Careful where we lay the blame

Brian Fallow writing in his normal clear and intelligent manner has come out discussing the government budget.  As he says, a slump is not the time for “austerity” in terms of cutting back the size of government, and we should allow temporary deficits to help ease the blow – the point of automatic stabilisers is that they help out those that are struggling the most during a protracted slowdown.  Furthermore, I agree that the low level of long-term government bond rates does imply that government should be shifting investment forward now – something they seemed willing to do in 2009 but have moved away from since.

But, I have to slightly take issue with this:

Especially so since the Reserve Bank yesterday voiced concern at signs that the improvement in household saving rates may be stalling and that household debt is rising from a level already high relative to incomes.

The Government also argues that by running a tight fiscal policy it allows the bank to keep monetary policy looser than it otherwise could – lowering pressure on interest rates and the dollar.

However, as the bank reminded us yesterday, that silver lining comes with an increasingly ominous cloud in the form of rampant house price inflation, most notably in Auckland.

With the dollar as high as it is, the bank is reluctant to raise interest rates.

With the supply side of the housing market, especially in Auckland, unlikely to relieve the pressure on prices for years, and with gruesome examples in the Northern Hemisphere of what happens to an economy when a housing bubble bursts, at some point the bank is going to have to crush the demand side by raising interest rates.

If that coincides with fiscal contraction from a debt-obsessed Government, the effects could be unpleasant.

I don’t like where this logic is starting to go.  The RBNZ is responsible for “aggregate demand” in the economy.  If this is too low, then the RBNZ has set monetary conditions too tight, it is their fault.  Sure they may say it is not, some may say I am being unfair saying this … but if there is anything history has shown us, whenever we try to say “this time is different” with regards to a demand shortfall we usually end up coming back to blaming the central bank.

Relatively high debt levels and high house prices are not a monetary policy or demand issue.  They are an issue of financial stability, an issue of economic structure.  Yes, they create risks and can have negative welfare consequences.  Yes, competition, fiscal, and financial stability policy needs to account for them.  But monetary policy needs to take fiscal, competition, and financial stability policy AS GIVEN and then focus on “demand” from there.

Not dealing with demand because of concerns about these issues isn’t prudent, it is policy failure.  Blatant policy failure.  If you don’t believe me, ask someone who is both smarter and more articulate than me such as Nick Rowe.

Now, if the government remains on course and the RBNZ tightens monetary conditions to “fight the housing market” while it expects inflation to be low and unemployment high, they are explicitly violating their mandate and best practice of a central bank.  It is as simple as that.  I’m happy saying this out loud because they would not do that, they know these things, and will continue attempting to set monetary policy at the right level to deal with demand issues (as represented by their forecasts for inflation and unemployment over the next two years).  But given that the RBNZ does this appropriately, the government deficit does not matter outside of its impact on the composition of the economy.

If we want to criticise government policy during the recession, do it in terms of investment (it would have been a good time to move a bit more investment forward), and social policy related things.

Note:  If we believe that the response to interest rate changes will be very small, that in some sense investment demand is very “inelastic” then we can make a claim for government investment – we just need to be very clear on that AND we need to ask why in that case we still have a positive cash rate.  Remember, government investment here also works by driving up the “natural” interest rate … so through the same logic it will lead to a higher real exchange rate and higher government borrowing … unless the “cumulative impact” of rising demand pushing activity towards potential outweighs that.  And if we are using that “cumulative impact” argument for government spending then it also holds for a cut in domestic interest rates, just with a lower real exchange rate and compositionally more private sector activity.  So protip:  we can’t complain the exchange rate is too high and that government spending is too low at the same time!

Update:  Also after today’s unemployment and employment numbers I think people should be willing to rethink whether they think there is a “demand” issue in NZ going forward … 😉

  • Luc Hansen

    In response to your final sentence, Matt:

    (From the Statistics NZ press release)

    ” Excluding Canterbury from the national estimates shows a much weaker labour market, with both the employment rate and labour force participation rate falling over the year.”

    We are going to be in for a scary ride if the “Canterbury Effect” is ignored when setting policy for the vast majority of us who live outside that region.

    • Monetary policy is set over the economy as a whole, not for specific regions. I think saying that the rest of the country will recover more slowly due to the fact that Canterbury is sucking in capital and labour is true – but saying it is a “scary ride” is an exageration.

      Of course I think the RBNZ should look past “relative price shifts” due to Canterbury, but ignoring its impact on capacity entirely would be folly. In fact, I would venture the opinion that we are saying the same thing from different directions 😉

      • Luc Hansen

        Indeed. Let’s hope the RB steers a path safely positioned at a neutral point that lies somewhere between ‘scary’ and ‘folly’, and we do not go anywhere near ‘gruesome’!

  • Blair

    Great post Matt. I hope it gets picked up by the MSM.

    It would be possible to go even further though, and construct an argument that tight fiscal policy is actually optimal for NZ in May 2013. Hypothetically, for example, what would happen if the government targeted a fiscal position that was consistent with the RBNZ lowering its overnight rate to 0.5%, to maintain aggregate demand? The heat would come out of the NZD, creating an immediate boost to demand through exports, domestic holidays, import-competing manufactures and services etc. Resources would be freed up by government to flow to these sectors, Christchurch etc. Asset prices would rise, boosting household and corporate balance sheets and creating a good environment for investment. There would be even stronger pressure to do something about the supply of housing in Auckland, although a runaway bubble in house prices wouldn’t develop as the RBNZ wouldn’t allow it. Government debt would reduce quickly. The effect on private debt would be ambiguous, as both savings and investment would increase. However, in my view, it would decrease as a percentage of GDP.

    What’s not to like? Well, it’s probably not healthy for interest rates to be below trend NGDP growth for extended periods. But I think you could run this strategy for a few years quite comfortably. (BTW I consider myself a Keynesian, but when you are in a world of inflation targeting and your interest rates are 3% higher than most of your lower-rated trading partners you need to think outside the box).

    • I agree with you in a descriptive sense – however, I think the waters get a bit muddier if we expand things out a bit.

      Moving away to the medium term, and to the short term, we need to think about how responsive the interest rate “needs to be” to deal with a fundamental shift of government spending in this way. If the central bank lacks the appropriate ability, or knowledge of tools, to do this in the short term (they would likely be the first ones to say this) trying to keep a budget close to balance at all times is a dangerous path.

      Furthermore, there are distributional issues which you touch on when you look at the housing market. The RBNZ would let a bubble develop in the housing market, even if they actively didn’t want to, because they (in fact no-one) don’t have the precision or foresight to deal with that. Now if we “replaced” short-term monetary stimulus with a short-term budget deficit the liability would fall on the government side rather than with the private sector – and the type of investment and spending made would differ.

      And finally, the way we “deal with spending” helps to determine the response of the “real exchange rate and competitiveness”. Lower government consumption and transfers will lower the real exchange rate. Lower government investment has an ambiguous impact – and as a result, we need to be careful.

      Overall, the principle that we run a “cyclically adjusted balance budget” which goes into deficit when unemployment is elevated etc works pretty well for us while we have a positive cash rate.

      With regards to the cash rate, it probably didn’t need to be as much higher as it was through 2012, but that is behind us now. An important point to remember is that we are about to have an “investment boom” – if it wasn’t for the rebuild, the RBNZ would have cut rates a fair amount from here. It is upcoming investment holding up interest rates relative to other nations at the current point in time.