession –  which would be pretty severe, similar to 2008/09 –  would only raise the share of spending to GDP by little over one percentage point.   Spending, at the trough of a severe recession, would still be under 30 per cent of GDP –  which was presented in the budget responsibility rules as something they want to fluctuate around, not as an untouchable electric fence.

The only plausible explanation I can see –  after all, the government show no “small government” inclinations when it comes to, eg, regulation –  is the weight they ended up placing on the net debt target.  But that was even more arbitrary than the spending rule.

In isolation, they could spend $5 billion more in 2022/23 and still only have spending as a share of GDP at around the average level of the previous Labour-led government.   Given the low quality of many of the things they are already spending on (fee-free tertiary education, regardless of means or ability, or the Provincial Growth Fund, to take just two examples), I’m reluctant to encourage them.  But it still looks odd.

The Treasury is New Zealand’s lead advisor to the Government on economic and financial policy.The Treasury is New Zealand’s lead advisor to the Government on economic and financial policy.The Treasury is New Zealand’s lead advisor to the Government on economic and financial policy.The Treasury is New Zealand’s lead advisor to the Government on economic and financial policy.

Three central bankers

Three heads of central banks feature in this (perhaps rather bitsy) post.

The first is one of the heroes of modern central banking, Paul Volcker.  Now aged 91, and clearly ailing, he has a new (co-authored) book out tomorrow, part memoir and part (apparently) his perspectives on various public policy challenges now facing the US.  (His successor Alan Greenspan, now aged 92, also had a new book out a couple of weeks ago.   At this rate, Don Brash –  a mere stripling at 78  –  could be just getting going.)

There are various articles and interviews around (I liked this one with the FT’s Gillian Tett) but what I wanted to write about was an extract from the Volcker book, published last week by Bloomberg (and which a reader drew to my attention), under the heading “What’s wrong with the 2 per cent inflation target”.     Volcker was, of course, the person who as head of the Federal Reserve from 1979 to 1987 took the lead role in ensuring that monetary policy was finally run sufficiently tightly, for long enough, to get US inflation enduring down.   One can debate how much was the man, and how much was an idea whose time had come, but it was on his watch that the hard choices were made.

This was, of course, before the days of formal inflation targeting.  Volcker has never been a supporter, citing approvingly in his article Alan Greenspan’s famous response to a mid -1990s challenge from Janet Yellen.

Yellen asked Greenspan: “How do you define price stability?” He gave what I see as the only sensible answer: “That state in which expected changes in the general price level do not effectively alter business or household decisions.” Yellen persisted: “Could you please put a number on that?”

The Fed finally came to do so, now adopting its own numerical target (2 per cent annual increases in the private consumption deflator.

Volcker takes the opportunity to blame us, writing of his visit to New Zealand in 1988 (when I recall meeting him).

The changes included narrowing the central bank’s focus to a single goal: bringing the inflation rate down to a predetermined target. The new government set an annual inflation rate of zero to 2 percent as the central bank’s key objective. The simplicity of the target was seen as part of its appeal — no excuses, no hedging about, one policy, one instrument. Within a year or so the inflation rate fell to about 2 percent.

The central bank head, Donald Brash, became a kind of traveling salesman. He had a lot of customers. After all, those regression models calculated by staff trained in econometrics have to be fed numbers, not principles.

He is probably a little unfair.  Rightly or wrongly, the rest of the world would have got there anyway (eg Canada adopted an independent inflation target very shortly after we did), and in time it was the New Zealand inflation target that was revised up to fall more into line with an international consensus centred on something around 2 per cent. His bigger point is that he doen’t like tight numerical targets: some of his reasons are defensible, but it is also worth recalling the Volcker was in his prime in an age when there was much less transparency and accountability more generally.

But my bigger concern with the article, and argument, is about what comes across as complacency about the risks the US (and many other countries) face when the next serious recession hits.  He is opposed to any steps to push inflation up to, or even a bit above, 2 per cent, and he also  doesn’t propose doing anything to remove, or even ease, the constraint posed by the near-zero lower bound on nominal interest rates.

Deflation, or even a period when monetary policy is constrained in its ability to bring the economy back to normal levels of utilisation following a serious recession, just doesn’t seem to be a risk that bothers him, provided financial system risks are kept in check.

The lesson, to me, is crystal clear. Deflation is a threat posed by a critical breakdown of the financial system. Slow growth and recurrent recessions without systemic financial disturbances, even the big recessions of 1975 and 1982, have not posed such a risk.

I found that a fairly breathtaking claim.  After all, the effective Fed funds interest rate in 1974 had peaked at around 13 per cent, and in 1981 it had peaked at around 19 per cent.  There was a huge amount of room for real and nominal interest rates to fall.  Right now, the Fed funds target rate is 2.0 to 2.25 per cent.

For most of history the Federal Reserve didn’t announce an interest rate target, but in this chart I’ve shown the change in the actual effective Fed funds rate (as traded) for each of the significant policy easing cycles since the late 1960s.

fed funds cuts

The median cut was 5.4 percentage points (not inconsistent with the typical scale of interest rate cuts in other countries, including New Zealand, faced with serious downturns).  Some of those falls were probably falls in inflation expectations, but even in the last three events –  when inflation expectations have been more stable –  cuts of 5 percentage points have been observed. (I was going to use the word “required” there, but there seems little doubt that policy rates would have been cut further after 2007 –  consistent, for example, with standard Taylor rule prescriptions –  if it had not been for the lower bound on nominal rates.)

And what of the current situation?  With a Fed funds target rate of about 2 per cent, if a serious recession hit today the Federal Reserve has conventional policy leeway of perhaps 2 percentage points (if they treat 0 to 0.25 per cent as the floor next time as they did last time) or perhaps as much as 2.75-3 percentage points (if they treat the effective floor as more like the -0.75 per cent a couple of European countries have operated with).  The Fed has given no public hint that they would actually be prepared to take policy rates negative in the next recession, so for now markets can only guess –  and perhaps hope.   But either way, the conventional monetary policy leeway is much less than was used in any of the significant US downturns of the previous 50 years.   That should be worrying someone like Paul Volcker more than it seems to, especially when three other considerations are taken into acount:

  • when markets know those limitations –  and firms and households will quickly learn them when the recession comes –  inflation expectations are likely to drop away more quickly than usual, because no one will be able to count on the Fed being able to keep inflation near target,
  • US fiscal policy has been so badly debauched that there is going to be little (political) leeway for material discretionary fiscal stimulus in the next recession, and
  • most other advanced countries have even less conventional monetary policy capacity now than the US does (and even less than usual relative to past history).

Reasonable people can quibble about the place of formal inflation targeting, but there needs to be much more urgency in planning to cope with the next serious recession, whatever its source or precise timing.

As readers know, I was not one of the biggest fans of former Reserve Bank Governor Graeme Wheeler.  But in Herald economics columnist Brian Fallow’s article last Friday there was some quotes from a recent speech Wheeler had given in Washington that had me nodding fairly approvingly as I read.

If the advanced economies face a recession in the next few years, much of the burden for stimulus will fall on fiscal policy, Wheeler says. The scope to cut interest rates is limited as policy rates in several countries remain at or near historic lows. Countries accounting for a quarter of global GDP have policy rates at or below 0.5 per cent, whereas policy cuts in recessions have often been of the order of 5 percentage points.

“In such a situation central banks would rely on additional quantitative easing and governments would face considerable pressure to expand their budget deficits through spending increases and/or tax cuts.”

They are words that need more attention even in a New Zealand context, where the OCR is only 1.75 per cent.  It was 8.25 per cent going into the last serious downturn.

Wheeler’s speech (a copy of which Brian Fallow kindly, and with permission, passed on) – to a conference on sovereign debt management –  is mostly about debt management issues.  It has a number of interesting charts from various publications, including this sobering one.

wheeler chart

Perhaps what interested me was that in his discussion of the issues and risks, Wheeler seemed not to touch at all on the two approaches often used in very heavily indebted countries –  even advanced countries – facing serious new stresses: default and/or surprise sustained inflation.   To the credit of successive New Zealand governments, fiscal policy here is in pretty good shape, and debt is low, but looking around the world it would perhaps be a surprise if Greece is the only advanced country to default on its sovereign debt (or actively seek to inflate it away) in the first half of this century.

And finally, our own current Governor.  He has just brought up seven months in office without a substantive public speech on the main policy areas he has responsibility for; monetary policy and financial stability.   It is quite extraordinary. He has been free with his thoughts on climate change, infrastructure financing, tree gods, and so on and so forth, while batting away questions about the next serious recession and its risks in a rather glib, excessively complacent, way (hint: QE and its variants is not –  based on international experience – an adequate answer).

Anyway, the Governor has repeatedly told us about his commitment to greater openness and communications.  I’ve been a sceptical of that claim –  both because every Governor says it in his or her own way, but also because of the track record that is already building.  There have been, as I said, no substantive speeches from Orr on his main areas of legal responsibility.  Speeches that are published apparently bear little or no relationship to what the Governor actually says to the specific audience.  There have been no steps taken to, say, match the RBA in making generally available the answers senior central bankers give in Q&A sessions after speeches, and we heard not long ago of a speech Orr gave to a private organisation, commenting loosely on matters of considerable interest to markets and those monitoring the organisation, but with no external record of what was said.

And it seems that there is likely to be another example today.  The next Monetary Policy Statement is due next week, as is the joint FMA-RB statement on bank conduct and culture (FMA responsibility that the Governor has barged into), both surely rather sensitive matters.  And yet the Governor is giving a significant speech this evening at the annual meeting of the lobby group Transparency International.

Guest Speaker: Adrian Orr

Adrian’s speech will encourage discussion about the relevance of transparency, accountability and integrity in the New Zealand financial sector.

Adrian Orr will be introduced by State Services Commissioner, Peter Hughes, and thanked by new Justice Secretary, Andrew Kibblewhite.

And yet his speech –  to Transparency International, introduced by the State Services Commissioner, thanked by the head of the Prime Minister’s department –  on transparency, is to be, well, totally non-transparent.  From the Reserve Bank’s page for published speeches

Upcoming speeches
There is nothing scheduled.
It seems like a bad look all round: for Transparency International (admittedly a private body) and its senior public service people doing the introductions, and for the Bank itself.   This isn’t some mid-level central banker doing a routine talk to the Taihape Lions Club, but the Governor himself on a topic of a great deal of interest –  to a body itself reportedly committed to more transparency and better governance.
I’d encourage the Bank to rethink, and to make available a script (or preferably a recording, given the Governor’s style) of his speech, and of the subsequent Q&A session.  It should be standard practice, and Transparency International would be a good place to start.