Neville Bennett - Balances
This article by Neville Bennett was published in the NBR on the 23rd of July. To subscribe to regular material from Neville Bennett visit www.bennetteconomics.com.
One advert tells us that one can have expensive things because “you are worth it”. Economists, who are not invariably dismal, might comment that “Yes, you can have it, but it has to be paid for, and you may be foregoing other preferences”. Life is a balance. Pile up costs one side and decrease assets on the other.
Too often public discussion centres on one factor and forgets that by changing it, many other changes follow in the balance or equilibrium. My argument is that there are many matters of policy today that cannot be resolved without disturbing the equilibrium, involving many other macro policies. This may seem boring, but if the reader persists, I believe they will have a rare understanding of the grand economy.
I will certainly explain, for example, why the Kiwi is inherently unstable. I may be wrong, but I think this explanation has not been aired in public discourse.
The Trilemma of international finance
A trilemma is where a person has a choice of three options, each with problems. Statesmen often try to achieve the following three goals simultaneously but they always fail. It is possible to attain two but inevitably one loses out on the third.
#1 Open the country to flows of international capital
Capital mobility allows a country’s citizens and business to invest abroad, and encourages foreign investment at home.
#2 Use Monetary Policy to stabilise the Economy
Central Banks can increase money supply and lower interest rates when the economy needs stimulus, and can increase interest rates when it is over-heating.
#3 Maintain Stability in the exchange rate
A stable rate allows business and households greater certainty in their plans. A volatile rate, often influenced by speculators, has an adverse economic impact.
Like the USA, New Zealand has opted for the first two of the trilemma. A kiwi business or individual can easily invest abroad, and foreigners can readily advance loans, buy shares, set up a business and (sometimes with trifling restrictions) buy land on the open market. The RBNZ sets monetary policy mostly with price stability in mind but it tries to aid full employment. It lowered the OCR substantially in the Financial Crisis.
The consequence of open capital markets and an independent monetary policy is great volatility in the Kiwi Dollar. Its value fluctuates hourly, and it has ranged from about 40 cents to 85 cents to the US$ in the last decade. It has been rather high in the decade and this has made life easier for importers and tough for many exporters, especially manufacturers.
China’s trilemma
The trilemma may be more appreciated if we now focus upon China. China has decided to control monetary policy and the exchange rate. This means that it must restrict capital flows. If China removed restrictions on capital flows it would allow its people and business to move capital overseas, and allow foreigners access to its markets and assets. Without controls money would flow in and out of the country, and the central bank would have to set interest rates appropriate to international interest rates.
Europe’s trilemma
Europe has adopted a third way. By adopting a common currency; France, Germany etc have eliminated all exchange rate movements within a huge, expanding zone. Capital movements are basically free too. The price is that countries have lost the right to make their own monetary policy.
The spotlight has been on Greece and other countries which have great imbalances (more of those later) but have to live with interest rates set by the EU Central Bank. Greece has been denied the classic remedies for recovery, especially devaluation (to aid its exports and discourage imports) and higher interest rates (to squeeze costs).
More discussion.
NZ policy tends to follow US policy without much deliberation. Our choices of an independent central bank, a floating currency, free trade, and free capital movements seemed to be best practice, partly because the US said they were. Yet these policies do not have a long history in the USA: it fixed the price of the dollar and gold until the 1970’s for example, and its attitude to free trade remains ambivalent ( it still subsidises agriculture). More enlightened discussion could lead to a better appreciation of New Zealand’s potentialities.
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FINANCIAL BALANCES.
There are 4 financial balances for every country that have to be in equilibrium. A change in one, needs adjustment in the others. A sector cannot increase its surplus without affecting others. There are four sectors:-
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Household Financial Balance
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Business Financial Balance
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Government Financial Balance
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Foreign Financial Balance.
For example, since the financial crisis the US private sector has changed its behaviour: household and business have increased their surplus, but the public sector has increased its deficit markedly. The external sector is in deficit.
Now we will extend this simple model to cope with the Foreign Financial Balance. The US at present is arguing that it is deficit partly because the developing countries are in surplus. It is urging them, especially though pressure on China to change its exchange rate, to reduce their surpluses by exporting less and increasing their domestic demand and consume more US exports. This is utopian at present, but it may happen eventually.
One important insight that emerges from this discussion is that if, growing pressure for financial austerity continues, and governments reduce their deficits, there will be a corresponding fall in private sector surpluses.
This adds weight to the old adage: “be very careful what you ask for!”. I have urged greater fiscal responsibility in NZ , but am aware that there is a cost. Unless new sources of revenue are found (and I have suggested looking at land and housing) greater fiscal responsibility means government spending cuts and a degree of deflation.
There is a real danger that the US, UK and Europe might concertedly adopt tougher fiscal policy and depress aggregate demand enormously, creating a depression.
The risk of depression is increased by the reality of structural unemployment, aging populations, climate change, and a reduction in credit creation in the developed world.
