Speech: Inflation is not the only risk – it’s time for NZ to pay more attention to our exchange rate
David Parker | Tuesday, September 25, 2012 - 17:15
Speech to 2012 Eriksen’s Conference
Hilton Hotel, Auckland
9 am, 25 September 2012
Welcome and thanks for the invitation to be here today.
I want to talk to you today about some of the big economic issues facing New Zealand and much of the developed world.
I know that you are concerned about the future of New Zealand, and I welcome your questions at the conclusion of my speech. If there are issues I have not addressed, feel free to raise them.
Many of you are actuaries, risk or investment managers. You have seen the global financial crisis lay bare many imbalances in economies around the world. Today I want to focus on two problem areas for New Zealand.
The main topic I intend to address is how the objectives of the Reserve Bank need to be broadened, to stop our exchange rate being subjugated to the primacy of inflation targeting.
This is essential if we want to meet the cost of our imports and interest through the sale of our exports, which is a key to stopping our slide into indebtedness.
I will also address the unsustainability of our current superannuation settings.
In both cases I will outline Labour’s proposed solutions, which we are willing to be held accountable for.
An economy has to work for the ordinary person. If it does, they stay and work in New Zealand, raise their families and help grow our economy. People are not stupid. If the economy does not work for them, many give up and leave.
For the economy to work for the ordinary person, it has to sustain well-paid jobs which enable us to meet the cost of living and housing. It has to enable businesses and those employed in them to pay their bills.
In any year if I, or any of you, don’t earn enough to cover our expenses and interest costs, then we meet that deficit either by selling something we owned or by borrowing.
Our economy is but a collection of individuals, and the business and government we own together.
If, collectively, we don’t earn enough to pay our bills, then our country runs a deficit – an external deficit – a current account deficit.
Every year we run a current account deficit, the gap is plugged by a combination of selling assets that were previously owned by New Zealanders to foreign buyers and borrowing more money from overseas lenders.
That external, or current account, deficit increases the country’s net international liabilities. Our nation’s balance sheet gets worse.
Except to the extent that these additional liabilities fund real capital improvements, an increase in net international liabilities as a percentage of GDP is a measure of a country getting poorer.
Over time more and more of our earnings go to servicing interest and payments to overseas owners.
Our economy is hollowed out both directly, and via the underinvestment in our own productivity which also happens when the country’s balance sheet gets worse. Job prospects and wages deteriorate relative to other countries.
In other words, for the economy to work for ordinary people and their businesses, we need to earn enough from the rest of the world via our exports and overseas investments to pay the cost of our imports and interest.
We haven’t for decades.
New Zealand’s external deficit and liabilities are why our credit rating was downgraded last year.
Our net international liabilities have risen for decades. After a dip from the recession, and the insurance inflows following the earthquakes, our liabilities are projected to increase further – and they’re already at European levels.
This is another way of saying we’re getting relatively poorer as a country.
New Zealand has not exported enough to cover the cost of our imports and interest for forty years. There is an obvious pattern here. If we don’t change, that pattern will continue.
It is bleedingly obvious that for our exporters to earn enough to cover the cost of our imports and interest, we have to have a competitive exchange rate which is not inflated above the fundamentals of our economy.
There are a number of reasons for our current account deficit:
- One is our tax system. New Zealand’s tax system is very unusual by developed country standards. It has a bias which encourages investment in speculative land based assets to the detriment of investment in our productive export (and import substitution) businesses. This is why we need pro-growth tax reform. A capital gains tax, excluding the family home, encourages investment on the basis of the profitability of the business. It removes the tax bias which encourages speculative investment in land and directs more investment into plant, equipment and export development. A capital gains tax is favoured by the OECD, the IMF, the Treasury, the Reserve Bank, the governments of just about every OECD country and the Labour Party. It is also fairer, because currently some of New Zealand’s wealthiest people pay lower rates of tax than less wealthy NZers, which is wrong.
- Another reason is our savings record. We do not save enough as a nation, and as a consequence are overly reliant upon overseas capital for investment. Labour introduced Kiwisaver. We believe it should now be made universal and cover all people in work, with limited exemptions along the lines which currently apply in Australia.
- The third reason, which I want to focus on today, is our exchange rate.
For long periods this is kept at artificially high levels which hinder our exporters. Those defending this orthodoxy have not convinced me the current regime is correct.
Stand back and answer me this – can you justify NZ having had a current account deficit for decades despite the best terms of trade for our primary produce in a generation? And how can it be that Australia – a decade in to a resources boom bigger than any before - has an external deficit?
I’m going to argue that to get the modern, prosperous and fair economy, we need to make changes.
What is my aim? I want our economy to work for ordinary people. I want to build a society with a vast middle of prosperous people in good jobs, a fair share of assets, and a high degree of social mobility. For me this is the meaning of economic success.
A prosperous and secure working population allows political support and economic means to stand with the vulnerable.
This is why Labour has challenged and is willing to change deeply rooted orthodoxies passed their use by date. This is true of CGT, savings, the age of eligibility for superannuation and monetary policy.
None of this is populism. They are all hard sells. But they are right.
Increasing numbers of New Zealanders understand we will be better off with these changes through more jobs, more profitable businesses, higher incomes and opportunities which keep more of our children in our country.
Our economic pie simply has to grow in order for us to be able to deliver the kind of society where our children and grandchildren want to stay, work, and play, and contribute to our society.
Over 150,000 NZers have departed permanently for Australia under National. 53,000 last year alone. Four out of ten - 40% - are between 18 and 30. When you reflect on why so many twenty-somethings are giving up on New Zealand and putting their shoulder to the wheel of the Australian economy, you realise we must change.
Our economy needs to delivers prosperity for businesses and those who work in them.
This brings living wages, world class education and health, a clean environment – and hope.
So how do we go about growing the pie?
We need to transform more of our products, and create value. We need to sell more goods and services overseas.
Government has at its fingertips levers only it can pull - to change the settings that stimulate growth and opportunity.
New Zealand needs a government willing to change out of date orthodoxies.
While governments have been promising ‘added value’ and more exports for ages, exports as a proportion of our GDP haven’t grown, our share of world trade has been dropping, and we have a prolonged current account deficit.
We’re not work shy. We work longer hours than most, but we earn less.
In the 2000s, Labour sought to ameliorate these problems.
We were successful in some crucial areas: we got unemployment down lower than anywhere in the world. We sustained the longest period of continuous growth in a generation. Growth was over reliant upon debt fuelled consumption. Labour reacted in a number of ways. We started Kiwisaver.
Importantly, we ran very substantial budget surpluses and so left stronger government books than most countries had when the global financial crisis hit. This is why even now we have low government debt.
Growth is now modest. Exports are dropping and we are still over-reliant on consumption and overseas debt, instead of exports and productivity growth.
And that balance of payments deficit with the rest of the world is still not fixed. Negative $10 billion last year alone, and projected to get worse from here.
As private borrowing and asset sales have mounted up, more of our income goes to overseas lenders.
Our net liabilities and our projected external deficit are why our credit rating was downgraded last year.
Our net international liabilities are projected to rise more. After a dip following the recession, and the insurance inflows following the earthquakes, our liabilities are projected to increase further – and they’re already at European levels.
It is abundantly clear to me that New Zealand cannot survive on the back of our pastoral, fishing and forestry industries.
Yes, they are critical to our economy.
Yes, some of our potential lies in further processing of our fish and wood products.
This is important, but even that additional manufacturing is not enough.
We must broaden the base of our exports.
To do that we must address out of date economic settings.
Businesses move overseas, or choose not to take the risk to invest in exports from New Zealand, for many reasons.
Where the reasons for relocation are unavoidable, then we can’t stop it.
But if monetary policy drives them away, or holds them back with an inflated exchange rate, then it needs to change.
Inflation targeters emphasise that businesses need price stability. Exporters emphasise that they need to know the currency, which makes or breaks their business, will not be held at uncompetitive levels unrelated to the fundamentals of our economy.
Labour is not afraid to make these changes
Our dollar is volatile against many currencies outside Australia, and is sustained at uncompetitive levels. This is often the difference between profit and loss. Between employing, exporting and not.
The IMF agrees our currency is overvalued. They said 15% earlier this year, and it has got worse since.
A former business partner of mine, the late Howard Paterson, said to me we face competitive devaluation and ignore it at our peril. As was often the case, he was ahead of most of us. He was right.
Other countries are competing to increase their exports by devaluing and manipulating their exchange rates.
But we operate monetary policy as if the history of the last two decades didn’t happen.
Our Reserve Bank Act was written in a time when the main economic threat was inflation. It gives primacy to targeting inflation. By law the Reserve Bank has to pursue targeting inflation ahead of all other factors.
This means insufficient priority is given to how our exporters, and their employees, are hindered by an uncompetitive dollar – not just in the short term. This in turn affects us all.
You don’t have to be soft on price stability to recognise that we have a problem with our international liabilities.
I met with Joseph Stiglitz recently. He is a Nobel Laureate in Economics. He is critical of inflation targeting having primacy above other economic settings.
He makes the point that control of inflation is not an end in itself. It is meant to be an aid to economic stability and prosperity.
Yet inflation targeting reacts to external shocks causing imported inflation by making the internal economy even tougher.
And the narrow definition of CPI inflation (which excludes assets) means that it has been almost blind to the price of houses rising hugely. This has not worked to the advantage of ordinary Kiwis. And it reinforced distortions in our economy.
In New Zealand the differential between our interest rates and lower rates overseas has led to enormous influxes of credit, which jacked up our exchange rate to the detriment of our exporters and fed the very consumption that higher interest rates were supposed to curb.
Even short of financial instability, a setting or philosophy which sees little problem in the country’s balance sheet getting worse and worse through prolonged current account deficits (funded by asset sales to foreigners and increased overseas debt) must be wrong.
I agree with our exporters and the IMF that our exchange rate is inflated above our economic fundamentals – it is sustained at a level at which we do not pay our way in the world.
Orthodoxies are hard to change.
They became orthodox with a broad consensus of support that was believed correct at that time.
They survive because they are comfortable and are surrounded by institutions that favour the status quo.
There is always resistance to change, and this resistance means some orthodoxies are held onto after their use-by date.
But sooner or later there has to be a breakthrough, because what we have isn’t working.
We have a willingness to challenge the deeply rooted orthodoxy around monetary policy.
I have recently returned from visiting some of the leading economists in the world. Experts in monetary policy at the OECD, the IMF, Harvard and New York.
I have reported on their comments to me and their published views.
Whether defenders of the status quo agree with me or not, alternative views opposed to giving primacy to inflation targeting over other aspects of economic management, such as the exchange rate, are widespread and credible.
More and more countries are actively lowering their currencies so they can export more and improve their balance sheet ie get wealthier.
China – with the biggest surplus in the history of the world – is holding their currency low.
Japan has for decades.
The USA is devaluing, in part via quantitative easing.
So is the UK, and this is credited as a major reason its car industry is now the most successful in Europe.
The Swiss are printing money to cap their currency to protect their exporters.
Europe is too. Germany has for years profited from a Euro at low levels relative to the success of their exporters.
Brazil intervenes. So does Singapore. So does South Korea. The list goes on and on.
And they are all inflating NZ’s currency. Our lack of response is leaving us poorer.
It is serious.
I understand why we adopted inflation targeting and gave it primacy above other aspects of economic management.
I do not criticize that decision. It was never a perfect tool and involved trade-offs, but was introduced to tackle entrenched inflation.
But as another world authority on monetary policy I met with – Jeffrey Frankel at Harvard - says, no one system of monetary policy is correct for every country. And no one system of monetary policy is right for any one country at all times.
I am surprised that others are surprised by this.
The colonial order once pursued trade and economic progress by conferring geographic monopolies upon trading companies. That passed its use buy date.
The gold standard was favoured by most of the developed world
After the great depression and WWII, the gold standard was dropped in favour of controls on exchange rates.
That worked for a while, but was replaced by a focus on the money supply.
That in turn was replaced by inflation targeting in many developed countries.
The different choices available are shown in the following diagrams.
My point is that after two decades of inflation targeting being given primacy over other aspects of management of the economy, it is time to move forward given the challenges of today.
It’s not just the IMF that says our currency is overvalued. Our exporters have been lamenting this fact for years.
Labour has said we will:
- Amend the Reserve Bank Act to broaden the objectives of the Bank, so that inflation targeting does not trump the exchange rate, jobs and our current account.
- Broaden the membership of the Bank so that it is more representative of the interests of the productive economy and less dominated by bankers. We want more exporters and the interests of the people who work in the real economy better represented when these crucial decisions are made.
- Encourage use of other macro-prudential tools (in addition to interest rates) like loan to valuation ratios, loan repayment periods and capital ratios.
- Amend the Act to allow those ratios to be used for economic outcomes, not just for the narrower role of stability in the financial sector.
- Amend the Act so that we integrate the use of all tools by making all of these decisions for the board, rather than the governor. Currently the interest rate decision is taken by the governor and other decisions by the board. They should be integrated. It is wrong that they are not.
- Introduce a capital gains tax, which the Reserve Bank and others note will reduce reliance on higher interest rates and will push against asset price bubbles.
None of these steps is radical, but they would both enable and make the Reserve Bank responsible to pursue policies which are less damaging of our economy. This would help our export and import substitution sectors.
It is too easy for National to say our currency is overvalued, and then do little to help. It is wrong to refuse to amend the Reserve Bank Act, and then pretend government nor the bank can help.
I am pleased this debate has now passed the point of heresy. The initial critics were personally attacked by Steven Joyce. But exporters and senior analysts like JB Were’s Bernard Doyle have persisted and have shown there is an alternative. The Joyce assertion that this is voodoo economics or snake oil does not work.
Yet another noted economist who challenges the primacy given to of inflation targeting is Rakesh Mohan, a professor at Yale and former deputy governor of the Reserve Bank of India. Mohan says sound economic management requires a combination of sound macroeconomic policies (both fiscal and monetary), plus exchange rate flexibility with some degree of management, and a relatively open capital account, but with some degree of management and control is needed. I agree.
As Olivier Blanchard, the chief economist at the IMF, said when we recently met that in practice most countries see a need to address both inflation and the exchange rate.
Blanchard says the effects of a high exchange rate relative to fundamentals mean that we “need a twist to monetary policy” as well. To make interventions for the benefit of exchange rates work it may be wise “to introduce friction in the wheels of capital flows, which make exchange rate interventions work better”. “Untrammelled flows of capital are bad”.
I don’t have time today to expand upon why this is even more important for a small economy where parts of the export sector are dominant over others, but I am happy to answer questions on that at the end.
In terms of giving primacy to inflation targeting and leaving exchange rates alone, the IMF has moved on.
It’s time we did too.
In conclusion, a few words on superannuation
Labour believes that a sustainable superannuation system is essential. We are determined to protect it and keep it on a sustainable footing that is fair to all generations.
National talks tough on welfare reform, but it ignores one of the largest fiscal pressure facing our country.
Over the coming decades, the number of New Zealanders in work for each person on super halves from 5 workers per superannuitant to between 2 and 3.
Action is required now.
Treasury has projected that just four years from now superannuation payments will be close to 20 times the unemployment benefit.
It’s already more than all benefits combined.
Worse still - in just four years super costs more than total government spending on pre-school, primary, secondary and tertiary education combined. That cannot be right.
The longer it is left, the more likely it is that the rate will be cut or eligibility narrowed. National’s alternative is in effect to give people insufficient notice that change is needed.
Labour wants a fair and sustainable superannuation scheme.
We have signaled a transition for the age of eligibility from 65 to 67 years. We have adopted the retirement commissioner’s proposal to lift the age by 2 months per year from 2020.
Labour is committed to ensuring that those who cannot work past 65 in their normal work and need super then will get it.
The sooner the age of entitlement for superannuation is tackled, the fairer the adjustment will be.