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MAR 16

The New Dragons

There is an old saying: generals tend to fight the last war; a war they were themselves much exposed to the action forming solid memories of their fights. So it is with politicians and policy makers, confronted by a new world they cling to the learnings and responses of the past, fighting what was once real.

The set piece event that opens each year by the Reserve Bank Governor, was an example, in rhetoric at least, of fighting past battles that appear less important to positive outcomes in our economy. So desperate was need frame the world as it was the dragon of inflation had to be redefined to make it seem even a little bit real.

Looking for inflation in a world of balance sheet recessions (Richard Coo) and debt overhangs (Adair Turner) is like looking for the Jabberwock, nice story but in the real world? The limitations of Inflation targeting are being observed, the idea: that one target (inflation) and one lever (short term interest rates) can guide an economy, that sectors of the economy do not need different settings, that debt, banks and money play no significant in the economy are slowly losing favour, and to be fair this is showing in the actions, if not the words, of central banks around the world including the Reserve Bank of New Zealand (RBNZ).

The point is well made by Turner, given the banking system is able to create essentially unlimited credit at will, paired with the propensity of the banking system to lend against real estate, is it any real surprise that prices rise on the limited supply of desirable real estate as those that can compete for ownership borrow to inflate the asset bubbles we see around the world? Low growth leaves central banks in a bind – interest rates need to be low to spur growth and spending, but low rates also reinforce incentives to borrow and push up asset prices, small changes have little impact when assets are expected to inflate at much higher rates.

Conversely any substantial interest rate increase to push back on asset price growth would mortally wound the real economy and employment, while risking systemic financial collapse.
The 2008 global financial crisis started to expose the inadequacy of inflation targeting, highlighting misallocation of investment and the growth in debt driving price inflation of pre-existing assets and as a consequence threatening financial stability and the real economy.

Deflation, debt, sectoral imbalance and inequality are the new dragons. They need to be fought, interest rates are impotent in this battle, macro-prudential tools require much more thought and finesse from central bankers and policy makers. There is a need to consider the interplay of inflation and financial stability with particular attention to debt outcomes: will new debt be GDP enhancing going to new business and the real economy or will new debt go to inflating the price of pre-existing assets. The old dragons need be watched but no longer be fought, the new dragons need different weapons and new thinking for central banking and politicians.

To some extent the RBNZ has been a leader in the macro prudential area but more is needed, not least in the messaging coming from the bank. More broadly we see Government moving away for a fixation on a fiscal surplus; this is highly desirable, (Steve Keen) to increase aggregate demand in our economy, here again it would be helpful if the messaging recognised the economic reality of dealing with the new dragons.

The picture tells a story, credit flowing to non-GDP enhancing sectors, driving house price inflation not increasing business investment. In the below graph, we can see how credit has grown in New Zealand by sector. The numbers for 2015 are likely to be even more dramatic in regard to the Auckland housing market and debt growth.

Adair Turner -
Richard Coo -
John Kay -
Steve Keen -

tags: currency, inflation, growth, turner, gfc, debt, finance, keen, stability
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