Getting ready for the next crisis
The world is a risky place — how ready is NZ to face the inevitable downturn?
If you live in New Zealand and it stretches to your horizon, it is a bit easy to forget about the other 99.8 per cent of the world economy and its endless capacity to sideswipe us. The central bank, however, cannot afford to be insular and complacent. And in times like these, when the international threat level is elevated, businesses and households need to think about resilience to shocks as well.
It is not hard to compile a list of potential epicentres for Global Financial Crisis II: The Sequel.
The escalating bellicosity on trade emanating from the United States, whose President is a stranger to truth, reason and moderation, could get out of hand.
Or, as Turkey’s woes demonstrate, the recent ebb tide of capital flowing out of emerging market economies, which have filled their boots with foreign currency debt, and into the higher yields now available in the US, could turn into a rout.
Meanwhile, the chances of a nodeal Brexit are mounting. What happens if a country which is still the world’s fifth or sixth largest economy and home to a global financial centre crashes out of the European Union without a safety net, because the Mother of Parliaments has forgotten what representative government is?
Ten years after the trauma of GFC, the global economy is still heavily medicated — to an extent that leaves its immune system compromised — with exceptionally loose monetary policy, or latterly in the case of the US, fiscal policy.
Former US Treasury Secretary Larry Summers, speaking at a European Central Bank forum in June, warned that the world is in no shape to handle an economic downturn.
There is the risk of policy mistakes by central banks “normalising” interest rates too aggressively because they are still preoccupied with inflation, when the shocks we face are much more likely to be deflationary, and when they may well be underestimating how far neutral interest rates have fallen.
The potential damage of a global economic downturn, in the face of which central banks are impotent, vastly exceeds that of inflation getting above 2 per cent, Summers argued. Who could disagree?
Back in New Zealand, Reserve Bank governor Adrian Orr sounded pretty relaxed at last Thursday’s monetary policy statement release when he was asked how well the bank is placed to handle a major negative shock. This at a time when the official cash rate is sitting at 1.75 per cent, compared with 8.25 per cent when the GFC hit and Alan Bollard was able to cut it by 575 basis points.
We are well placed, said Orr. The first line of defence is the floating exchange rate.
Clearly, if you have to abandon ship it is better to have a lifejacket than not, but you are still in trouble. The GFC saw the kiwi dollar fall by a third against the US dollar and a quarter on a trade-weighted basis, and we still had the deepest recession since the 1970s and a painfully slow recovery.
With far fewer bullets in its OCR bandolier, the Reserve Bank has been thinking about the prospects of using unconventional monetary policy measures that other central banks have resorted to.
They all have their limitations, especially if other, and much larger, countries are trying to ease at the same time.
One option would be to have a negative official cash rate. Banks would have to pay interest even on positive overnight balances at the central bank. The limiting factor there is the option of holding physical cash instead.
Overseas experience suggests that at most, a negative policy rate might move the effective lower bound for interest rates 75 basis points into the red. Moving it lower still would require, economist Michael Reddell suggests, imposing a fee on banks switching from virtual to physical cash.
More common overseas has been quantitative easing (QE) or large-scale asset purchases, especially of government bonds, with a view to moving longer-term interest rates lower.
But the New Zealand Government does not have all that much debt on issue which the Reserve Bank could seek to buy — only about a third, relative to the size of the economy, as much as the US or Britain, for example. And most of it is held by overseas investors. Whether they would be interested in selling to the bank would depend on the relative attractiveness of other options available to them at the time.
In any case, the jury is still out on whether the benefits of QE have outweighed the costs. Sceptics point to how weak the post-GFC economic recoveries have proven by historical standards for both the US and Europe, even with massive QE purchases.
They also worry about addiction, as the wealth effect on consumption from frothy asset markets underpinned by QE could work the other way as that life support is turned off.
Another option being considered is targeted term lending, where the Reserve Bank would provide funding to banks at subsidised rates, tied to their lending it to sectors of particular concern.
But that sort of microeconomic intervention is properly the domain of fiscal policy and should not be left to an independent central bank.
Assistant governor John McDermott said last Thursday that New Zealand was in the fortunate position of having lots of fiscal headroom should the need arise.
The Government routinely points to the need to conserve the balance sheet’s strength to respond to shocks, to justify the restrictive budget responsibility rules it has adopted.
With net government debt around 20 per cent of gross domestic product, it does have more room to manoeuvre than other advanced economies, among whom that ratio averages about 75 per cent of GDP.
Given the limited capacity at the Reserve Bank’s disposal, it looks like the fiscal Boy Wonder will have to take over from the monetary Caped Crusader when — and it is when, not if — Gotham City is next in peril.
In the meantime, if ever there was a case of an ounce of prevention being worth a pound of cure, this is it. Just as well, then, that the Reserve Bank is now sounding distinctly dovish.
Ten years after the trauma of GFC, the global economy is still heavily medicated.