Speech to the Auckland Rotary Club on the economic challenges facing New Zealand
When the sharemarket value of the largest banks in the world falls by more than 90% in a year; when shippers offer to move containers from Asia to Europe for not much more than a contribution to the cost of stevedoring them; when the international price of oil falls by more than two-thirds in six months; and when the US economy loses more jobs than in any year since the Second World War, nobody can have the slightest doubt that the international economy is in the worst shape in decades. Certainly, in the worst shape since the 1930s. Little wonder that the Governor of the Bank of England observed recently that British banks are in worse shape than at any time since the beginning of the First World War, or that last week’s edition of The Economist magazine concluded that “this crisis is so huge that seeing beyond it is hard”.1
It’s become fashionable to blame this unholy mess on “free and unregulated markets”, especially free and unregulated financial markets. And there’s been a call for banks to be regulated.
There’s not the slightest doubt that some banks have behaved with reckless disregard for prudent risk control, and some individuals have been guilty of criminal fraud.
But of course none of the countries where banks have got into serious trouble have “free and unregulated” banking markets. All those countries, without exception, have bank regulators who lay down the rules which banks must comply with – the minimum equity capital they must have, the limits they must observe on risk concentration, the liquidity they must hold, the risk control systems they must have – and regulators who monitor compliance with those rules with frequent on-site inspections.
Indeed, to the extent that that regulation created a perception, on the part of bank customers and bank directors, that as long as those rules were being complied with the banks must be safe and above reproach, the regulation may actually have contributed to the financial crisis which triggered the current economic problem.
Other policy mistakes contributed to the disaster: with the benefit of hindsight, it seems undeniable that monetary policy in some major countries was too loose for too long; in the US at least, banks were under political pressure to lend to customers who did not meet any of the usual criteria of creditworthiness; and the restrictive zoning of residential land in some urban areas created the illusion that house prices would rise indefinitely, inducing an attitude to borrowing and lending on residential property which has turned out to be foolhardy in the extreme.
So let nobody away with the claim that the disaster was all the result of a “free and unregulated” banking industry.
But whatever the causes of the present serious problem – and discussion of the causes is essentially a digression from my main purpose today – what does it all mean for New Zealand? How badly will we be affected?
There can be no doubt that the international slowdown will have a significantly adverse effect on New Zealand. If we needed to be reminded of that, the second reduction in Fonterra’s forecast payout in two months last week should have left us in no doubt. All those serving foreign markets – exporters, in-bound tourism operators, and all those who supply those businesses – will be adversely affected, and the situation will be made immeasurably worse if we see the emergence of barriers to our trade and subsidization of the exports of other countries, such as we have seen in the European dairy market in recent days. Then we really would be faced with a repeat of the disastrous mistakes of the thirties.
In some respects, we are better placed to deal with the crisis than many other countries.
When the downturn began, our unemployment rate was lower than that in any other developed country; our government debt relative to the size of our economy was one of the lowest in the developed world (thanks to the privatisations of the eighties and nineties and 15 consecutive years of Budget surpluses); our banking system was in very much better shape than that in the United States or much of Europe; and there was ample scope to ease monetary conditions, with lower interest rates and a lower exchange rate.
But in many other respects we are facing the perfect storm.
To begin with, the government’s Budget position was set to deteriorate rapidly even without an economic downturn. The Economic and Fiscal Forecasts prepared by The Treasury and released by the Minister of Finance in mid-December show that government spending is projected to rise by an astonishing 15% in just two years, between the year to June 2008 and the year to June 2010. This is largely a result of increased spending committed by the previous Government. It has little to do with either the slowdown or improving our longer-term growth rate, and much to do with trying to get the last Government re-elected.
Coupling this increased spending with a marked decline in the growth of tax revenue as a result of the economic slowdown results in the government’s fiscal position moving from comfortable surplus to very uncomfortable deficit in short order. The Treasury projects that, unless policy changes are made, gross government debt will rise from a very respectable 17.5% at the end of June 2008 to 33% by the end of June 2013, and to a distinctly disreputable 57% by 2023. When the Minister refuses to be panicked into announcing large new spending programmes to stimulate the economy, and points to the fact that the fiscal stimulus built into current programmes is already very large by the standard of most other countries, he is absolutely right. Our scope to move further is distinctly limited.
Secondly, even without the impact of the international slowdown, we are dealing with our own internal slowdown. According to official statistics, the New Zealand economy has been moving backwards – in other words, in recession – since the beginning of last year. Initially, that slowdown was in significant measure the result of drought, which always knocks the stuffing out of our economy because of its effect on both farm output and electricity generation.
But as time has gone on, another important factor has influenced the economy, namely the gradual deflation of our very own housing bubble. When house prices were rising strongly, as they did from about 2002 to 2007, those who owned their own homes felt richer – and they increased their spending accordingly. Why bother saving when you are getting richer by the day without saving? New Zealanders have been among the world champions in dis-saving over many years, and a rapid escalation in house prices has been an important part of the explanation for this. With house prices falling, many people are becoming more cautious and the growth of spending is slowing, as many retailers discovered over the Christmas period.
The risk is that this part of the reason for a slowing economy has a long way to go. Of course, those involved in the real estate industry, and those who for whatever reason need to sell residential property, want us all to believe that the downturn in prices has almost run its course. And they might be right. But it isn’t at all clear why house prices in New Zealand – which international surveys have revealed to be among the highest in the English-speaking world relative to incomes – should fall any less than those in, say, the United States or the United Kingdom, where they have certainly fallen a good deal further than they have to date in New Zealand.
And if you need convincing about the scope for house prices to fall quite a bit further, take a look at this graph, showing inflation-adjusted house prices in New Zealand since the start of the seventies:
As you can see, house prices rose steeply in the first half of the seventies, fell steeply in the second half of the seventies, and didn’t reach the 1975 level again until earlier this decade, more than a quarter of a century later. Then of course, they took off with a hiss and a roar, almost doubling (in real terms) between 2002 and 2007. There has to be at least a strong possibility that they could fall a long way from their present levels, and if that happens overall spending in the economy is likely to be constrained.
You might claim that a fall in prices which could take real prices back to their level of 2002 is highly implausible. Perhaps, though a fall of almost that magnitude would be needed to take the median house price back to an historically more normal three times average household income.
And if you need further convincing, take a look at this graph showing the inflation-adjusted price of Japanese land in recent years. As you can see, following an enormous bubble in Japanese land prices until the early nineties, those prices have fallen by almost half in the years since that time, with prices having fallen in every year for the last 15 years.
If New Zealand were to experience even a mild echo of that experience, the effect on slowing the growth of spending in New Zealand would be dramatic.
And the third challenge we are facing – which is related to the strong growth in consumer spending until recently – is the extent to which we have become indebted to foreigners.
The last time New Zealanders earned more overseas than we spent overseas was in the early seventies. In every year since that time, we have spent more overseas than we have earned. In other words, we have had a deficit in the current account of the balance of payments. Relative to the size of the economy, our worst deficit was in the early seventies, when we were hit by the first oil shock and a collapse in our export prices: the deficit reached some 14% of GDP. As this graph shows, it hasn’t been as large as that since that time, but in the last few years the deficit has been running above 8% of GDP, a very large deficit by international standards amounting to some $15 billion per annum. (In other words, we need to find additional funding of some $15 billion each year to pay for the goods and services which we want to buy beyond what we are producing at home.)
Once upon a time, in what now seems like a world far far away, New Zealand piled up foreign debt by the government’s borrowing to fund those deficits. But the government eliminated all net foreign currency debt in the mid-nineties, and today has net foreign currency assets (if the assets in the New Zealand Superannuation Fund are taken into account). The funds required to pay for our over-spending have come partly from foreigners willing to invest in shares and property in New Zealand but mainly from borrowing, much of it undertaken by banks faced with our poor savings habit and our insatiable demand to borrow. As you can see from this table, of the estimated total of gross liabilities which New Zealand companies and individuals owed to foreigners at the end of September of almost $300 billion, nearly half, or $148 billion, was owed by the banking system. At the moment, some 40% of all the funding needed by the New Zealand banking system comes from offshore.
If we subtract from our total external liabilities an estimate of our external assets we arrive at a figure for our net external liabilities of some $166 billion. For those of you who have become accustomed to listening to reports of the US economic situation, where the economic drama is discussed in terms of many hundreds of billions, or even trillions, of US dollars, $166 billion may not seem an overwhelming amount. But it is equivalent to more than $40,000 for every man, woman and child in the country, and to over 90% of GDP. We have the unenviable distinction of having a higher ratio of net external liabilities to GDP than any other developed country except Iceland – certainly well above the net external liability ratio of other English-speaking countries such as Australia, the United Kingdom, the United States or Canada.2
New Zealand’s relative position is well illustrated in my last graph:
What is ironic in the extreme, considering how poor most people in China are, is that much of the borrowing done by the English-speaking world in recent years has been funded by the frugality of East Asians.
One way or another, we have to start living within our income and that will inevitably involve a painful adjustment for many people and many companies. Companies whose business model is based on the continued growth of consumer spending well in excess of the growth in our incomes are likely to find themselves in difficulty. And the same applies to businesses based on catering for the demands of those who have imagined themselves to be getting ever richer on the basis of highly leveraged plays in the property market.
Nothing the Government can do can avoid that adjustment process taking place. Indeed, the Government shouldn’t try to avoid the adjustment. Collectively we face the need for the adjustment, and the best thing the Government can do is help to facilitate it.
There will be a variety of views on how the Government can best achieve that. My own hope is that the Government uses our unavoidable need to move from an economy driven by a very high level of consumer spending to an economy which lives within its income to encourage people and capital into activities which will deal not only with the short-term crisis we face but also with the long-term crisis.
At the moment, not many people are focused on the long-term crisis. Indeed, many people don’t even understand that there is a long-term crisis.
Our long-term crisis is that, in recent decades, the living standards of New Zealanders have drifted down relative to those in countries to which New Zealanders can readily move. Despite an early commitment by the last Government to raise New Zealand living standards into the top half of the international league table within 10 years, we’ve actually drifted down over that period – and that despite some of the best international trading conditions in a generation. As a result, we are seeing increasingly large numbers of New Zealanders vote with their feet and move to higher living standards in Australia and elsewhere. Often, those who leave are the very people on whom any hope of reversing our relative decline depends.
Unless we deal with that long-term crisis, solving the very serious short-term crisis will be a Pyrrhic victory.
1 The Economist, 24 January 2009, page 10.
2 Iceland’s net external liabilities are significantly higher than New Zealand’s, and to make matters worse Iceland’s net figure is calculated by subtracting a very much higher level of gross liabilities from a very much higher level of gross assets. Part of Iceland’s recent difficulties have been caused by serious doubts about the quality of the gross assets.
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