Careful where we lay the blame

By Matt Nolan 09/05/2013


Brian Fallow writing in his normal clear and intelligent manner has come out discussing the government budget.  As he says, a slump is not the time for “austerity” in terms of cutting back the size of government, and we should allow temporary deficits to help ease the blow – the point of automatic stabilisers is that they help out those that are struggling the most during a protracted slowdown.  Furthermore, I agree that the low level of long-term government bond rates does imply that government should be shifting investment forward now – something they seemed willing to do in 2009 but have moved away from since.

But, I have to slightly take issue with this:

Especially so since the Reserve Bank yesterday voiced concern at signs that the improvement in household saving rates may be stalling and that household debt is rising from a level already high relative to incomes.

The Government also argues that by running a tight fiscal policy it allows the bank to keep monetary policy looser than it otherwise could – lowering pressure on interest rates and the dollar.

However, as the bank reminded us yesterday, that silver lining comes with an increasingly ominous cloud in the form of rampant house price inflation, most notably in Auckland.

With the dollar as high as it is, the bank is reluctant to raise interest rates.

With the supply side of the housing market, especially in Auckland, unlikely to relieve the pressure on prices for years, and with gruesome examples in the Northern Hemisphere of what happens to an economy when a housing bubble bursts, at some point the bank is going to have to crush the demand side by raising interest rates.

If that coincides with fiscal contraction from a debt-obsessed Government, the effects could be unpleasant.

I don’t like where this logic is starting to go.  The RBNZ is responsible for “aggregate demand” in the economy.  If this is too low, then the RBNZ has set monetary conditions too tight, it is their fault.  Sure they may say it is not, some may say I am being unfair saying this … but if there is anything history has shown us, whenever we try to say “this time is different” with regards to a demand shortfall we usually end up coming back to blaming the central bank.

Relatively high debt levels and high house prices are not a monetary policy or demand issue.  They are an issue of financial stability, an issue of economic structure.  Yes, they create risks and can have negative welfare consequences.  Yes, competition, fiscal, and financial stability policy needs to account for them.  But monetary policy needs to take fiscal, competition, and financial stability policy AS GIVEN and then focus on “demand” from there.

Not dealing with demand because of concerns about these issues isn’t prudent, it is policy failure.  Blatant policy failure.  If you don’t believe me, ask someone who is both smarter and more articulate than me such as Nick Rowe.

Now, if the government remains on course and the RBNZ tightens monetary conditions to “fight the housing market” while it expects inflation to be low and unemployment high, they are explicitly violating their mandate and best practice of a central bank.  It is as simple as that.  I’m happy saying this out loud because they would not do that, they know these things, and will continue attempting to set monetary policy at the right level to deal with demand issues (as represented by their forecasts for inflation and unemployment over the next two years).  But given that the RBNZ does this appropriately, the government deficit does not matter outside of its impact on the composition of the economy.

If we want to criticise government policy during the recession, do it in terms of investment (it would have been a good time to move a bit more investment forward), and social policy related things.

Note:  If we believe that the response to interest rate changes will be very small, that in some sense investment demand is very “inelastic” then we can make a claim for government investment – we just need to be very clear on that AND we need to ask why in that case we still have a positive cash rate.  Remember, government investment here also works by driving up the “natural” interest rate … so through the same logic it will lead to a higher real exchange rate and higher government borrowing … unless the “cumulative impact” of rising demand pushing activity towards potential outweighs that.  And if we are using that “cumulative impact” argument for government spending then it also holds for a cut in domestic interest rates, just with a lower real exchange rate and compositionally more private sector activity.  So protip:  we can’t complain the exchange rate is too high and that government spending is too low at the same time!

Update:  Also after today’s unemployment and employment numbers I think people should be willing to rethink whether they think there is a “demand” issue in NZ going forward … ;)