Below is a useful graph from the ANZ Quarterly Economic Outlook – full publication here. It covers Aggregate Demand in the New Zealand economy and the relative importance of each of the four components AD = C+I+G+(X-M).
C = Private Consumption I = Business Investment G = Government Consumption (X-M) = Net Exports
Notice how consumption and investment become negative during the Covid-19 pandemic – over 15% of GDP in the first quarter of 2021. However it could be expected that net exports will start to bring in much needed growth in the economy – New Zealand is lucky to be a producer of food an inelastic product meaning the demand remains quite stable. With weak domestic demand there is no such need for imported capital goods as business investment starts to dry up. With net exports, Government spending also will be a significant part of a recovery and to offset the deficit in consumption (C) and investment (I).
Income from the tourism industry will be limited in New Zealand as the country closes its borders although domestic demand could offset some of this loss. But with a loss of income and job insecurity this spending might not be forthcoming.
The recovery will require a massive stimulus – monetary and stimulus. For the RBNZ negative interest rates might be considered as a policy option especially with a depressed labour market and the threat of deflation. As the ANZ point out in their publication there are plenty of long-term challenges ahead. But New Zealand is resilient, and has come into this crisis with a lot of advantages:
We have been in a position to respond to the outbreak quickly;
We produce a lot of essential goods domestically and our exports are still in demand;
We have a well-functioning health system and government;
We have plenty of fiscal firepower to respond;
The financial system is resilient; and
The exchange rate and monetary policy can provide a buffer.
Modern Monetary Theory says that you can basically print your own currency by having your own central bank, run large deficits, have full employment, have no inflationary pressure and do this year after year. Nouriel Roubini (see video below) warns that while large deficits and monetary stimulus make some sense during a short deflationary economic contraction, sustaining those policies for years, as he expects will happen, will lead to inflation and economic stagnation – stagflation.
However in a time of crisis like Covid-19 there seems to be a lot more justification for this type of policy over the short-term – when you have a collapse of economic activity, a recession, deflationary concerns and a major reduction in the velocity of circulation of money (MV=PT) – a sort of stag-deflation. At this time a ‘helicopter drop’ makes sense because we have a massive fall in supply as well as demand. But monetising fiscal deficits over a number of years produces a negative supply shock that reduces potential output and increases costs ending up with stagflation like in the 1970’s.
Background to MMT
MMT has its roots in the theory of John Maynard Keynes who during the Great Depression created the field of macroeconomics. He stated that the fact that income must always move to the level where the flows of saving and investment are equal leads to one of the most important paradoxes in economics – the paradox of thrift. Keynes explains how, under certain circumstances, an attempt to increase savings may lead to a fall in total savings. Any attempt to save more which is not matched by an equal willingness to invest more will create a deficiency in demand – leakages (savings) will exceed injections (investment) and income will fall to a new equilibrium. When you get this situation it is the government that can get the economy moving again by putting money in people’s pockets.
MMT states that a government that can create its own money therefore:
Cannot default on debt denominated in its own currency;
Can pay for goods, services, and financial assets without a need to collect money in the form of taxes or debt issuance in advance of such purchases;
Is limited in its money creation and purchases by inflation, which accelerates once the economic resources (i.e., labor and capital) of the economy are utilised at full employment;
Can control inflation by taxation and bond issuance, which remove excess money from circulation, although the political will to do so may not always exist;
Does not need to compete with the private sector for scarce savings by issuing bonds.
Within this model the only constraint on spending is inflation, which can break out if the public and private sectors spend too much at the same time. As long as there are enough workers and equipment to meet growing demand without igniting inflation, the government can spend what it needs to maintain employment and achieve goals such as halting climate change.
How does it differ from more mainstream monetary policy – see table below.
Those against MMT are dubious of the idea that the treasury and central bank should work together and also concerned about the jobs guarantee. They argue that if the government’s wage for guaranteed jobs is too low it won’t do much to help unemployed workers or the economy, while if it’s too high it will undermine private employment. They also say that trying to use fiscal policy to steer the economy is a proven failure because politicians rarely act quickly enough to respond to a downturn. They can’t be relied upon to impose pain on the public through higher taxes or lower spending to quell rising inflation.
I blogged yesterday regarding the shape of recovery after the coronavirus pandemic and have been reading Paul Krugman who suggests that conventional monetary policy can’t offset an economic shock like coronavirus.. Since the GFC in 2008 it is evident that low interest rates are the new normal and according to Larry Summers (former Treasury Secretary) we are in an era of secular stagnation. This refers to the fact that on average the ‘natural interest rate’ – the rate consistent with full employment – is very low. There can be periods of full employment but even with 0% interest rates private demand is insufficient to eliminate the output gap. The US was in a liquidity trap (see graph below) for 8 of the past 12 years; Europe and Japan are still there, and the market now appears to believe that something like this is another the new normal.
Krugman suggests that there are real doubts about unconventional monetary policy and that the stimulus for an economy should take the form of permanent public investment spending on both physical and human capital – infrastructure and health of the population. This spending would take the form of deficit-financed public investment. There has been the suggestion that deficit-financed public investment might lead to ‘crowding out’ private investment and also how is the debt repaid? Krugman came up with three offsetting factors
First, when the economy is in a liquidity trap, which now seems likely to be a large fraction of the time, the extra public investment will have a multiplier effect, raising GDP relative to what it would otherwise be. Based on the experience of the past decade, the multiplier would probably be around 1.5, meaning 3% higher GDP in bad times — and considerable additional revenue from that higher level of GDP. Permanent fiscal stimulus wouldn’t pay for itself, but it would pay for part of itself.
Second, if the investment is productive, it will expand the economy’s productive capacity in the long run. This is obviously true for physical infrastructure and R&D, but there is also strong evidence that safety-net programmes for children make them healthier, more productive adults, which also helps offset their direct fiscal cost.
Thirdly, there’s fairly strong evidence of hysteresis — temporary downturns permanently or semi-permanently depress future output (Fatás and Summers 2015). Again, by avoiding these effects a sustained fiscal stimulus would partially pay for itself. Put these things together and they probably outweigh any fiscal effect due to stimulus raising interest rates.
Can the Japanese experience tell us anything?
The policies proposed are similar to those by Japan in the 1990’s but the environment there was unique from what most other developed economies are experiencing. Krugman makes two points:
Japan allowed itself to slide into deflation, and has yet to convincingly exit.
Japan’s potential growth is low due to extraordinarily unfavourable demography, with the working-age population rapidly declining.
As a result, Japan’s nominal GDP has barely increased over time, with an annual growth rate of only 0.4% since 1995. Meanwhile, interest rates have been constrained on the downside by the zero lower bound. Even with this Japan still faces no hint of debt crisis. Therefore according to Krugman, with negative shocks to economies becoming more prevalent it maybe better to implement a productive stimulus plan instead of trying to come up with some short-term measures every time there are shocks to our economy.
Source: “The Case for a permanent stimulus”. Paul Krugman cited in “Mitigating the COVID Economic Crisis: Act Fast and Do Whatever It Takes” Edited by Richard Baldwin and Beatrice Weder di Mauro
Below is a link to a very good interview with RBNZ Governor Adrian Orr on Radio NZ ‘Morning Report’ programme. Loads of good material on monetary policy – useful for discussion purposes with my A2 class today – online.
The Monetary Policy Committee decided to implement a Large Scale Asset Purchase programme (LSAP) of New Zealand government bonds. The programme will purchase $30 billion of New Zealand government bonds, across a range of maturities, in the secondary market over the next 12 months. The programme aims to provide further support to the economy, build confidence, and keep interest rates on government bonds low. The low OCR – 0.25%, lower long-term interest rates, and the fiscal stimulus recently announced together provide considerable support to the economy through this challenging period.
Currently covering Keynes vs Monetarist in the A2 course. Here is a powerpoint on the theory that I use for revision purposes. I have found that the graphs are particularly useful in explaining the theory. The powerpoint includes explanations of:
– C+I+G+(X-M) – 45˚line – Circular Flow and the Multiplier – Diagrammatic Representation of Multiplier and Accelerator – Quantity Theory of Money – Demand for Money – Liquidity Preference – Defaltionary and Inflationary Gap – Extreme Monetarist and Extreme Keynesian – Summary Table of “Keynesian and Monetarist” – Essay Questions with suggested answers.
Supply shock – will become more visible in the coming weeks as importers from China maybe unable to source adequate supply given widespread shutdowns across Chinese manufacturing.This loss of intermediate goods for production of final products cause a decline in revenue and consumer well-being. A good example of supply shocks were the oil crisis years of 1973 (oil prices up 400%) and 1979 (oil prices up 200%).
Demand shock – is already affecting consumer demand as travel slows, people avoid large gatherings, and consumers reduce discretionary spending. Already many sports fixtures have been cancelled which in turn hits revenue streams. With the uncertainty about job security demand in the consumer market will drop – cars, electronics, iPhones etc. Also tourism and airline industries are also exposed to the fall in demand.
Financial shock – although the supply and demand shocks will eventually subside, the global financial system is likely to have a longer-lasting impact. Long-term growth is the willingness of borrowers and lenders to invest and these decisions are influenced by: increased uncertainty regarding the global supply chain; a loss of confidence in the economy to withstand another attack; and a loss of confidence regarding the infrastructure for dealing with this and future crises.
Monetary policy is limited to what it can do with interest rates so low. Even with lower interest rates this does not tackle the problem of coronavirus – cheaper access to money won’t suddenly improve the supply chain or mean that consumers will start to spend more of their income. The RBNZ (NZ Central Bank) could instruct trading banks to be more tolerant of economic conditions.
Fiscal policy will be a much more powerful weapon – the government can help households by expanding the social safety net – extending unemployment benefit. Also the guaranteeing of employment should layoffs occur. Tourism and airline industries are being hit particularly hard. Although more of a monetary phenomenon the ‘Helicopter Drop’ could a policy tool of the government. A lot of governments already have introduced ‘shock therapy’ and unleashed significant stimulus measures:
Hong Kong – giving away cash to population – equivalent NZ$2,120.
China – infrastructure projects and subsidising business to pay workers.
Japan – trillions of Yen to subsidising workers. Small firms get 0% interest on loans.
Italy – fiscal expansion and a debt moratorium including mortgages
Just completed the Keynes 45˚ line (still in the CIE A2 syllabus) with my A2 class and find this graph useful to explain it. A popular multi-choice question and usually in one part of an essay. Make sure that you are aware of the following;
1. C and S are NOT parallel
2. The income level at which Y=C is NOT the equilibrium level of Y which occurs where AMD crosses the 45˚ line. To Remember:
1. OA is autonomous consumption.
2. Any consumption up to C=Y must be financed.
3. At OX1 all income is spent
4. At OB consumption = BQ and saving= PQ
5. Equilibrium level of Y shown in 2 ways
a) where AMD crosses 45˚ line
b) Planned S = Planned I – point D
Remember the following equilibriums:
2 sector – S=I
With Govt – S+T = I+G
With Govt and Trade – S+T+M = I+G+X
Below is a link to a very good interview with Corin Dann and Don Brash this morning on National Radio’s ‘Morning Report’. Former Reserve Bank Governor Don Brash says that the major Central Banks need to act together and reduce interest rates to offset the impact of Covid-19. The Central Banks he refers to are: US Fed, Bank of England, Bank of Japan and the European Central Bank. Good discussion of the impact of the NZ dollar on trade and the fact that just the past month in New Zealand, the virus may have cost as much as $300 million in lost exports to China. Worth a listen
Economists use the term Japanification as shorthand for the situation where economic growth remains stagnant even with significant monetary easing – lower interest rates and increased government spending. With interest rates already at record low levels it seems that a lot of economies are going the same way as Japan. However as discussed in the video below from the FT, Japan is a nice place to live and has a very high life expectancy. The concern for central banks is what other policy instruments do they have after really low interest rates – they are running out of ammunition. To boost growth in the USA is a lot different than in Japan according to Ben Friedman. He states that Japan does not have the problems of widening inequality and the stagnation of the middle income groups.
The question is why Japanese society seems to cope with an economy that doesn’t respond to very low interest rates and increase government spending? The FT look to Robert Pringle’s book ‘The Power of Money’ and suggest three reasons:
Long established business – 5500-odd companies that are 200+ years old, more than 3,000 are Japanese. They are much more resilient to change and have less of a focus on short-term profits but too service, patience and a disdain for pecuniary motives.
Immaterialism – unlike a lot of western countries (US in particular) money in Japan is less significant in showing success. Therefore there is less social conflict.
Japanese version of capitalism – US = individualism and democracy. Japan = individual is part of a group and discourage competition = a stable society.