A time to do nothing
Fri 27 Mar 2009 by Infometrics Ltd in Government

As the New Zealand economy delves deeper into recession, there appears to be a growing disquiet that the government has yet to produce a comprehensive fiscal solution.   National’s laissez faire approach is in stark contrast to the aggressive monetary and fiscal stimulus being embraced in the US; a stimulus that is ratcheted higher on an almost weekly basis.

But this is an invalid comparison.   New Zealand’s economic situation is less serious by an order of magnitude, and current stimulus measures are substantial.   Further fiscal stimulus at this stage would bring no clear benefits and court significant financial risk.

In the last three months, the US Federal Reserve has cut short-term interest rates to zero, and initiated quantitative easing (printing money) designed to lower other market interest rates.   Meanwhile, the Obama administration has passed a sizable spending package (resulting in a budget deficit of 12% of GDP).

The New Zealand Reserve Bank has also cut interest rates, but in contrast, has indicated that an OCR of around 2.5% will be low enough.   The National government has seemed content with the quantum of spending 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 below potential), the US is experiencing an 8% shortfall which is expected to be sustained for a lengthy period.   The Reserve Bank of New Zealand expects to see an 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 real incomes are both painful and unnecessary (in the sense that with perfect foresight, such cycles could be avoided).   But the greater concern is that with such a dramatic amount of spare resources in the economy, prices will start to fall, and that before long deflation will become entrenched.   The output gap is normally 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 time the US starts with inflation of only 3%pa.

Falling prices may not immediately seem to be 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 severe threat 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 most significantly, traditional monetary policy loses effectiveness, because deflation pushes up real interest rates even if nominal interest rates are kept to zero.

In light of the threat of persistent deflation, the US stimulus policy makes sense.   The Fed has reached the limit of what it can achieve with traditional monetary policy (interest rates are at zero).   Fiscal stimulus and non-traditional monetary policy are the only remaining options.   However, the rarity of historical parallels means that empirical evidence is lacking on their effectiveness.

The New Zealand situation is vastly different.   To begin with, traditional monetary policy is far from exhausted.  The Reserve Bank can still cut the OCR by 300 basis points, and by signalling that rates will remain low, it can substantially reduce fixed mortgage rates.

The New Zealand economy is also benefitting from the depreciation in the exchange rate (and could expect more of the same if interest rates continue to fall).   This avenue for stimulus is far more effective in a small open economy like New Zealand than in the United States.

It is much harder to make the case that deflation is a serious risk in New Zealand.   Two-year inflation expectations were 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 the rare situation where the spike in tradable inflation as the result of a falling dollar is welcome.

There is also a tendency to forget that the fiscal stimulus set in train by the previous government is already quite sizable (over 3% of GDP over the 2009 June year).   This is incredibly fortuitous timing – one common criticism of fiscal stimulus is that by the time it comes on line, more often than not the recession is already over.

The scope of monetary and fiscal stimulus in New Zealand is extensive, and should both in still confidence that economic growth will resume, and vanquish any spectre of deflation.   This is not a case where more is better: once a steady rate of inflation is guaranteed, we have reached the limit of what is possible with stimulus.

Furthermore, fiscal stimulus and fiscal deficits are not without risk.   The massive net international debt position revealed in the latest current account data is a pertinent reminder of our increasing reliance on international funding.   Our future economic prosperity is as dependant on reassuring our creditors through ongoing fiscal rectitude as it is on increasing output in the short-term.

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