With New Zealand's net international debthitting 98% of its annual production (GDP) in March there has been a lot of talk regarding the fact that we seem to have borrowed excessively relative tothe rest of the world. As the global economic situation gradually makes it more difficult for a small country like New Zealand to bury ourselves in debt, it is important to look at why we could be borrowing so heavily.
Excessive borrowing occurs when households,businesses, and/or government borrow more than is justifiable given areasonable outlook for future income.
Economic theory suggests that there arethree main causes of excessive national borrowing:
- Unrealistic expectations regarding future growth in income/production,
- A biased assessment of the risks associated with investments/borrowing.
- Policy settings that may encourage borrowing or investment in the wrong places.
The house price bubble of recent years wasa clear example of where New Zealand Inc fell into the first trap. A large number of individuals looked at their house and priced in larger price gainsthan potential buyers would have anticipated for the given house. As a resultof this gap, national wealth was believed to be greater than it really was , and households used some of this illusionary wealth to buy things.
However, this gap is relatively small in the grand scheme of things. Recent research regarding this wealth effect (by Calomiris,Longhofer, and Miles) in the United States suggests that there is no direct link between house prices and total household spending, and it is likely thata similar result held in the New Zealand case.
The more important issue is the issue of risk.
New Zealanders are smart people, but theconcept of risk and return is not a natural one for the human brain. Systematic biases are rife in the decisions we make, and the way an interest rate isframed (per annum or per week) or whether a deal is made to sound like a lossor a gain can have a significant impact on our actions.
However, it is not the individual's difficulty with piecing together disparate bits of financial information thatis the issue. The (lack of) transparency in information provided by the finance industry and the incentives provided by government policy are the two areas where individual biases can be transformed into wasteful investment/borrowing.
This issue was made abundantly clear by the Morningstar study of global fund managers. In the study New Zealand was given a D- stating that "transparency in prospectuses and reports, investor protection, and taxation were the main areas where New Zealand did not rank well". Fundamentally, they are saying that the structure of our tax system (interms of investment) and the information given to prospective investors were both not up to scratch compared to international standards.
The impact of this failure becomes clearwhen we look at the Gross Domestic Product (GDP) figures produced by Statistics New Zealand. Over the past eight years the share of GDP spent on consumptionby households has stayed close to its average level since 1988 (Graph). However, spending on gross fixed capital formation (a measure of total investment) has risen well above its 1988-2009 share Effectively, our rising current account deficit has been the result of greater and greater investment in the New Zealand economy, not an unjustifiable thirst for consumption goods.
The lack of income growth stemming fromthis investment suggests that something is amiss, even if New Zealand has not really "over-borrowed" in the strictest sense, it appears we may have invested poorly. This misallocation of investment is the unfortunateresult of a policy failure, bad luck, and further misinformation regarding thereturn/risk to investment.
Even so New Zealanders may have borrowed for other reasons. A net debt position of 98% of GDP seems too large to be explained by an understatement of risk, a misallocation of investment, and abelief that house/asset prices would rise into perpetuity.
In one sense this is true, even if everyonein New Zealand was in a position where all the risk associated with borrowing was apparent, and where they could foresee what would happen to asset prices in the future, they would have borrowed.
But there is nothing wrong with this. Interest rates have been low, credit has been abundant, and goods have been cheap.
Ultimately, this implies that it is not even the fact we have accumulated debt that is of concern for New Zealand; it is what we have done with it. And in this sense it appears that New Zealand as a whole has made poor investment decisions. We have collectively whittled away a golden opportunity to improve the New Zealand economy by borrowing to invest in things that offered very little return.
Of course, there is always the chance that thereturn on our investment is yet to come, that within the coming years we will see productivity climb as our prior investments bear fruit. However, I'm not holding my breath.
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