The Beehive will have been happy, I suppose

[Note significant UPDATE at the end of this post.]

The only good case for having an entity like the Productivity Commission is if it delivers serious in-depth research and analysis – insight – on significant public policy issues, and does so without fear or favour. In principle, there might have been a decent argument for such an institution (I used to be persuaded) given the weaknesses of academe (at least on New Zealand policy issues), the relative absence of think-tanks, and the deterioration in our core public service advisory agencies. But it is hard to fix just one small part of organisational mix, and even more so when those (a) holding the purse strings,and (b) making key appointments demonstrate no appetite for, or interest in, serious research and analysis. And thus, 10 years into its existence, we have the diminished Productivity Commission.

It was never likely to be easy to create and sustain a good entity of that sort, with no critical mass (unlike the much larger Australian equivalent which initially inspired the creation of the New Zealand one), and just up the street from key ministries (the Australian equivalent is an Melbourne, so an attractive option for people who do not want to live in Canberra). But this government seems to have basically given up trying. But then they’ve consistently indicated little or no interest in reversing the decades of relative productivity decline, even though fixing this failure would provide the best long-term support for fixing many of the things they often claim to have gone into politics for.

That was all exemplified with the appointment a year ago of their mate Ganesh Nana as the new chair of the Commission. Doubts that I and others expressed at the time have been more than vindicated since (be it speeches, interviews, or other public statements).

But if there was still any doubt, the diminished state of the Commission was fully on display with the release yesterday of the draft report on the immigration policy inquiry. Immigration (of non-citizens) is a huge government intervention lever, deployed in New Zealand on a scale far larger than in almost any other countries, with (potentially) significant economic, social, and cultural implications. In New Zealand, champions of the large-scale non-citizen immigration policies – run for much of the last 150 years – repeatedly claim that there are significant economic benefits to New Zealanders from such policies, even as for decades now our position in the global economic league tables has kept on dropping away. Perhaps the advocates are right, perhaps they are not. But you might suppose it was a topic warranting some serious and in-depth research and analysis, New Zealand specific but engaged with diverse cross-country experiences, that really engaged with the issues and experiences and offered compelling insights on what might work best, for what end, and how.

But if that was the sort of report anyone was hoping for, it bore no resemblance to what the Commission has delivered. I’m sure there may even be a first-rate case that could be made for how New Zealand’s immigration policies of recent decades have made (or will soon make) most or all of us economically better off – that is, after all, the thrust of the rhetoric from successive governments, and ministries like MBIE (that used to tout New Zealand immigration policy as being a “critical economic enabler”). It would be fascinating to read – and engage with – such a document. But even though it largely champions something like the (pre-Covid) status quo, the Productivity Commission’s piece offers nothing serious to engage with. I wasn’t a great fan of the New Zealand Initiative’s report on immigration policy/experience a few years ago (and offered extensive commentary in a series of posts collated here), but it was a worthier effort – on fewer resources – than the Productivity Commission’s.

The essential vapidity of the report – most especially on anything relevant to productivity and economic performance – seemed well-captured in this extract from the final page of the Commission’s four page summary of the report.

prod comm summary

So the very first recommendation – one of three in that shaded box – is that ultimate Wellington-insider type of recommendation: more jobs for bureaucrats writing policy statements for the governments. Nothing about the substance, all about process. It isn’t necessarily a stupid idea, but surely as about item 25 on a list of second-tier recommendations?

I suppose every Wellington bureaucrat these days feels obliged to invoke (or conjure up) Treaty of Waitangi dimensions, and so the Commission also has it in its top-3. But the focus of the Commission is – or was supposed to be – primarily economic in nature (there is something of a clue in the name) and all the commissioners – and probably all the professional staff – are economists so one if left wondering what they have to add on Treaty issues, at least beyond their personal politics (quite far left in the case of the chair). Same goes for that weird suggestion that learning Maori might be made a factor in granting residence – I suppose some might think it a good idea, but you might have thought there would be at least some attempt to highlight potential trade-offs (in which, for example, some of the more potentially valuable migrants might find learning a niche language – or least jumping through hoops appearing to do so – something of a deterrent).

I don’t have any particular problem with something along the lines of a couple of the recommendations. Providing more flexibility for those of time-limited work visas to change employer makes some sense (although would make more sense as part of my scheme whereby employers would pay a significant fee to hire short-term migrant workers), and the suggesting about limiting the rights of return of permanent residents who leave seems sensible (if niche), as might a provision to allow only citizens to vote (a more normal practice overseas). But relative to the scale of the intervention immigration policy represents these are second or third order issues at best.

And all that is left, which might have some substance (for good or ill), is the second of those highlighted recommendations, but even there is less to it than meets the eye. Net migration flows (in, out, New Zealander, other) are volatile, but that isn’t mostly because New Zealand policy is volatile. Instead, most of the volatility arises because when the Australian labour market is strong the net outflow of New Zealanders to (higher-paying) Australia increases, and when the Australian labour market is less strong the net outflow diminishes (often quite sharply). There isn’t anything much New Zealand governments can do about that – other than (which would be grossly against the interests of New Zealanders) begging the Australian government to limit our escape option. It is disconcerting that in the draft report the Commission still seems to be hankering to attempt to smooth the net flow (without changing the average rate of immigration over time) and says it will be thinking more about options before presenting their final report. I suspect that if there is one thing the champions of high immigration and the sceptics (like me) agree on is that attempting to use policy to fine-tune flows is a daft, and probably unworkable, idea (it always used to be MBIE’s line to me when I was still an official – and not championing such fine-tuning – and I was at a meeting at the Commission within the last couple of months at which a strongly pro-immigration economist and I (united on almost nothing else in that discussion) strongly urged them not to try. If the Commission thinks they, or MBIE, can forecast the Australian labour market that well, that far in advance – and then adjust policy and movement that quickly – then the macro authorities in Australia probably have jobs on offer for them. And if the government does want to encourage large average migration inflows – to an underperforming remote economy – changing the rules frequently (with forecasts and mis-forecasts of the economic cycle) simply isn’t a sensible way to be attractive to the few really able people likely to be seriously interested in settling here.

The draft report (at 68 pages) is much shorter than many of the Commission’s reports over the last decade. Unfortunately, with the greater brevity has come an absence of much serious analysis or engagement, or even a framing of the issues. The report is accompanied by a series of special topic papers, and I turned, hopefully, to the one headed “Impacts of immigration on the labour market and productivity”. That alone is 98 pages, but (a) the text runs out after 48 pages (the rest is mostly just charts) and (b) most of the rest is boilerplate description of the data, offering no insight to anyone who knows the New Zealand story. And when we finally get to a few pages on productivity – and you will recall that over the years the Productivity Commission has consistently highlighted New Zealand’s long-running poor outcomes – the Commission’s treatment involves no serious engagement with the New Zealand data or experience, no fresh analysis or research (commissioned or in-house) but rather (a) on the global picture a description of one academic paper, and (b) on New Zealand specifically, a single paper done for the old Department of Labour by the Commission’s chair some years ago, in which sure enough gains to per capita income show up, but solely by construction (it is a CGE model) and in which any possibility of productivity gains (or losses) is assumed away by construction. Nana has long been on record as a champion of large scale immigration, and juicing the population of our cities (he was my interlocutor in this RNZ discussion) but his paper sheds no light (and really can’t do so by the technique used).

Overall, the report is the sort of thing an average MBIE policy team could have churned out. It offers little or no insight, no fresh analysis or research, but offers a few tweaks (some sensible, some not) which a government that likes mass migration (and Labour has for several decades now) can nod sagely at and perhaps make the odd change (and of course some red meat to the Labour Maori caucus).

Now regular readers might be wondering how the Commission has treated the arguments I have been making over the last decade or so about New Zealand’s immigration policy and our disappointing economic performance.

I noticed that a recent speech was shown in the list of references so I searched the document to find out where they had referred to it. The solitary reference was here

This raises the question of whether overall resident approval numbers (the “planning range”) should be reduced or linked to
other factors, such as outflows of New Zealanders or the state of the economy. If other changes are not made to ease restrictions on housing construction and to boost investment, a “least regrets” approach implies setting the planning range at lower levels
than has been the case in recent years. Some commentators and submitters argued for setting the planning range at much lower levels (Reddell, 2021).

Which is, to say the least, a bit naughty, as neither in that speech nor in anything I’ve written in recent years, have I suggested tailoring the residence approvals numbers to housing construction, the cyclical state of the economy, the outflow of New Zealanders, and the “least regrets” framing is one that I have not used (I think it originates with the economist Julie Fry).  But, however they describe it, the Commission simply presents the idea of lower numbers of residence approvals, makes no comment and moves on.

A few pages earlier, the Commission does devote half a page to a discussion of “arguments from a macroeconomic perspective suggesting that fast population growth may have suppressed New Zealand’s productivity growth”.   I recognise some aspects of some of my arguments and analysis in what follows, and I suppose it is welcome that –  without further analysis or testing – they comment that 

Aspects of New Zealand’s economic performance over the past 30 years are consistent with these arguments, including a persistent high real exchange rate (despite poor relative productivity growth which would tend to push the exchange rate down), a flat or falling share of exports to GDP, slow rates of productivity growth, and high real interest rates compared with other developed countries. Immigration is unlikely to be the sole cause of these trends, but the symptoms are consistent with it being at least a contributor.

But that is it. Which is strange, because the story has implications. If it is right (in whole or in part), it argues for much less trend immigration (at least to the extent economic outcomes matter a lot), and if it is wrong, well it should be exposed and demonstrated as wrong. Instead, we get “symptoms are consistent with it being at least a contributor” and then they move on to the next topic. It does not create much confidence that they have thought hard or engaged much. Instead, as they move to the next paragraph, they seem to confuse and conflate these arguments with quite different issues and arguments (that I’m certainly not making) about housebuilding and construction of public infrastructure.

When people refer back to this report in years to come – as no doubt some will – no doubt the champions of large scale non-citizen immigration will find support. But no one – pro or con – will find illumination. But with nothing challenging, nothing troubling, no doubt the Beehive will have been happy, and the powers that be at the Commission will have rewarded the trust ministers showed in appointing their mates.

I have tried to look at the report not just through the lens of my own views on a sensible immigration policy for New Zealand. If one is evaluating the quality of a report, what matters isn’t just (or even mainly) if the authors end up agreeing with you, but how. I can’t believe that any serious champion of large scale immigration to New Zealand (and there are some, not just among the self-interested) would regard this report as a serious and useful contribution to a better understanding of the issue in New Zealand. If those were my views – and of course they aren’t – I’d be a bit embarrassed that this was the best the government’s Productivity Commission had managed to come up with.

As it happens, I am very curious as to how the Commission ended up where it did. I chose not to make a submission, on some combination of lack of confidence in the Commission, health, and a sense that staff and at least some commissioners were well aware of my arguments, which had been documented extensively over the years. But about three months ago I had an approach from a senior staff member asking if I would write a paper for them, which they would have reviewed and would then publish, articulating the “Reddell hypothesis” and reviewing the experiences here and abroad that might help shed light on the issues etc.

I declined almost immediately, and after some further engagement not only declined but suggested that such a paper would not necessarily be in their best interests even if the Commission was to be sympathetic to my story (they’d have been much better off getting someone not precommitted to review the arguments and evidence). But I have since had a couple of sessions with staff and commissioners on the issues and arguments, and while I’m not going to go into detail on the substance of those discussions, suffice it to say that it was something of a surprise to read the report, and the lack of serious engagement with the issues and experiences.

It is, of course, up to the Commission what issues and arguments and experiences it addresses. But for anyone interested in exploring mine further

this was the speech the Commission (somewhat misleadingly) linked to

and these were notes for a recent lecture at Victoria University

and this is a longer version of a recent book chapter in which I explore New Zealand’s longer-term economic underperformance, distance, and the inconsistency between our immigration policies and producing first world living standards at this distance from the world.

UPDATE:

Silly me. I assumed that any substantive discussion of effects of immigration policy on productivity might appear either in the main report or in the supplementary paper I linked to earlier “Impacts of immigration on the labour market and productivity”. However, the Commission has just pointed me to another supplementary paper which – because it was under the heading “The wider wellbeing effects of immigration” and I am mainly interested in economics and productivity – I had not read. It turns out that “the wider wellbeing effects” is mostly about economic effects, and that there is a whole chapter (pp12-19) on macroeconomic issues and arguments, including a sub-chapter on the “Reddell hypothesis”. I had seen an earlier draft of that chapter and had provided some comments on it.

It is a little strange to have (a) published this core economic material in a chapter under such a heading and then (b) not to cross-reference it in the main report, but for what it is worth the chapter includes this specific official “finding”.

Reddell hypothesis

House and land prices

The local Wellington magazine, Capital, which seems to be a curious mix of the serious and the lifestyle, earlier in the year asked if I would write a piece on house prices. That article outlined the story I’ve run here repeatedly, that durable and very large reductions in house and land prices are quite possible – we see everyday examples in perfectly pleasant urban areas in the United States – but are only likely to happen if there is genuine aggressive competition among owners of land beyond existing urban areas. It is that sort of competition, from land whose best other use is probably for something agricultural in nature, that would durably lower land (and house) prices in existing urban areas.

That article ran in April. In late September the editor got in touch and asked if I was interested in doing another piece. Since there had been numerous policy announcements around housing this year – from the government, from the Reserve Bank, sometimes from the government to the Reserve Bank – I suggested that a piece along the lines of “sound and fury, signifying not much at all other than some new inefficiencies and distortions” might be in order. That article is in the issue on sale in Wellington now, and the text is here. I will include the full text at the bottom of this post.

I wrote the article four weeks ago. It isn’t quite the article I would write today because since then we’ve had the joint Labour-National announcement on new legislation that is being rushed through which will allow more intensive (but still relatively low-rise) development in existing urban areas of our larger cities, but appears to do nothing of substance to free up land-use beyond existing urban areas (and, as I noted in both articles, there is lots of undeveloped land in greater Wellington, much of it with little economic value in alternative uses). But if I’d write a slightly different article today, the bottom line does not change: there is no sign (from ministers, Opposition spokespeople, city councillors or whoever) that those who hold power have any interest at all in delivering much lower house prices on a durable basis. They refuse to express any such interest, and nothing they have done or are now doing seems likely to bring about such an outcome. Urban density may be all very well and good, for those who like that sort of lifestyle (and good luck to them), but the international evidence offers no example I’m aware of in which allowing much-greater density in cities has been followed by move towards house/land prices dropping back towards what we see in (typically quite low-density) cities in much of the US.

In the article I suggested that much of what had been announced this year was little more than “performative display” – doing stuff for the sake of being seen to act, seen to care. That seems right for most of the initiatives, since typically the supporting advice that has been published doesn’t suggest any likelihood of a sustained impact on prices. It is possible that the parties to the latest deal actually believe that this initiative might actually make a difference – partly because they have been cheered on by some people from the genuinely pro-liberalisation side of things. But even if they do believe that – and refuse to openly say so for fear of scaring some heavily-indebted voters – they are almost certainly wrong.

The second reason for scepticism I included in the article was this

The second clue is that prices have kept on rising, and at best are perhaps expected to fall back just a few percentage points over the period ahead (despite the huge increases we’ve seen). If people – smart people with lots of money at stake – really thought that the policy changes already made (tax rules, access to finance) or those in the works (such as the replacement for the RMA, or the National Policy Statement on urban development) were going to make an enduring difference, we’d see to
see it in the prices of the assets already. That is how asset markets work, whether stock markets, foreign exchange markets, or (a little more murkily) land markets. But there are no signs or reports of substantial falls, whether for existing properties or potentially-developable land

I still reckon that is basically right, but were I writing today I might put more emphasis on the possibility of quite a shakeout over the next year or two, even while the structural problems are unchanged. In a way, this is just the sort of point the Reserve Bank has been making in its discussion around “sustainable” house prices. “Sustainable” in their terms does not mean affordable, or US-style normal. It really just means where a market might be expected to settle given all the policy-settings and distortions in the system (that underpin land prices well above best alternative use price). One can see material, even significant, falls in house prices in such markets without the longer-term structural fundamentals being fixed at all. Such falls aren’t likely to last (and in New Zealand aren’t likely to pose a financial stability threat) but they could get the headlines for a time. Many of the falls in house prices that happened around 2008/09 were of that sort – whether those in San Francisco (now incredibly expensive), New Zealand (now incredibly expensive), or even Dublin.

Building activity in and of itself does not solve the underlying problem – land prices – but it can still lead to shorter-term overhangs in the market. There has been quite a lot of housebuilding going on.

Interest rates have risen and seem likely to rise further. A return to rapid population growth, from immigration, still seems some way off. The fiscal stimulus which has helped boost economic activity will be fading, and there are all those tax and access-to-credit restrictions. None of these address the longer-term problem of a rigged market that renders peripheral (developable) land incredibly expensive in a land-abundant country, but in combination they could be a recipe for a non-trivial fall at some point soon. Of course, prices ran up so much in the last year or so that even such a fall is unlikely to take prices back to real levels even two years ago, but…..falls of that sort would grab the headlines, and would probably lead some politicians to want to claim credit for having solved a problem they haven’t really even begun to address.

Without further indenting or block-quoting here is the full text of that article.

Lots of action, but none that will fix the housing market

Michael Reddell

(Published in Capital magazine, November 2021)

October 2021

Even before Covid, house prices in much of New Zealand were very high.  Over the last year or so they’ve again risen sharply almost everywhere, putting home ownership further beyond the reach of most, and underpinning rising rents.  This dreadful situation, transferring resources (wealth) from the relatively poor and young to the relatively rich and the risk-takers, is utterly unnecessary and deeply unjust. 

In a well-functioning market, times like these should be a renter’s dream.  Purchasing a house should never have been cheaper, and rents should be lower (in real terms) than ever.

That’s because interest rates are at record lows.  The New Zealand government’s 20-year inflation-indexed bond currently trades at about 0.8 per cent.  25 years ago the comparable rate was about 5 per cent.  Basic finance theory suggests that when rates of returns on one long-term asset fall so will those on other long-term assets. And in a well-functioning market, rents are the main source of return to the owner of the rental property.

But a well-functioning market is one in which it is easy to bring to market and develop new land and new houses. In that sort of market, developing the new land (building the new houses) would now be easier and cheaper than ever.   It takes time to develop a subdivision and build houses, and finance costs are one of the major costs those in that business face.   New Zealand has abundant land, that could readily be converted to urban uses. So, of course, does Wellington, and much of the land surrounding Wellington isn’t worth much in alternative uses.   But if regulations make land artificially scarce, then lower interest rates (or other sources of higher demand) can translate quite quickly into higher house/land prices.

The alternative isn’t just some theoretician’s dream.  When I wrote here six months ago, I highlighted Little Rock, Arkansas, as one example of the many growing, pleasant and highly-affordable US cities.  Real house prices in Little Rock hadn’t changed much in 40 years and median house prices appeared to be about NZ$300000.  Interest rates are at least as low as those here.  Check any website and you’ll easily find modern townhouses to rent in Little Rock for no more than NZ$1000 per month.   Try that in Wellington.

In a well-functioning market, when interest rates fall and prices look like beginning to rise, owners of land (whether existing sites in the city or new areas at the periphery) should be falling over themselves to get new land, and then new houses, to market, and owners of rental properties should be competing aggressively to get and keep tenants.  The alternatives would be a vacant property (earning nothing) or money in the bank (earning little more).

But this is New Zealand where, absent a well-functioning market, house/land prices have surged again, where rents have been rising, and where price to income ratios –  which should be less than 4 in well-functioning markets –  are now more like 10.

There has been all manner of policy announcements this year, some substantive and others little more than rhetorical.   The government has extended the “bright-line test”, so that investors selling properties within 10 years will pay a sort of capital gains tax, and – in one of the more bizarre moves – is legislating to stop businesses owning investment properties deducting their interest costs against taxable income.  A select committee is looked into new resource management legislation.    And, of course, some councils – including Wellington’s – are moving to allow some more intense development in some parts of the city.     Bureaucrats have got in on the act too, with renewed loan-to-value (LVR) restrictions from the Reserve Bank and the threat of more restrictions to come.  And the government has insisted that the Reserve Bank should talk more about house prices.

But there are two pointers that none of this amounts to much more than performative display. The first is that government ministers – from the Prime Minister down – refuse to express any interest in lower house prices.  Instead, they talk repeatedly about just lowering the rate of increase. Councillors, and Opposition parties, are rarely much better.

The second clue is that prices have kept on rising, and at best are perhaps expected to fall back just a few percentage points over the period ahead (despite the huge increases we’ve seen).   If people – smart people with lots of money at stake – really thought that the policy changes already made (tax rules, access to finance) or those in the works (such as the replacement for the RMA, or the National Policy Statement on urban development) were going to make an enduring difference, we’d see it in the prices of the assets already.  That is how asset markets work, whether stock markets, foreign exchange markets, or (a little more murkily) land markets.  But there are no signs or reports of substantial falls, whether for existing properties or potentially-developable land.

This year’s measures aren’t designed to fix the broken housing market, just to throw some sand in the wheels, be seen to be doing something, and perhaps to buy a bit of temporary relief.  Nothing done or promised is likely to make very much sustained difference at all, because none of it gets to the source of the problem.

Some put a lot of hope in provisions allowing for greater urban density – even as our cities are already quite densely populated by New World standards.  They are probably wrong to do so.   Increasing density has already been a feature of the last few decades – think of all the infill housing a decade or two back – and, of course, the physical footprint of our cities has also expanded.  But in the face of rapid population growth – likely to resume once Covid passes – these grudging changes have only been enough to avoid house prices rising sooner to even more outrageous levels.  

Without a radical freeing-up of land use at the periphery, creating aggressive competition between development options in cities and those at the margins, simply allowing a bit more densification will not bring land prices down. It may even bid up the prices of some sections, now able to be developed more intensively.  A lot of houses are being built right now, but there is no prospect of enduringly much lower prices unless or until owners of vacant land, on the peripheries of our city, are free to bring that land into housing and other urban uses.

New Zealanders should be able to count on a well-functioning housing/land market and ready access to finance.  Increasingly we have neither; just more complexity, more inefficiency, and more-unaffordable house/land prices.


Walking the path?

At 11am the New Zealand Initiative released their latest report, by Bryce Wilkinson and Leonard Hong, under the title “Walking the Path to the Next Financial Crisis”. It comes complete with a Foreword from former Reserve Bank chief economist (and former Board chair) Arthur Grimes, under the title “A short walk?”, foretelling doom and repeating his recent attacks on the Reserve Bank’s conduct of monetary policy over the last 20 months, ending with the ominous – and printed in bold – declaration “This time is not different”.

The Initiative was kind enough to send me an embargoed copy yesterday. Perhaps the first thing that rather surprised me – in a document that is really quite critical of both monetary and fiscal policy and aspects of the way the Bank does other things – is that the acknowledgements include thanks to a Reserve Bank MPC member (Bob Buckle) for “valuable feedback and suggestions”, and to a Reserve Bank economist (Andrew Coleman) for “careful comments on a draft version”. Perhaps it is an encouraging sign. Perhaps one day the Governor will also get MPC members to give speeches and openly account for their own thinking and actions. But more likely not.

It is hard to know quite what to make of the report. It probably won’t surprise the authors that my bottom line is that, amid some interesting material, much of it seems a bit overblown. In a way it was captured best in the final paragraph of the authors’ Executive Summary

The less prudent the government, the more prudent individual New Zealanders will need to be. Borrowing heavily to buy property or shares at current prices is like playing Russian roulette with one’s financial future. Portfolios should be
diversified. There are risks of both deflation and inflation.

As an advertisement for inflation-indexed bonds (eg 19 year ones, yielding a real 0.88 per cent yesterday) that final sentence could hardly be bettered, but isn’t it always so? The future is uncertain, diversification is usually prudent, and hedging (in this case against inflation uncertainty) usually is too. As for borrowing at present, well even if the government was running a balanced budget I’d be pretty hesitant myself about taking on lots of debt secured on assets like New Zealand houses but (a) it is much less risky if you are buying a house you intend to live in for 40+ years (hedging etc) and (b) people like me (including successive Governors) having been saying as much on many occasions over the last 30 years. Those with particularly long memories – and I’m sure Bryce is one of them – will recall Don Brash, newly appointed as Governor, refusing to buy a house in Wellington in 1988 given how expensive they were.

As for the government, just how imprudent is it? Well, I’ve been as critical as anyone (well, more than most) of the large structural deficit they chose to run in this year’s Budget, when there was no obvious macro or Covid need for such deficits, but if it is stocks (of debt) you are worried about – which for Wilkinson’s and Hong’s purposes you are – then here is the OECD’s series of net general government liabilities as a percentage of GDP (including the May 2021 forecasts, so there should be an update shortly).

nzi nov 21

Is it more net debt than I’d like to see? Indeed. But on the OECD numbers we’d have the 6th lowest net debt (per cent of GDP) of all the OECD member countries next year, and an absolute level that poses no risk to anyone or anything, even if we were to get a severe recession/crisis in the next few years (the global risk the authors are most focused on).

There are also curiously anachronistic touches to the report. Again from the Executive Summary

The composition of New Zealand’s official overseas reserves should be reviewed, particularly in respect of gold.

For those who aren’t aware the Reserve Bank is among a small number of advanced country central banks that hold no gold at all in their foreign reserves (New Zealand has not done so for decades). What really clear from the report is why the authors think the Bank should do things differently. It can’t be as an inflation hedge, since most of the Bank’s reserves are already hedged (funded with foreign currency liabilities). And since the reserves are held to enable crisis intervention in the foreign exchange market – and thus immediate access to liquidity has always been a priority – it isn’t obvious why we should want our central bank holding a non foreign exchange asset that has a very volatile price. If we must have a New Zealand Superannuation scheme (and I suspect the authors agree with me that we shouldn’t) perhaps that is the place to think about whether gold – or Bitcoins for that matter – have a place in a diversified investment portfolio.

Of the authors’ other recommendations for New Zealand, I’m with them on the idea of a independent fiscal council – although it is hard to see it making much difference given the degraded state of New Zealand government agencies generally. On monetary policy their call is for

The Reserve Bank should have a clear path for reversing its emergency credit creation and lifting its control interest rate.

And I have some sympathy when it comes to the future of that huge stock of bonds the Bank bought in a fit of “look, we are doing something/anything” frenzy but in fairness to the Bank they have (a) stopped increasing the stock of bonds, and (b) were one of the earlier advanced countries to start raising official interest rates. No one really doubts there are more increases to come, but then no one wise will be pre-committing to a particular path for the OCR because no one, but no one, knows what sort of interest rates (real or nominal) will be required a few years from now.

The authors seem quite enamoured of the thesis advanced in a recent book by economists Charles Goodhart and Manoj Pradhan who argue that demographics will drive interest rates much higher in the coming decade. It is an interesting argument – and I’m open to it (if not yet convinced) – but in the same paragraph in which they mention this thesis they cite Germany and Japan (countries with particularly unfavourable demographics). But surely the problem then is that both Germany and Japan have far lower interest rates than New Zealand (or, say, the United States). Sure, asset-buying programmes may influence those rates to some extent, but there is just no sign the market thinks real rates (or nominal actually) are going to go a lot higher, even on a 20 year view. The market could be quite wrong – it has been known – but so could Goodhart, Pradhan, and the NZI authors.

Without trying to caricature the authors I think it would be fair to represent their views in this stylised way:

  • things haven’t been the same since the world moved to fiat money,
  • fiscal discipline has been breaking down globally, but especially in the big Western countries,
  • moral hazard (around government bailouts of failing financial institutions) is an increasing problem

And that, in combination, the way is set that will lead to crisis (globally, even if our financial system itself were to be fine).

There are aspects of the argument I sympathise with. It wouldn’t surprise me if the next serious recession were to see a major euro crisis, and perhaps even the end of the euro. But then that has been my view for a decade now, and yet life goes on. Fiat money has had its downsides – look at how much prices have risen over the last 100 years compared with the previous 100 – and yet the reality of the decade prior to Covid was one of inflation in most of the advanced world repeatedly undershooting targets. And much as I abhor structural fiscal deficits – of the sort established in places like the US, UK, and Japan – it remains true that real interest rates (servicing burden) are extraordinarily low, and have now been low not for a few months but for really rather a long time. Perhaps 3 per cent real interest rates will return and endure, but for now there is little credible sign of such a development anywhere, and quite a bit of what Wilkinson and Hong worry about seems to rest on such a scenario. If I were advising New Zealand’s Minister of Finance today – or his Opposition counterparts – risks around advanced world fiscal debt would not be high on the list of things I’d be worrying about. And I’m not keen on bailouts either, but surely there is at least as credible argument that in much of the world capital ratios are now so much higher than they were that – to some extent at least – the moral hazard argument is less strong than it might have appeared in 2009.

It is good to be challenged, and there is some interesting material in the report including (at least for those less aware of monetary history) on how the current global system came to be. And I strongly endorse the authors’ scepticism about the self-politicisation of our Reserve Bank (and the tendency of many other central banks to want to weigh on on matters simply not their responsibility). Even that weird new central bank ‘network for indigenous inclusion’ gets a mention (I keep waiting for the day when the Icelandic central bank is signed up, their “indigenous people” having settled Iceland just a few hundred years before Maori first settled New Zealand). And counsels of vigilance rarely go astray when it comes to macro and banking policy. But I wasn’t persuaded we were quite as far along the path to perdition as the author’s fear.

Curiously, there is a launch event going on at present at which former Prime Minister John Key (current chair of the ANZ) is speaking (I didn’t tune in). Aside from the name recognition he offers, it seemed curious to have such an establishment figure, known more for his sunny optimism than for his willingness to make hard calls and choices, to be launching this jeremiad. But if Key is persuaded, I wouldn’t want to be a borrower at the ANZ at the years to come, as presumably materially-tighter lending standards would be a corollary of the Wilkinson/Hong analysis?

Half a million a head

In yesterday’s post I drew attention – yet again – to New Zealand’s continued drop down the international productivity league tables. There are all sorts of caveats to the details – PPP comparisons are inevitably imprecise, and the data are subject to revisions – but few seriously doubt that we do much worse now relative to other advanced countries than we did just a few decades ago.

But it is easy to lose sight of what the numbers actually mean for ordinary New Zealanders, so I thought today I might do just a short stylised illustration.

In yesterday’s post – as on various occasions in the past – I’ve contrasted our outcomes with those of a group of highly successful OECD countries (but excluding Norway (oil), Ireland (even their own authorities don’t use GDP as a measure of Ireland’s outcomes) and Luxembourg): Switzerland, Denmark, Belgium, the United States, Sweden, Austria, France, Netherlands and Germany. They can be thought of these days as some sort of “leading bunch”, at least as regards labour productivity.

In 1970, when the OECD data start, our real GDP per hour worked was about 82.5 per cent of the median for this group of countries. By 1990 that proportion was about 64.5 per cent.

In 1990 the confident hope – among officials and ministers, and more than a few outsiders – was that we were on the brink of turning things around. I’ve shown before this photo of then Finance Minister David Caygill’s aspirations/expectations.

caygill 1989 expectations

Let’s suppose it had worked.

The fall in our performance relative to that OECD leading bunch had taken 20 years, so suppose that over the following 20 years we had steadily improved such that by 2010 our real GDP per hour worked was again about 82.5 per cent of that of the leading bunch, and then held at that ratio subsequently. That wouldn’t have made us a stellar performer, but at least on the OECD’s numbers we’d be doing about as well as Canada and a little better than Australia. Since we’d more or less tracked Australia for many decades earlier it wouldn’t have been an unrealistic aspiration at all.

How much difference would it have made?

There are lots of possible moving parts, but I did this little exercise by taking as my starting point actual real GDP per capita for New Zealand each year over the last 30 years and scaling it up by the ratio of the assumed productivity performance to our actual. Fortunately the official GDP per capita series starts in 1991.

This is what the chart looks like.

scenario productivity 1

By the end of the period, the annual difference – per man, woman, and child – is about $20000.

But what does it add up to? After all, every year since 1991 our incomes could have been higher than they were. And $1000 extra from 1991 invested even just at a real government bond rate adds to quite a lot by now (especially given New Zealand’s interest rates over that period). Applying a (stylised) series of real interest rates – falling over time – and applying them to each year’s difference in real GDP per capita, the total difference came – in today’s dollar terms – to a bit over $500000 per man, woman, and child. For almost everyone in New Zealand that would be serious money.

You could produce a different number with different scenarios. Slower convergence would, of course, produce a lower number. On the other hand, using the sort of discount rate The Treasury requires government agencies to use – rather than just a long-term real interest rate – would value past gains more highly and produce a materially bigger number.

The point also is not to suggest that if somehow economic policy had been run better and produced these stronger productivity outcomes that everyone would have banked all the proceeds and be sitting today on an extra nest-egg of $0.5 million. That wouldn’t have happened at all. In a more productive economy, people would have been able to – and no doubt would have- consumed more. Government revenues would have been stronger, and better public services might have followed even at the same tax rates. Some might have chosen to work less (a real gain to them too). The half million is a way of putting a number to the options that much better performance would have created. And the gains would be mounting further every single year. Another way of putting that is that every single year, the failure of successive governments means a median family of five is missing out on another $100000.

To repeat, this exercise is entirely stylised. Depending on one’s view of which set of policies might have delivered these better outcomes. some other things might have been very different. Perhaps our terms of trade would have been different (since probably a somewhat different mix of products). Perhaps our real interest rates would have been closer to world levels. Perhaps…perhaps. The point is simply that decades of economic failure adds up to really large amounts of income (and potential consumption) just lost. In New Zealand’s case, half a million per capita will do to be going on with, mounting at $20000 per capita with each year we languish so far behind the bunch.

And just think of how much better off our country would be – avoiding all the systematic and deeply unjust redistributions – if over the same period successive governments also had not so badly messed up the land market, in a way that has delivered us such extraordinary house prices.

What might have been……

But what still could be if there were to be a government of courage and vision.

Pushing down the league tables

Next Monday morning in Paris, the OECD’s Economic and Development Review Committee will be gathering to discuss the draft of the latest Economic Survey of New Zealand. These mid-level public servants will pose some questions, offer some observations (some insightful, most probably not), and their French and Hungarian members will lead the questioning and – if the past is any guide – get to enjoy a very nice lunch at the New Zealand Embassy. Some weeks later, after the text has been haggled over line by line, we will get to see what the OECD has to say about our economic performance and policies.

But in many respects, the numbers speak for themselves, and the OECD does a pretty good job – one of the useful things it does – of collating and making accessible a wide range of data for its member countries.

The OECD’s series of labour productivity data (real GDP per hour worked (in PPP terms)) starts from 1970. New Zealand joined the OECD in 1973 when it was a club of 24 countries. For all but two (Austria and Greece) of those countries there are labour productivity estimates back to 1970. By 1970, New Zealand had already dropped a bit below the median OECD country, but the countries either side of us were France and the United Kingdom, and we were just slightly behind Germany.

In relative terms, New Zealand’s economic performance was particularly bad in the 1970s. Of those 22 OECD countries for which there was a consistent series of data, over the course of the 1970s New Zealand’s real GDP per hour worked fell from about 95 per cent of that of the median country to about 75 per cent. By 1980 only four of those countries had lower labour productivity than we did, and we were no longer between the UK and France but between Ireland and Finland. To younger readers, Ireland may not sound too bad, but Ireland in those days was still an underperforming economic backwater.

Things didn’t look too different in 1990. The number of countries for which there is data had increased a bit and of the 1973 membership we now stood between Japan and Greece.

The 1990s was an era of opening-up. A variety of countries re-emerged from the ashes of the Soviet Union and Yugoslavia, other countries formerly under the thumb of the Soviet Union began turning themselves into market economies. And the OECD itself started to broaden its membership, looking to Asia and Latin America for new members. That process has continued and there are now 38 OECD countries, and (more importantly for this post) labour productivity data for all of them since at least 2000.

In 2000, 17 of those 38 countries had average labour productivity lower than New Zealand’s. We were still between Greece and Japan.

By 2010, 16 of those 38 countries were below New Zealand. By then we stood between Greece and Slovenia, the first of the former eastern-bloc states to match us.

So far, so mediocre.

But what about the more recent period? 2020 marked the end of another decade.

It takes many many months to get a complete set of annual data (and, of course, many of those numbers – including our own – are still subject to revision). But the full set of 2020 estimates is now available.

I have been quite hesitant about using 2020 data for anything other than Covid purposes. Countries had quite diverse Covid experiences – some good (bad) luck, some good (bad) policies etc but most of any differences probably not telling us much about the longer-term economic performance story. And measurement was a real challenge – both GDP and hours worked. Bear those caveats in mind in what follows, but looking at the data (and checking against trends to 2019) the distortions seem less than I might have thought/feared.

Here is how things looked in this snapshot.

OECD GDP phw 2020

Only 9 countries now do less well than us, and we are bracketed between Korea and Poland (for all the hype around Korea’s economic performance – and it is impressive over several decades – only now has their average labour productivity matched that of underperforming New Zealand). Former laggards Turkey, Slovakia, Slovenia, Lithuania, the Czech Republic and Estonia have now moved past us – some well past us – and mostly just in this last decade.

And if you think this is just a story about other countries doing really well – which we shouldn’t begrudge for a moment, it is something to celebrate – bear in mind that on these estimates New Zealand’s productivity growth rate in the 2010s was less than it was in the 1970s. That’s the New Zealand of Key, English and Ardern – oh, and record terms of trade – managing to underperform the New Zealand of Kirk, Rowling and Muldoon.

If that chart is bleak enough about New Zealand’s standing in the OECD league tables, just think where it might be a few years from now. It is good of the OECD to have welcomed in the four Latin American members – the diversity hires – who will keep New Zealand off the very bottom of the league table for a long time. If Chile is managing pretty good productivity growth. Mexico in 2020 had real GDP per hour worked no higher than it had been in 2000.

But of the five countries below us last year, three are likely to go past us in the next few years.

the next three

Portugal could pass us too, but they’ve been just slightly behind us for 30 years now.

2025 was once – briefly – the year when we were supposed to have caught up with Australia by. Instead, most likely, on this metric the only OECD countries that will be doing worse than us will be Portugal, Greece, and the four Latin American members that don’t even make most lists of advanced economies.

What a woefully bad set of outcomes successive waves of politicians and officials have delivered for New Zealanders. (All while they’ve delivered us some of the most expensive housing anywhere.) And what is perhaps most depressing is that none of this seems to bother either side of politics, and neither political parties nor (so far as we can tell) officials seem to have any real interest in reversing decades of underperformance. These outcomes aren’t some exogenous given, but the outcome of repeated sets of policy choices. And if the policy choices of the previous government in this area were bad (and they were) those of the current lot seem materially worse (exemplified in recent days by the tens of billions of taxpayers’ money they want to spend on glorified trams, as if money were no object).

Incidentally, lest anyone be under the illusion that Australia itself is some sort of success story, Australia (7th in the OECD in 1970) is now close to the middle of the league table – much better than New Zealand, but not exactly a multi-decade success story.

There is a group of countries near the left hand side of the first chart – from Switzerland to Germany – that I’ve often contrasted us with. Even in 1970 we were behind all of them on this measure (basically level-pegging with France). But now, to catch up with the median of those countries it would require a 69 per cent lift in New Zealand average labour productivity.

It could be done – it would take productivity growth averaging 1.3 per cent per annum faster than in those countries for 40 years – but it isn’t going to happen by simply ignoring the issue, hoping for different outcomes, or by adopting sets of policies that are only likely to continue our decades of relative decline.

Massive losses, for nothing

All sorts of items of public spending have attracted attention since March 2020 when the Covid-related spending really began. Some of the things money has been spent on – the wage subsidy for example – were large but necessary and appropriate. Some things, often quite small in scale, were pure waste. Others were dressed up under a Covid label but were really just poor-quality (but quite large scale) spending.

One of the items that has had almost no attention is the huge losses that have resulted from the Reserve Bank’s Large Scale Asset Purchase (LSAP) programme. I guess it is a bit harder to report on, since neither the Bank nor the government puts out press releases boasting of losing $4bn or so.

The government has, with no parliamentary authorisation or scrutiny, agreed to idemnify the Reserve Bank for any losses it incurs on the LSAP. That, at least, has the merit of encouraging/requiring some transparency. On the Reserve Bank’s balance sheet there are two line items, show in this chart

LSAP indemnity claims

To be honest, I’m not quite sure what the orange line is, since as I read the indemnity the liability is one-way only (Crown pays Bank if Bank loses) but it looks like it may reflect periods early on when the LSAP bonds were valued at more than they had been purchased at (lower yields than is). In any case, it is irrelevant now as the remaining number is tiny. The blue line – the Bank’s claim on the Crown – is where the focus should be. That claim was almost $4 billion at the end of September, and nominal yields have risen further this month.

Since the Bank discloses all its purchases, in principle someone could go through and identify the losses on each and every purchase undertaken over the period (more than a year) that purchases were undertaken. But for our purposes here, suffice to say that government bond yields are a lot higher than they were. Here are few medium-long term government bond yields

govt bond yields

Recalling that bond prices move inversely with yields, September/October last year would have been a great time to have been selling bonds (top of the market and all that). But the Reserve Bank went right on buying more bonds (albeit at a slower pace), all of which will now be valued at less than the Bank paid for them. They were still buying (lossmaking) government bonds right through the June quarter – when core inflation was already above the target midpoint, and unemployment was back at pre-Covid levels – not finally stopping the purchases until mid-July.

Accounting for the LSAP isn’t simple. In some quarters, there is a tendency to say “well, since the bonds are (almost) all government bonds and the Bank is owned by the government it is all a wash, and nobody is any the worse off”. That is simply wrong, as I will demonstrate shortly.

But it is also wrong to simply look at the indemnity claim (blue line in the first chart above). If all the bonds were held to maturity – in some cases 19.5 years from now – the indemnity claim would come back closer towards zero (since, whatever the market value of a bond now, eventually it will pay the full face value). But it would also be quite wrong to deduce from that correct observation that if only the bonds are held long enough no one is any worse off. Bottom-drawing doesn’t address the issue. (It is worth noting that a few of the bonds the Bank purchased have already matured).

Instead, we need to think about what difference has been made to the overall Crown finances as a result of the independent choices of the Reserve Bank and its Monetary Policy Committee. Assume the rest of the government would have made exactly the same choices they did – spending, taxes, bond and Treasury bill issuance- and assess the marginal financial impact of the Bank’s choices and actions.

The government, of course, did quite a lot of spending and quite a lot of borrowing through the course of the Covid crisis. The Reserve Bank publishes tables of the monthly influences on settlement cash (deposits banks hold at the Reserve Bank). There is a weirdly long lag (for data which really should be available next day), but for illustrative purposes between March 2020 and August this year the government issued domestic debt (bonds and bills) on market, net of maturities, that raised $73.2 billion of cash. Over the same period, its cash outgoings exceeded cash revenue by $33.6 billion. In other words, the government issued a great deal more debt than the net spending it needed to fund. As a result, the balance in the government’s account at the Reserve Bank went up sharply. The balance used to be kept just modestly positive, but this is how things have unfolded since the start of last year.

CSA balance

Mostly the government issued so much debt because it expected to need the cash. Tax revenue came in a lot stronger than the fiscal forecasts had allowed, as the economy rebounded more strongly than forecast (and inflation came in stronger than forecast). But the debt issuance plans were about fiscal policy. As it happens, the Crown ended up issuing a lot of debt earlier than it needed to, at yields that were mostly attractive. The gain to the taxpayer arises from the fact that the bonds were issued last year at, say, 0.5 per cent rather than this year (or next year?) at 2 per cent.

But as far as the Reserve Bank was concerned, all that was a given.

And, incidentally, it is also why a large part of the huge increase in the size of the Reserve Bank’s balance sheet since Covid began is also a given, largely outside the Bank’s control.

When the government overfunds (raises more than its net outgoings) all else equals that reduces the balances commercial banks hold at the Reserve Bank. The net of tax payments, settlement of bond purchases, and government disbursements results in money flowing from the private sector (who bank with commercial banks) to the Crown.

But when Covid began, aggregate settlement cash balances held by commercial banks were about $7 billion, and had been so for some years. A net $40 billion drain to the Crown (see numbers above) needed to be funded somehow.

In normal times, if there were to be a persistent drain it would typically be countered by (funded by) a large buildup in the stock of short-term Reserve Bank loans to the financial system (typically fx swaps or repurchase agreements. Those loans would be rolled over quite often, until the underlying imbalance (government borrowing more than it needed to) was remedied. Doing so would have been pretty much of a wash all round: the Bank would be paying something like the OCR on the Crown Settlement Account, and earning something close to the OCR on its short-term collateralised loans. There would have been little or no market risk or credit risk (the loans would have been well-collateralised) and short-term interest rates would have been kept near the OCR. Most likely, the Bank would have made a small profit (monopoly provider of settlement cash is a position of some strength).

But nothing like this happened.

Instead, we had the LSAP. Now, to be clear, the LSAP was not launched with the intention of filling a hole in system settlement cash. No doubt at the time the Bank assumed that the government would, more or less, be borrowing as required to fund its own deficit, and that if anything, borrowing might be a bit less than the deficit at least while the programme was scaled up (recalling the global bond market illiquidity pressures in March 2020). The Bank’s primary intention – this isn’t a matter of dispute – was simply to lower market interest rates, buying bonds and driving (as they expected) a long way up aggregate system settlement cash balances. Had the government more or less funded just what it was spending over the last 18-20 months, then all else equal settlement cash balances now would be a lot higher than the $37 billion they were last Friday. Recall too that the Bank changed its policy in March 2020 such that all settlement cash balances – without limit – now earn the OCR (previously there was a quota system in which the Bank really only fully remunerated banks for the balances they “needed” to hold for interbank settlement to operate smoothly).

The intent of the policy was to take a big punt on interest rates (that is why they sought and obtained a Crown indemnity). The intent was to buy tens of billions of dollars of long-term fixed rate bonds to which the counterpart would be tens of billions of floating rate settlement account deposits. The Bank initially expected that all those deposits would be held by banks, but because the government overfunded the real counterpart is now in the much-increased balance in the Crown settlement account. But it was a large scale asset swap, which would turn very costly if bond yields went up rather than down. It represented a staggering amount of market risk, assumed by unelected (and not very accountable officials) on a scale with no precedent in New Zealand central banking history.

Views will differ on whether the LSAP made (or is still making) any material sustained difference to (mainly) long-term government bonds rates, and whether even if so that made (or is making) any material difference to New Zealand macroeconomic outcomes. I’ve been consistently somewhat ambivalent on the former, although my reading of the international experience with QE leaves me fairly sceptical. But since long-term interest rates do not matter in the transmission mechanism here in a way they do in (in particular) the United States – since very few fix mortgages for more than a couple of years, and most corporate borrowing is swapped back to floating – I’ve been consistently sceptical that the bond-buying programme (heavily focused at the long end) was making any material macro difference (the more so once the Bank decided to pay OCR on all settlement cash balances, actively preventing one possible transmission mechanism from working). Even if I did – which I do not concede at all – that usefulness ended long ago now (given what we know of the subsequent inflation outcomes and the push to raise the OCR quite aggressively now).

Whatever useful macro impact the Bank might sought last year – simply exploring the hypothetical – could as readily have been achieved by cutting the OCR further, including into modestly negative territory. And using that mechanism would not have involved big financial risks for the taxpayer

And instead now they are stuck with tens of billions of dollars of bonds, many with very long-term maturities, sitting on the Bank’s balance sheet, while the cost of funding (the counterpart liability) looks set to rise quite rapidly further.

In the end, what the MPC has done in effect is to neutralise or reverse the gains the Crown would otherwise have made through the good luck (mostly) of issuing so heavily last year when interest rates were so low, over and above what they were spending then. The Crown will borrow less in the next (more expensive) couple of years and the CSA balance wil no doubt over time be returned to more normal levels. Because more than all the excess bond issuance was, in substance, reversed through the Reserve Bank’s action, bringing tens of billions of long-term bonds back onto the wider Crown balance sheet. If they were to sell the bonds now (or in a scheduled programme over the next couple of years) the loss would be crystallised. That might be a good thing, to help sharpen debate and accountability. But whether the bonds are sold back now or held to maturity, the loss has already occurred. (This is not to say that rates might not go lower – perhaps even much lower – again in future, but that is just another bet at the expense of taxpayers, and no more likely than that bond yields rise further from here, deepening our (taxpayers’) losses.

But it as well to keep the choices by two parts of government separate, reflecting the different sets of decisionmakers. In borrowing as it did (and probably largely by luck re the revenue rebound) the government’s overfunding programme saved taxpayers a lot of money (for which there is no line item in the government accounts). By contrast, the Reserve Bank’s choices — quite conscious and deliberate ones – have cost the taxpayer a great deal of money.

The LSAP simply was not necessary, and it clearly was not well thought through. If there was an arguable case for some action in March 2020, that need quickly passed, and any bonds purchased then could relatively easily have been offloaded back to the market – probably at a profit (crisis interventions should generally be profitable) – by late last year. One might blame the Minister of Finance for providing the indemnity, but the main responsibility rests with the (supposed) technical experts at the Bank and on the MPC (albeit appointed by Robertson). It has cost us billions of dollars already – a $4bn loss is $800 per man, woman, and child, and most families could think of better things to do with such money – and the Bank now sits with a huge open market risk position, the value of which fluctuates by the day.

Having outlined my story – on which I will welcome comments – it is worth pondering why this hasn’t been an issue elsewhere or previously. A lot of bonds have been purchased by central banks in the decade after the 2008/09 crisis. Most likely there will have been two reasons. The first may be around transparency. It is great that we have the indemnity claim is reported each month.

But the much bigger factor must surely have been the continuing decline in global bond yields over the decade. This chart shows long-term bond yields for some of the more significant places where central banks reached effective lows on policy interest rates and engaged in large-scale asset purchases.

long bonds

When yields just keep trending downwards, having built up a portfolio of long-term bonds is (a) profitable, and (b) much less likely to be controversial. Who knows how much this was a subconscious backdrop to Reserve Bank (and Treasury/Minister) thinking here.

Finally, throughout this post I have treated government and Reserve Bank choices are separable and assumed both parties would have done what they did pretty much regardless of what the other did (around debt issuance and bond purchases). That seems sound for the most part, although the extent of the Crown overfunding is such that it is conceivable that without the LSAP – pouring huge amounts in settlement accounts – pressure (including from the Bank) might have mounted on the government to wind back the borrowing programme more aggressively than it did. But even if there is something to that argument, it is unlikely it would have become salient for several months – it took quite a while for the extent of the economic rebound to be fully appreciated, and by that time the bulk of the LSAP purchases had already been done.

As for where to from here, the losses from the LSAP have already occurred – the mark to market estimates largely capture that – but that is no excuse for the Bank continuing to maintain a large open position in the bond market. The bonds can’t be offloaded very quickly, but there is no reason not do so in a steady predictable preannounced way over the next year or two (say $2 billion a month). Given the extent of the CSA balance, there could even be merit in considering a partial government repurchase of the LSAP portfolio (say half of it). Doing that would not change the substance, but would put duration choices around the public debt and overall Crown liabilities back more nearly where they belong, with The Treasury and the Minister of Finance.

The Money Illusion

Or to give the book its full title, The Money Illusion: Market Monetarism, the Great Recession and the Future of Monetary Policy.

I was engrossed in the 2008/09 recession – and the associated financial crises – at the time it happened, as an official at the New Zealand Treasury, and it must have been very early in the piece that I started reading Professor Scott Sumner’s then new blog, also The Money Illusion. I’m not a regular reader now, but found much of what Sumner had to say about the conduct of monetary policy – mostly in the US – stimulating and thought-provoking, even (perhaps especially) when I didn’t end up agreeing. So I was keen buyer when his 400 page book appeared.

It is an interesting mixture of a book – partly textbook, partly personal intellectual autobiography, and partly a tract championing a different approach to policy (and history). It would be well worth reading for anyone interested in monetary policy, with a particular focus on the recession of 2008/09 and it aftermath, and possible reforms for the future. Were I an academic teaching a monetary economics class I’d encourage all my students to read it (and have commended it to my economics-student son), not as replacement for a textbook but as a practically-oriented complement to it.

I usually read books of this sort with a pen in hand. But flicking through the book again I see that the pen was hardly deployed at all in the first 60 per cent of the book, which is a really clear and useful introduction to how the monetary system works, through a slightly different lens than most will be used to. If I didn’t agree with it all – and there were a few straw men tackled – people coming to grips with the system and concepts and history will almost inevitably see things more clearly for having read it. It is an achievement in its own right.

The second part of the book is focused much more on the policies adopted, mostly by the Fed, in 2008/09, and on the way ahead (bearing in mind that the big was largely finished before Covid, although I doubt the thrust of Sumner’s arguments would have been much changed by the experience of the last 18 months). And it is there I start to differ (and thus have lots of marginal notes).

It isn’t, I think, that we differ that much on how the economy works (or even how monetary policy works). Like Sumner I’m a champion of the potency of monetary policy. It can’t make countries rich, or solve things like New Zealand’s decades-long productivity failure, but it can – and should – do all it can to keep the economy as fully-employed as (labour market regulation etc makes) possible consistent with keeping inflation in check. It really matters, given the pervasiveness of sticky wages and prices in the economy. Sumner’s previous book, on the US experience of the Great Depression, was a really nice illustration of both the potency of monetary policy, and the way that misguided regulatory interventions (in that case much of the New Deal) can mess up economic performance.

And I’d also endorse two of his specific criticisms of choices the Fed made in 2008.

The first was the failure to cut official interest rates at the FOMC meeting a couple of days after the Lehmans failure. I think everyone – including Bernanke – now recognises that it was a mistake, but it really was an almost incomprehensible one. The justification was that the FOMC saw the risks of higher inflation as balancing the risks of lower growth. Now, as I noted in my post yesterday, headline inflation in September 208 was high – oil price effects mostly – but it is still hard to see how smart people could have reached the conclusion that a cut in the Fed funds rates was more risky than sitting tight. There was, for example, nothing disconcerting about the medium-term inflation outlook revealed in the breakevens in the government bond market (and by this time the Fed had already cut the Fed funds rate by quite a lot over the previous year. This is, of course, consistent with one of Sumner’s themes: central banks really should be taking more of a lead from market-price indications (which embody more wisdom and perspectives than a few dozen economists in any central bank can, and – he hopes – with less risk of (eg) groupthink).

It was a bad call. But in isolation it can’t have mattered much. After all, the FOMC went on to cut over the next couple of months, reaching their (self-identified) floor in December 2008.

The second questionable call was the move to pay interest on excess reserves held at the Fed (“settlement cash” in New Zealand parlance). I’ve written about this move in an earlier post, reviewing a book by George Selgin. This step was taken to stop short-term interest rates falling further…..in the depths of the most serious recession in decades…..by underpinning the demand for (willingness to hold) settlement cash. Selgin argued that this move deepened and extended the US recession – an interpretation I challenged in the earlier post – but it certainly dramatically changed any relationship that had previously existed between money base measures and wider nominal variables (nominal GDP, inflation, or whatever) – one of Sumner’s points – and did nothing to assist in getting inflation and activity back on course. (Our Reserve Bank made a similar decision last March, moving to pay the OCR on all settlement cash balances and thus underpinning short-term rates, at a time when the Bank also thought it needed to do massive bond-purchasing programmes.)

And while Sumner constantly (and rightly) cautions about simplistic reasoning from price changes, one of his other points about this period – and how the Fed was too slow and unaggressive in its approach – is how surprising it was to see real interest rates trending up over much of 2008. Discount the extreme surge if you like – though Sumner will argue that changes in market prices like that (tied in with risk aversion, market illiquidity) probably in any case support monetary easing – but that real yields were higher in January 2009 than in January 2008 does not sit that comfortably with a story of an aggressively-easing Fed.

TIPS 08

(At the time New Zealand had only a single indexed bond, then with about 7 years remaining to maturity. Yields on that bond did not start falling until November 2008, even though the economy had been in recession all year.)

But there is a tension in Sumner’s book. At least early on there is a sense that he thinks the Fed could have avoided the recession together if only they’d done a better job, but the specific failings he explicitly highlights cannot credibly have been large enough in effect to have avoided the recession (and further on in the book he notes that they might only have dampened the severity of the recession, which is a much weaker – and harder to test – claim).

In many ways his starting point is that the responsibility of a central bank is (or should be) to manage nominal spending in ways that avoid big and disruptive fluctuations (which often involve recessions, and sometimes exacerbate periods of banking stress). I have no particular problem with that. I still prefer something like inflation targeting (at least in countries like New Zealand and Australia) as the operational form that responsibility takes, while Sumner now prefers nominal GDP targeting (preferably in levels form, but in growth rates still better than nothing.

His bolder claim seems to be that if there is a recession – and he makes explicit exceptions for one where, as in March 2020, governments temporarily close down economies/societies – it is the fault of the central bank. And that is a step far too far for me. He might be right that in an ideal world no one would ever unconditionally forecast a recession, since they would also forecast that the central bank would take the steps required to forestall it. And so he might be right to say that neither the housing bust nor the associated financial crisis caused the US recession – central bank failure to react in time did – but that seems to me to simply assume away the problem, in a way that there are no easy or quick substantive or technical fixes for.

Here is a chart of US nominal GDP growth (note, as we see it now, not as people first saw it at the time).

us ngdp

Sumner thinks the Fed should aim to keep nominal GDP on a path consistent with about 5 per cent annual growth. Clearly that did not happen in 2008/09. Nominal GDP fell by more than 3 per cent in the worst 12-months and (consistent with then policy) there was never a later overshoot to get back on that 5 per cent annual growth levels track.

Here is a similar chart for New Zealand (from the low inflation era)

nz nom GDP

Our nominal GDP path is a lot noisier than that of the US – commodity price fluctuations are a key reason why NGDP targets are not a good idea for New Zealand (or Australia) – but you can see how much nominal GDP growth fell away in the two recessions (1997/98 and 2008/09) – and actually in the double-dip recession in 2010 too. Broadly speaking that doesn’t count as a successful outcome – but then nor does the real GDP recession, the rise in the unemployment rate, and (the extent of) the sharp fall in the core inflation rate.

But here’s the thing though. Had Alan Bollard – then the sole decisionmaker – been presented with credible forecasts at the start of 2008 that nominal GDP growth was going to go negative over the coming year, I have little doubt that he would have been prepared to cut the OCR sharply (he wasn’t exactly an anti-inflation hardliner). But he wasn’t. Not just from the internal forecasters, but from the wider forecasting community or the financial markets. Inflation breakevens weren’t plummeting, long-term real interest rates weren’t falling, the exchange rate wasn’t falling much (as late as May 2008 it was still higher than it had been at the end of 2006). The share market was falling back but (a) the New Zealand share-market wasn’t very representative of the wider economy, and (b) few if any one in New Zealand has ever put much weight on local share prices as an indicator. The Bank did not cut early or hard enough (and I was one of Bollard’s advisers until August 2008 and although I was one of those more focused on global risks I wasn’t recommending deep early cuts)….but we did not have the information on which to do so. I would argue that no one did. In a sense, it was the point of that period…..for a very long time no one understood quite how bad some of the lending had been, or who was exposed, or what the macro consequences (absent monetary offset) would be.

From all I read or saw of the US at the time, and since, I don’t think anyone in the US did either. It wasn’t as if the Fed was totally blind: they had been taken by surprise in 2007, but actually starting cutting in September (you can see in the chart above, nominal GDP growth was beginning to slow).

Could the Fed or the RB have done better? Almost certainly (some identifiable Fed mistakes above), but it is inconceivable that they could have prevented the recession – not because the techniques weren’t there, but because the information and understanding wasn’t.

One of my criticisms of Sumner’s book is that he largely avoids this issue, and more or less assumes much more was achievable over 2008/09 (the issues re the recovery are different but note that in NZ and in the US markets were often keener on tightenings than either central bank – and Sumner urges paying more attnetion to market prices). An example of what I have in mind is his treatment of Australia.

We are told that

Among all the developed countries, Australia was the one with that sort of devil-may-care attitude, and it breezed through the Great Recession with only minor problems. And yet from a conventional point of view the Aussies did the least aggressive monetary stimulus. Unlike most other developed countries, they did not cut interest rates to zero.

He goes on to present a table showing that average nominal GDP growth in Australia for 2006 to 2013 was much the same as in the previous decade (unlike the US and the euro-area).

And yet….the RBA was still raising interest rates into 2008 (I recall a conversation at a conference in early 2008 at which a very senior RBA figure expressed astonishment at what the Fed thought it was doing keeping on cutting), the RBA ended up cutting by 425 basis points, there was a huge fiscal stimulus, and yet here is the Australian nominal GDP growth chart.

aus nom GDP

And yet look how much nominal GDP growth fell away in that downturn (a bit more than in the US). And it wasn’t as if there were no real consequences, with the unemployment rate rising 2 percentage points.

I’m not saying it was a bad performance…..it might even have been about as good as the authorities could have managed. But that is sort of the point. Limitations of knowledge, understanding etc…..not just in central banks, but much more broadly.

I could go on, exploring some of this points and Sumner’s specific policy prescriptions in more depth. But this post has probably gone on long enough already. He favours targeting a futures contract on nominal GDP, which may be a reasonable idea (at least in the US context), but it isn’t going to change the basic problem around knowledge. In countries like New Zealand (as Sumner notes) something like an aggregate wages series would probably make more macroeconomic sense (but would have its own political problems). I’m all for using monetary policy aggressively, but there are limits to what short-term stabilisation can be hoped for, no matter the indicator, the specific target, the instruments, or the individuals.

(Rather than labour points about nominal GDP targeting, I’ll link to some remarks I made on the topic at a conference a few years back.)

Good books make you think, and think harder. The disagreements are often where the most value lies in forcing one to think harder about one’s own view. This one is worth reading and reflecting on. And I’m going to finish where the book does with a quote I endorse (even if a bit more relevant in the US than here):

In other words, the goal is a world in which policy makers don’t view fiscal stimulus or the bailout of bankrupt firms as a way of “saving jobs”, but rather as a sort of crony capitalism that favors one sector over another.

But there will still be recessions, real and nominal.

Inflation and monetary policy

No posts here for a while as I’ve been bogged down in trying to make sense of some events – little more than one week in history – from 30 years ago, where the uncertainty as to what actually happened (a precondition for making sense of what the events mean) is greatly magnified by really poor documentation and recordkeeping by….the Reserve Bank.

I was planning to return with something a bit more longer-term (perhaps tomorrow) but wasn’t yesterday’s inflation number interesting? It seems to have taken almost everyone – notably the people who do detailed components forecasts, including the Reserve Bank – by surprise to some extent.

Almost all the media focus has been on the headline number – 2.2 per cent increase for the quarter, 4.9 per cent for the year – because (I guess) it makes good headlines. (Excluding the two quarters when the GST rate was increased) it was the largest quarterly increase since June 1987 – an unexpected rise of 3.3 per cent, at a time when the Bank thought inflation was falling away, and when the Bank’s chief economist, Grant Spencer, was interviewed about the number that night he declared himself “flabbergasted”. That one number helped prompt an overhaul of, and marked improvement in, the Bank’s short-term inflation forecasting (not previously much of a priority).

But in annual terms, it is only 13 years since we had an inflation rate about this high. It was 5.1 per cent in the year to September 2008, a rate that may be beaten when the next CPI number is released in January, since last December’s (relatively modest) 0.5 per cent quarterly increase will drop out of the annual rate. Note that in the September 2008 quarter, the Reserve Bank had already (and appropriately) started cutting the OCR.

But my main interest is in core inflation. There are all sorts of different measures, from simple ones (useful for cross-country analysis at least) like the CPI ex food and energy, through varying degrees of complexity (and occasionally even special pleading by the people constructing them). For New Zealand though, my favourite measure – and the one the Bank openly favoured for some years (it is less clear how the current Governor and MPC see things) – is the sectoral factor model measure of core inflation. It was developed a decade or so ago by one of the Bank’s researchers, and initially got little attention even inside the Bank (mostly because the Governor and his advisers on the then Official Cash Rate Advisory Group were not really advised of it). I’ve been something of a lay evangelist for this measure ever since I realised it existed, and had some small role in getting this explanation of the measure published. The gist of what is going on is this

The sectoral factor model estimates a measure of core inflation based on co-movements – the extent to which individual price series move together. It takes a sectoral approach , estimating core inflation based on two sets of prices: prices of
tradable items, which are those either imported or exposed to international competition, and prices of non-tradable items, which are those produced domestically and not facing competition from imports.

Using very disaggregated data, it is an attempt to get at the systematic elements in the annual inflation numbers, recognising that tradables and non-tradables can be influenced by different systematic influences (notably the exchange rate in the case of tradables).

But the best argument for the series has been its usefulness – in some sense it “works”, telling useful stories, not subject to much revision, about what is going on in ways that square with what is going on with other things (notably capacity pressures, but also expectations) that are thought likely to be important influences on the trends in inflation, abstracting from the noise.

And the “noise” can be considerable. Here is annual headline inflation and the annual sectoral factor measure for the period since 1993 (as far back as the sectoral factor measure has been taken).

core oct 21

Big deviations have not been uncommon (although less so in the last decade), and spikes in headline inflation have never (yet) foreshadowed a commensurate increase in core inflation (as,say, stickier prices caught up with more flexible prices). If you did want a prediction of where core would be 12-24 months from now, historically today’s core inflation has been a much less bad (far from perfect of course) predictor than today’s headline inflation.

And so from here on I’m focusing solely on the core inflation measure. There are a few observations worth drawing from simply this chart.

First, the range in which core inflation has moved over 28 years has been 1.1 per cent to 3.5 per cent. And although the inflation target was centred on 1 per cent until the end of 1996 and 1.5 per cent until September 2002, the low in the series wasn’t then, but in late 2014 (a time when, curiously, the then-Governor was raising the OCR).

Second, over the 28 years not much time has been spent very close to the midpoint of the respective target range. In fact, the median gap between the core inflation estimate and the target midpoint has had an absolute value of 0.7 per cent over the history of the series. As it happens, yesterday’s core inflation estimate was 2.7 per cent, 0.7 percentage points above the target midpoint.

Third, for the first 15 years of the series core inflation was almost always at or above the target midpoint, and for the decade until last year it had been consistently below.

Now it is worth pausing here to note that prior to about 2012 the Reserve Bank (a) did not have the sectoral factor measure readily available to policy advisers, and (b) was not explicitly required to focus on the target midpoint. However, neither point really diminishes the usefulness of such comparisons because (a) sectoral core inflation was simply trying to put in a single measure something the Bank had constantly thought and written about since inflation targeting began, and (b) if Alan Bollard was personally disinclined to give much weight to the target midpoint, Don Brash certainly was (and revealed evidence – see those sectoral factor numbers from 2014 – suggests that Graeme Wheeler was more focused on where he thought in principle the OCR should be heading than on the target midpoint.

There are a couple more relevant observations. First, core inflation now (2.7 per cent) is about the same as it was (2.6 per cent) in the last year or so of Don Brash’s term (2001/02), and back then the target midpoint was 1.5 per cent, not the 2 per cent the Bank is now charged with. And, second, core inflation is still well below the 3.4/3.5 per cent seen in late 2006 and throughout 2007.

But perhaps the change in the inflation rate has been unusually sharp.

I put this chart on Twitter yesterday before the Bank published the sectoral core numbers.

core change

On the series now published, the sectoral core inflation rate rose by 0.3 percentage points in the latest quarter (so large but not exceptional). However, this sort of model is prone to end-point revision issues – new data leads the model to, in effect, res-estimate which recent prices moves were systematic and which were not. The previous estimate for sectoral core inflation for the year to March 2021 was 2.2 per cent. But that has now been revised up to 2.4 per cent. I don’t have (but the Bank should really publish) a database of historical real-time estimates, but a change from a previous estimate of 2.2 per cent in the year to March to one of 2.7 per cent for the year to June is likely to have been large by any standards.

What about changes from year to year? Again, I don’t have a real-time database, but here is how the annual rate of core inflation has changed from that a year earlier.

change in core

What we’ve seen so far – on current estimates which are subject to revision – is not exceptional. The rise in the rate of core inflation over the last year has been less than we saw around the turn of the century, and the magnitude of change is less than than the fall seen over 2009. But it isn’t a small change either.

When (last quarter, per the Bank’s published estimates) annual core inflation was estimated at 2.2 per cent, I was prepared to say (and did) that that rate of core inflation was unambiguously a good thing, given the target the government had set. After a decade of core inflation below the target midpoint, it was good to finally see an outcome on the other side, which would help to underpin medium-term expectations near the goal set for the Bank. That was doubly so because 2.2 per cent inflation went hand in hand with an unemployment rate right back down to pre-Covid levels (4 per cent) and probably pretty close to the NAIRU (itself a rate the Bank can’t meaningfully do anything about). I’d not have been uncomfortable with a core inflation rate going a bit higher still – not as a desired outcome, but not something to be too bothered about for a short period (as the MPC raised the OCR, which works with a lag). 2.7 per cent is somewhat less comfortable.

But quite a lot might have depended on where the unemployment rate (or other measures of excess capacity) was going. There have been two previous troughs in the unemployment rate. The first was in the mid 1990s, when the NAIRU appeared to be around 6.2-6.5 per cent. Core inflation reached its cyclical peak then at much the same time unemployment dropped into that range, and showed no signs of going higher. The second was just prior to the 2008/09 recession, when the unemployment rate was in the 3.4-3.9 per cent range. Core inflation had risen as the unemployment rate fell, but core inflation was not going higher in 2007, nor was it forecast to into 2008. In both cases, the Reserve Bank had been raising interest rates (or allowing them to rise) and things stayed more or less contained (before core inflation fell away in the two following recessions).

One of the great unknowns now is how things might have unfolded here without the Delta outbreak and the ongoing restrictions and lockdowns. We will get the HLFS numbers for the September quarter early next month, and the unemployment rate there is unlikely to have been much affected yet by the lockdowns etc. Most likely, the unemployment rate will be lower than 4 per cent, but how much?

But the outbreaks and restrictions did happen, and so even if the unemployment rate for the September quarter was in fact 3.6 or 3.7 per cent, it probably isn’t safe to assume anything of the sort as a December quarter starting point. Yes, most likely economic activity will eventually rebound when controls are finally lifted but (a) there isn’t the fresh policy impetus there was last year, and (b) for those who believe in house prices stories, the worst of this particular house price boom has most likely passed. It isn’t implausible that the unemployment rate for December and March could be back at or above 4 per cent.

What does it all mean for policy? No doubt the MPC is feeling vindicated in having raised the OCR at the last review, even amid the-then extreme Covid uncertainty, and even though the MPC is likely to have been very much taken by surprise by yesterday’s core inflation number. Absent Covid there was a strong case for a robust tightening of monetary conditions – reversing the LSAP bond purchases, ending the funding for lending programme, and getting on with OCR increases – and that case would have been considerably strengthened by yesterday’s outcome.

Perhaps fortunately, the MPC does not need to make another OCR decision until late next month, and that review will come with a full MPS which will allow them space to provide some careful and considered analysis of their own. We might hope that by late next month, something close to normality has returned or is on the brink of returning. There are no guarantees, but if that is the situation, the MPC should be starting to sell off the bonds, and ending the FfL programme (most likely they will do neither), and should probably still be considering seriously a 50 basis points OCR increase (albeit with one eye on the emerging China slowdown). We were told they had considered the option in August. There isn’t a need for panic or headless-chookery about the Bank having lost the monetary policy plot. But a fairly robust response does seem likely to be warranted next month, especially as the MPC has (most unwisely) scheduled decision dates in a way that gives them a long summer holiday with no OCR review at all in December and January.

Finally, I have been highlighting for a long time how the market-based indications of inflation expectations (from the indexed bond market) had consistently undershot the target midpoint for some years. Yesterday’s data seems to have prompted a move to (or above, depending on maturity) 2 per cent for the first time in a long time. That isn’t concerning – rather the contrary – but it will be worth keeping an eye on how those spreads – the breakevens – develop over the period ahead.

Monetary policy, expectations etc

I’ve been reading a few books lately on aspects of monetary policy, and might come back to write about some or all of them. But there has been quite a bit of discussion recently – on economics Twitter, and blogs – about a new working paper from a senior Federal Reserve researcher, Jeremy Rudd.

Judd’s paper runs under the title “Why Do We Think That Inflation Expectations Matter for Inflation? (And Should We?)”, which seems like a worthwhile question, especially at the moment when – and especially in the US – debates rages as to how just how transitory (or otherwise) the recent surge in inflation rates will prove. It is common to hear central bankers opining about how much may turn on whether these higher headline rates get into (alter, affect) the expectations about future inflation of firms and households.

If you come at these things from a New Zealand perspective, the most remarkable thing about the paper is probably that it was published at all. How well I recall getting rapped over the knuckles, with severe expressions of disapproval from Alan Bollard, when I used a quiet New Year’s Eve in the office a decade ago to write a short discussion note, circulated in that form only among a dozen or so senior colleagues, in which I had the temerity to suggest that we might consider advancing the case for a legislated Monetary Policy Committee. Not exactly radical stuff, given that it was the way most countries did things (and NZ now does things). When somewhat later word of the paper got out – a Treasury official who had a copy mentioned it in a reference in a paper that was OIAed – the Bank insisted on fighting all the way to the Ombudsman (where the Bank won) to prevent release. Sceptical perspectives on LVR restrictions, before they were put in place, were equally unwelcome, even internally. And when I say “unwelcome”, I don’t mean anything of the sort of “interesting arguments, but I’m not persuaded because of x, y, and z”, but much more of a “back in your box” sort of thing.

And both of those examples are just about internal circulation. I’m pretty sure that no Reserve Bank analyst, economist, researcher or the like has ever published anything that made the hierarchy even slightly uncomfortable in the entire 31.5 year history of the modern (operationally autonomous) Bank. Consistent with that, of course, even though we now have a Monetary Policy Committee with non-executive members, it operates totally under the thumb of the Governor and nothing of a diversity of view is ever heard. The contrast to, say, the Bank of England, Sweden’s Riksbank, or the Federal Reserve is stark.

I don’t want to appear all starry-eyed and naive here. Every institution – every central bank – has its limits, and even the more-open places seem to be quite a bit more open than they were. But it is inconceivable that anything like Rudd’s paper could have been published by the Reserve Bank, even though in many respects it is much less radical than some commentary has tried to suggest, or than the tone Rudd affects on page 1, with his

Economics is replete with ideas that “everyone knows” to be true, but that are actually arrant nonsense.

And

One natural source of concern is if dubious but widely held ideas serve as the basis for consequential policy decisions.2

I have no idea of Mr Rudd’s politics, but like many readers I was intrigued by the footnote to that sentence

2  I leave aside the deeper concern that the primary role of mainstream economics in our society is to provide an apologetics for a criminally oppressive, unsustainable, and unjust social order.

To be honest, I used to edit Reserve Bank research and analytical papers etc for publications and – keen on openness and diversity as I am (see above) – I’d have insisted that sentence come out. Attention-grabbing but quite unrelated to the substance of the paper (or the functions of the Bank) would no doubt have been the gist of my comment.

But what of the substance of the paper? There isn’t really much there that is new. Quite a bit of it is about the limitations of how formal macroeconomic models capture, and ground, a role for inflation expectations. I don’t think any of that will have surprised most readers, or disconcerted anyone who has been associated with the actual conduct of monetary policy in recent decades. Perhaps you might be slightly disconcerted by his point that the models often seem to put more weight on short-term expectations (where surprises/shocks can generate real consequences) but that “one of the few shreds of empirical evidence that we do have suggests that it is long-run expectations that are more relevant for inflation dynamics”.

But even then I’m not sure that you should be disconcerted, in part because nowhere in the entire paper are interest rates mentioned, or financial instruments, and I (at least) have always thought of the role of inflation expectations as potentially most important in the context of a willingness to borrow (in particular) given the prevalence still of long-term nominal debt contracts (particularly so in countries such as the US where long-term fixed rate debt is a large chunk of the market). A 5 per cent mortgage rate is one thing if I’m working with an implicit, perhaps even unconscious, sense that normal inflation is 5 per cent, and quite another if I’m working with 0 per cent inflation as my norm.

There is a school of thought (class of economic rhetoriticians) who will assert, sometimes quite strongly, that in the long-run inflation expectations are the only determinant of inflation. I had a boss for some years who regularly ran that line. And, to be sure, you can set up a model in which it is true, but that model typically won’t be very enlightening at all, since “inflation expectations” (however conceived or measured, and measurement is a real challenge) don’t occur in a vacuum. If we had the data in the early 1980s, New Zealand inflation expectations might well have been about 12 per cent (say), but inflation expectations were that high because of some mix of (a) the government and the Reserve Bank not having done much to get inflation any lower, and (b) the government and the Reserve Bank not being thought likely to do much in future to get inflation much lower. Policy tended to validate the expectations, but it wasn’t the expectations that determined inflation, but the policy itself. When policy stopped validating those high expectations, they came down (albeit often quite slowly, sensibly enough (on the part of those forming the expectations).

Those misperceptions can matter. When we were trying to get inflation down (to something centred on 1 per cent) in the late 80s and early 90s, no one put much weight on the chances of success. Quite probably many of us didn’t either (I recall a conversation with the-then Westpac chief economist in which I suggested that I’d be reluctant to bet on inflation averaging below 3 per cent for the following 20-30 years). That made it harder (and costlier) to get actual inflation down, but – through some mix of good luck, bureaucratic resolution, and close-run-thing political commitment – we did. And indications of expectations about future inflation followed. A 14 per cent bank bill rate by the mid 1990s no longer meant what it had in 1988, when the inflation targeting scheme was first hatched.

On the other hand, it seems likely (but I’m more open on this) that during the period over the last decade when core inflation was persistently low – repeatedly surprising the Reserve Bank, among others – the fact that indicators of inflation expectations mostly tended to hold up nearer the target midpoint may have helped, a little, avoid more of a fall in inflation itself (although even this is arguable since had inflation expectations fallen away more sharply and obviously, the Reserve Bank might well have used policy more aggressively than it did, including getting unemployment down earlier/further).

One of the other limitations of Rudd’s paper is that there is barely any mention of any country’s experience other than that of the United States. Of course, he is American, writing in an American institution for a primary audience that is America, but…..data. In truth, there just is not that much data in any individual country (because no matter how many series and how high-frequency the data, there are only so many genuine cyclical episodes to study). In almost no other country in the world is it conceivable that someone would write such a paper without looking beyond their own borders, and own central bank. Even for the US, it should be more important, since the Fed focused on an index which doesn’t have a great deal of general public visibility, whereas many other inflation targeters will at least start from the CPI.

For me – as someone with (mostly) a policy focus – the most significant part of Rudd’s paper was the last few pages on “Possible practical implications” and “Possible policy implications”. I had a tick beside this paragraph

Another practical implication is rhetorical. By telling policymakers that expected inflation is the ultimate determinant of inflation’s long-run trend, central-bank economists implicitly provide too much assurance that this claim is settled fact. Advice along these lines also naturally biases policymakers toward being overly concerned with expectations management, or toward concluding that survey- or market-based measures of expected inflation provide useful and reliable policy guideposts. And in some cases, the illusion of control is arguably more likely to cause problems than an actual lack of control.

But for all the glib rhetoric that sometimes comes from senior central bankers, I wonder how many – if any – practical central bankers operate as if they really believe that everything (about future inflation) rests on inflation expectations. I’ve had many criticisms of the Reserve Bank of New Zealand over the years, but not even Don Brash acted and operated policy as if that was his view, and certainly none of his successors have.

Perhaps more interesting was this

Related to this last point, an important policy implication would be that it is far more useful to
ensure that inflation remains off of people’s radar screens than it would be to attempt to “re-anchor” expected inflation at some level that policymakers viewed as being more consistent with
their stated inflation goal. In particular, a policy of engineering a rate of price inflation that is
high relative to recent experience in order to effect an increase in trend inflation would seem to
run the risk of being both dangerous and counterproductive inasmuch as it might increase the
probability that people would start to pay more attention to inflation and—if successful—would
lead to a period where trend inflation once again began to respond to changes in economic
conditions.

It harks back a bit to the definition of price stability Alan Greenspan once used to give, that it is when inflation isn’t a consideration for people (firms and households) in the ordinary course of their lives, but also seems to be a bit of dig at the current FOMC policy of aiming to run core inflation above target for a time. I’m probably more sympathetic to that approach than Rudd – including for New Zealand after a decade of undershooting the target – but his comment is a perspective that should be taken seriously.

HIs final main point is this

A related issue is more pragmatic. In some ways, the situation that arises from a focus on
long-term inflation expectations is similar to one in which a policymaker seeks to target a single
indicator of full employment—for instance, the natural rate of unemployment. Like the natural
rate, the long-run expectations that are relevant for wage and price determination cannot be directly measured, but instead need to be inferred from empirical models. Hence, using inflation
expectations as a policy instrument or intermediate target has the result of adding a new unobservable to the mix. And, as Orphanides (2004) has persuasively argued, policies that rely too
heavily on unobservables can often end in tears.

People (including central bankers) fool themselves if they think that survey responses, or implied breakevens from inflation-indexed bond markets, “are” inflation expectations (for the economy as a whole) themselves. They are what they are, and always have to be taken with at least some pinches of salt. In New Zealand, for example, household surveys regularly produce numbers suggesting households expect to average between 3 and 5 per cent over periods 1 to 5 years ahead, but no one has ever taken those absolute numbers seriously (there is little or nothing else anywhere in the economy suggesting that whatever people tell surveytakers they act as if they think inflation will be this high). At best, they are indicators, straws in the wind, and sometimes what look like good relationships then no longer do.

As an example of the latter, the Reserve Bank economics department at times articulated a line that the two-year ahead measure of inflation expectations in the Bank’s survey of informed observers) almost was a measure of core inflation itself.

expecs and core inflation

It held up quite well over the best part of 15 years, until it didn’t. It left the Bank too complacent through the following decade (but the error could equally have run the other way).

I guess my bottom line is that one should rarely put too much weight on any specific indicator, and perhaps especially ones that are hard to observe (or to know what one observes actually means). If we see medium-term inflation expectations – among informed observers – at 5 per cent, we (and central bankers) should be disconcerted, but it is highly unlikely that such an inflation expectations number will have been the first sign of trouble.

Changing tack, what of current monetary policy in New Zealand? There is an OCR review tomorrow. Expectations measures here don’t appear troublesome at all – even the inflation breakevens are getting nearer the target midpoint than we’ve known for some years. But core inflation has been rising, unemployment had fallen quite low, and a lot of indicators pointed to emerging capacity pressures. All that was, of course, before the latest Covid outbreak.

I still think there is a very good case for things the Reserve Bank MPC will not do tomorrow: discontinue the Funding for Lending programme, and start a well-signalled programme of bond sales to reverse the LSAP programme. But what of the OCR itself? I won’t be particularly critical of the MPC if they do raise the OCR by 25 basis points tomorrow, but I think if I was in their shoes I wouldn’t. There is a full forecast round and full MPS at the next review and a lot of uncertainty about the Covid outbreak and is its implications (as well as some emerging downside global risks, notably from China). Yes, monetary policy works with a lag, but the starting point for (core) inflation is not so high that we need to be in a hurry to raise the OCR in such an uncertain and unsettled climate. We will know a great deal more – including about vaccinations, and hopefully about exit pathways – on 24 November than we do now. If all is going really well by then, or if core inflation in the CPI later this month is really troubling, there need be no problem with going 50 basis points then, if the data support such a call. But I wouldn’t be rushing right now.

Vaccinations by age

Still on health matters, I’ve been intrigued for a while at what was happening to vaccination rates stratified by age. For all that politicians and the media burble on, emote even, about differences by ethnicity, the data on Covid itself seem crystal clear: by far the biggest demographic risk factor for getting seriously ill or dying of Covid (and thus of resulting in pressure on the health system) is age. The Hendy et al modelling used this data (from this 2020 paper).

age factor covid death

I’ve seen people suggest these absolute numbers may be out of date, and epidemiologists can argue about that, but my point simply is that no one seems to dispute the significance of age. It isn’t just a linearly increasing risk: the risks for (say) the over-80s are far far higher than those for even people in their 50s.

The government of course recognised this initially in allowing old people to get vaccinated before (progressively) most of the rest of us. If you are my age, it is only about six weeks since one could get a first dose, and so many (like me) will be getting second doses only in the next few weeks. But the very elderly have had a lot of time to have had both doses of the vaccine. And, so you would think, people in that age range would generally have a strong personal incentive to get vaccinated – and their children to encourage them to do so. Public spirit might be necessary to help encourage the young, but for the very old death from Covid is a non-trivial risk (and thus the strict rules one hears rest homes have in place). The rest of us have a strong interest in these old people getting vaccinated because pressure on the health system is one of the key perceived constraints on opening up.

And so I’ve been a bit surprised that the vaccination rates among the elderly have not been higher. The Ministry has come and gone a bit on how much information it makes available, but for now it seems to have settled on promoting this chart.

moh vaccine by age

None of the elderly age bands have yet got to a 90 per cent second dose vaccination rate, and only one (the 80-84 group) has got to 95 per cent for even a first dose. And these people have had months.

But the real situation seems to be even less good than the Ministry of Health portrays it. The denominator they use in all their charts and tables is not the population in that age group as estimated by our official statistics agency, SNZ, but something called the “Health Service User population” (HSU), which is defined thus

The Health Service User population estimate counts the number of people who received health services in a given year. Someone is counted in the population if their associated National Health Index (NHI) number received public health services; or was enrolled with a primary health organisation (PHO). 

I suppose they must have their reasons, but using this HSU measure seems to assume away part of the problem – people unknown to the health system seem, all else equal, less likely to be turning up (to the health system) for a vaccine. Of course, it is a hard count (administrative data) and the SNZ population numbers are only (informed) estimates. But some people just don’t go to the doctor very often (I know in my 20s I prided myself on not having been for a decade).

Anyway, here is the difference it makes

hsu popn

There are some anomalies. I’m not sure how there can be so many more 90+ health service users than SNZ think there are in the country (and they keep track of deaths, and there can’t be that much migration among the over 90s), and the 80-84 band is a bit of a surprise too, but the key point is that both for older ages (65+) and the the 12+ population as a whole, the HSU appears to undercount the population by 3.5 per cent. All else equal then, vaccination rates are a bit overstated.

Here is how the two measures look for first doses for the older age groups

vaccination rates hsu vs snz

Using the SNZ population numbers, not quite 90 per cent of the elderly have yet had a first dose. And yet we hear almost nothing about this from our government, our health bureaucrats (who seem to champion the messaging of politicians) or even – so far as I could see – in the perspectives provided by the opposition political parties.

Here is the same chart for second doses.

2nd dose vacc rates by age

Not much more than 80 per cent of even the 75+ population have had two doses, many months into the programme. And this is the demographic most exposed to serious illness death, and the demographic that thus poses the greatest threat to the health system if/when Covid gets more established here.

Using the SNZ population estimates here are the vaccination rates for each age-band.

vacc rates by SNZ age

Can better be managed? Well, it would appear so from the experiences of other countries. At an aggregate level, for example, Portugal has about 85 per cent of the population with two doses (about 95 per cent of the 12+ population). I’ve been keeping an eye for some time on NHS data for England (and remember that a lot of people in England have already had the virus itself), and they appear to be showing close on 100 per cent of those 70-74 having had two doses (albeit rates tail off somewhat above that age band).

But when it comes to Covid, Australia still appears to be the country most similar to us, including in that they were slow to get their vaccination programme going. This is the latest set of charts

aus vacc rates

Of course, Australian states and territories have a quite diverse range of experiences with Covid (ACT, NSW, and Victoria with ongoing outbreaks) but their record in getting the elderly vaccinated seems to be consistently (NT aside perhaps) better than New Zealand’s, with particularly impressive numbers in ACT (where all but one age-band over 40 have 95 per cent first dose rates, and most second doses done).

Perhaps there are denominator issues in those other countries too, but even if so the bottom line remains one in which the New Zealand elderly vaccination rates are just not that good, given the risks (to their own health, and – indirectly – to the wider freedoms and opportunity of the community more generally).

And there is no sign our politicians are taking this very seriously.

On a final note re age, the Hendy et al modelling released last week (and touted by the government) assumes the same vaccination rate for all eligible age bands. That seems somewhat unrealistic, even if at some point in the middle distance all age bands were to eventually converge to very similar vaccination rates. It seems unfortunate that model estimates using a range of different assumptions about the age pattern of vaccination rates have not been published. Superficially, it would seem that very high vaccination rates among the very old might be more valuable – in reducing death and serious illness, and facilitating opening up – than very high rates among some of the younger cohorts. In a brief exchange on Twitter last week with one of Hendy’s co-authors, he indicated that (a) they had done some such modelling, and (b) that sometimes one could get counter-intuitive results. Which is fine, but it would be helpful for the public to be able to see this sort of material, especially when the government itself if touting the modelling of these particular researchers. In its absence, it looks as though the government should be putting a lot more emphasis on getting elderly vaccination rates well up than is evident at present.