Managing a Growing Economy: Challenges and Opportunities
Good afternoon and thank you for having me.
I wanted to take the opportunity today to stand back a bit from some of the day to day issues and pick one of two things which are forcing us to change the way we think.
But before I do that I want to cover the economy briefly.
New Zealand’s economic prospects are good.
There are a lot of events going on around the world that cause concern on any day of the week. We can’t do much about any of them.
But domestically, a diversifying and strengthening export sector, solid growth in the construction sector and the boom in tourism mean that over the next two or three years the outlook for New Zealand households is positive.
One of the things we are trying to get to grips with is the impact of what - now look to be semi-permanent - low interest rates will be.
I’m not talking about the Reserve Bank Governor’s decisions about interest rates. In my view, far too much time is spent in the financial markets on this very short term focus on what central banks around the world are doing.
More important is the impact of interest rates on the real economy; in households and businesses.
So we should stand back a bit from the noise in the financial markets.
The prospect of longer-term low interest rates is only just starting to bed in.
When governments around the world issue debt over 10 to 15 years at interest rates of zero or below, it shows that at least some people think that interest rates are going to be quite low for quite some time.
The impacts of this in our own economy mean we are having to re-learn the relationships between different variables in the economy.
The first one is connected to housing markets.
One of the things that has encouraged the focus on housing in New Zealand has been that those who’ve gone into the housing market have largely been right when they’ve taken the view that house prices will keep rising.
One of the drivers of demand for housing has been what is now a 25 year track of decreases in interest rates.
Apart from the odd blip in the 2000’s, there has been a fairly consistent reduction in interest rates from 20 per cent down to around four per cent today.
That trend has probably continued for five years longer than we thought.
Following the GFC, it looked like interest rates had bottomed and they’d be up again by now to seven to eight per cent for mortgages. Anyone who has bet on them going down further has bet correctly – people are still making money out of government bonds which are being issued at negative interest rates.
When we look at house prices, supply matters a lot, particularly because of the cyclical effects in the housing market – that is, more flexible supply means prices will be less volatile.
But there’s no doubt that the increase in prices that we’ve seen – particularly in Auckland but, now, increasingly around the country – is driven by the fact that interest rates just keep on dropping.
And that effects all asset classes.
The New Zealand stock exchange, for example, has gone up a lot more than the housing market. And our exchange rate is regularly seen by anyone who analyses it as over-valued.
If we expect to see interest rates continue where they are – or go lower - over the next 10 years, we will have to rethink the relationship to asset values. All other things being equal, these asset prices will stay up, if interest rates stay low.
A simple measure of it is the cost of servicing household debt. While house prices have increased, debt servicing costs have remained remarkably stable over the last 20 years. Although, of course, there will be more risk to households who borrowed a lot at the bottom of the cycle, and could see significant interest rate increases over time from where they are now.
Another effect of low inflation and interest rates is that we are having significant real wage increases without people really noticing.
If you go out on the street and ask people, many will logically point to the nominal increase in their wages – and most of their pay rises are two-three per cent but some are less than that.
But inflation has been remarkably low.
It turns out that even though we have lower nominal wage increases compared to, say, the 15 years up to 2008, real wage increases that are significantly higher than they were pre-GFC.
In the past five years, for example, the average annual wage has gone up 13 per cent while inflation has been just 3.7 per cent.
It does help explain why we’re not hearing a lot about ‘the cost of living crisis’ – it seems everything that is an issue becomes a ‘crisis’ – but it’s not a crisis. In fact, we’re not even having much of a discussion about it because people can see that prices are not moving up every time they go back to the shop.
Along with this increase in asset values, we’re seeing what are, by historical standards, quite high real wage increases. These moderate but consistent increases we’ve seen over the past five years are relatively unusual in the developed world.
Another effect of low interest rates, and the low inflation that goes with them, is the impact on government and fiscal discipline.
Traditionally we have relied on clearing budget deficits by economic recoveries that have generated five or six per cent inflation and, therefore, significant increases in tax revenues.
That’s not happening now and it means we have to try and beat the political cycle of tight fiscal management when things are tough and loosening up when higher inflation drives stronger increases in revenue.
Currently, you don’t have the increases in revenue to cover large increases in spending.
New Zealand experienced a number of decisive events in 2009/10 in the shape of the recession, earthquake and global financial crisis which forced us to change the way we managed government spending.
Those experiences taught us the need to move away from what has traditionally been a short term, ‘annual cash’ mind set which has had a negative effect on the effectiveness and on the efficiency of our agencies.
These are perpetual monopolies. Government agencies don’t have to worry about what’s going to happen to their revenue – they’re conditioned to the fact it will either stay the same or grow – and if they do a poor job, they’re not going to go out of business.
Agencies should be able to take a 10-15 year view of what they’re doing.
We are gradually trying to push the system to take those longer-term views where they consider their capital assets but, more importantly, their human services. That’s because about 25 per cent of the output that drives the economy is the provision of public services.
It’s my view that in a low inflation environment, a government won’t be able to conduct reasonable fiscal management without understanding much better what drives its costs, what drives its services, and what drives the long term impact that it’s trying to have.
With the use of data analytics, we’re now able to get much better insights into our customers - many of whom are with us in a kind of perpetual sense for 20-30 years. Take, for example, a 23 year old female with mild schizophrenia – she could be on our books for 30 years and will only move off to go onto national Super. We can now use analytics to show the need, to then intervene to change her life, and the trajectories of others like her.
In the pasts governments have thrown money at social problems.
Government interventions have regularly failed to change lives, in fact, worse than that, they have rewarded failure.
As more people have demanded a service, more money has been thrown at it. The departments grow, the ‘business’ grows. They have effectively been servicing the misery.
This is the wrong kind of incentive, and we’re trying to change it.
Thus far I’ve outlined three ways in which low interest rates are going to have a long term impact on the economy; higher asset values are becoming the norm, New Zealanders are getting real wage increases, and the government is changing its approach to the way it manages its books.
This will have an impact on an election.
The traditional model in a recovered economy is for parties to out-bid each other for showing how much they ‘care’ by using hundreds of millions of dollars of your money on projects or programmes that they have no idea will work or not.
However, we’re trying to reframe that debate away from how much is spent to how much of an impact can be made – and to show a willingness to be accountable for that impact.
A final point around low interest rates is that we shouldn’t let the discussion around central bank rate setting and deflationary risk leave the impression that low interest rates are somehow an inherently bad thing. Deflation certainly is. That’s why central banks around the world are creating the most unimaginable monetary policy that you won’t find in any text book – although, I hope you would now.
For most businesses and households, stable low interest rates are positive, not negative. Households are encouraged by that stability. The question is whether the worry that eventually those rates turn around will mean people hold off from investing and risk-taking to keep growth momentum going.
The Government, in the meantime, will focus our economic programme on some of the old fashioned stuff; micro-economic reform.
That includes the regulation of the housing market in New Zealand – it’s been shockingly economically ignorant – and the planning system needs to start understanding the impact of the decisions it makes on households, on costs and on the economy - not just on amenity value.
Another area we’re spending a lot of time on is the balance of environmental quality and economic growth, both through climate change and fresh water quality. Because we are a resource-based economy with an environmentally-based brand, getting these things wrong could cost us a lot of growth opportunity. Getting it right, though, could give us some real dynamism through the next ten years.
My final point is this; one of the unique opportunities we have in New Zealand is that we have choices. Most other developed economies are faced with a toxic mix of problems; aging populations, very high public debt levels, and low growth. Because of those factors, there are growing questions about their political institutions.
We, along with Australia, are very fortunate to be among a handful of countries where we have relatively low levels of public debt.
In New Zealand’s case we actually have budget surpluses – which only half a dozen other countries have. We have populations that are aging but not as fast as other countries - and are more open to immigration.
Therefore, we can make active choices about where to invest in more growth and about what we think about inequality and inequity in our country.
That is going to become more and more unique to New Zealand and Australia – and we look forward to being a part of that opportunity.