The world's a very dangerous place

14 November 2011

At the end of last month, I took five days out of the campaign to visit London and Washington.  Some people suggested that was an odd thing to do just five weeks before the election, but I’m quite sure it was a good use of my time.  I made the trip because I was worried about the outlook for the international economy.  After talking with senior people at the Bank of England, the IMF, and other institutions, I came back even more worried.

The major concern at the moment is that most developed countries have far too much debt – household, government and country debt.  With the exception of Germany and Switzerland, virtually all developed countries are trying to deleverage simultaneously.   To avoid global deflation, creditor countries such as Germany, China and Japan should be actively stimulating demand to offset the deleveraging in other countries.  But they are not: Germany has passed a constitutional amendment requiring fiscal restraint, China has been tightening monetary policy to head off inflationary pressures, and Japan already has such a large budget deficit (and accumulated government debt) that there’s not much prospect for strong stimulus from that quarter.

So it’s very hard to avoid the conclusion that we’re in for a prolonged and possibly quite deep recession.

Part of the problem the world faces stems from currency arrangements.  The countries within the Eurozone have effectively enjoyed German-level interest rates for the last decade.  These unaccustomedly low interest rates led to a huge increase in property prices in countries like Ireland and Spain and allowed the governments of southern Europe to fund large fiscal deficits at interest rates which were not much higher than those in Germany. But then the chickens came home to roost and now they’re in a coq au vin of their own creation.

The property bubbles have burst, the banks which funded them have collapsed – or would have had they not been bailed out by their governments – and the investors who bought the bonds of countries like Greece and Italy have started asking questions about whether the governments of those countries will ever be able to pay back the money they borrowed.

To make matters worse, the property bubbles often led to big increases in balance of payments deficits.  Now the countries concerned are left with large international liabilities to service and no quick way to improve their international competitiveness.  They don’t have their own currency, so depreciation of the exchange rate is out of the question.  The only way they can improve their international competitiveness is by reducing internal costs – which in the short term means reducing internal incomes.  This implies years of deflation for a country like Spain, where unemployment is already over 22%.

The other currency regime causing severe problems is the decision by the Chinese authorities to maintain the exchange rate of the renminbi at a rate which is widely perceived as too low.  This low exchange rate has led to a flow of cheap imports into developed countries and an enormous accumulation of foreign exchange reserves on the part of the Chinese.  While this arrangement suited China by enabling it to employ hundreds of millions of people moving from rural China to the cities, it has caused severe pressures in many developed countries, with a resultant increase in demands for protection against Chinese imports.

So the world is a very dangerous place right now.  What does this mean for New Zealand as we head into the last days of the election campaign?

Happily, we have our own currency.  That means that the Reserve Bank can run monetary policy to meet the needs of our own economy.  Interest rates can be set to meet the inflationary pressures within New Zealand.  Our exchange rate can depreciate to make New Zealand producers more competitive.

Unhappily, in a world grown suddenly wary of debt, our government debt, while still relatively low, is growing very fast – by $20 billion in the latest year.  And the net international debt of New Zealand as a whole (public and private sector) is 70% of GDP – not the highest in the world, but among the highest.  With our balance of payments deficit forecast to increase over the next few years, net international debt looks like getting bigger, not smaller.

Does selling minority stakes in four of the SOEs help this situation?  Yes, selling those stakes certainly makes good sense from an economic point of view – it increases the likelihood that the SOEs concerned will operate commercially, it adds depth to the New Zealand capital market, and at the margin it reduces the amount of borrowing the government has to do.  But it is not a panacea and won’t make a huge difference to the growth of our economy,  or directly reduce our external indebtedness.

What we desperately need is a plan to radically increase our growth rate.  We should be appalled that the IMF believes 148 countries in the world will have faster growth in per capita income over the decade to 2016 than New Zealand.

And notwithstanding the grim outlook for the world economy, that growth must be focused on international markets so that we can gradually reduce the high level of our international debt.

How do we do that?  It is absolutely fundamental that we get government spending under control.  Right now, government spending is a higher fraction of GDP than in any year of the last Labour Government.  It has led to a high level of government borrowing and, because much of that borrowing is funded offshore, it has led quite directly to upwards pressure on the exchange rate – to the detriment of the export sector.  It has also led to indirect upwards pressure on the exchange rate because the OCR has had to be held at a level well above that in almost all other developed countries.

If we get government spending under control, sharply cut the corporate tax rate, and take the upward pressure off the exchange rate, we could have more investment, more exports , and more jobs.

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