Finance Minister Michael Cullen faces the political reality of election year

Listener: 23 April, 2005.

Keywords: Macroeconomics & Money;

How to slow an economy that is pressing on its capacity to produce? A couple of decades ago, the government might have imposed a credit squeeze, reducing private investment. Additionally, it would have tightened restrictions of consumer credit (especially hire-purchase), raised taxes to reduce household consumption (but not in election year), reduced government current spending and told government agencies to defer their investment plans. Today, it appears to rely only on the Reserve Bank to squeeze credit by raising interest rates.

In the past, expenditure was restrained across the board, easing pressure on all production. Today, the direct restraint is only on that affected by interest rates – mainly private investment, leaving three-quarters of expenditure untouched. The change came about in the late 1980s, when the Reserve Bank was given the task of restraining inflation, via its monetary policy.

Unfortunately, the way that this was presented seemed to imply that fiscal co-ordination was unnecessary. But the resulting credit squeeze has to be much tougher, and interest rates higher, compared to the government also restraining private consumption and public spending, sharing the burden across the entire economy rather than imposing just on the investment sector. Of course there will be collateral damage, as those paying interest will report. Perhaps they will cut back their consumption, which will ease the pressure on available resources. Damage also occurs when higher interest rates drag up the exchange rate, making exporting more unprofitable, so that exporters reduce their production. That also eases the pressure on resources for production, but, together with the cutback in investments, the cost is New Zealand’s long-term growth prospects.

The policy was adopted in the 1980s, in part because extremist monetarism was then fashionable. We were besotted by the US experience, where fiscal management – especially a tax hike – is difficult because the President does not command Congress in the way that our Prime Minister commands Parliament. So, Americans have to rely on monetary policy exercised by the Federal Reserve (chaired by Alan Greenspan). We have more possibilities.

Those who uncritically adopted the American way, despite our different governance, argued that fiscal management was unnecessary. Not having to be fiscally disciplined makes political management easier, since politicians do not have to make the tough decisions. Not surprisingly, during much of the late 1980s the fiscal position was far too slack, a major reason why the economy stagnated for seven years, while the rest of the world prospered.

None of the above will surprise Minister of Finance Michael Cullen. He knows that, with low unemployment and high utilisation of productive capacity, the government fiscal stance has to be restrained. But he faces the political reality of election year. Other Cabinet ministers are keen to spend more: many of their proposals are worthy – no doubt, Cullen secretly thinks so, too. Meanwhile, there is the clamour of other political parties promising substantial tax cuts and public expenditure increases. How to resist the siren calls?

It will be easier than 1990 when the Labour government, not expecting to get re-elected, made numerous fiscally extravagant promises. Cullen expects to be Minister of Finance after the election, and will not want to have to reverse his pre-election decisions. We may see a Budget that will spend only a little more and tax only a little less, if at all. But it will promise more spending and tax cuts in the future. Expect those promises to be played up during the election campaign, rather than the admirable fiscal discipline the government has shown.

Need we take measures to restrain the economy? The automatic adjustment mechanism is a little more inflation. It may move outside its target range in the next few quarters. The Reserve Bank is not required to worry about such short-term fluctuations. But, in practice, it is deeply concerned that a higher inflation track will build in higher inflation expectations of the public. In which case, it won’t be just a little more inflation, but a little more, and still more. Ideally, the Reserve Bank would like to hold interest rates at their current level, although overseas events could change its plans. Hopefully, onshore events – including the Budget – will not.

PS. As I filed this column, Cullen indicated that some public capital investment would be deferred and some public expenditure trimmed.