As Good As It Gets

Professor Lars Svensson, of Sweden,has run his rule over our Reserve Bank monetary policy and finds: “monetary policy in New Zealand is currently entirely consistent with best international practice of flexible inflation targeting”.
The professor criticised some past practices used by the Reserve Bank, in particular describing the former Monetary Conditions Index (MCI) as “a significant departure from best-practice inflation targeting”. I too, was critical of the MCI from the outset, as were some others.
The report will be carefully studied. It has hardly inspired, nor will it, bout of ecstatic celebrations. Why, if we are so good?
The memories are still too fresh of the stresses imposed upon the export and internationally competing sectors by the excesses of past monetary policy cycles. Bouts of high interest and exchange rates – and of their legacy of ongoing structural economic burden: chronic current account deficits (up to $8.2 billion pa); burgeoning foreign debt ($109 billion when I last looked); high penetration of foreign ownership of our productive assets businesses and resources, and of their future wealth-creating potential; low national savings; and static or declining living standards for the majority of Kiwis.
Add to these: the increasing servicing burden of foreign investment, which progressively absorbs more of our GDP; and, as consequence of all these factors, our inability to fully fund government services: police, military, health, education and social services.
All of these contribute towards flight of skills and businesses, as the gap between our living standards and other countries’ relentlessly widens.
There will certainly be further scrutiny of some of Svensson’s views. The principles of monetary policy are imprecise. There are few objective truths, more subjective philosophy and theory.
For example, is it valid to assume New Zealand, with its economy’s particular structural characteristics, should conform to “best practice central banks, like the Bank of England and the Bank of Sweden” which have quite different economic characteristics?
And are they, in reality, best practice? In comparison, we are tiny vulnerable economy. I concluded, some time ago, the one-size-fits-all approach was illogical. Considering the structural burdens which now exist within the New Zealand economy – which have built up over 20 years, so have nothing to do with the present government – I finally concluded customised tailoring was essential.
The issue as I see it, is to ensure monetary policy doesn’t decrease the growth rate of GDP and employment, by imposing excessive interest and exchange rates on an export-dependent economy which is extremely vulnerable to such interventions.

Lost opportunities
The evidence of such damage – past and future – is compelling. Periods of lost opportunities are totally perishable. Wealth the economy loses in one period, by under-performance, cannot be recovered in another, by over-performance. We cannot afford such leakage.
The stark reality now facing New Zealand is that it needs sustainable average annual rate of GDP growth of four to five percent to have any hope of regaining parity with the average living standards. This is due significantly to monetary policy pressure on the export and internationally competing sectors – we are now around 20 percent behind.
We would need an increase of 25 percent – or around $25 billion pa – additional GDP right now to retain parity. Even more sobering, other countries are still moving further ahead.
In fairness, it was not within Professor Svensson’s brief to address the wider issues of New Zealand’s lagging economic performance. Most would agree monetary policy of itself, cannot be used as an instrument of economic growth. The point – which should be self-evident – is it must contribute to better environment for economic growth. Otherwise why do it? Monetary policy is not an end in itself. The end must be better economic performance.

Towards better performance
How do we achieve four to five percent per annum growth to GDP, to regain future comparable with other economies?
It would surely be obvious we will not achieve that by doing the same as we have in the past, when we have fallen so far behind. Under present conditions, it is impossible. The Reserve Bank gets twitchy about inflation when GDP growth approaches even three percent pa. Consequently, more of the same offers no solution.

A new methodology
In my personal submission to Svensson’s review, I proposed new methodology for the operation of New Zealand’s monetary policy: to use instruments which are tailored to the particular structural characteristics of this economy.
There are two key recognitions. First, with our high level of foreign debt, it is surely absurd to use interest rates as the primary instrument of monetary policy. We literally give away our wealth and our potential national savings, by way of monetary policy interest premiums voluntarily paid to foreigners. Second, it is surely inexcusable, in an export-dependent economy, to impose overvalued exchange rates to use the earnings of exporters and import substitution businesses – which are the economic lifeline of this economy – as pawns of monetary policy, to combat domestically induced inflation risk. This destroys wealth.
These two key recognitions explain why the conventional wealth creation cycle theory, which should underlay monetary policy, is invalidated within an economy having structural characteristics such as New Zealand now has. This wealth creation cycle has five elemental phases: growth to the economy; national savings to skim off consumption surpluses; investment of savings to expand economic capacity; attainment of higher level of GNP; income distribution to provide consumption demand; growth to the economy – cycle complete.

The missing link – savings
In the New Zealand context, the key missing link is national savings. Monetary policy interest rate premiums imposed by the Reserve Bank are largely paid to foreigners, on our $109 billion foreign debt. They become their wealth, not the national savings of New Zealand residents. Consequently, to obtain funds for investment generally requires additional foreign sourcing, which thereafter increases the annual servicing burden. In turn, this diverts an increasing proportion of GDP to foreigners. The methodology literally requires New Zealand to voluntarily give away its wealth, and to then have to borrow it back again to fund the consequentially increased current account deficits.
There is catch-22 situation. Unless there is different methodology, it is probably unlikely the capacity of the economy can ever be expanded fast enough to keep ahead of increases to foreigners’ share of GDP and the expansion of population. New Zealand faces being gridlocked into circumstance where average living standards lag progressively further behind.
I advocate replacement of interest and exchange rates, as the primary instruments of monetary policy, with the introduction of flexible savings instrument controlled by the Reserve Bank. This would be the sole primary instrument. Interest and exchange rates would remain as part of the Reserve Bank’s arsenal, as secondary instruments, to be used only in the unlikely event they may be needed. The flexible savings instrument is the cornerstone first new instrument I propose.
By this new methodology, when the Reserve Bank wants to rebalance supply and demand levels, to neutralise inflation, instead of increasing interest rates – by monetary policy surcharge, which largely transfers wealth to foreign lenders to become their savings – it simply places similar savings surcharge above the interest rates determined by prevailing market conditions.
On finance of, or spending upon, consumer durables the savings surcharge

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