Tuesday, September 11, 2007

Reserve Blues

The finance and expenditure select committee is looking into whether or not there are better ways to manage our economy than via the Reserve Bank. According to Brian Fallow BERL say the Reserve bank isn't helping, Bruce Sheppard says our interest rates are comparable with Indonesia's (a dubious level of sovereign risk) but VUW says nothing's broke so don't fix it.

Personally I wonder if our Reserve Bank isn't the creation of academic purists. According to its own website (policy targets and section 8 of its Act) the bank's policy target is primarily to ensure price stability. By comparison the US Federal Reserve "goals of monetary policy are spelled out in the Federal Reserve Act, which specifies that the Board of Governors and the Federal Open Market Committee should seek "to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates." These outcomes are sought via price stability, but in New Zealand price stability itself is the goal." [Ref 1Mb PDF]

The idea of price stability is attractive, especially if you don't have any. Inflation in history has eroded the savings of the middle classes resulting in dangerous political instability. If a dollar today is only worth ten cents tomorrow then planning one's life starts to get pretty damn hairy. Ask any Argentine. Thus one can see the attraction of ensuring that a dollar today is worth a dollar tomorrow and preferably forever more.

But the problem is that in the real world prices aren't stable because supply and demand aren't stable. When this affects things like toothpicks this doesn't matter a hell of a lot. If the price of toothpicks goes up then some people will stop buying them and more people will make toothpicks and the price will stabilise again. The problem really kicks in when we talk about prices of things that are somewhat more fundamental. These are things like the price of energy, the price of labour, and the price of land.

This is partly because such prices are what economists call "inelastic", i.e if the price goes up the demand doesn't necessarily drop away all that much, but also because they are unavoidable. It is impossible to do business of any kind without somewhere to work, people to do the work and applied energy to help them do the work with. Another highly inelastic price is the price of Government, i.e that income we forgo for the social system we construct around us.

The Reserve Bank Act defines a bunch of prices that it keeps an eye on. These are measured by the Statistics Department and are called the consumer price index. Among them are common or garden things which people buy, including energy and the charges Government makes. What is not directly included is the price of land. Land is not included because it is assumed including the price of land would become recursive because as the price of land increased the inflation rate would increase so the price of land would increase. Personally the lack of a land price index is a source of great irritation to me but that is by-the-by.

But there is another effect that economists have not traditionally handled very well and that is the changing affect of technology on national wealth. For example $2000 today can buy me the same computing power that $2 million would have bought me 20 years ago. If demand was constant this would be strongly deflationary but demand isn't constant. It expands as the opportunities in the marketplace expand. Today there is a popular market for mobile phones that 20 years ago were limited to very few people. In other words we can buy more things today than we could 20 or 40 years ago. Despite this a pound of butter has pretty much remained at a fairly constant price vis-a-vis incomes since Shakespeares time. This increasing availability of goods and services is a genuine increase in wealth.

Monetarists believe that money supply is the source of all inflation. Structuralists believe that some inflation is built into growth and distinguish between ordinary inflation and hyper-inflation. In the latter case the Government tries to extracate itself from fiscal problems by printing more money. This was certainly the policy of the Weimar Republic during the 1920s.

The problem with all "isms" (except for pragmatism) is that they try to fit the facts to the circumstances and then justify themselves. The advantage of the objectives of the US Federal Reserve objectives is that they state outcomes not methods. The NZ Reserve Bank can argue that it has done its best to achieve price stability but that does not mean it has done its best to achieve those other important aspects of economic stability defined in the Federal Reserve's Act of "maximum employment, stable prices and moderate long-term interest rates".

In particular one has to look at the relationship between land prices and money supply. Fundamentally land prices drive the demand for money at the deepest level for the fundamental transaction that every entity must meet its need to pay the rent. The value of land is derived partly from the income it can itself generate (eg by growing things on it) but also depending on the value others believe a plot of land may have as a (largely) appreciating asset. Obviously the value of land in the former instance will depend on the income generated in similar adjoining land wheras in the latter case it will depend on the size of the available market for that land. That is the more people who may want to bid for it the more valuable it becomes.

In New Zealand we currently face a number of inflationary pressures. The price of energy is increasing and this time (unlike the early 80s) the oil companies aren't going to do us all a favour by over-investing in capacity so that their profits are slashed for the next 20 years. The cost of Government is escalating. It was the second largest source of inflationary pressure after energy in the past year. The price of labour is increasing because we are reaching almost full employment and people can pick and choose among employers. And the price of land is increasing because local government has been constraining supply of urban land, central government has allowed more people (both resident and non-resident) to buy New Zealand land, and (to a far lesser extent) the returns from farming land have improved lately. All of this increases demand for money.

If the demand for money increases naturally only two things can happen. Either the supply remains the same and the price (interest rates) goes up. Or the supply increases and the price remains the same and potentially the dollar devalues versus other currencies. Effectively the Reserve Bank is setting the exchange rate by restricting the money supply. Currently the Reserve Bank is choosing the former option over the latter in the name of price stability.

But lets take a look at where these price increases stem from. In the case of energy they are imported. We simply have to wear these costs. This is the kind of inflation the world got in the 70s where oil prices skyrocketed by productivity remained static so we ended up with stagflation.

In the case of land, they are also largely imported as we invite foreigners to speculate on New Zealand land values. That leaves labour inflation and consumer demand led inflation as more people queue up to bust their credit limits. Against that we have increased export receipts for primary products and reduced prices for manufacturered goods from China. However what a lot of people are really doing is exchanging their land revaluations due to land price inflation into consumer inflation as they buy more crap that will be useless in ten years time on the house. By maintaining the value of the dollar the Reserve Bank is effectively acting as guarantor to foreign land speculators who are inflating the value of our land so we can buy more crap.

So what do we really need? To achieve an optimum investment environment business needs low land prices, low Government costs and low interest rates. This would allow business to obtain a better return on capital from productive investment than in an environment with high land prices, high Government costs and high interest rates.

This means that the Reserve Bank instead of restricting money supply by increasing prices should gradually increase money supply. This would devalue the dollar, warn off foreign land speculators who would become edgy about their investments under a depreciating currency, increase the cost of imports (including energy) increase inflation, boost the value of the sharemarket, and in the long term incentivise business to invest in productive capital. This is actually what the US Federal Reserve started doing a couple of years ago.

The only problem is there is a political cost to such manouvres. That is a strong currency and inflated land values make people feel richer, even if it is actually making them poorer in the long term. Thus the only way this can be accomplished politically is by reducing the surplus and giving back some of the tax. By putting more money in people's pockets they may feel happier about declining purchasing power.

This would of course make it more difficult for the Government to become saver of last resort as it has under the Cullen regime. Dr Cullen has effectively built up the Government to become a massive saver/investor through fiscal surpluses unheard of outside of oil rich nations. Personally I have always had some problem with the Government effectively becoming the biggest investor on the stockmarket by a country mile. It smacks of state capitalism. I would much rather see more private investment and entrepreneurship. In my view the best superannuation plan is to live in a rich country which is booming rather than clinging on to an outsized pension in a poor country in decline because in the latter case you know, one way or another, the Government of the day will steal it off you again, while in the former case the Government can afford to be magnanimous.

So are there any proposals I would have for the Reserve Bank? Merely to increase its objectives beyond price stability to include goals such of those of the Federal Reserve which include consideration of providing an optimum investment climate (moderate interest rates) and a degree of equity ( maximum employment).

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