Not a time to muddy the water: a rebuttal to the BERL/NZ First report on the PTA
The recent BERL/NZ First report on changing the policy targets agreement (PTA) suggested that the importance of inflation targeting was gone – but this conclusion is simply wrong, and rests on a misunderstanding of what has been going on with the New Zealand economy in recent years. As a result, they confuse the facts about the New Zealand economy and come up with a fallacious recommendation to scrap inflation targeting to target a range of other factors.
Sifting through the report, BERL and NZ First’s recommendation to scrap inflation targeting is based on a fear of “hot money”. As they say, between 2002 and 2007, New Zealand saw a significant lift in private borrowing, much of which was sourced from overseas. They state that the lift in foreign lending was due to the higher interest rates in New Zealand.
However, this is only part of the story – a loan only appears when there is both a lender and a borrower. To understand the sharp increase in private debt levels, we need to ask what was driving up private sector demand for credit during this period. When we approach the issue in this way, we can recognise that the demand for credit was not the fault of interest rates being “too high”.
As the Reserve Bank and, more recently, the NZIER have stated, the key issue in New Zealand over the past 40 years has been the high real exchange rate (the exchange rate adjusting for changes in prices between countries). Our persistent current account deficits and high level of net liabilities indicate that there is a significant issue in the New Zealand economy that needs to be addressed – but this is not a consequence of the PTA, inflation targeting, or interest rate setting.
The purpose of inflation targeting is to help wage and price setters set expectations of what will happen to the price of goods and services over time. The Reserve Bank controls inflation by announcing its target and adjusting the official cash rate in a way that is consistent with changes in saving and investment behaviour within the economy. The reason interest rates have had to be higher in New Zealand is due to the economic fundamentals that have driven up debt – blaming the Reserve Bank involves getting the explanation the wrong way around!
So what are some of these fundamentals? A lack of competition in the domestic economy due to our small size, the large size of government relative to GDP, tax policy, and the nature of our housing and residential building industries are all significant factors. The solution to these issues involves the government recognising the full macroeconomic costs of policies it puts in place – not arbitrary changes to the Reserve Bank Act. The Bank may also play a role, through the introduction of macroprudential policy, but these policies do not override the Bank’s monetary policy role of inflation targeting.
There is also the argument that a number of developing economies are intervening in to knock down their exchange rates – and as a result so should we. However, this nexus does not lead to “excessive borrowing” in New Zealand, but instead merely means we are receiving goods and services from overseas for a discounted price.
Making our Reserve Bank less transparent while ignoring the real economic issues that plague New Zealand will not make everyone better off – it will make most New Zealanders significantly worse off.
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