Fixation on public debt has its tradeoffs

Doctoral student at the School of Government, Victoria University of Wellington

As the economic fallout from Covid19 has shown, shocks can strike from unexpected directions and very quickly throw a seemingly healthy economy into crisis. Our resilience to such shocks has been something of a preoccupation for New Zealand, with broad agreement that the country needs to be prepared for a rainy day. Such resilience is often conflated with a single primary measure – a low level of public debt.

In fact, the resilience of the national economy is better understood as a multifaceted concept, and ought logically to include the resilience of the households and firms that comprise it. Resilience includes being adaptable in our day-to-day operations, holding buffers in excess of critical thresholds and maintaining a degree of spare capacity within a system.

In recent years, New Zealand has boasted levels of public debt among the lowest in the Organisation for Economic Co-operation and Development. This can be an advantage in terms of building political support for using fiscal policy – higher government spending – to support the economy during a crisis.

The more we rely on fiscal policy in the near future to cushion the economic impact of Covid-19, the more likely it is the political debate will begin to refocus on the idea of paying down the public debt that’s been incurred. It is important that we fully consider the tradeoffs associated with our fixation on public debt.

One such tradeoff relates to the position of monetary policy. In recent decades, the textbook policy response for responding to major downturns was to cut interest rates by something like 600 basis points (6 per cent). However, since the global financial crisis New Zealand has never been able to build up sufficient inflationary pressure within the economy for interest rates to rise to anywhere near this level.

By the end of March, the Reserve Bank had not only exhausted what it views as its conventional monetary policy capacity (75 basis points), it had also resorted to unconventional (and in New Zealand, untried) measures in the form of quantitative easing. Were we not so focused on paying down public debt in recent years, government spending might have done more to allow monetary policy to regain its capacity to help stabilise the economy.

A second area of tradeoffs concerns the capacity of our health system. Real health spending per person increased only 1.4 per cent a year between 2008 and 2019 on average, well below the pre-GFC trend. This is less than what we might have expected to see, given an ageing population and the tendency of costs in health to increase faster than overall inflation.

The result of this underfunding is that New Zealand has a health system that operates at close to maximum capacity in normal times. Its ability to respond to major events, and pivot towards challenges like virus testing and contact tracing, is therefore weakened.

There are also tradeoffs in the ability of households to manage the micro-level effects of the crisis. The real cost of necessities like housing, childcare and education has been rising, in spite of the low rate of headline inflation. This leaves households facing a lot of fixed costs even as their incomes might be falling.

Recent child poverty data from Statistics NZ show that our poorest households are also vulnerable to adverse shocks. Three-quarters of children classified as being in material hardship lived in a household that would not be able to cover an unexpected $500 bill without borrowing. A more measured approach to keeping public debt at reasonable levels would not have materially affected the Government’s ability to support the economy now through borrowing and spending.

Moderately higher levels of spending might have made a big difference to other parts of the system that collectively determine our ability to withstand shocks of the sort we face now. We cannot undo past decisions, but the mindset that led to them remains deeply ingrained in our political debates. An obsessive focus on public debt at times when it is not a pressing issue may weaken, rather than strengthen, our ability to manage economic crises.