I’m really happy that Phil Goff has taken monetary policy up as an issue. The current system – a puritanical neoliberal model set in place twenty years ago – has never worked particularly well and has now become a major threat to this country’s ability to export competitively. Monetary policy is a big issue, as important as any fiscal policy like spending or taxes, but one that’s largely been ignored in recent years, so I guess I’ll split the topic into several posts.
Before the detail, the politics. Hasn’t it been interesting to see the kneejerk reaction from the Right? They won’t even countenance a debate despite the clear problems being caused by our widely fluctuating dollar and the negative side-effects of inflation-targeting (using interest rate to keep inflation within a certain band). Ironically, the Right’s behaviour matches the original definition of politically correct – the received wisdom can’t even be questioned. Key’s come out against any change but, then, he’s a money-trader.
OK, first, the carry trade:
David Farrar writes “declaring monetary policy is no longer working is silly, because of course it is. You can’t blame the high NZ dollar on monetary policy considering we have the official cash rate at a very low 2.5%.”
That’s just ignorant. The Reserve Bank Act is a major cause of our high currency because the Reserve Bank’s myopic focus on inflation causes the carry trade.
The carry trade, where people borrow in one country (say Japan) to invest in another (say New Zealand), which results in currency transactions pushing up the exchange rate of the destination country, works because of interest rate differentials, not absolute interest rates. Sure, our OCR is 2.5% but Japan’s is 0% and it’s that differential that investors are exploiting in the carry trade. We can’t lower our official interest rate to 0% because that would fuel inflation but the result is the carry trade, which pushes up our currency, hurting exporters.
Ironically, the carry trade itself is inflationary because it creates a flood of credit into New Zealand, which lets banks lower their mortgage rates more than they otherwise could and, crucially, offer home loans to people with very small deposits. People use all this cheap and easy credit to buy houses, prices go up, more people use the cheap and easy credit to get on the speculation wagon. Rising houses prices = inflation. Inflation means the Reserve Bank has to keep the Official Cash rate relatively high or even increase it, which brings more hot money on the carry trade, which lifts the exchange rate and provides fuel for the housing bubble. While exporters are being hammered, housing becomes a great investment, which distorts investment towards housing rather than productive capacity.
What we’ve got here is a feedback loop that looks almost custom designed to screw over our economy by making the exchange rate too high for exporters to be profitable and by creating housing bubbles, which in turn draw capital away from investment in productive things into housing. The system is broken.
The first solution is to do what Australia and nearly every other country does. Rather than the Reserve Bank being fixated on keeping inflation within a tiny, low range, it should be tasked with balancing a set of economic factors – inflation, the exchange rate, and unemployment – within healthy ranges.
The second is to give the Reserve bank more tools than just the OCR, more on that next post.