Time for drastic measures

BY ROD ORAM

OPINION: The challenge for individuals is the same as the nation's. We need to borrow and spend less, invest and earn more.

While each of us feels irrelevant to the national economy, together we powerfully influence its course. In essence we've written three chapters of New Zealand's economic history over the past third of a century.

The first, from the early-1970s to the mid-1980s, was a story of misguided ambition. We worked hard at what we'd always done commodity exports. We hoped to regain the wealth we'd enjoyed in the 1950s and 1960s.

But when the world changed dramatically in the mid-1970s, we failed to adapt. We were too slow to find new markets when we lost our preferential access to the United Kingdom. We were too quick to invest in alternative energy when two temporary oil crises struck. The private sector earned too little and government borrowed too much. The economy hit the wall.

The second chapter, from the mid-1980s to the late-1990s, was a story of painful, protracted reform. Much good came out of it, economically and socially. We made ourselves much more efficient, enough to give the old, low-value commodity model another decade of earning power.

But we didn't fundamentally change the way we earned our living in the world. We remained dependent on commodities, and not just in agriculture. We've consistently under-sold ourselves in tourism, education and the other ways we earn a living from foreign consumers.

In this chapter, the private sector still earned too little, but the government was drastically under-investing in science, education and infrastructure. It was myopically focused on bringing its debt back to sensible levels. It tried to save rather than invest its way out of trouble.

The third chapter, from the late-1990s to last year, has been a story of excessive consumption. When all our hard work on economic reforms failed to deliver us higher incomes, we decided we deserved a reward anyway. We significantly increased our consumption, paying for it by dramatically increasing our debt.

Our households became the biggest dis-savers in the developed work, the polite term for accumulating debt rather than assets. Only a handful of nations are so profligate. The rest are savers. In 1990, our average household debt as a percentage of disposable income was less than 60 percent. We peaked last year at over 160 percent, second only to Iceland.

While households were piling on debt, businesses were enjoying brisk economic growth. Glossing over the very brief, shallow recession during the Asia Crisis, we enjoyed the longest period of continuous economic growth in 60 years.

But businesses and government failed to understand this was a sugar high, a debt-fuelled spending boom. They, like households, were living for the present, rather than investing enough in the economic future.

It was so easy to enjoy the ride, here and around the world. Thanks to unprecedented and often reckless innovation in the financial sector, the world surfed a tsunami of credit. Central banks and commercial banks made it exceptionally easy to borrow at unhealthily low interest rates on scandalously lax lending criteria.

In the UK, for example, credit as a percentage of economic activity rose from 125 percent in 2000 to over 200 percent last year. With seemingly limitless money chasing finite goods, prices of houses, shares, commodities and other assets soared.

Here in New Zealand, we plunged in boots and all. Our banks scooped up cheap money overseas, and showered it on us. They made a mockery of monetary policy. The Reserve Bank kept raising the OCR to try to cool down the economy. But the banks' funding costs were largely set instead by the cheap money they accessed abroad. In mid-2007 the OCR matched the effective mortgage rate, yet the banks were still piling on profitable mortgage business, keeping the housing boom going.

And the excesses ran far deeper than housing, particularly into finance companies and dairy farming. In fact, homeowners and dairy farmers have much in common. They borrow heavily to buy assets they believe will appreciate in value. They expect to profit from these capital gains rather than from income.

It worked while house and milk prices were spiking at unprecedented and unsustainable highs. But now that they have both collapsed back to long-term trend levels, the over-indebted investors in both sectors are in deep trouble.

Perhaps some 20 percent of home and farm owners have uncomfortable levels of debt. They can take the pain as long as their income holds up. But for dairy farmers, it isn't. Global dairy prices are forecast to bump along at current levels for at least a couple of years. Consumer demand overseas is so subdued because households, confronted by the global recession, are conserving cash, paying down debt. As a result, dairy land prices are falling fast here.

We don't know how much wealth is being destroyed in New Zealand because we don't know how deep and long the recession will be, or how weak the recovery will be. But so far investors have lost some $6 billion of real money in finance companies plus billions more from house and farm sales. These unrealised losses will run into scores of billions of dollars, creating a drag on enterprise and investment for years to come.

In these and many other ways, we've long lived far beyond our means. As a nation, our net international liabilities are now 100 percent of GDP. Only Hungary and Iceland among developed countries are deeper in hock.

In 2007 the cracks began to appear in the massively over-indebted economy here and around the world. By late 2007, the rot had spread to the entire finance sector in the US and Europe, and by March of last year it was a full-blown global crisis. Between July and October the global financial system repeatedly came close to complete collapse.

But, against the odds, thanks to desperate measures by central banks and governments, a very rudimentary stability has begun to appear. So many people believe, here and abroad, we're back to a "normal" recession and that recovery is coming soon. That's a very big mistake to make for two reasons. First, the world's recovery from the surge and subsequent collapse of debt will take years. Second, as a result, the global economy is changing massively, as this column described in a three-part series in February.

Every individual, community, company and economy will have to find a way through. But there is one overwhelming message for deficit households and deficit economies like ours: we have to borrow and spend less, invest and earn more.

Over the past year, the first part has started to happen. Consumption's share of economic activity has fallen and the dis-savings rate is easing, although on current trends it could be 2011 before our households are net savers again.

Reserve Bank governor Alan Bollard worries, though, that the message has not fully sunk in. Housing and consumption are showing signs of reviving too quickly. If so, they will drive up interest rates and the dollar, thereby killing the recovery.

In other words, we'll be back to our old consumption habits before we've worked out how to invest in radical new ways to earn a bigger living in the world economy, how to make the most of these seismic shifts.

There's no debate about these issues in New Zealand. The most we ever argue about is incremental efficiency gains in the old economic model.

If we don't seek radical ways to engage with the world's new economy, the recovery will leave us poorer than ever.

- © Fairfax NZ News