A technical recession in New Zealand: What’s the big deal?

Since the March quarter retail numbers have been released it has been apparent that New Zealand was heading down the road of a technical recession (two quarters of negative economic growth – seasonally adjusted). This has led the countries finance minister to once again admit that a technical recession is likely – (something he admittedly said earlier in the year, much to my irritation at the time 😉 ).

By Tom Scott 20/06/08 (link)

The fact that we are so close to a recession that it has gotten the attention of foreign economists – in a sense we could be viewed as world leaders, in so far as we are the first developed country heading towards a technical recession 😉

For some reason or another the idea of a recession scares us. For example Queen Bee at the Hive is stating that it is imperative that the Bank now cuts interest rates. However, in order to understand whether cutting rates is appropriate, we have to ask ourselves – why are we suffering from a recession.

On the demand side of the economy there are the factors that lowering interest rates will help with, namely:

  1. The negative wealth effect from falling house and equity values,
  2. The higher realised interest rates stemming from credit crisis.
  3. Plummeting consumer confidence.

However, on the productive side of the economy there are also shocks that require less urgent action from the Bank – namely, if agents in the economy are able to adjust themselves for these negative productive shocks then we shouldn’t do anything about it:

  1. Drought,
  2. An increase in the relative price of petrol (a negative terms of trade shock).

The way we can think about these different shocks is as follows: In the short-term, there is some level of output the economy can create without leading to undue pressure on prices (upwards or downwards) – this is the rate of output we would want the economy to sit at.

Now, when these demand shocks occur, they lower the realised level of output – so the Bank can cut interest rates and help the economy reach this ideal level. However, the supply shocks lower the ideal level itself, implying that if the Bank tries to “re-inflate” the economy it will ultimately just cause inflation.

As a result, if we believe that the fall off in activity is mainly the result of consumers becoming “scared” there is scope for the Bank to cut rates and save the day. However, if the main driver of the recession is actually a fall in productive capacity stemming from the drought and higher world price of oil then the Bank is not in a position to do much.

Many people find this production based view of matters irritating, as it implies that we are stuck, and people don’t like that. However, if we think of it on the personal level, a production side shock is equivalent to getting your pay cut at work – if you are now stuck on this lower level of pay you have to just accept it and move on, fiddling with other parts of your budget won’t change the fact that you now have a lower income!

I’m currently viewing things from the production side – and as a result I find myself more concerned about the outlook for underlying inflation than I do about the near term outlook for growth.

This view primarily stems from a look at the labour market – as long as unemployment remains low and wage growth remains high I can’t see a recession occurring where government intervention would actually help the problem. The government (and the Bank) is not as all powerful as politicians would have us believe – which is why they can do less about dips in economic activity (and deserve less credit for increases) then most people actually expect.