THINK little

Friday 31st March 2000

IT DOES COMPUTE: With the computer and communications revolutions influencing production and changing business, it seems production can increase without wage pressure, despite the Reserve Bank's attempt to limit growth to 3%

The Reserve Bank has put a cap on wealth. NEVILLE BENNETT explains

The December quarter growth spurt shows the economy is capable of high rates of expansion but all the signals point to a Reserve Bank wanting to keep it below 3% over the longer term. This would mean accepting our relative poverty with per capita incomes sinking in comparison with other OECD countries.

It also means not keeping pace with Australia or several small European economies (Ireland, Finland, Luxembourg and Norway) where growth is running at heady rates of up to 8%.

One wonders what deficiencies handicap us in the race for wealth. It could have a depressing effect on the country to be told, despite its best efforts, it is not allowed to grow faster than 3%.

Former prime minister Jim Bolger once set a goal of 5%. Should we really "think little?"

I believe Reserve Bank governor Don Brash is too pessimistic. He confesses the bank had "a rather higher estimate of the sustainable growth rate ... in the mid-1990s but revised it down as we found inflation consistently pushing up toward, and briefly beyond, the top of the target range."

Certainly the bank is highly suspicious of inflation. It has raised rates three times in the past six months despite the economy being in recession or in negative growth in the March and June quarters in 1998 and the June quarter in 1999. This tightening occurred despite a consumers price index of only 1% in 1999 and the bank's surprise inflation was "much lower than we expected in the December 1999 quarter."

Why does the bank tighten monetary conditions while growth is fragile? The reason is an analysis tool known as the "output gap," also used by other central banks. This assumes any growth above or below 3% will leave the economy with excess or under-used capacity.

Thus the bank's outlook shows for the year to March, 2000, real GDP might grow 3.5% and there will be an output gap of minus 0.8%. But the bank looks ahead for two or three years for its interest rate changes to take effect.

For March 2001, growth is projected at 3.6% and an output gap of plus 0.2% is indicated. The growth rates for 2002 and 2003 are 3.4% and the output gaps are 0.6% and 0.8%. This positive output gap is regarded as too high and interest rates are being raised now to curb growth exceeding 3% in future years.

The output gap is a dangerous weapon in the hands of the doctrinaire. It can be used to curb growth. But the concept is not accepted universally and is unsupported empirically. Indeed, there is evidence the recent surge of growth in the US - three years at 4% - occurred because Federal Reserve chairman Alan Greenspan ignored it.

The Fed decided in the early 1990s the rate of sustainable growth was 2%. During 1997, Mr Greenspan began to raise interest rates to curb growth. He stopped doing so because of the Asian crisis and cut rates further in 1998. Thus the financial contagion of 1997/98 unexpectedly caused the Fed to leave the output gap in abeyance.

The dramatic consequence is the US has discovered, by accident as it were, its sustainable rate of growth is closer to 4% than 2%. In short, US authorities did not know the sustainable rate of growth until it actually let growth occur with few monetary curbs.

It follows New Zealand cannot really know its sustainable growth rate because of Reserve Bank intervention. Its projections show its intentions - New Zealand will not be allowed to see 4% growth because the bank has decided 3% is appropriate.

It is a moot point whether the bank is correct in its assumption surplus capacity was exhausted in the mid-1990s. It is merely observed there is no historical example of surplus capacity being exhausted when the unemployment rate was high and when wages were fairly restrained (in New Zealand they rose only 1.3% in 1994; 2.1% in 1995; 3.6% in 1996; 4% in 1997 and 2.6% in 1998).

The rate of inflation during that time was shaped by the large increase in money supply from immigration and the issue of eurokiwi bonds. Asian migration was especially high. The migrants brought large savings and spent heavily on houses, furnishings and cars. The bank raised rates in part to cool the Auckland housing market and this had the unforeseen consequence of stimulating more inflation, for those rates attracted eurokiwi.

>From negligible amounts in 1993-95, eurokiwi bonds worth $5 billion were issued in 1996, $8 billion in 1997 and $11billion in 1998 - a total of $21 billion, about a quarter of GDP and a larger sum than government bonds ($18.3 billion). The proceeds went mostly into housing.

Growth slowed not so much through a shortage of capacity (especially of labour) but more because of a high exchange rate and high interest rates which generated a real monetary conditions index (MCI) average of 975 in 1997.

Monetary conditions were immensely eased subsequent to the Asian crisis and the severe drought with the real MCI is projected to average -200 in the year to March 2000. Monetary conditions have undertaken extreme changes and their influence on the sustainable growth rate are hard to estimate. However, it seems prudent to be sceptical whether this period proved beyond reasonable doubt the sustainable growth rate is 3%.

There is also a possibility the economy has increased its capacity to grow since the 1990s and some evidence the "old economy" is much more responsive than seven to eight years ago.

Whenever one looks at the old commodity exports, there is evidence of higher-quality products and better marketing. Domestic industries have also made considerable progress. Service industries often reveal flair. It would be most unfortunate to overlook the achievements and investments of business in the past five years.

Indeed, there is a strongly growing "new economy." The knowledge economy is a reality and already covers some 40% of business.

Certainly there are claims for evidence for a "new paradigm." This concept has been somewhat overused overseas where extremists have predicted the end of the business cycle. But if it describes a higher rate of sustained growth it is more useful.

The "new paradigm" is a metaphor for an age, with the belief computer-driven activity in an era of open global markets can bring sustained growth. Moreover, the internet and e-commerce are influencing production and changing business. It seems production can increase without great wage pressure. The bank perhaps should not have been surprised, as it admits, by the low inflation in the last half of 1999.

It seems possible the bank under-estimates rising productivity. The figures it uses indicate massive fluctuations, with falls of about 5% in 1993-94 and rises of about 5% in 1996-97. The Treasury seems more plausible in the Diewert-Laurence study which indicates productivity gains are higher than most of the OECD economies (NBR, Mar 24).

The output gap is also arguable. The bank calculates the gap at -0.8% rising to 0.2% for the March 2000-01 year. The OECD estimates New Zealand has the fifth-largest degree of spare capacity and estimates the output gap of 2000 at -0.9%.

The bank has also been surprised by the strength of growth in 1999. This continues the run of unpleasant surprises received since the March policy statement, in particular its underestimation of import prices and foreign exchange rates.

The composition of the December quarter GDP figure is encouraging - manufactures up 4.9%, construction 4.4%, transport 3.8% and agriculture 2.8%. Moreover, demand is coming not merely from private consumption (only 1.1%) but from exports (1.8%) and, best of all, business investment at 4%.

While this growth is delightfully high, Deutsche Bank for one feels it will not persist at this rate. Nevertheless the market expects the Reserve Bank to try to stop it with further interest rises of 25-75 points because it has decided 3.5% is unsustainable.

If the bank's intention is to limit growth to 3% there is reason to contest it. It would be tragic for those in work, and those who are unemployed, if higher growth is not encouraged.

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