Labour breaks shackles

Photo: Dominion Post

Reserve Bank monetary policy has come at a cost.

Relevant offers

OPINION: LABOUR'S BREAKING of the 20-year consensus on monetary policy is a great relief. It allows us to consider how we might respond to radical changes in the global economy, a debate resisted by complacent leaders dominating business and politics.

While the current monetary policy framework enshrined in the Reserve Bank Act has served us very well in taming inflation, it has come at a cost. It didn't tame the housing market bubble and, in attempting to do so, it raised interest rates and the dollar to high levels that seriously hurt the productive economy.

But there are no new tools that could do a better job, argue the National-led government and other defenders of the monetary policy status quo. In doing so, they ignore how fundamentally the New Zealand and world economies have changed in the past 20 years, how profound the current global crisis is, and how urgent and vigorous is the international debate about new policies and tools.

When the Reserve Bank Act was passed in 1989 it led the world in creating an independent central bank with inflation targeting as its prime policy objective and tools to do the job.

Back then, the domestic economy was far simpler and slower. For example, that year we began Sunday shopping and gained a third television station. Today, instant consumption and ubiquitous entertainment have burgeoned, fuelled in part by debt raised overseas.

And, back then, the local economy still had some protection from global forces. In 1989, we ran our first balance of payments surplus since 1973. But we've since plunged into deeply structural trade and investment deficits, likewise reliant on overseas borrowing to finance the shortfall.

This growing addiction to overseas capital is reflected in forex volumes. As recently as July 2004, NZ dollar trading here varied widely between $1.2 billion and $7b a day. Today it is regularly in the $10b-$15b a day range. More startling is the global trade in our currency, up from a daily average of only $6.7b in December 2001 to $58.7b in December 2007.

But we knew all that when parliament last reviewed monetary policy in 2007-08, the complacent declare. Indeed, the finance and expenditure select committee did spend 15 months hearing evidence and writing its report. It concluded the status quo was working as well it can.

This judgement was notable for four reasons:

The report was published September 18, 2008, four days after Lehman Brothers' collapsed at the height of the global financial crisis. But the report didn't mention, let alone analyse, the turmoil.

It offered no new insight into monetary policy. Instead, it restated the obvious that monetary policy only works if it is fully supported by good fiscal policy and an efficient and productive economy; and that proposed new tools such as mortgage interest levies were so minor they were irrelevant.

It noted, however, that financial supervision was pro-cyclical. When the economy boomed, risk was deemed to diminish so it was easier for institutions to raise money to lend on easy terms, thereby further fuelling the boom. The majority of the committee recommended that the Reserve Bank should make regulation counter-cyclical so it could "lean against" the likes of asset bubbles.

The National Party members on the committee, led by Bill English, rejected this. They argued that the Reserve Bank should not use such powers to help it achieve price stability, the key goal of monetary policy. Doing so would set New Zealand apart and create cost and confusion in the financial system.

How wrong National was. It was obvious even last year that the pro-cyclicality of credit and the lax regulation driving it was seriously undermining monetary policy around the world. And the cost of the clean up is horrendous. Central bank support of financial systems and government stimulus of economies equals some 30% of global GDP, the IMF said in its latest global financial stability report. And no sooner did the world economy stabilise in mid-year, asset prices began to soar again. Shares, houses, oil, gold, other commodities and other speculative vehicles are racing ahead again in many countries. The S&P500 US sharemarket index is up more than 50% since March and the MCSI index of emerging-economy shares is up 120%. And our house prices are back near record levels, albeit on low volumes.

The flood of money is a particular problem for many economies and their currencies. To try to stem it, Brazil has imposed a 2% tax on foreign portfolio investment to ease the rise in the real. Taiwan has banned foreigners from investing in local fixed-income funds.

Central banks and regulators are worried monetary policy will once again be blunted if these massive, hot flows persist, thereby re-inflating asset prices with a speed and international inter-connection that was unheard of 20 years ago.

So, there's lots of debate in international forums such as the G20, the Financial Stability Board and accounting bodies on new ways to tame these fierce forces. Many of the ideas and most of the little action to date has focused on better controlling the liquidity of financial institutions. The aim is to prevent them flooding the economy with funding in good times, and starving it in bad.

Much of this falls under the heading of macro-financial regulation. Purists argue this isn't monetary policy. But it is an increasingly important grey area between banking supervision and monetary policy that will help strengthen the latter.

Our Reserve Bank was the first in the world to develop one of the new tools. It has added to its core funding ratios for banks a new "sticky funding" requirement. From next April, 60% of their core funding (rising to 75% over two years) will have to come from retail deposits, or from wholesale market instruments with maturities longer than a year. This will make the banks less vulnerable to the drying up of international markets they experienced last year.

The Reserve Bank and its colleagues around the world are also working on other measures to regulate financial institutions through the entire economic cycle, not just the boom times. Hopefully, these will help deal with the dramatic and probably permanent increase in volatility and inter-dependence of markets.

But they will only be very small steps towards the nirvana our productive sector craves: low interest rates, a comfortable currency and stability in both. The Reserve Bank couldn't deliver them even if it were loaded up with multiple goals such as growth, jobs and exchange rate stability, in addition to its core one of price stability, and it had all sorts of tools yet-to-be-invented. Quite simply, it can't fly in the face of our economic reality of being a deep deficit country.

We will achieve a somewhat more stable currency only when our interest rates are down near international norms. We'll do that only when we stop needing to import so much capital. We'll do that only when we save more. We'll do that only when we earn more through exports. We'll do that only when many more companies learn how to export high value, sophisticated goods that are immune to commodity cycles.

These achievements will require massive changes to business models, science and innovation, the tax regime, government finances, delivery of public services and a myriad other government and business drivers.

It remains to be seen whether the government's work in many of these areas will be as game-changing as it promises. But it is hobbling itself by parking monetary policy. It is cutting itself off from the global debate about how to better run the world economy.

- © Fairfax NZ News