Ten years on

It is the season for books and articles reflecting on financial crises of a decade or so ago, the aftermath, and whatever risks might –  or might not –  be building today.  The collapse of Lehmans –  and the wise decision of the US authorities not to bail it out –  was 10 years ago this month, and although the US crisis had been underway for at least by a year by then, the Lehmans moment seems set to take a place in historical memory around the Great Recession rather parallel to the sharp falls in US share prices in October 1929 (the ‘Wall St crash’) and the Great Depression.  Not in any real sense the cause of what followed, but the emblematic moment in public consciousness nonetheless.

I’ve just been reading the big new book, Crashed: How a decade of financial crises changed the world, by esteemed economic historian Adam Tooze.  I might come back to it in a separate post, but for now would simply caution people that it is less good than his earlier books (around the Nazi economy, and the economic history of the West after World War One running into the Great Depression) had led me to hope.

But on a smaller scale, I picked up the Listener the other day and noticed on the front cover ’10 years after the GFC, former Reserve Bank governor Alan Bollard warns of new risks’.  Conveniently, I see that the article is freely available online.  The sub-heading tantalises potential readers

Former New Zealand Reserve Bank governor Alan Bollard warns that, although lessons were learnt from the global financial crisis, new risks have emerged that could trigger a repeat contagion..

Alan Bollard writes well, and often quite interestingly.  Extremely unusually (and in my view quite inappropriately), he actually published a book on his perceptions of the previous crisis in 2010, while still very fully-employed as Governor, a senior public servant.  There were quite severe limitations as to who, or what, he could be critical of (as I was reminded last night rereading my diaries of some crisis events I was closely involved in, and the Bollard published perspective on those events).     The Bank’s early reluctance to take seriously the emerging issues, as they might impinge on New Zealand, is not, for example, something you find documented in the book.

He must be in a somewhat similarly difficult position now.  He is Executive Director of the APEC secretariat, that grouping of Asian and Pacific (loosely defined) countries and territories, that includes China, Russia, the United States, Indonesia and so on.  I dare say Xi Jinping and Donald Trump won’t be watching nervously to see what Alan Bollard is saying, but the Executive Director knows that there are quite severe limits to what public servants can say while in office.

And, thus, much of the Listener article is a bit of a, perhaps slightly rose-tinted, rehash of some of the policy responses here and abroad (I will come back to deposit guarantee schemes on the tenth anniversary, next month).  There is some loose descriptive stuff on various developments in parts of the APEC region.  There was the suggestion that some countries (actually “much of the region”) in Asia is “anxiously worrying” about whether they could face a Japan-like low productivity future but to me, Japan still looks pretty attractive by regional standards.


(New Zealand, for example, is at 42.)

In fact, I looked in vain for the promised analysis or description of the “new risks” that might “trigger a repeat contagion”.   Perhaps that was never Bollard’s intent, but the Listener had to attract readers to a fairly tame advertorial for APEC somehow.  The most we get is

We need to remember that the global financial crisis was originally triggered by a building bubble, and that is still on the minds of regulators throughout the region.


Meantime, we are very worried about the likely effects of the growing trade wars. It is too early to judge, but the stakes are high – trade growth has been the big driver behind the immense improvement in living standards through the Asia-Pacific region ……We are now on the alert for signs that these trade frictions could weaken exchange rates, hurt commodity prices, hit stock markets or cause financial volatility, against an unusual background of tightening monetary policy and loose fiscal policy in the US.

But then what more could a serving diplomat, not hired to be a high-profile problem solver (unlike, say, the head of the IMF) really say?

And it all ends advertorial style

As a big trader, New Zealand has always been susceptible to these tensions. But one international platform where they play out is coming closer: in just over two years, New Zealand will commence its year of hosting Apec. The organisation is a voluntary, consensus-driven one, where for 30 years we have promoted regional economic ties and tried out new ideas for trade and investment. As the upcoming chair of Apec, New Zealand will have to contend with continuing antiglobalisation pressures, big-economy tensions, climate-change damage and financial risks in the region. It sounds daunting, but there are many positives: We have learnt some of the lessons of the global financial crisis; banking regulation is tougher; banking chiefs are more cautious; economic demand is still growing; and the Asia-Pacific region is tied ever more closely by its trade flows.

It could have been a paragraph from a speech by one of his political masters.   I guess one wouldn’t know that one of his members (the People’s Republic of China) poses an increasing political and military threat to another (Taiwan) or –  closer to his own territory –  that few major economies have very much effective macroeconomic firepower at all when the next crisis or severe recession hits.  And really nothing at all about financial sector risks.  His final sentence –  “September 2018 should be a month much better than September 2008” –  is almost certainly true (at least outside places like Turkey and Argentina) but not really much consolation to anyone.

In his column in the Dominion-Post this morning, Hamish Rutherford touches a theme of various recent posts here: the limited macro capacity of many countries.  He rightly highlights how low global interest rates are, and the much higher levels of government debt in many countries.

To make matters worse, interest rates are already so low that some economists are speculating that if the Reserve Bank was to respond to a slowdown by slashing interest rates, in a bid to stimulate the economy, it may find that little of the money finds its way to households.

Debt levels among the world’s leading economies are, by and large, far higher than they were a decade ago. In the US, as well as threatening to kick off a global trade war, President Donald Trump’s administration is running the kind of deficit that would be wise in a recession, but at the late stage of a long economic growth cycle appears reckless.

But there was one point I wanted to take issue on.  He argues

Back in 2008, New Zealand benefited from its largest trading partner, Australia, avoiding recession and having almost no debt. This time Australia’s debt is climbing and there are doubts as to whether Canberra will have the discipline to return to a surplus, as the political state becomes more populist.

I don’t think that is true about either the past or the present.  We didn’t get any great benefit out of Australia’s fiscal stimulus in 2008/09, largely because if fiscal stimulus hadn’t been used, the Reserve Bank of Australia would probably have cut their official interest rates further.  Fiscal policy can be potent when interest rates have the effective lower limit, but they hadn’t in Australia (or New Zealand).  More importantly, and for all the New Zealand eagerness to bag Australian politics and policies, here is the OECD’s series of the net financial liabilities of the general government (federal, state, and local) for Australia and New Zealand, expressed as a share of GDP.

debt govt au and nz

Australia’s net public debt has been consistently below that of New Zealand for the entire 25 years for which the OECD has the data for both countries.  The gap is a little smaller now than it was a decade ago, and (on a flow basis) the New Zealand budget is in surplus but Australia’s isn’t.  But if there is a desire to use large scale fiscal stimulus in the next serious downturn, debt levels themselves aren’t likely to be some technical or market constraint in New Zealand, and even less likely in (less indebted) Australia.

And finally in this somewhat discursive post, a chart I saw yesterday from the BIS.

real house prices BIS

A story one sometimes hears is that low interest rates have driven asset prices sky-high setting the scene for the next nasty crisis.  Even if there are elements of possible truth in such a story, the story itself mostly fails to stop to ask about the structural reasons why interest rates might be so low.   All else equal, had interest rates been higher asset prices probably would have been lower – and CPI inflation would have undershot targets even further.  But as this particular chart illustrates, across the advanced economies as a whole real house prices now are much same as they were at the start of 2008.  That isn’t true in New Zealand (or Australia for that matter).  Interestingly, even in the emerging markets –  centre of current market unease –  real house prices are still not 15 per cent higher than they were at the start of 2008, when interest rates generally were so much higher.

But then only rarely is the next major economic downturn or financial crises stemming from quite the same set of financial risks as the last one.

Orr off the record on major policy matters

A reader mentions news that Reserve Bank Governor Adrian Orr was in typically loquacious form at a finance industry “networking event” held in Wellington last night.

Typically loquacious but, so the report suggests, perhaps going rather beyond the Bank’s public lines on monetary policy as articulated in the August Monetary Policy Statement, in a very dovish direction.     And weighing in on what sort of person he wanted (and did not want –  economists apparently not wanted) on the new Monetary Policy Committee –  the one where the Minister supposedly makes the appointment, the one where the legislation has not yet been dealt with by the relevant select committee.

Central bankers need to be very cautious in their communications around monetary policy.  The standard approach has been to communicate primarily via Monetary Policy Statements, where everyone has access to the same information (although I gather the Bank still holds confidential debriefs for bank economists as a group after each release, and if that isn’t potentially market sensitive it is hard to imagine what would be).  That approach is sometimes supplemented with speeches: on-the-record ones where there is anything at all interesting, important, or potentially sensitive being said, and off-the-record ones where it is just repeating the same lines previously made public.

The speeches themselves are not without their problems as the Reserve Bank of New Zealand handles things.  For instance, although the Governor has been in the role for five months now, there has been no on-the-record speech at all.  And even when Governors have spoken in the past, there is often considerable potential for nuance or shades of information in the Q&A sessions afterwards.  At the Reserve Bank of Australia, it is common practice for those Q&A sessions to be recorded and made available on the RBA website.  There is nothing comparable here, and the Bank has often refused to allow media access to events where the Governor –  a senior public official – is speaking.  If you are lucky enough to be there you get information that the market as a whole doesn’t have.  That simply shouldn’t be acceptable.

Perhaps some journalists might like to find out from participants, or from the Governor, what he actually said last night, complete with (potentially market-moving) nuances.  Any other readers who were there who want to flesh out the account I’ve heard feel free to get in touch or comment (anonymously if you like) below.

But as it was relayed to me, it doesn’t sound like the sort of approach we should expect from any serious person holding a major public role.

Options for the next serious recession: fiscal policy

I’ve run various posts over the last few years urging the authorities (Reserve Bank, Treasury, and the Minister of Finance) to get better prepared for the next serious recession (and lamenting the relative inaction on this front in other countries too, many of whom are worse-positioned than New Zealand is).

As a reminder, we went into the last recession with the OCR at 8.25 per cent, while the OCR now –  years into a growth phase, with resources (on official assessments) fairly full-employed –  is 1.75 per cent.  In that last recession, the Reserve Bank cut interest rates a long way, the exchange rate fell a long way, there was really large fiscal stimulus cutting in as the recession deepened, and there were lots of other interventions (guarantee scheme, special liquidity provisions) and it was still as severe as any New Zealand recession for decades, and took years to fully recover from (on official output and unemployment gap estimates perhaps seven or eight years).   Lives were blighted, in some cases permanently, in an event where there were no material constraints on the freedom of action of the New Zealand authorities.  In fact, our Reserve Bank cut the OCR (over 2008/09) by more than any other advanced country central bank.

Next time, whenever it is, it seems very unlikely that the Reserve Bank will have that degree of freedom, particularly around monetary policy.  On current policies and practices around bank notes, it seems unlikely that the OCR could be usefully cut below about -0.75 per cent.  Beyond that point, most of the action would be in the form of people shifting from bank deposits etc to physical currency, rather than buffering the economic downturn.

Our Reserve Bank has long appeared disconcertingly complacent about this issue/risk.  The latest example was comments by the new Governor and his longserving chief economist following the latest Monetary Policy Statement.    They talk blithely about the unconventional policy options other countries have used, but never confront the fact that almost no advanced country could have been comfortable with the speed of the bounceback from the last recession.   Output and unemployment gaps of eight or nine years (the OECD’s estimate for advanced countries as a whole) aren’t normal and shouldn’t be acceptable.

Quite why the Reserve Bank is so complacent is something one can debate.   My hypothesis is that it is some mix of assuming we will never face the problem (recall that they have spent years hankering to get the OCR back up again) and of noting that other people/countries will most likely face the problem before New Zealand does.   They also like to remind us that New Zealand has a floating exchange rate as if this somehow differentiates us (as a reminder so do Australia, Canada, Norway, Sweden, the US, the UK, Japan, Korea, Israel, and even the euro-area as a whole).  Whatever the explanation,  robust contingency planning, and building resilience into the system, is what we should be expecting from the Reserve Bank (and Treasury).  There is no sign of it happening.  Meanwhile, the Governor plays politics in areas (eg here and here) that really aren’t his responsibility.

In my post on Saturday, I touched again on the desirability of doing something –  specific and early, consulted on and well-signalled –  about removing the effective lower bound on nominal interest rates.   That would tackle the issue at source.    Monetary policy has been the primary stabilisation tool for decades for good reasons.  Among other things, it is well-understood and there is a fair degree of (political and economic) consensus around the use of the tool.  And confidence that the tool is at hand in turn proves (somewhat) self-stabilising, because people expect –  and typically get – a strong monetary policy response.

Perhaps the other reason why authorities –  perhaps especially in New Zealand – have been so complacent is the view that “never mind, if monetary policy is hamstrung there is always fiscal policy”.  After all, by international standards, public debt here is low (on an internationally comparable measure from the OECD, general government net financial liabilities, about 1 per cent of GDP, which puts us in the lower quartile –  less indebted – among OECD countries.)

The implicit view appears to be that, with such modest levels of debt, if and when there is another serious recession, New Zealand governments can simply spend (or cut taxes) “whatever it takes” to get economic activity back on course again.   After all, the upper quartile of OECD countries have net general government liabilities in excess of 80 per cent of GDP.

I’m sceptical for a variety of reasons.

One of them is the experience of the last recession.  For this, I had a look at the OECD data on the underlying general government primary balance as a per cent of potential GDP:

  • general government = all levels of government
  • underlying = cyclically-adjusted (ie removing the impact of the fluctuating business cycle on revenue (mostly), and adjusted for identified one-offs (eg recapitalisations of banking systems)
  • primary balance =  excluding financing costs, so that comparisons aren’t affected by changes in interest rates themselves
  • as a per cent of potential GDP =  so that a temporary collapse in actual GDP doesn’t muddy the comparison

The numbers aren’t perfect, and there are inevitable approximations, but they are the best cross-country data we have.  Changes in this balance measure are a reasonable measure of discretionary fiscal policy.

Here is how those underlying primary balances changed from 2007 (just prior to the recession) over the following two or three years.  I’ve taken the largest change I could find, and in every case that was over either two years to 2009, or over three years to 2010.

fisc stimulus

Some countries (Hungary, Estonia) were engaged in severe fiscal consolidation from the start.  Several others experienced almost no change in their structural fiscal balances.

Quite a few countries saw 5 percentage point shifts in their underlying fiscal balances.   Spain –  a country with no control over its domestic interest rates –  is recorded as having gone well beyond that.  I don’t know much about the specifics of Spain, but for those who are upbeat about the potential scope of discretionary fiscal policy I’d take it with at least a pinch of salt – on the OECD numbers, the Spanish primary deficit dropped again quite sharply the next year (and Spanish unemployment didn’t peak until several years later).

Note that both Australia and New Zealand are towards the right-hand end of that chart.  In Australia’s case, most of the movement resulted from deliberate counter-cyclical use of fiscal policy (the Kevin Rudd stimulus plans).  In New Zealand, by contrast, the change in the underlying fiscal position was almost entirely the result of discretionary fiscal commitments made by Labour government at a time when Treasury official forecasts did not envisage a recession at all.  From a narrow counter-cyclical perspective, those measure might have been fortuitous, but they were not deliberate discretionary counter-cyclical fiscal policy measures.  In fact, at the time they were seen in some quarters as exacerbating pressure on the exchange rate, and limiting the scope of any interest rate reductions.

Perhaps it is worth stressing again that in not one of the OECD countries did the reduction in structural fiscal surpluses (expansion in deficits) last more than two years.  In every single country, by 2011 structural fiscal policy (on this measure) had moved –  sometimes modestly, sometimes quite sharply –  into consolidation phase.  In most countries, either conventional monetary policy limits had been reached or (as in individual euro area countries) there was no scope for conventional monetary policy.  And it was to be years before output and unemployment gaps closed in most of these countries.

What is my point?   Simply, that it looks as though the political limits of discretionary fiscal stimulus were reached quite quickly, even in countries where there was no market pressure (any of the established floating exchange rate countries other than Iceland), and even though the economic rebound in most was anaemic at best.   That is why so many countries needed more conventional monetary capacity than in fact they had (and QE in various forms was not much of a substitute).

The OECD table on underlying primary balances only has data going back a few decades.  No doubt experiences in wartime were rather different –  in those circumstances huge shares of the nation’s resources can be marshalled and deployed in ways which (incidentially) stimuluate demand and activity.  But looking across the OECD countries over several decades, I couldn’t any examples of discretionary fiscal policy being used as a counter-cyclical tool materially more aggressively than happened over 2008 to 2010.  In Japan, for example, the structural fiscal balance worsened by about 6 percentage points over seven years after 1989.

So from revealed behaviour patterns, I’m sceptical as to just how much practical capacity there is for fiscal policy to do much, and for long, in the next serious recession, even in modestly-indebted New Zealand.    The limits aren’t technical –  they mostly weren’t last time –  but political.   Perhaps people will push back and run some argument along the lines of “oh, but we’ve learnt the lessons of unnecessary premature austerity last time round”.     To which my response would be along the lines of “show me some evidence, or reason to believe that things would, or even should, be much different next time”.   When – outside wartime –  has it ever happened?  And what about our political systems makes you comfortable that it is likely to happen next time?     We could probably run large structural deficits for a year or two, but pretty quickly the pressure is likely to mount to begin reining things back in again (especially if, for example, the next recession is accompanied by heavy mark-to-market losses on government investments –  eg NZSF).

And recall that here in New Zealand we had almost as much fiscal stimulus last time as any country, and even supported by huge cuts in interest rates (and without a home-grown financial crisis), we had a nasty recession (even a double-dip in 2010) from which it took ages to recover.

And all of this is without even examining how effective realistic fiscal policy is likely to be.    The easiest fiscal stimulus is a tax cut (or even a lump sum cash handout).   You can do clever ones, like the UK temporary cut in GST, which not only put more money in people’s pockets, but actively encouraged them to shift consumption forward –  only to then create problems as the deadline for raising the value-added tax rate loomed.   But putting money in people’s pocket –  in a recession, and often explicitly temporarily –  doesn’t guarantee they spend much of it.  The most effective demand-stimulating fiscal policy (supply side measures are another issue –  but lets just agree that deep cuts in company tax and related rates will not happen in the depths of a recession) is direct government purchases of goods and services.  Most talked of is government capital expenditure, infrastructure and all that.

But, approve or otherwise, no government has a reserve list of projects, designed and consented, just waiting to get starting the moment it is apparent the next deep recession in upon us (that moment usually being several months after the recession has begun).  It is almost certainly politically untenable for them to do so –  if the project is so good, so the argument will run, why not do it when times are good?  And so realistic government fiscal stimulus through the capital expenditure side will take months and years (more probably the latter) to even begin to get underway.   Faced with the actual physical destruction in Christchurch, look how long it took for major reconstruction to get underway.

What of income tax cuts?   Either the cuts are focused on those who pay the most taxes (in which case there is quickly one form of political pushback) or perhaps they take the form of a tax credit paid as a lump sum to everyone (in which case there is likely to be pushback of another political type –  ideas around “everyone becoming a welfare beneficiary).  I’m not attempting to defend either type of response, just to anticipate the risks.

By contrast, monetary policy –  the OCR –  can be adjusted almost immediately, and often begins to have an effect before the central bank even announces its formal decision (market expectations and all that).  And if monetary policy changes don’t affect everyone equally, they affect the entire country –  a borrower/saver/exporter in Invercargill just as their counterparts in Auckland.  In the line from a US Fed governor, monetary policy gets in “all the cracks” (although he was contrasting it with regulatory interventions).  Government capital expenditure is, by its nature, very specific in location.  There probably isn’t a natural backlog of major (useful) capital projects in Invercargill or Dunedin.

I’m not saying fiscal policy has no useful place in the stabilisation toolkit –  although my prior is that it is better-oriented towards the medium-term, with the automatic stabilisers allowed to work fully –  but that we should be very cautious about expecting that it is any sort of adequate substitute for monetary policy in the real world of politics, distrust of governments and so on, in which we actually dwell.    It is well past time for the Reserve Bank and the Treasury, led by the Minister of Finance, to be taking open steps towards ensuring that New Zealand has the conventional monetary policy capacity it would need in any new serious recession.


Towards a (physical) currency auction

A week or so back, at the Monetary Policy Statement press conference, veteran Herald economics journalist/columnist Brian Fallow asked the Governor about how well-situated New Zealand was to cope with the next recession, given how low the OCR is now (1.75 per cent, as compared with 8.25 per cent going into the previous recession).

As I recorded in a post the same day, the Governor and his offsiders responded with a degree of confidence that wasn’t backed by much substance.  It all smacked of a worrying degree of complacency.

Fallow also apparently wasn’t persuaded, and returned to the issue in his weekly Herald column yesterday.  I wanted to pick up today on just one of the topics he touched on in that column.

The key issue is the effective lower bound on nominal interest rates.  The Reserve Bank has indicated that it believes the OCR probably couldn’t usefully be taken lower than -0.75 per cent (I agree with them, and that assessment of the effective lower bound is consistent with the lowest any other country has set its policy interest rate).  Beyond that point, it seems likely that an increasing proportion of holders of short-term financial assets would transfer into holdings of physical cash.  There is no direct cost of conversion, although there are storage and insurance costs for physical cash (which is why large scale conversion doesn’t occur at, say, -5 basis points).

When official interest rates were dropped below -0.75 per cent it still probably wouldn’t affect very much much (or how) little cash you hold in your wallet/purse.  If you hold much cash at all, it is probably for convenience (or privacy), balanced against (say) risk of loss/theft.  And a secure physical storage facility for even $10000 of cash would be much more inconvenient –  and probably expensive – than holding a short-term bank deposit.  You might well, grudgingly, live with an interest rate of -2.0 per cent per annum (as it is, since the last recession, marginal term deposit rates have been well above the OCR anyway).   Or you might seek to shift your money to riskier (potentially higher-yielding assets) –  in which case the lower policy interest rate would still be somewhat effective.

But the big issue here isn’t so much what the ordinary householder does.  Most don’t have that many financial assets that could be converted directly to cash anyway.  The bigger issue is institutional investors (resident and foreign, including –  for example –  Kiwisaver funds).   The funds management market is pretty intensely competitive, and (risk-adjusted) yield-driven (as an example, I was in a meeting yesterday where we looked at a restructuring option to save perhaps 3 basis points).     So if the Reserve Bank tried to cut the OCR to, say, -2.0 per cent (and it was expected to remain at least that low for a couple of years), there would be big incentives to find alternative assets yielding a less-negative (or positive) return.  The most obvious example is physical cash.   And if there are incentives for fund managers to find such alternative options, there are incentives for trusted operators to provide them (secure physical storage for large quantities of physical currency).   Willing buyers and willing sellers usually find a way to get together, at least if regulators don’t come between them (in this case the regulator –  the Reserve Bank –  actually creates the problem.  People sometimes talk about a lack of secure storage facilities, but $1 billion in $100 bills doesn’t take much space (nor, really, does $100 billion).  (On US note dimensions, the calculations are here.)  If conversions of this sort happened on a large scale, a lower OCR won’t have any material effect –  other than encouraging remaining asser holders to convert to cash.  It wouldn’t lower retail interest rates (much) and wouldn’t lower the exchange rate (much).

These sorts of conversions wouldn’t happen overnight.  Probably most funds managers and the like won’t have physical cash in their list of approved assets.  Some will be able to change that faster than others. Those that can will be able to offer better returns than those that don’t.   And such conversions would be much more likely in the next recession precisely because the starting point –  initial low interest rates –  is so bad.  It is quite likely that official rates could be negative for years.  Or perhaps the conversions will just never happen because central banks (here the Reserve Bank) just don’t lower their official rates far enough to make conversion economic.  But, if so. they will have made the point: conventional monetary policy will have very quickly exhausted its capacity.

And so various people, including me in the New Zealand context, have been arguing for some years now that something needs to be done –  and needs to be done early, to condition expectations about the next recession –  about the effective lower bound.  Brian Fallow refers to this in his article

Overseas experience suggests that at most, a negative policy rate might move the effective lower bound for interest rates 75 basis points into the red. Moving it lower still would require, economist Michael Reddell suggests, imposing a fee on banks switching from virtual to physical cash.

It wouldn’t be difficult.  There are more complex models on offer –  see Miles Kimball or Citibank’s Willem Buiter – but the desired results looks to me to be able to achieved quite simply by setting a cap on the regular holdings of physical currency (say 10 per cent above current levels).  It might need to be a seasonally adjusted cap (currency demand rises around Christmas and the summer holidays, and then falls back again).  The cap would need to rise through time (currency demand rises with the size of the nominal economy).  But the key point is that any net issuance beyond that level would be auctioned (perhaps fortnightly or monthly).   Any creditworthy entity –  the sort of institutions the Reserve Bank deals with routinely –  could participate in the auctions, and the marginal exchange price between settlement cash and wholesale volumes of physical cash would then be established quite readily, and could alter through time.  If the state of the economy and inflation meant the Reserve Bank needed to cut the OCR to -5 per cent (and in the US context, there are estimates that such a – temporary –  rate would have been desirable in 2009), there would be a lot of demand for physical currency, and no more supply.  The market-clearing price would rise, perhaps sharply.

Of course, banks supply currency to retail customers on demand, mostly through ATMs.   Banks would be free to respond to the rise in the marginal cost of obtaining new notes by passing those costs onto customers (retail or wholesale).   A (say) 5 per cent conversion cost of obtaining cash would encourage retail customers to economise on cash holdings (using EFTPOS etc instead), while allowing those who put most value on having physical currency to pay the price.  These days very few domestic transactions strictly require much cash.

Perhaps there are pitfalls in such a scheme.  If so, now is the time to be identifying them, not in the middle of the next serious recession.  Now is the time to be socialising –  including with the public – possible solutions, not in the middle of the next serious recession (when putting a premium price on physical currency suddenly announced might actually be seen as a negative signal about the soundness of banks –  ie discouraging people from holding cash).   Perhaps there even legislative obstacles – I’m not aware of any, but all sorts of obscure issues can arise when one looks into anything in depth. But, again, now is the time to identify those issues and fix them, not in the middle of the next serious recession.  There would probably need to be an override mechanism to cope with a genuine financial crisis driven run to cash.

And if there are better, workable, models, now is the time to identify them, and to test the alternative models in open dialogue, to ensure things are easily pre-positioned to cope with the next serious downturn.

Unfortunately, there is no sign of any of this sort of preparation occurring.  Certainly, nothing has been signalled by the Reserve Bank or by the Treasury or by the Minister of Finance.  If they aren’t doing the work, it is (complacent) negligence.  And if they are, but simply aren’t telling us, it would be quite unwise.

After all, as I noted in the earlier post, a key consideration the authorities need to be addressing is expectations (about inflation and policy).  In a typical serious downturn, inflation expectations fall but not too much, as all market participants expect that the downturn will be relatively shortlived, partly because of aggressive cuts to official interest rates.  But going into the next recession –  whenever it happens –  it seems increasingly likely that few central banks will have the interest rate adjustment capacity they would like.  And all economists and market participants will recognise the constraint, and are likely to factor it into their expectations are seen as a downturn in underway.  A rational response would be to cut inflation expectations (actual or implicit) much more sharply than usual  –  in turn, driving up real interest rates (for any given nominal rate), worsening the downturn, and worsening the reduction in inflation.  This issue doesn’t seem to get the attention it deserves even in the international discussions of these lower bound issues, but it looks to me like a pretty straightforward implication of the current situation.

Since none of us knows when the next severe recession will hit –  it could be years hence, but it could be next year –  this isn’t the time to let the issue drift.  Too many people paid the (unemployment) price of central bankers reaching their limits last time around to contemplate with equanimity going into the next recession starting from a situation where current low official interest rates are still only consistent with inflation at or below target in most countries, including New Zealand.  Dealing with the lower bound issue should be treated a matter of urgency.

(For those who are quite relaxed because of fiscal policy options, I might do a post next week on why it shouldn’t be very much consolation at all.)

Summers on macro policy

At the end of yesterday’s post, I included a reader’s comment highlighting a recent lecture by prominent US economist (and former Treasury Secretary) Larry Summers in which, among other things, he posed the question of how it was that so much of the advanced world has had pretty underwhelming economic growth rates even with real interest rates so much lower than we had been used to (for several hundred years) and –  at least in the US case –  with such large fiscal deficits.  Linked to this, he raised some of the sorts of concerns I’ve repeatedly raised here about the preparedness of authorities to cope with the next recession –  as he notes, the recipe for dealing with recessions in the US has been 500 basis points of cuts in the Fed funds rate, and no one –  including market prices – thinks that the US (or Japan or the ECB) is going to have that sort of capacity when the next recession comes.

At the time, I hadn’t gotten round to listening to that talk –  to the New York Economic Club in May – or to another talk Summers had done about the same time to an ECB conference.  But I did get round to doing so this morning.   For those who, like me, prefer to read texts of addresses (a lot quicker), there aren’t transcripts unfortunately, but both talks are only about 20 minutes long (there is a long Q&A session in the first).

Both talks are worth listening to.  I don’t find everything in them persuasive at all –  he is, for example, a big fan of increased tax and government spending, and of much-increased government infrastructure spending (even as he recounts the extreme inefficiency of the way much US infrastructure spending is actually done).  But he is a smart speaker, and the talks are not riddled with excessive amounts of jargon.   And, even if our neutral interest rates are still higher than in most other places, we face some of the similar challenges.  In particular, about coping with the next serious recession, whenever it comes.

And Summers reminded his listeners of stylised results that the probability of a recession in any one year (conditional on not already being in a recession or just emerged from it) seems to be about 20 per cent.   Recessions are almost never recognised until far too late –  again he reminded listeners of an Economist magazine exercise in looking at IMF forecasts: not once, in some 180 case of countries experiencing a year of negative GDP growth had the IMF forecast such an outcome 12-18 months in advance.  Closer to home, in writing the other day about the Reserve Bank’s survey of expectations, I noticed that in the August 2008 survey, respondents (including many of the main forecasters) on average still didn’t see any sign of a recession.

Summers takes the view –  hard for any serious person to contest –  that the eventual recovery in the US after 2009 was very slow, unsatisfactorily so.  On OECD estimates, only this year has the output gap closed, and last year the unemployment gap closed.  Many other countries had at least as bad as experience:  our own wasn’t much better.   He argues more should have been done with fiscal policy, but perhaps the key point is that more needed to be done (on top of 500 basis points of interest rate cuts, several rounds of QE, other specific liquidity measures, and a significant fiscal stimulus).   Next time round, there isn’t 500 basis points of conventional capacity.

We had 575 basis points of OCR cuts, a bigger swing in the structural fiscal position than in the US, bank guarantees, special liquidity provisions, and a big fall in the exchange rate.  Despite that, we had years and years of excess capacity (whether on RB, Treasury, or OECD numbers) and core inflation still isn’t back to target.   Next time, there isn’t 500 basis points of conventional capacity.

I’m less convinced that Summers has a solution to the problem.   Structural reforms to lift potential growth would be good, but even if they happen they don’t deal with the natural cyclicality of the economy, take years to produce their full effect –  and don’t seem remotely likely in today’s dysfunctional US political system.

On monetary policy, if I heard him correctly, he toys with the possibility of moving from an inflation target to something like a price level target or a nominal GDP target: both might have some merit, although both would be hard to make credible, especially for policymakers who have erred on the side of caution for the last decade.  Perhaps his closest-to-specific advice was that if the inflation target is supposed to be symmetric (as both the US and NZ ones are), surely 9 years into a recovery, with unemployment at 4 per cent or just below (and pretty subdued productivity growth) if ever inflation should be a bit above 2 per cent it is probably now.    The same could, almost certainly, be said for New Zealand (or, perhaps to a lesser extent, Australia).  Such higher inflation outcomes would help hold up inflation expectations, and help induce a little more resilience (gains at the margin) in coping with the next serious recession.

Perhaps it isn’t his specific domain, but I was a bit surprised that Summers made no mention of actually addressing the fundamental administrative barrier that limits the ability of central banks to lower official short-term interest rates below about 0.75 per cent.  If, as Summers does, you take seriously the view that low neutral rates will be with us for some time –  he seems to see little in prospect (from savings behaviour or investment demand) to change that situation – then it should be untenable to keep in place the adminstrative restriction that allows people to move limitless amouts from interest-bearing accounts (potentially negative interest) at no substantial cost.  One doesn’t have to call for the abolition of cash to believe this constraint can be very substantially alleviated (whether by capping the overall note issue, and auctioning new increments) or putting a conversion fee in place for significant transfers.   If authorities –  politicians and central banks –  aren’t willing to address that issue, and soon, they really need to be thinking again about raising inflation (or price level or NGDP) targets, to allow more leeway in recessions.  These issues have to be addressed now: to do so only in the middle of the next recession will undermine the effectiveness (including in stabilising expectations) of any change.

What staggers me is the apparent indifference of policymakers and politicians to these issues and risks.    The experience of the last decade really should be fresh enough in everyone’s mind –  and the awareness of the limitations of conventional policy at present –  to create a sense of urgency about getting prepared. But there doesn’t seem to be such urgencty….in the euro-area, in the US, in the UK, in Japan, or in New Zealand.  I touched yesterday on the rather glib complacent responses the Reserve Bank senior management gave at the press conference

I see that rather shortsighted attitude was carried over to the Bank’s FEC appearance (from Newsroom’s account).

Orr said that should this scenario [sustained weak growth] eventuate, the bank had a set of “unconventional tools” that it had been developing.

Assistant governor John McDermott spoke in May about five unconventional tools the bank had been working on that could be used during a financial crisis. One of these is quantitative easing, essentially the practice of printing money to buy bonds to stimulate the economy.

The bank would buy Government and commercial bonds as well as foreign government bonds, with the intention of weakening the Kiwi dollar.

Other approaches the bank could take include negative interest rates of as low as -0.75 percent, and guaranteeing bank liquidity by offering term lending facilities for banks.

But this scenario remains unlikely – it would effectively be a crisis occurring on top of an existing crisis.

Orr and McDermott know that even with all the quantitative easing and associated liquidity measures in other countries –  that eventually reached the limits of conventional policy –  the recoveries were very slow and painful almost everywhere.  And if that final sentence is really to be read as them suggesting we can’t have a significant downturn now because somehow we are still in an “existing crisis”, they really aren’t fit to be doing their job.   Nominal interest rates in New Zealand at present might be low at present by historical standards, but there is no credible sense in which the New Zealand economy has been in “crisis” in recent years.

In passing, one aspects of Summers’ talk I found unconvincing was his suggestion that despite the big apparent fall in neutral interest rates, the underlying fall is likely to have been much larger, masked –  he claimed – by the effect of fiscal policy across much of the advanced world.  He refers to both stock and flow measures.  On stocks, government debt is certainly higher than it was in many/most advanced countries, but as this IMF chart highlights total debt in the advanced world as a whole total debt (public plus non-financial private) as a share of GDP is barely changed over 25 years, and is lower than it was going into the last recession.

IMF debt chart

As for flow measures, here is a chart showing OECD estimates of the structural primary fiscal deficit (general government) for the OECD as a whole, median OECD country, and for the United States specifically (where deficits are widening again now).

structural bals aug 18

Actually, the latest observations for all three series are no worse than they were in 2006 or 2007, just prior to the last recession.  The median OECD country has been running a small primary surplus, and the average for the last five years is little different than for the five years prior to the recession.        It is hard to see much compelling basis for the suggestion that fiscal policy is masking an ever deeper decline in the underlying neutral interest rates than what we (appear to) observe.

Anyway, for those interested in such issues, Summers is worth listening to and thinking about.


Central bank complacency

There are plenty of things I could comment on around the Reserve Bank Monetary Policy Statement released this morning:

  • there was the questionable view that GDP growth is about to snap back (this very quarter) to above-potential rates,
  • there was the welcome acknowledgement (departing from the Wheeler view) that changes in net migration tend to have larger (short-term) demand effects than supply effects,
  • there was the Governor’s rather glib claim that they had looked back, reviewed their own past performance, and concluded that nothing should have been done differently.  The Governor claimed they’d been at the lowest end of expectations etc, which while no doubt true about the major banks, certainly isn’t true if he’d checked out (say) the lower quartile responses to the bank’s own expectations survey.  More starkly, the Bank –  unlike anyone else –  is paid to deliver core inflation near 2 per cent, and it has consistently failed for years now to do that.  Some things should have been done differently.  But I guess contrition is too much to hope for from public sector agencies.

But what disconcerted me most was the rather glib complacency that continues to flow from the mouths of senior Bank management about readiness for the next serious economic downturn, whenever it happens.

Brian Fallow asked them how well-placed they were to cope with such a downturn, given that the OCR is now at 1.75 per cent, whereas going into the previous recession it was at 8.25 per cent.  The Governor claimed we were well-placed because we have a floating exchange rate, and suggested it had always been the key shock absorber in New Zealand. There is some truth in that observation, but it isn’t that relevant here: we’ve had a floating exchange rate for decades now, and in each downturn during that period cuts in short-term interest rates (the OCR since 1999) have been a significant part of responding to, and mitigating the severity of, any downturn.  In fact, the exchange rate falls so sharply partly because of the size of the cuts in short-term interest rates.  But in the next downturn it seems likely that the Reserve Bank won’t be able to cut the OCR by the 500 basis points or more that have been typical.  On their own telling, they can only usefully cut it by about 250 basis points.   That might enough in a mild downturn, but the focus of the question was (rightly) on the next serious downturn.

Then the Bank’s chief economist John McDermott chipped in.  He reminded Fallow, and other listeners, of the Bulletin article the Bank had published a couple of months ago looking, in particular, at alternative monetary tools (eg QE) used in other countries.   He went on to add that New Zealand also had “lots of fiscal headroom”.

I wrote about the Bulletin article in a post here.  There was some good and useful material in the article, but as I noted then it was inadequate

they know how poorly the world economy coped with, and recovered from, the last downturn, even deploying all sorts of unconventional policies  (fiscal and monetary) on top of the considerable conventional monetary policy leeway that existed going into that recession.  Even here –  where we never reached the limits of conventional policy –  the output gap remained negative, and the unemployment rate above official estimates of the NAIRU for eight or nine years.   Eight or nine years……..  That is just a huge amount of lost capacity, and of lives that are permanently blighted (prolonged involuntary spells of unemployment do that to people).

I’m at a loss to know how any serious people, who actually care about the consequences –  for people’s lives among other things –  can be so complacent.   After all, as surely even the Bank senior management recognises (a) every OECD country (bar Japan) went into the last recession with more conventional monetary policy capacity than the Reserve Bank has now, and (b) the performance (even cyclical performance) of almost every OECD country in the last decade has been pretty deeply underwhelming, even with the combination of conventional monetary policy, unconventional monetary policy, and considerable fiscal stimulus in many cases.

Here, for example, are the OECD estimates of output and unemployment gaps for the OECD as a whole.

OECD gaps

These are massive gaps, losses that will never be made up (in the sense that people only have one life –  years unemployed aren’t usually made up for by more working years later in life).  There is nice column in today’s Financial Times that reflects –  with some anger – on this failing and the responsibility of central bankers, well-intentioned as they all, no doubt, were.

And yet Orr and McDermott seem unbothered about our situation if we were to be faced with a new serious recession.

Lets take the fiscal headroom strand of their argument.  We certainly do have fairly low levels of government debt –  not yet as they were in 2008, but towards the low end of OECD countries.   Australia had low public debt in 2008 too, and is famed for its aggressive use of fiscal policy in the 2008/09 downturn.  Between 2007 and 2009, the OECD’s estimate of the change in the structural primary fiscal balance (the bit, in principle, under discretionary government control) was equal about 5 percentage points of GDP (from a 1 per cent surplus to about a 4 per cent deficit).

But it isn’t as if Australia just used fiscal policy.  The RBA cash rate was also cut by 425 basis points. Oh, and the exchange rate fell very sharply indeed –  as one would have expected.    Even with all that policy support –  and some considerable Chinese fiscal/credit stimulus thrown in – Australia’s unemployment rate still rose by almost 2 per cent (and in the subsequent decade has never got close to the 2007 levels again).

I looked through the complete set of OECD countries for the period around the 2008/09 recession.  Quite a number of them sought to use fiscal policy in a counter-cylical fashion in the last recession, but none did more (on this metric) than Australia.  In fact, New Zealand –  which didn’t do discretionary fiscal easing to counter the recession, but had had big fiscal loosenings in train anyway (which Treasury thought were quite sustainable), saw our structural primary balance widen almost as much as Australia’s did.

What I take from that experience is that it is very unlikely  – no matter how much headroom New Zealand might appear to have –  that a change in the structural fiscal position larger than Australia implemented in 2008/09 would prove politically tenable.  Otherwise, surely, somewhere in the OECD –  eg among those countries without a floating exchange rate, without Chinese stimulus –  we’d have seen it happen.   And even in Australia the peak fiscal stimulus didn’t last long, and debates about trying to get back to surplus consumed a fair degree of political oxygen over the following few years.

And, recall, we had that sort of fiscal stimulus in play ourselves over the 2008/09 period and even then, with big OCR cuts –  more than any other country –  and a falling exchange rate, we still ended up with a serious recession, and a very slow re-absorption of excess capacity.  So the Reserve Bank’s complacency now is pretty alarming. We pay them to worry about contingencies and tail risks, not to blithely suggest everything is fine.

The other aspect of all this that the Reserve Bank has never openly engaged with is that, all else equal, the next downturn will be more troublesome for policymakers precisely because people increasingly recognise that conventional monetary policy is reaching its limits, and unconventional policy as others have applied it just isn’t that powerful.  Going into the last recession, most people worked on the assumption that central banks would cut rates deeply and then the economy would rebound, and that there was no reason to think of medium-term inflation deviating far from target.  Thus, while short-term interest rates fell sharply, implied longer-term nominal interest rates (eg implied 5 year rates five years forward).  But when the next serious recession happens, there will inevitably be a great deal of questioning of just how much monetary policy can do.  Inflation expectations –  whether embedded in bond yields, or just in how firms and households behave –  will be likely to fall away quite quickly.  Central banks will need to cut nominal interest rates more aggressively just to avoid real interest rates rising.   And most central banks don’t have much nominal interest rate space left.     Rational fears of looming deflation are likely to be even more to the fore –  and better-grounded –  than they were in the years after 2008/09.   It seems reckless not to be addressing these issues now.

And for all that the Reserve Bank continues to repeat the line that current inflation expectations are just fine, the bond markets still don’t agree.  If anything, inflation breakevens (a proxy for inflation expectations in reasonably settled times) have fallen back a bit in recent weeks.

IIBs aug 18

The current average observation of the two series is about 1.4 per cent.  It has now been 18 months since there was any sign of consistent progress in getting back to 2 per cent.  But again, you never see the Reserve Bank engage with this indicator either.  The narrative, after all, always seems to be that there is really nothing to worry about.

And it is ordinary working people, not senior central bankers, who will bear the brunt if things do go badly in the next recession, and central bank failure to act now contributes to those bad outcomes.    Since politicians also tend to pay the price, one might hope the Minister of Finance would be taking the lead in requiring the Reserve Bank and Treasury to fully, and openly, address these issues.  Ours, unfortunately, also seems too invested in a “nothing to worry about” narrative.

As I was typing this post, a reader sent me an email prompted by watching the Bank’s press conference

Larry Summers [former US Treasury Secretary, former President of Harvard etc] earlier this year gave a talk on ‘secular stagnation’ – how it is remarkable that so much monetary and fiscal support is now needed to keep economies afloat.  What’s going on in NZ such that, at time when the terms of trade are so good, monetary policy you say is very stimulatory 1.75 ocr compared with 3.5 for neutral?) , and fiscal policy is stimulatory, and to become more stimulatory, yet the outlook for the economy and inflation, by any historical standard, is very subdued.  What do you think the NZ economy would look like in a 2-3 year’s time if monetary and fiscal policy now were both returned to ‘neutral’?  What’s going on?

It is a good question (although not sure I’d phrase the final main sentence that way).  After all, for all that the Bank talks in the MPS of other countries starting to tighten monetary policy, outside the US –  itself recipient of a big late-cycle fiscal stimulus – the changes are pretty patchy and small.  And yet global inflation is pretty subdued, and (as the chart above shows) after all these years, output and unemployment gaps are only closing just now.  I suspect part of the answer is that neutral nominal interest rates are lower than most people think, but that only pushes the question back one more step to ask why that would be.  In part –  but only a part –  it will have reflected the failure to use monetary policy more aggressively soon enough.   That’s clearly true here as well (and with less excuse here as those conventional limits –  to cutting the OCR –  simply weren’t reached here.

A sharp fall in expected GDP growth

The Reserve Bank’s expectations survey results were released this afternoon.  The Bank itself will have had the results last week, and will have been able to take them into account in finalising tomorrow’s Monetary Policy Statement.

Mostly, only the inflation expectations numbers get reported.  They didn’t change materially, whether at a 1, 2, 5 or 10 year ahead horizon.   Perhaps that isn’t too surprising, but it is encouraging given the lift in the sectoral core inflation measure evident in the most recent CPI.

There was also hardly any change in wage inflation expectations –  a slight lift in one year ahead expectations and no change at all in two year ahead expectations.  On these measures, real wage inflation is expected to no higher than 1 per cent per annum –  not high in absolute terms, but rather faster than recent productivity growth (itself next to non-existent).   The Bank themselves produced a graph of the results suggesting real wage inflation is actually expected to slow from here.

wage expecs

I was more interested in two other series.  In the first, the Bank asks respondents to indicate how tight they think monetary conditions are now, and how tight they expect them to be a year ahead.  Ever since 2011, the mean respondent has judged conditions to be easier than neutral –  despite which inflation has consistently undershot the target –  but what is somewhat interesting is how respondents expect things to change.

In this survey, there has been a bit of an increase in the proportion of respondents who expect monetary conditions to tighten over the coming year.

mon cond year ahead 18

Those expectations still aren’t as strong as they were at the peak of the (misplaced) tightening fervour in 2014, but they aren’t far away now.    Quite why, or what has changed, is a bit of a mystery (noting the unchanged inflation expectations).  “Monetary conditions” isn’t further defined in the survey, so includes (implicitly) not just official interest rates, but the exchange rate, credit conditions or whatever the respondent has in mind.  Perhaps respondents are expecting credit conditions to tighten (further)?

Whatever the explanation, it does seem a little surprising set against the backdrop of respondents’ expectations for GDP growth.  The survey asks about expectations for GDP growth one year ahead and two years ahead.  The one year ahead numbers can be thrown around by all sorts of short-term noise, but the two year expectations should be a better reflection of the underlying sense of what is going on (as with the two year ahead inflation expectations).  Three months ago respondents expected real GDP growth two years ahead of 2.7 per cent.  This time, the two year ahead expectation is 2.2 per cent.

Is that difference material?  Well, I had a look back over the history of the series.  If we go all the way back to 1996, there have only been three quarters when two year ahead growth expectations have been revised down by more than the fall this quarter.

When were they?

The first was in the September 1997 quarter, just prior to the 1997/98 recession (a fall of 0.8 percentage points).

The second set were the December 2008 (a fall of 0.8 percentage points) and March 2009 quarters (a fall of 1.6 percentage points), in the midst of the last recession, and the financial crises abroad.

(The quarters with large increases in expectations also come, as one might expect, just after these recessions.)

The fall in two-year ahead expectations this time is still a bit smaller than the falls in 1997 and 2008/09, but it doesn’t look like a result that should be lightly dismissed.  In one sense, people can say “oh, just consistent with the fall in business confidence measures”, but this survey isn’t just a sentiment indicator, but asks about specific macroeconomic aggregates.   And the fall isn’t just concentrated in one year ahead expectations (which actually fell less than the two year ahead expectation), suggesting that whatever is influencing respondents isn’t something they expect to dissipate quickly.

I’d be a bit rattled if I was the Reserve Bank.  It just adds to the sense that growth has probably slowed further already (beyond what is reported –  last official data was the March quarter and it is now August) and may have further to fall.  And respondents –  who include most of the economic forecasters –  don’t see much reason to think a significant rebound is likely any time soon.

Such expectations aren’t accurate predictions of what will happen two years hence –  partly because if things get bad, policy (including monetary policy) responds –  but large falls in the past have coincided with the two periods of worst economic outcomes in the last couple of decades.

(And readers of the Minister of Finance’s speech today won’t have found anything in it to instill much confidence in the sort of rebalancing  –  or stronger productivity growth in the medium term –  the Minister claims to be pursuing.  Strangely, the Minister continues to repeat the election campaign lines about how well the economy has done in recent years –  the economy that saw weakening per capita GDP growth, little or no productivity growth, weak business investment and a declining relative size of the tradables sector.)