As the New Zealand economy delves deeperinto recession, there appears to be a growing disquiet that the government hasyet to produce a comprehensive fiscal solution. National’s laissez faireapproach is in stark contrast to the aggressive monetary and fiscal stimulusbeing embraced in the US; a stimulus that is ratcheted higher on an almostweekly basis.
But this is an invalid comparison. New Zealand’s economic situation is less serious by an order of magnitude, and current stimulusmeasures are substantial. Further fiscal stimulus at this stage would bring noclear benefits and court significant financial risk.
In the last three months, the US FederalReserve has cut short-term interest rates to zero, and initiated quantitativeeasing (printing money) designed to lower other market interest rates. Meanwhile,the Obama administration has passed a sizable spending package (resulting in abudget deficit of 12% of GDP).
The New Zealand Reserve Bank has also cutinterest rates, but in contrast, has indicated that an OCR of around 2.5% willbe low enough. The National government has seemed content with the quantum ofspending laid out by its predecessor (fiddled to reflect policy preferences).
However, context is everything. New Zealand’s recession is without question painful, but it pales before the US example. Using an output gap measure (how much actual production and income is belowpotential), the US is experiencing an 8% shortfall which is expected to besustained for a lengthy period. The Reserve Bank of New Zealand expects to seean output gap of -3.7% over 2010, reducing to -1.3% in 2011.
Expressed in more familiar terms, while New Zealand unemployment will rise to 7%, US unemployment will peak at 10%.
Unemployment and the reduction in realincomes are both painful and unnecessary (in the sense that with perfectforesight, such cycles could be avoided). But the greater concern is that withsuch a dramatic amount of spare resources in the economy, prices will start tofall, and that before long deflation will become entrenched. The output gap isnormally a good predictor of prices. The last time the US had an output gap of this size, inflation was rapidly reduced from 13% to 3%pa. But this timethe US starts with inflation of only 3%pa.
Falling prices may not immediately seem tobe a cause for concern, but the historical experience of the great depression,or Japan’s lost decade of growth, both suggest that deflation is a severethreat to the prospects for a normal economic recovery.
Deflation creates three main problems. Firstly, deflation tends to raise real wages, pricing workers out of jobs. Secondly, nominal debts (like mortgages) become more burdensome. Finally, and mostsignificantly, traditional monetary policy loses effectiveness, becausedeflation pushes up real interest rates even if nominal interest rates are keptto zero.
In light of the threat of persistentdeflation, the US stimulus policy makes sense. The Fed has reached the limitof what it can achieve with traditional monetary policy (interest rates are atzero). Fiscal stimulus and non-traditional monetary policy are the onlyremaining options. However, the rarity of historical parallels means thatempirical evidence is lacking on their effectiveness.
The New Zealand situation is vastlydifferent. To begin with, traditional monetary policy is far from exhausted. The Reserve Bank can still cut the OCR by 300 basis points, and by signallingthat rates will remain low, it can substantially reduce fixed mortgage rates.
The New Zealand economy is also benefittingfrom the depreciation in the exchange rate (and could expect more of the sameif interest rates continue to fall). This avenue for stimulus is far moreeffective in a small open economy like New Zealand than in the United States.
It is much harder to make the case thatdeflation is a serious risk in New Zealand. Two-year inflation expectationswere high prior to the crisis, and even after three quarters of recession,remain above the midpoint of the Reserve Bank’s target band. And this is therare situation where the spike in tradable inflation as the result of a fallingdollar is welcome.
There is also a tendency to forget that thefiscal stimulus set in train by the previous government is already quitesizable (over 3% of GDP over the 2009 June year). This is incrediblyfortuitous timing â€“ one common criticism of fiscal stimulus is that by the timeit comes on line, more often than not the recession is already over.
The scope of monetary and fiscal stimulusin New Zealand is extensive, and should both instill confidence that economicgrowth will resume, and vanquish any spectre of deflation. This is not a casewhere more is better: once a steady rate of inflation is guaranteed, we havereached the limit of what is possible with stimulus.
Furthermore, fiscal stimulus and fiscaldeficits are not without risk. The massive net international debt positionrevealed in the latest current account data is a pertinent reminder of ourincreasing reliance on international funding. Our future economic prosperityis as dependant on reassuring our creditors through ongoing fiscal rectitude asit is on increasing output in the short-term.
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