Chicken Broth For An Ailing Economy

An interview with NZIER chief economist Shamubeel Eaqub, about how to nurture this frail economy through its convalescence

by Gordon Campbell

The economy continues to grope uncertainly towards a recovery that is eluding most New Zealanders. In coming months, family budgets and consumer demand are likely to be squeezed, given the dual impact of the existing high levels of household debt and the price rises looming up over the horizon – for GST, for costs related to the Emissions Trading Scheme, for ACC charges, and for the rises in mortgage payments as the Reserve Bank cranks interest rates back up again. For most ordinary New Zealanders, the pittance they will get in tax cuts on October 1st will not be adequate compensation. The prospect is for quite a long convalescence before anything resembling normal levels of economic activity (or job creation) return to the economy.

The ruling business mindset – for two decades it has been geared to quick fixes and short term profit taking – is simply not emotionally capable of giving sensitive, sustained care to an economy that has chronic weaknesses. As indicated by the interview below, no one even knows what the causes of the current sickness are – let alone what might restore health to the old economy, much less create a more productive new one. As if in its sleep, the Reserve Bank is reaching for the lever to raise interest rates, while the government rummages in its kitbag of 20 year old policies – cut taxes for the rich, reduce services for everyone else, give more power to employers, build more prisons and hope for the best.

The recently announced intention to extend the 90 day probationary period for new employees seems, for instance, more likely to reduce flexibility in the work force than to increase it. Why would anyone leave their current job and risk taking up a new one, if by doing so they would lose all of their employment rights and job security? The assumption has always been that employers need certainty and security in order to succeed – yet their new recruits are being expected to thrive on insecurity. No wonder we’re in trouble.

In mid July – shortly before the decision to extend the 90 probationary period was announced – Werewolf editor Gordon Campbell met with Shamubeel Eaqub, chief economist at the New Zealand Institute of Economic Research.

Campbell : How would you characterise the state of this recovery ?

Eaqub : Quite shallow so far. It has been slow off the mark and weaker than in previous recoveries.

So we’re not seeing the sort of bounce back that you’d expect, in a normal business cycle upswing?

No. Typically this far into a recovery you’d see very strong growth, very strong household spending,very strong recovery in house sales. You’ve seen a recovery from last year’s lows, but not to anything like the same extent as in previous cycles.

Is this just a temporary holding pattern or are these conditions likely to endure for some time?

To answer that, we really need to briefly indicate where we’ve come from. In the last 10-15 years, we have boosted our economic growth and have boosted capacity, but have done so largely by borrowing a lot of money. We seem to be at a stage where we are now paying off debt. What that means is there’s less money to go around. And we will experience lower growth than we’ve seen in the last decade.

So the essential drag on the economy right now is due to debt repayment?

It is a large part of it. What we’re seeing is that households are actively managing their debt repayments rather than just interest, and we’re seeing business debt going backwards and reducing. This is very unusual at this stage of the cycle, because interest rates are very, very low and normally with low interest rates you have a lot of borrowing and that drives the recovery. But we’re at a point where both households and businesses are wary of debt….

So while at the household level we’re seeing a virtuous paying off of debt, we’re not seeing businesses take up the opportunity for virtuous investment?

In the short term, it means there is less activity in the economy. But from a medium term perspective its good, because you can’t afford to live beyond your means forever. But at the business level…what’s kind of scary is that businesses do need some level of debt in combination with their own money, to invest in the plant, the machinery, the office buildings that enable us to have a better economy. If you can’t get those investments, it gets that much harder to have a long term and productive growth cycle.

OK, and so what policy settings would facilitate that?

At the moment, the reason a large number of businesses aren’t taking on debt is because they’re not sure that its going to be productive. Its not as if the policy settings are wrong – or that government should be stepping in. …[its just that] you have to have a business [sector] that has sufficient cash and reserves, and prospective sales, to take on the debt.

Is the lack of demand that underlies the hesitancy mainly a local problem, or is it an international one?

It has been fairly widespread. In the domestic sector in particular it has been a lack of demand internally. But when we look at it internationally, only a few countries like Australia and China have been doing well. The rest of the world really isn’t demanding much [in the way of our exports].

Right. But the people who are more optimistic about this current situation are saying….Gee those regional economies like Australia and some of the Asian economies are doing fine and so, why can’t we base a growth strategy around the health and wellbeing of those near neighbours ? Why are we transfixed by the state of Europe and the US ?

We still export and import a lot from those other advanced economies. Although we have become more integrated with the global economy and more so with the Asia Pacific region – we still have very strong trade and financial capital ties to the rest of the world. It is almost a two part process. Yes, we have done well out of the resilience of the Australian economy and from the very strong nature of the Chinese economy – and one contribution has been the very strong visitor growth. Tourism growth from Australia right through the recession has really underpinned the tourism sector – which could have been hit much harder, because arrivals from Europe and America fell off very sharply. Also the strength of China…we exported a lot more logs and forestry products and dairy.

Now that’s very nice for dairy farmers and for foresters but not so good for the other manufacturers. We have a range of exporters in New Zealand who are not simply producing commodities, but a whole bunch of niche manufactured products. For them, it has been much harder.

Overall, is the economy back yet to its pre-crisis condition?

Not at all. We are probably about a sixth of the way back. So, we fell off very, very sharply during the recession, on a per capita/GDP basis, which is a measure of how much, as an economy, we are earning. We have recovered about a sixth of that.

We are in the middle of a debate about the wisdom of raising interest rates There are several one-off factors – the GST hike, the ACC charges, the excise tax increase on cigarettes, the costs related to the Emissions Trading Scheme. Apart from that, is there anything in the underlying rate of inflation that should be any cause for concern to the Reserve Bank?

There are a few things that will go up quite quickly over the next 6-9 months. Food is one of them….But when you step back and ask what should the Reserve Bank really be worrying about – it is excess demand in the economy and widespread inflation, and we are not seeing that at the moment. We still have an unemployment rate that is relatively high, and labour is still pretty easy to find. Wages are still quite soft. And we are not seeing firms using capacity in ways that are going to be very inflationary.{ [For that to happen] You would need to have a very strong recovery where demand exceeds supply. That is not the case.

So you would argue that even a gradual and stepped approach by the Reserve Bank to the raising of interest rates is not justified?

Well, the reason why I’m a little bit worried about interest rates is when you look at real interest rates – the ones that you and I see, as opposed to what the Reserve Bank’s Official Cash Rate says – they’re about normal, when it comes to things like mortgage rates. They’re not particularly cheap right now. Given a floating mortgage rate at around 6% or a two year mortgage rate at about that level – the question is, is that cheap? Is that encouraging investment by households and businesses? And the answer is that monetary policy settings are currently not being particularly supportive of growing the economy.

Not to mention that a hike in interest rates would effectively limit any likelihood of an increase in consumer demand.

Yes. Even though a small increase in interest rates may not make a huge difference to borrowing rates immediately, if there is a programme of interest rate increases by the Reserve then obviously, the cost of borrowing will go up – more than normal – and we will consume less than normal.

The interesting thing about this situation is that even though we all give lip service to the notion that the factors pushing up headline inflation are all one off factors that have nothing to do with the underlying health of the economy –

And I agree, it doesn’t

Yet regardless, there seems to be a degree of seepage into the price intentions of business. Even though one part of their brain is telling business that these factors aren’t relevant, the figures still seem to be feeding through into a general intention to raise prices.

Well, we know that pricing intentions have gone up. We also know that intentions don’t always translate into reality. Businesses can’t arbitrarily raise prices. There has to be demand for the goods – and if demand isn’t there, they can’t raise prices. That’s what we’ve seen over the last 12 months. Because the recovery has been weaker than expected, businesses simply haven’t been able to pass on the price increases they have expected.

What I’m getting at is – the Reserve Bank really shouldn’t be being spooked into action on interest rates by the expressions of price intentions, because they would then be reacting to what is, in many ways, a mirage.

In fact, I think that is exactly what is happening right across the economy at the moment. When you look at most of the forward surveys like business confidence and consumer confidence, there is a lot of optimism. The problem isn’t the optimism. Optimism is a necessary but not a sufficient condition for activity. What we’re seeing is business saying we will do a whole bunch of things but they don’t actually do it. Until businesses start to act on this optimism and until we start to see investment and growth and actual sales going up –

Can the Reserve Bank afford to wait, given its actions are supposed to be predicated on medium term outcomes?

At some point in time, interest rates have to return to normal. Normal can be anything, right? But my argument is – when the balance of risks facing the economy are back to their more normal levels, that’s when you should take interest rates higher. What we’re seeing right now isn’t a balanced set of economic risks. What we’re seeing now – number one, is an economy that’s recovering very shallowly out of a recession and number two, the most concerning element when it comes to inflation occurs when households become fully indebted and consume too much. We are seeing absolutely no evidence of that. One of the best indicators of that is house sales. They are stuck in a quagmire.

The risks facing the domestic economy remain on the downside. We have mortgage rates that have generally risen and the impact of that still hasn’t come through. We are going to see that net migration will slow. The Australian economy is growing strongly and that is going to suck more and more Kiwis across the ditch. That is going to be a big driver is restraining domestic demand. And at the same time, the international economy really hasn’t become much easier to deal with. We have these worrying signs out of Europe.

Sure, Athens might be 17.5 thousand kilometers away. But it doesn’t mean we are detached from what is happening there. And what is happening there is telling us that governments have too much debt, and that monetary policy is not being able to stimulate enough demand. Most commentators are expecting growth forecasts for the US and Europe to be revised downwards for the balance of the year.

And then you ask – what is happening in Asia ? Yes, they have been really strong. But it seems that at least the initial part of it was re-stocking. During the recession, they ran down the inventories. So there are more risks to the downside than to the upside – and until we see those balance of risks shift, we’d like to see the Reserve Bank wait. There’s no harm in waiting two months.

As we saw Australia do recently when it put a hold on interest rates rises?

Yes. And [formerly] when Australia decided to raise interest rates, its housing market was going through the roof. So there was a clear need to raise domestic borrowing costs.

OK, looking beyond the interest rate lever – what other policies can usefully be deployed to nurse an economy through an extended period of convalescence like this?

Monetary policy generally works, right? Its important to understand that monetary policy is all about affecting the cycle. It doesn’t affect long term growth. What is tries to do is manage the cycle of ups and downs and tries to see that inflation is even, on average. What the government tends to do is affect medium term growth. Because that is all about incentives. Do we save more? Do we consume more? It is these questions that the government influences, and those benefits take a long time to get through. In the massive reforms we saw in the late 1980s and early 90s, it took almost a decade to really come through in terms of economic health.

Right, and that was with a large assist from the international economy –

So the dividends of government policy take a long time. Generally speaking, New Zealand is an easy place to do business, We have very little corruption.,.One thing though, is that we’re very small. We don’t have the market, we don’t have scale. We need to engage with other, bigger markets. Which we are engaging with, through free trade agreements.

What about the contraction in public spending and its impact on this process? Is there anything about the current content or direction of that process that concerns you?

The evidence on public spending is really mixed, both in the opinions and on the empirical evidence about how public spending affects the economy. Is it better for the government to give you a handout in tax cuts, or is it better for them to spend it themselves? The role of government is to provide the basic infrastructure to ensure property rights, to ensure there is competition, to ensure there are proper institutions and proper regulations in place. You don’t want to cut back spending to where any of that is comprised. And we won’t know what the latest spending cuts will mean, for some time.

Right now though, we do know that government spending is only 34 % of GDP and is forecast to track downwards to just over 32 % over the next couple of years. Neither of these figures seem like a blanket thrown over the birdcage of economic activity – not to any extent that should affect the outcomes unduly.

For the government, its spending is not so much an issue in the short term, or government spending as such. The real issue is looking out for 15-20 years to where there’s pressure from an ageing population that’s going to impact on National Superannuation and on the health system. If you let government spending grow unabated it will over time, be going to crowd out private enterprise.

Which means perhaps that we shouldn’t demonise the spending as such, but get into the parts of it that add value. In that respect, do you see the recent dip in commodity prices as being only a temporary blip?

If I look out 20 years I feel very comfortable about commodity prices. New Zealand has a lot of land, a lot of water and the rest of the world doesn’t – not in relation to the population growth that is projected to come through. But in the next 12 months, its very difficult to say – because most commodity prices have taken a dip recently [due to] fears about the global economy. For dairy, there are also specific circumstances to do with the European production season and the like, that is also creating a more balanced demand and supply situation which might see prices drift back a bit more. Over the longer term I’d expect food prices to remain relatively high.

So can a foundation in commodity prices be sufficient to base an export led recovery for us, primarily to China and to other Asian countries?

Well.. I guess the thing with food prices is when you think about it….how many people actually benefit from higher commodity prices? Not that many. All of us however, pay higher prices at the supermarket for our food. So in the short term, there is an economic impact where food prices go up, but most of those benefits go to a very small proportion of the economy – only about 10 per cent. But then over time, those farmers have to go out and spend more, and there is [an eventual] flow on effect.

Unless they’re not paying off debt.

Well, even if they are paying off debt it increases their capacity for spending in the future. I don’t think that’s a bad thing.

Yes, but I’m talking about whether those prices will feed through into an ailing economy, any time soon.

Well….I’ve heard the talk about the tsunami of dairy payout money and all that stuff, and yet we never really saw that kind of big pickup of growth [from dairy prices] in regional economies. What we saw was Waikato doing pretty well during the dairy boom, but did it underpin a broader economic recovery? Not really. [The economy] is still very Auckland-centric. It is still very much about housing. It is very easy to lose sight of the fact that the majority of people in New Zealand are very detached from agriculture.

Finally, can I ask the same question about the global economy as we discussed at the outset about the domestic economy – namely, do you think the Americans and the Europeans should be taking a razor to their deficits right now, or should they be waiting until there are more robust signs of economic growth?

That’s a really tough one. There’s one school of thought – the very Keynesian one – that says the economy is far too weak, we should continue to spend. But then the question is – how do you spend? Where do you get the most bang for your buck? Just because you’re spending doesn’t mean that it is helpful spending.

I guess the chances are that state spending is more likely to be virtuous right now, if only because there isn’t much private sector money sloshing around.

Yes. Essentially what we are talking about is a failure of demand and the government deficit is there to boost it. That’s well and good – except when you know the government doesn’t have any money in the kitty, and you expect that taxes will have to rise in the very near future to make up for its largesse.

Or subsequent growth will replenish it.

We’re in a very tricky situation. Its not at all easy for me to say how this is going to pan out. If we spend too much now, it just puts us deeper into the hole, in terms of government debt. And if people realize that too much debt will lead to higher taxes, then they’re not going to be encouraged to buy more stuff. So it comes back to more debt, and not enough economic growth to pay off that debt.

Maybe. But the weirder aspect of what David Cameron and Angela Merkel are doing is that it seems based on a belief that if governments inflict pain now and get debt quickly under control they will be rewarded by investors. By that logic, contractionary policies are actually expansionary, because they will allegedly foster confidence in the angels of the market. That’s really odd –

Well, short term gain versus long term gain is the message that the UK is trying to push. Its a very Austrian view, that if you’ve got too much debt its better to take care of it now and get your house in order. And if there’s confidence that you’ve got your house in order then the private sector will pick itself up.

Isn’t that what Paul Krugman (pictured left) has called a belief in the confidence fairy ?

Yes, and there’s a confidence fairy on the other side as well. [that spending will promote growth] It is a mirage. The whole thing is a mirage. But you can’t borrow and spend and expect that to be a sustainable recovery.

And you can’t put the economy into traction and get good outcomes, either.

How we got into this mess was having too much debt.

Was it? The Keynesian view is that at a certain point, the stimulus will eventually help the private sector to pick itself up off its sickbed and back into genuine economic activity. And the other – what you call Austrian view – is saying no, you can get the same outcome by fostering confidence among investors that these governments mean business, and this will bring investors back into the market earlier, and the public will simply have to wear the pain of the contraction in the interim. It seems fairly alarming either way, don’t you think?

I should send you this Greg Mankiw paper about humility. The patient is very sick. The doctor doesn’t know what remedies will work. In fact, we don’t even know what the sickness is. We are sort of flying blind at the moment. When we had the Great Depression, it was the war that really catalysed the US economy out of the Depression.

That, and the New Deal.

Well, when I think about what could go wrong….Something could go wrong with either theory, right? You can see the holes in both of them. If the government is going to spend more and no-one believes that is sustainable, then why would they go out and spend more money?

That begs the question. Why wouldn’t they [the private sector] surf on the back of that spending, or choose to invest in the likes of public – private partnerships? I could just as easily say the alternative – the belief that contraction now will prove to be virtuous later – sounds like Herbert Hoover in 1932. That didn’t turn out too well. What we’re trying to work out is which option is more likely to be sustainable.

There is very, very good reason to assume that we don’t know. Macro-economics is a very complex subject, especially when it comes to these big questions. When you look through history there have been periods when certain things have worked, and certain things haven’t…I’m not convinced that either of them is the answer. We just don’t know. And we won’t know until we try it. So in ten years time we might be having this conversation, and some countries will be bankrupt. Or some countries might be in a better position to try one or other. The UK might not be in a position [to try the Keynesian approach].

But Germany might be?

Yes Germany might be more able to.

So to wrap this up, is there anything that New Zealand can do to lessen the chances of a double dip recession? What does the wise squirrel do in this situation?

I think that’s exactly what people are doing. They are squirreling. . They are just holding back, making sure that their finances are in good shape and that they are prepared for whatever comes, both on the upside and on the downside. The problem isn’t that we’re not being careful – the problem is that we are being careful. Everybody is just sitting on their hands. Which is a recession.

Or potentially, a deflationary lost decade as we’ve seen in Japan – which couldn’t figure out how to get out of it.

And still can’t. Japan also has that unfortunate ageing problem, one that’s hitting them first. Given their immigration policies, it is just going to get harder and harder for them…I’m not suicidally depressed about the economy. There are still a lot of things that are going well. We still have a population base that’s quite well skilled. We can attract more people if we want through immigration, We have a services economy that functions quitewell, and a set of institutions and structures that work. So fundamentally we’re still in a reasonably good position.

The question is – what is going to drive us into having 3-4 % growth? Right now, it is a little bit hard to see – because if interest rates are rising and government is cutting back on spending, there really isn’t much stimulus in the economy.