The worldwide financial and economic crisis which began in the US is leading to widespread questioning of the underlying assumptions of economic policy. This is long overdue. The events that led to the financial collapse in the US undermine standard assumptions by many of the most influential economists of the past few decades – adopted as a self-interested convenience by many in the finance and business sectors – that markets are rational, self-correcting, and therefore function best in the absence of government intervention.

Because of its worldwide nature and its depth, this is likely to be one of those seminal times in history in which – like the Great Depression of the 1920s and 30s – reality forces huge changes in the way the economy and the relationship between governments, business and society are conceived. In New Zealand the questioning is beginning, though not as obviously as in the US and Australia where the new President and Prime Minister respectively have expressly challenged the neoliberal assumptions of minimising government and trusting the market. A challenge will be to find sustainable solutions to problems that have beset the economy for many years. These will not necessarily be the same as those adopted in the US or other major economic powers. It is an ideal time for Labour to question the assumptions that it adopted in its nine years in office. It will be a crucial test of the National-led administration as to whether it has the courage to break away from old assumptions and convince its business allies that change is necessary.

At time of writing, New Zealand is in the calm before the storm. It is not clear how badly we will fare compared to the rest of the world. Falling commodity prices, particularly dairy and wool, and gathering recession or even depression (a word used by International Monetary Fund managing director Dominique Strauss-Kahn (1)) in most of our major markets are, to some extent, counteracted by lower oil prices, other export prices still rising, and the dollar approximating a viable value for many exporters, if they can find buyers. However, the warning signs are all there. The major economies of the world are suffering falls in output (Gross Domestic Product or GDP) unknown for decades. In the last quarter of 2008, GDP in the US and Europe fell at annualised rate of more than 6%; 8% in Germany; a depression-like 13% in Japan; 17% in South Korea and Singapore. China is still growing, but at a lower rate of 6.8%, and its exports fell by 18% and imports 43% in the year to January 2009 (2). Japan’s exports fell 35% in December 2008 from a year earlier, and 46% in January (3). Even if our financial system is sound (and more to come on this) we simply cannot avoid major fallout in our open and deregulated economy.

One of the big risks though is the exposed position of New Zealand’s economy and banking system due to its high levels of international debt. Policies followed to date – bank deposit and wholesale funding guarantees by the Government, a huge expansion of lending by the Reserve Bank to the banking sector, large Government expenditure programmes – may get us through the crisis if it is short, but will not address the underlying weakness and vulnerability. Indeed, they will increase both our domestic and international indebtedness. This article focuses on this aspect of the crisis, which is of particular relevance to CAFCA (though does not necessarily express CAFCA’s views).

We have written on numerous occasions about the state of New Zealand’s international liabilities and the risks it entails. The international liabilities are made up mainly of foreign equity investment (shares in companies) and foreign financial investment (debt). They increase every year due to the chronic current account deficit: the difference between on the one hand the payments made overseas for imports of goods and services, income to foreigners from their investment in New Zealand, and other transfers; and on the other, the corresponding income earned by New Zealand from overseas. Since on average we pay our way on goods and services (though since 2004 not even that), the current account deficit has for many years been approximately equal to the deficit on investment income – the interest and dividends paid to the owners of foreign investments in New Zealand less the income New Zealand residents receive from investments abroad. The deficit must be funded by increasing our international liabilities: borrowing more, or selling further assets to foreign investors.

This Leaves Us Open To The Whims Of Those Investors

They may take a dislike to policies being followed in New Zealand and stop renewing loans (or threaten to); they may take fright in the belief that New Zealand borrowers can no longer service the loans (based on good information or, as in many recent crises, bad); or a systemic international crisis such as the present one could leave us without lenders available to continue to finance the deficit. The effect in any of these cases would be a sudden and substantial fall in the value of the New Zealand dollar, resulting in a fall in the real incomes of New Zealanders. Real incomes would be hit in a number of ways. There would be increased costs in servicing new foreign borrowing and unhedged foreign debt (that is, without protection against changes in the exchange rate). Prices would rise as a result of increased prices for imports and for goods (like dairy products) which are also exported. In addition, credit would dry up or become more expensive (higher interest rates) leading to a collapse in investment, and failure of some companies with high debt levels. Exporters would benefit from higher returns, but probably not sufficiently, certainly in the short run, to fully offset the increase in the cost of imports. Even in the medium turn they may find it difficult to raise the finance to fund expansion to take advantage of the higher prices. We would have a severe economic crisis in New Zealand with greatly increased unemployment, falling real wages (and possibly cuts in wages in dollar terms), and households and firms which have high debt levels in deep trouble.

There are some elements of this already appearing. The value of the New Zealand dollar has fallen sharply; the banks that have relied on overseas borrowing (see below and Geoff Bertram’s article elsewhere in this issue) to fund their domestic lending are finding it very difficult or impossible to refinance their overseas debt. We are already in a recession which began partly as a result of domestic factors. Avoiding something worse depends largely on external factors: crisis-ridden overseas banks and other investors being able and willing to resume lending; international interest rates not sky-rocketing; our export income (already falling alarmingly) improving despite the much deeper recessions occurring in other countries. Government action to increase its own borrowing and spending, and Reserve Bank lending to the banks to replace their expiring overseas debt will help prevent a severe recession as long as other economies and financial systems recover reasonably quickly. Reserve Bank cuts in short term interest rates will help a little too, but for reasons discussed below, only weakly. But all of this can only stave off deeper recession in the face of adverse international events for so long; and it will leave the Government with greatly increased debt that will require some combination of raised taxes and cuts in spending in future to pay it off. A Government containing many in love with privatisation may turn again to asset sales to reduce the debt, leaving new problems for future generations. What the financial crisis has highlighted particularly is the overseas debt – the financial portion of our international liabilities – because this is what is most susceptible to the international financial freeze. As will be seen, this also reveals the nature of our banking system.

The situation has reawakened policy interest in New Zealand’s indebted state. Victoria University of Wellington economist, Geoff Bertram, who has worked on such issues for many years, organised a forum on “New Zealand Economic and Social Policy in the Face of the Global Crisis” at the Institute of Policy Studies at the University in November 2008 (4). Papers by Bertram himself (5) and fellow economist Dennis Rose (6), a Senior Associate at the Institute of Policy Studies, are particularly relevant and will be quoted in what follows. In this article, I will use the work of these two economists to describe the features and difficulties of our current situation. I’ll then look at a framework for thinking about the issues raised, and suggest some possible policies that could help resolve this chronic but now dangerous state of affairs. Finally, I will look at barriers to adopting these policies.

Towering Debt

As a nation, New Zealand’s net overseas debt per capita is one of the highest in the Organisation for Economic Cooperation and Development (OECD) as a proportion of our output (7). New Zealand’s high levels of foreign debt are, unlike many other OECD countries, accompanied by relatively low levels of lending overseas. The debt is mostly private, and in large part bank debt. According to Statistics New Zealand, entities in New Zealand had borrowed $235 billion from overseas at September 2008, equivalent to 131% of our annual GDP (8). In addition there were $62 billion in liabilities in the form of equity – overseas owned shares in New Zealand companies – giving total liabilities equal to 165% of GDP. The debt was partially offset by $81 billion owed to New Zealand residents (though it cannot be assumed that it can be used to pay off the overseas debt) and there was also $50 billion in equity assets owned overseas by New Zealand residents.

Of the $235 billion in debt, almost two thirds (63% or $148 billion) was owed by the banks (9). Only 7% or $17 billion was Government debt. The banks as a whole source almost 40% of their lending from overseas (38.7% in September 2008 according to Reserve Bank data (10)). Given the dominance of the big four Australian banks and the fact that Kiwibank, for example, sources all of its lending from within New Zealand, it is essentially the Australian banks that are responsible for this overseas borrowing.

Of the total debt, over half – 51% or $120 billion – is due to mature some time within the following 12 months – to be repaid, refinanced, or renegotiated in an international financial system which has almost stopped lending. The New Zealand dollar value of the debt that is denominated in a foreign currency (51% of it) will increase further as the value of our dollar falls. Most of it is protected against exchange rate falls by hedging, usually moving the risk offshore, but the effect of the fall in the exchange rate will be felt as loans are refinanced, and as Bertram describes in this issue, some of the hedging is ineffective in the short term. Most of the foreign currency debt is denominated in US dollars, and that has risen by 39% in the year since September 2007 – from $55 billion to $76 billion. On the other hand, lenders will be reluctant to renew loans in New Zealand dollars while the dollar is expected to continue falling, thus moving the exchange rate risk to the New Zealand borrower.

The banks’ borrowing has largely been used to finance mortgages in New Zealand. This not only has enabled residential (and probably some agricultural) property values to be pumped up well beyond realistic valuations, and often the owners’ ability to service the debt, but has made the Reserve Bank’s use of interest rates to control inflation an exercise in impotency. As we will see shortly, it has had to raise interest rates much higher than should otherwise be necessary to reduce economic activity in order to control inflation. On top of this is a risk premium that increases the interest rates that New Zealand has to pay for its overseas borrowing due to lenders’ concerns about the country’s high level of overseas debt.

This has been a double blow to the real economy. High interest rates hinder new investment needed to raise productivity and for growth. They also raise the exchange rate which is largely set by capital flows attracted (or repelled) by the interest rates. The high and volatile exchange rate makes survival or expansion very difficult for exporters. It makes imports cheaper and more likely to knock out competing domestic producers. In a vicious spiral this increases foreign debt.

While, in response to the crisis, short term interest rates have been rapidly reduced, the equally rapid fall in demand, lack of credit for businesses and still high business interest rates, indicate that this new state is not one of balance and stability. Rather, it is a state of attempted damage control which, unless fundamental changes are made, is likely to return to the old, unsustainable settings, carrying the injuries inflicted by the crisis.

The economic orthodoxy which gave rise to the present financial crisis saw nothing wrong with rising foreign indebtedness. Treasury advised when advocating the opening of the economy in 1984 that such indebtedness and the consequent large current account deficit “would not be a cause for concern, and would merely be reflecting individuals’ choices between current and future consumption”. (11)  Now, in its 2008 briefing to the incoming Minister of Finance, Treasury does acknowledge that “the international financial situation has also highlighted the vulnerability associated with New Zealand’s very high level of external private debt”, and that “recent turbulence in global financial markets has highlighted some of the risks associated with globalisation” (12), citing similar data to that above. However the current account deficit is not mentioned and its remedies for international debt and the regulation of financial markets are vague and indirect: Treasury appears to believe that a continuation of the past several decades of policies which have fertilised the debt will now somehow get us out of it. Raising productivity is its primary answer to most of the economy’s problems. This might make some New Zealand firms more internationally competitive, generating exports or replacing imports, but there is no guarantee that will be sufficient to reverse the current account deficit. Other than that, its remedies include “increasing savings, a reduced reliance on international capital and a more diversified portfolio of assets on bank and household balance sheets”, yet at the same time advocating as critical “deepening New Zealand’s international links” including accessing foreign capital, removal of remaining trade barriers, and removal of remaining screening of foreign investment (minor though it is), with a principal objective of regional economic integration as part of an Asia-Pacific economic market. However it acknowledges that these barriers are already low, so changes in “broader domestic policy settings” will be necessary, including deregulation and corporate tax reductions at home in the hope that it solves our problems abroad. It does note that the volatile exchange rate is a problem (though, strangely, appears to attribute it to fiscal policy rather than monetary policy or the behaviour of private capital, despite the low level of public debt) (13).

The Evidence: The Drag Of International Debt

Dennis Rose investigated the problems caused by international debt. Firstly, he explored the relationship between interest rates and net international liabilities. Describing New Zealand as “a leader in the field” of net international liabilities as a proportion of GDP, he finds for the period 1980-2004 that

“countries with higher levels of net international indebtedness have higher interest rates. Broadly, countries that hold roughly equal amounts of international liabilities and assets can access international short term money at around 3%. Countries such as Switzerland, which has net assets equivalent to 100% of GDP, can tap into markets at very low rates. Countries such as New Zealand find themselves paying significantly higher rates of interest. Effectively the market is pricing country and/or currency risk into national interest rates”.

Noting that this evidence is at odds with standard economic models which assume a standard world interest rate, he estimates that New Zealand is paying a risk premium of about 1.5% per year more in interest rates at our current level of net international liabilities compared to a position where liabilities and assets were in balance. That is not the only reason for our internationally high interest rates though:

“In fact, New Zealand’s short-term interest rates have, since 1990, averaged some 2.75% above the average level of those prevailing in our TWI partner countries (the US, Euroland [countries whose currency is the Euro], Australia, Japan and the UK). What might explain the additional element within the overall differential? Again many factors are likely to be present, but some of us argue that the central and all but exclusive focus of New Zealand monetary policy on inflation control is a significant cause. Note that this influence reflects both the design of the statutory rules under which the Reserve Bank operates and the choices made by the Bank in operating those rules”.

(The TWI or Trade Weighted Index is an average of the value of the New Zealand dollar relative to the currencies of our main trading partners, weighted according to the volume of trade with each of them and their respective GDPs (14). It is a sort of “average exchange rate” for the New Zealand dollar). Rose notes four effects of the high interest rates:

2.   High interest rates reduce the number of investments that are likely to be undertaken, thus reducing the level of capital formation and growth.

3.   High interest rates encourage speculation rather than productive investment: “Rates of return on real productive investments are constrained, at any point in time, by the technologies currently available. High interest rates encourage investors to focus on markets in which there are apparent opportunities for high returns, and thus, arguably, bias investment towards areas in which there are prospects for gains from asset inflation rather than from increases in productive capacity”.

4.   “High real interest rates have an observable effect on nominal and real exchange rates (the real exchange rate is the nominal exchange rate adjusted for differential movements in prices between New Zealand and the other countries party to the exchange rate)”.

Volatility In Exchange Rate

It is notable that the first three effects all can worsen the debt situation, and/or increase the risk in the economy. Rose then moves on to look in more detail at his fourth point: the relationship between interest rates and the exchange rate. The evidence he finds is that “higher New Zealand interest rates … induce higher exchange rates” with our trading partners. This is expected: in an economy with free capital movements and floating exchange rate, the exchange rate is largely set by short term capital movements which are attracted by higher interest rates. The demand that the incoming capital creates for the New Zealand dollar raises the exchange rate.

He estimates the relationship as follows. “A one percentage point change in the real interest rate differential (e.g. from 2% to 3%) shifts the real TWI by about 6.9 points relative to its 1990-2007 mean of 60.1”. So, without the approximately 2.75% loading on our interest rates, the TWI’s level would have been around 41 instead of 60.1. “These are very substantial effects”, comments Rose. About half of this effect is due to our net international liabilities, the rest due to monetary policy and other influences.

So what is the effect of this chronically high New Zealand dollar exchange rate? Again, Rose had investigated (reported in a paper published in 2001). His conclusions have some surprises. The level of the exchange rate is less beneficial to the current account deficit than would be expected: “… exchange rate levels appeared to exert a significant influence on the level of exports but had little influence on imports… a rise in the real TWI by ten units, e.g. from 50 to 60 would lead to a deterioration in the balance of payments, stemming from changes in export and import ratios, equal to about 2.7% of total supply or about 3.6% of GDP”.

In addition, variability (volatility) in the exchange rate had a damaging effect on the balance of trade because it “appeared to inhibit exports and, to a lesser extent, to encourage imports”. So, what exporters frequently complain about has been validated: the constant changes in the exchange rate make exporting even more difficult. To make matters worse for the current account, for reasons that are not clear, volatility appears to help imports. Rose comments that the floating exchange rate has produced high exchange rate variability and hence has contributed to our indebtedness. While the floating exchange rate has advantages, he suggests further investigation of its workings and of alternatives.

Rose notes: “Taken together these are substantial effects, amounting to some 5% of GDP, which as it happens, is the average value of the current account deficit for the period 1990 to date”. More recent work suggested the effect of the higher level of the exchange rate on GDP could be smaller than the 3.6% indicated by the earlier study – instead, around 2% – but this is still substantial. The deterioration in the current account deficit as a result of these effects of course adds to our international debt and other liabilities.

So we have a full vicious circle. The high level of net international liabilities leads to higher interest rates which in turn raise the real exchange rate. This has the effect of increasing the current account deficit by disadvantaging exporters, adding to the disproportionately increasing international debt servicing costs. That then raises the level of international liabilities and we are onto the next cycle. At the same time, the high interest rates (probably worsened by monetary policies) damage our ability to increase our productive capacity.

It is notable that there does not appear to be any mechanism within the New Zealand – or any other – economy that will lead to this situation smoothly correcting itself as a result of market forces. New Zealand has been gathering international liabilities since the formation of a British colony here. The last two decades have been in an open economy with minimal Government intervention as to international capital movements, trade and related matters. If the market was going to make the adjustment, it has had plenty of time to do it. It seems that any correction would be initiated either from outside the national economy – such as overseas lenders refusing to provide funding – or by Government action. The former is likely to be sudden and damaging to New Zealanders’ welfare, leading to, at best, lasting recession, but more likely catastrophic change. Something similar is now happening. Our own Government’s actions have fallen far short of what is necessary. We can only hope that the downturn will be short, and that Government action both here and internationally will mitigate the damage.

The Evidence: Where Did The Debt Come From?

Where did the international liabilities come from and what might their effects have been on the sustainability of this position? Geoff Bertram provides some answers. He notes that since the 1970s, New Zealand has had a persistent current account deficit which has been financed by overseas borrowing in three main “waves”. From 1975 to the late 1980s it was led by Government borrowing, which took the total overseas debt to over 70% of GDP, more than half of which was owed by the Government. During the 1990s, the privatisation of state assets also privatised the overseas debt. In this period there was a rapid rise in New Zealand’s international liabilities as a result of privatised State assets and other New Zealand companies being sold to overseas buyers. This period concluded about 1997, by which time New Zealand’s total international liabilities had risen to $126 billion, or 129% of GDP, of which about a third ($45 billion) was foreign ownership of equity and the remaining $81 billion foreign debt. In net terms, the liabilities were $80 billion, of which $19 billion was in equity (15). The Government’s contribution to the international debt was by then a negative $0.8 billion (international debt was “only” 83% of GDP in 1997: recall it was 131% in September 2008).

The third “wave” is what Bertram focuses on, and is covered in more detail in his article in this issue of Watchdog. Between June 1997 and December 2001, “an extraordinary inflow” of $22 billion was injected into the New Zealand banks by their overseas parents. They used the money to expand their lending in New Zealand. Bertram comments:

“… in the absence of this large scale extension of short term credit by overseas parents to their New Zealand bank affiliates, the nominal exchange rate would have been under far greater downward pressure during 1999. Indeed, one might speculate that, without this private sector substitute for an activist central bank, the economy might have faced a classic financial and exchange rate crisis in the wake of the Asian meltdown”.

I suggest an alternative interpretation: that t his huge injection prevented the TWI from falling (or with suitable intervention, being brought down gradually) to levels that may have assisted exporters and thus New Zealand’s current account deficit. Instead, it protected the value to the parent banks of their New Zealand dollar holdings and loans. Moving on to 2008, Bertram reports: “in the past six years the offshore funding of their balance sheets with which the banks experimented in the late 1990s has returned with a vengeance and became something of an addiction”. By September 2008, banks had loans to New Zealand residents of $278 billion, but had only $180 billion from New Zealand residents to fund them. The $98 billion difference had been borrowed from overseas, $39 billion of which was in foreign currency. Remarkably, the banks’ overseas borrowing “has matched the current account deficit, enabling the economy to maintain its import levels without running into a foreign exchange constraint. Over the decade from March 1998 to June 2008 the cumulative current account deficit was $88.42 billion, while the cumulative increase in the banks’ net foreign liabilities was $79.69 billion. To a first approximation, the current account deficit has been fully funded by the banks’ offshore borrowing…”.

NZ Has Been Borrowing To Pay Its Foreign Debt

In summary, reports Bertram, the banks accounted for an astonishing 70% of the investment income sent abroad to foreign investors, and for an even greater proportion of the economy’s net overseas debt: 74%.To quote Dennis Rose, “in a very real sense New Zealand has been borrowing to pay the servicing requirements of its international debt”. Assuming that the banks’ assets are sound, Bertram points out that the position here is the opposite of the US. There is still a very low level of bad debts and it is unlikely that residential property values will fall so far as to affect the security on mortgages in material numbers, though he sounds a warning with regard to lending to agriculture where high commodity prices have attracted highly leveraged operations. In the US the weakness was on the asset side: sub-prime mortgages whose real (property) asset backing was inadequate in the first place, and in many cases is now falling in value as well. Here, “there is however an obvious risk of a collapse on the liabilities side if access to offshore funding were to dry up, as it finally did in September 2008”.

He highlights two aspects of this risk. Firstly, there is exchange rate risk due to the high proportion of liabilities denominated in foreign currencies compared to the assets (i.e. property in New Zealand). A falling dollar will eventually increase the size of these liabilities. Secondly, there is the exposure to the credit crunch, which has become a reality. The effects of the credit crunch could become obvious quite rapidly: according to Treasury, about 50% of the banks’ overseas borrowing is (astoundingly) for just 90 day terms or less. While some of this is longer term loans with 90 day revisions of interest rates, there is still a significant amount that is very short term. There is the classical problem here of “borrowing short, lending long”. In addition, Bertram shows in his Watchdog article that there was a mismatch between some banks’ short term US dollar borrowing and longer term debt swaps it used to hedge the exchange risk. Looking beyond the banks, 51% of all overseas debt was due within 12 months at September 2008 (16). The loans need to be refinanced frequently and repeatedly, and so are particularly susceptible to an international credit freeze.

In response to these risks, the banks put pressure on the Government to guarantee their overseas borrowing. The risks were significantly increased by the fact that the Australian and other governments had already done this, creating the prospect of flight of capital from New Zealand to countries with protected institutions. In the middle of an election, with the Opposition trying to make political capital out of the situation, the pressure was difficult to resist, whether or not the policy was sound. Bertram discusses the arguments for the wholesale guarantee, none of which he finds compelling. He observes that the guarantee is “effectively socialising the risks of Australian bank shareholders at the expense of New Zealand taxpayers” and “amounts to a significant subsidy, legislated without reference to Parliament and implemented largely behind closed doors”.

“The Minister of Finance conceded that in the event of the guarantee being ‘called’ on a large scale, the contingent liability for the New Zealand taxpayer could be $150 billion – ten times the size of the Cullen Fund laboriously built up over the previous years of fiscal surplus. Even on a probability-weighted basis the exposure was huge relative to the established fiscal strategy approved by the Parliament earlier in the year. In underwriting the banks’ offshore borrowing the New Zealand taxpayer would be in effect acting as an insurer/underwriter for risky private sector financial transactions, in a setting where the usual protection a real insurer gains from diversity of risks was completely absent – in the event of a full scale crisis offshore that brought the guarantee home to roost, it would be likely that several large guaranteed borrowers would go to the wall simultaneously”.

He comments:

“And yes, there are rigorous restrictions on the guarantee scheme that will undeniably reduce taxpayers’ exposure very greatly; rather than $150 billion we may be faced with a worst case contingent liability of, say, $30 billion. That is still a lot of money, and it has been amazing to see how readily it was available to underwrite an offshore-owned banking system that was and is very far from insolvency and which is arguably perfectly capable of looking after itself in difficult times. Think of the amount of future fiscal leeway to undertake social policies to ameliorate a major recession that may have been made hostage to the financial sector, just as that very recession looms over the horizon”.

In addition to the guarantee on wholesale borrowing, the Government has also provided a guarantee on retail deposits. The guarantee applies not only to banks, but also to other deposit takers, some in the fragile finance company sector which are of considerably higher risk. That has been all too quickly demonstrated by the receivership in early March 2009 of Mascot Finance, only weeks after it gained the Treasury guarantee, costing the Government several tens of millions of dollars (17).

Whether or not the guarantees were the appropriate response (in my view there was little choice), it is now crystal clear that the costs of these problems are eventually worn by all. Not only did the economy suffer and lose development opportunities from the banks financing huge amounts in mortgages and other lending (including even credit card debt) from offshore borrowing, but we now bear the consequences of the unwinding of those actions – either via providing guarantees, or via economic turmoil, and possibly both. The financial system and its institutions have huge externalities, in economist-speak. Almost all New Zealanders suffer, whether they made unwise financial decisions or not. Most of us thought the financial system was there to look after our finances, not for us to look after theirs!

What Other Options Do We Have?

There are two main sets of issues that current events and these two analyses highlight. They are inter-related. There are the economic consequences of our chronic current account deficit and mounting international liabilities. And there are the matters to do with the behaviour of the financial sector – the risks it takes, its effect on our current account and debt, whom it lends to and for what. These are huge issues which this article (and this author) doesn’t attempt to address in all their aspects, but there are some questions that are useful to ask in order to contribute to what should be a fundamental rethinking of policy in these areas. It is clear that we need solutions which are preventative rather than reactive, and sustainable rather than short term. Deposit and borrowing guarantees and a debt-financed injection of Government spending are neither, even if they are necessary in the short run (and need to be retained as policy options). The short run survival options need to be chosen to enable and not cut off long term solutions.

The Economic Issues

Looking first at the economic issues, we have evidence from Rose that New Zealand’s huge international liabilities and current account deficit are contributing to a vicious circle which is harming New Zealand’s development. This can only be resolved by moving the current account deficit into surplus by reducing the deficit on international investment income and increasing the surplus of export income over import payments.

To reduce the deficit on international investment income we need to reduce our reliance on both foreign equity capital and foreign debt. This is not easy: as long as the current account deficit exists, someone in New Zealand will be borrowing, or selling assets, to cover it. Increasing exports and reducing imports raises a host of issues around New Zealand’s economic development in general: why new enterprises do not thrive in sufficient numbers; why we are still so reliant (especially for exports) on the agriculture and forestry sectors, much of the products only lightly processed; why productivity is not growing faster despite strenuous efforts. From a social and environmental viewpoint we also need to ask how we can ensure that such development leads to improving living standards and reducing inequality while becoming environmentally sustainable.

One contributing factor that has arisen in this discussion is the damaging effect of exchange rate volatility as well as its actual value. Another is our trade policy, which exposes fragile and new industries to the gales and storms of international competition before they can hope to have reached a state in which they can survive and prosper. As well as increasing exports, we need to reduce our dependency on imports. In an open economy, import substituting industries suffer the same fate as would-be exporters. That leaves reducing people’s spending as the only way to reduce expenditure on imports – by cuts in real incomes, unemployment or increased savings (including Government savings through increased taxation).

All of this is reason to rethink current policies which see increasing economic integration with the rest of the world as a solution to these increasingly urgent problems. The point is not that we should become an isolated fortress state. It is that, just as the financial crisis has demonstrated for all but the wilfully blind, that we need to regulate the domestic economy, so we need to regulate external economic and financial relationships. That includes international investment.

A wide range of policies is available to regulate international investment. These policies can have a variety of purposes including preventing or slowing rapid and destabilising capital movements, stabilising the exchange rate, ensuring the economy is not put at risk by excessive short term debt, ensuring there is a balance between the foreign currency demands of servicing the debt and the foreign currency earning power of the assets it is invested in, limiting the extent of the country’s international debt, and controlling the quality of foreign direct investment. We come back to these possibilities below.

There is a framework for considering the international investment issues which is worth reflecting on. It is called the “open-economy trilemma” or “inconsistent trinity”. Originally proposed by supply side economist Robert Mundell, it has been restated, advocated and explored by prominent international finance economist Maurice Obstfeld. Both are ardent supporters of open economies, and open capital markets in particular, so we need to consider the proposition with a critical eye, but this makes their conclusions even more telling. To paraphrase a number of Obstfeld’s statements of the “trilemma”:

“A country cannot simultaneously pursue a monetary policy oriented toward domestic goals and maintain stability in the exchange rate while allowing the free movement of capital. Governments may choose only two of these”. (18)

If correct, it means we cannot both make use of the monetary system to control inflation and achieve social purposes (including helping to ride out crises as at present) and also have a stable exchange rate, unless we also have controls on capital movements. If we are willing to accept the interest rates of another country we can have a fixed exchange rate and free movement of capital – but will pay the price in bankruptcies and unemployment when those interest rates go too high and excessive inflation when they go too low for the state of our economy at any time. If we are willing to live with a volatile exchange rate, then we can make use of monetary measures and have free movement of capital, but will find exports suffering and mounting international debt. In actuality, Obstfeld and Mundell equate “independent monetary policy” with the ability to set domestic interest rates. For Obstfeld this is an approximation and for Mundell a belief. We will return to this below.

Naturally, in the real world things are not that simple. Obstfeld tested the proposition in a study published in 2004 (19) by looking at a large number of economies around the world over three historical periods: from 1870 to 1913 when currency values were fixed by being tied to gold (the “gold standard”) but capital was free to move between countries; 1959-73 during the period after the Second World War when, under the Bretton Woods agreements, capital movements were controlled and exchange rates were fixed but were moved from time to time; and following the breakdown of the Bretton Woods agreements, from 1974 to 2000. In this current period, controls on capital movements are relatively rare and there has been a variety of exchange rate policies, though floating rates are common.

Obstfeld concludes that “overall, this evidence supports a modified view of the trilemma for the modern era” and that “the overall lesson of our analysis is that the trilemma makes sense as a guiding policy framework”. His study confirmed that it was not possible to simultaneously maintain autonomy in setting interest rates, a stable exchange rate and free capital movements. But taking autonomy in setting interest rates as highly desirable, the power of the different policy combinations varied (20):

1.    A non-fixed exchange rate with capital controls provides the most “unfettered” interest rate autonomy.

2.     A non-fixed exchange rate without capital controls retains only some autonomy.

3.     A fixed exchange rate with capital controls retains only some autonomy.

4.     A fixed exchange rate with open capital markets retains little autonomy at all.

Without capital controls most autonomy is lost. A degree of autonomy can be gained by moving to a non-fixed exchange rate, and even more by the use of capital controls. Fixing an exchange rate also ties interest rates “substantially closer” to those of an external economy. It is important to remember that exchange rates which are not fixed are not necessarily completely free floats. There is a range of intermediate options which can give some stability to the exchange rate without fully fixing it to other currencies or to gold.

NZ Has Fully Floating Currency & No Capital Controls

New Zealand has the second combination above in its purest form: a fully floating currency and no capital controls. Obstfeld’s conclusion is consistent with New Zealand’s experience of this regime. As we have seen, the effectiveness of the policies used to control interest rates (and indeed monetary conditions) has been significantly undermined. The degree of loss of control has caused significant problems such as lack of investment and difficulties for exporters. Until the current crisis, a substantial cause was the floods of offshore capital undermining actions taken by New Zealand monetary authorities.

In the present conditions, the trilemma would predict that the effect of the Reserve Bank’s lowering of interest rates to levels unprecedented in recent times will be muted (even taking into account that monetary policies at their best are a weak remedy for a crisis such as this) because external monetary conditions will trump the effect of those lower rates. There is evidence for this in the widespread complaints from the business community that banks are not sufficiently lowering their interest rates for business lending, nor making as much credit available as would be justified by the Reserve Bank actions. The banks are still affected by the scarcity of credit overseas and the high interest rates being charged there for lending perceived as high risk.

The above analysis indicates that the use of capital controls would regain a considerable degree of monetary control, which makes sense in our circumstances. That may allow us to move somewhat away from the current pure currency float to reclaim some stability in the exchange rate, without going as far as to fix its value. Obstfeld notes that “the designers of the Bretton Woods system achieved their goal of exchange rate stability with more room for interest rate autonomy” – something lacking in the current era. This was achieved through international agreement, along with complementary domestic policies and a much less transnationalised corporate sector.

This discussion is about the difficult choices which are consequences of an open economy. Effectively the “open economy trilemma” is saying that if you want complete openness you will suffer high social costs. These costs could be avoided if other policies were followed. As Obstfeld, in general a supporter of open markets, concludes another paper on these issues, seemingly somewhat regretfully:

“Compared to the world of the late 19^th Century gold standard, however, we increasingly reside in broadly democratic societies in which voters hold their governments accountable for providing economic stability and social safety nets. These imperatives sometimes seem to clash with the reality of openness”. (21)

Currently New Zealand’s setting is at the extreme of openness: a fully floating exchange rate and free movement of capital. We should not be surprised at the penalty: high medium term volatility in our currency’s value, and difficulties for exporters. This contributes to our critical state of international indebtedness and our difficulty in getting out of debt. Our current monetary policies almost certainly add to these problems. Further, our room to move in monetary policy is not as great as we might think because of freedom of capital movement. Bertram’s evidence supports this conclusion.

This would have even wider consequences if the Government wished to use monetary policies in support of the social policies Obstfeld alludes to. This is done in many jurisdictions by requiring the monetary authorities to take account of economic and social conditions when setting interest rates and other monetary policies. The previous Government’s Policy Targets Agreement with the Reserve Bank (2007) (22), removed by the incoming Government, contained suggestive wording as to its aims: “to create full employment, higher real incomes and a more equitable distribution of incomes”. In New Zealand’s case, while this allusion can be made, the Reserve Bank Act prevents use of monetary policy for those broader aims except on a temporary basis. As well as interest rate changes, direct use of the money supply (“printing money” or withdrawing it from circulation) is also useful in some circumstances. Some governments are directly increasing the money supply in this way in response to the banking crisis. The UK and US are engaged in this in a large way, and the New Zealand Reserve Bank appears prepared to do so.

Managing International Capital Movements

It makes sense then to consider looking at options for managing international capital movements, and to returning towards the Bretton Woods stabilised-but-changeable currency options. Management of international capital movements would have two purposes. The first and most important is prevention. We should prevent our banking system from ever again becoming so dependent on foreign borrowing. In this global mega-crisis, it exposes us hugely and unnecessarily to the calamities threatening the rest of the world.

The second purpose for capital controls is defensive. We cannot avoid the juddering of the international shocks entirely, but we need shock absorbers to as far as possible reduce its effects on the employment and living standards of New Zealanders. We need tools to slow down or prevent capital flight, and just as importantly, the threat of it. Capital and currency controls were commonplace internationally until the 1970s. They were victim during the 1980s onwards to the same blind faith in the free market which has led to the current financial crisis; indeed their removal was often driven by large banks and other financial corporations, mainly in the US and Europe, demanding access to other countries for their expansion. One of them was US insurance giant AIG, now almost totally nationalised by the US government as a means to bail it out.

Some will argue that the world is so open now that complete control of capital is impossible. There is some truth in that, but only some. Malaysia, China, India and Chile are examples of nations which have successfully used capital and currency controls in recent years, Malaysia notably using them to emerge from the 1997 Asian financial crisis relatively unscathed; the others have used them for longer term reasons as well. Some control is still possible, even if considerably less than ideal. Putting controls in place when markets have slowed dramatically is the least disruptive time to do it. What would maximise the effectiveness of capital controls is international agreement to cooperate on such measures. This will be a litmus test of the various international summits on the financial crisis. If they do not include plans for international cooperation to manage capital movements they will simply be another attempt to patch up a failed system.

Economic Shock Absorbers

It is certainly more difficult to control capital movement than 30 years ago, but no shock absorber is perfect: a car still feels bumps in the road. Yet the shocks are sufficiently cushioned that the driver doesn’t lose control and the bones of its occupants remain intact. Early in 2008, Nobel Memorial Economics Prize winner Joseph Stiglitz and colleagues published a book on the theme of managing international capital movements, “Capital Market Liberalization and Development” (23). It warns persuasively of the risks of open capital markets (capital market liberalisation). While their main interest is in developing countries, their analysis and description of a wide variety of policies for controlling capital flows is of vital relevance to New Zealand.

They list the risks of open international capital markets. Rather than helping countries ride out downturns, as advocates theorise, they are pro-cyclical – that is, when the economy is booming, capital flows in, often leading to excessive debt, high currency values, and inflation in asset prices; when the economy is in recession and an external source of capital might be useful, it flees. These flows, particularly short term speculative flows, “have been at the heart of many of the crises in the developing world since the 1980s. Even when capital flows were not the direct cause of the crises, they played a central role in their propagation. These volatile flows have also made it difficult for policymakers to respond to the crises with traditional economic tools aimed at smoothing business cycles”. Crises cause large permanent income losses (much more is lost in a year of recession than is gained in a year of growth) and disproportionately hurt the poor. The capital flows may exacerbate the consequences of market failures in financial markets, and are subject to bubbles and herd behaviour (contagion). They affect the exchange rate in harmful ways, as already described. Particularly for developing countries, but to a large degree for New Zealand too as we have seen, the capital is frequently short term, making the country highly vulnerable to adverse events and investor panic. In a thin (capital-scarce) domestic capital market, international capital flows can worsen market efficiency through mismatches between terms of liabilities (borrowing short, lending long), and currencies (borrowing overseas for firms and private individuals who do not earn foreign currency which would help service and repay the loan). Treasury notes the lack of depth in New Zealand’s capital markets, though they are deeper than many developing countries. More on this below.

A particularly telling chapter by Andrew Charlton surveys cross-country studies providing evidence on “Capital Market Liberalization and Poverty”. Open capital markets lead to greater economic volatility rather than less (contrary to orthodox economic theories). Volatility hurts long term growth, countering any benefits of the availability of the finance, and has “profound and persistent effects on the poor”, increasing inequality. It reduces the bargaining power of labour, with studies finding that open capital markets reduce labour’s share of income relative to business. There is also evidence that a greater tax burden may be shifted onto labour from business, despite its reduced share of income. Policies to alleviate poverty (and for other social purposes) are constrained, both by the policy trilemma already described, and by the “discipline” imposed by fund managers and other investors using the threat of capital flight. Charlton comments:

“As Stanley Fischer, former first Deputy Managing Director of the International Monetary Fund, said in 1997, capital markets serve as an important discipline on government macroeconomic policies ‘which improves overall economic performance by rewarding good policies and penalising bad’. But underlying this belief is a fundamentally undemocratic ethic which would transfer authority from national democratic processes toward foreign financial interests”.

In any case, these “market disciplines” can be inefficient if the fund managers take a short term view, fail to differentiate sufficiently between long term investments and ones that fund consumption, and are erratic, over-reacting to policies suddenly after overlooking them for some time. (24) The concerns documented in the book are largely about finance capital. Foreign direct investment (FDI – where control of productive and relatively immobile assets is the norm) is seen as having quite different characteristics. However, Stiglitz gives a warning about this distinction. FDI also moves pro-cyclically, flowing in at good times and out at bad times when it is most needed. One reason is that much of FDI is really finance capital: for example privatisations and takeovers represent only a transfer of ownership. This should be distinguished from greenfield investment where a new productive asset is created.

It is noteworthy that there is support across a wide range of schools of economic thought for controls on international capital movements – from Mundell and Obstfeld to the social democratic Stiglitz. It is a fundamentally different issue from controls on trade and despite its frequent entanglement with trade agreements, the two should not be confused. One of the  best known advocates of free trade among reputable economists, Jagdish Bhagwati, wrote a famous article for the US journal Foreign Affairs in 1998 entitled “The capital myth: The difference between trade in widgets and dollars” (25) in which he concluded:

“And despite the evidence of the inherent risks of free capital flows, the Wall Street-Treasury complex is currently proceeding on the self-serving assumption that the ideal world is indeed one of free capital flows, with the IMF and its bailouts at the apex in a role that guarantees its survival and enhances its status. But the weight of evidence and the force of logic point in the opposite direction, toward restraints on capital flows. It is time to shift the burden of proof from those who oppose to those who favour liberated capital”.

The Financial Sector

Turning to the financial sector, there are a number of issues that the behaviour of the Australian banks has highlighted. They have raised huge volumes of funds which they have loaned mainly for property purchases in New Zealand. While this can be seen as financing our existing current account deficit, they have chosen to do so in a way that increases the deficit and reinforces our dependence on foreign borrowing. They have effectively taken an important – in current circumstances, critical – policy decision which should be a matter of public policy. Public policy should be aiming to reverse the deficit and reduce our international liabilities rather than deepening that dependency.

It is likely that at least some of this borrowing will be difficult to refinance in current circumstances. While Treasury and the Reserve Bank are taking action to protect the solvency of the banks through domestic funding arrangements and the deposit and wholesale borrowing guarantees, the rapid unwinding of this volume of overseas borrowing could have dire consequences for the economy. New Zealand’s economy has been put at risk to the advantage of the banks’ shareholders (whose dividends themselves are also a substantial burden on the current account), and we may end up paying a very substantial price.

Part of this risk is a result of the banks borrowing very short term (as short as 90 days) for a significant part of their funding. This greatly increases the vulnerability of them and the financial system to the current financial crisis, and would similarly do so in any crisis of liquidity or crisis of confidence. There is additional risk in loans denominated in foreign currencies if they are not fully hedged, or require refinancing, and the New Zealand dollar continues to fall in value relative to those currencies. According to Statistics New Zealand information, most borrowing is hedged though, as noted, Bertram reports that some bank hedging is badly flawed, but there are still borrowers – such as Fisher and Paykel – taking these risks.

A further exacerbating aspect is that while there is a place for overseas borrowing where it funds investment in New Zealand that increases the country’s production, and thus the income to pay the costs of the loans, housing only very indirectly does this (and where it is purchased solely for speculative purposes, does not at all). Particularly in our current circumstances, overseas borrowing should be used sparingly, reserved for productive investments, and preference given to purposes which increase overseas income, such as through exports.

A second set of concerns arises from the reliance we place on these institutions. The big four Australian banks which dominate our financial sector are individually and collectively too big for our Government to allow them to fail. The position is complex given their Australian ownership, but if the Australian operations were not affected to the same extent, or the Australian government declined to take action (which is unlikely, though their action would not necessarily help New Zealand), the New Zealand government would feel bound to bail out or nationalise the local operations, as is happening with banks in the UK, at great cost to the public. The deposit and wholesale borrowing guarantees, given at the urging of the banks, already make the public liable for huge costs.

The “too big to fail” syndrome raises a number of issues. If they are explicitly or implicitly relying on public funding and support, it suggests that the Government should have a stronger role than the current Reserve Bank supervision in the governance and aspects of management of the banks to ensure that their risk levels are responsible and that they are acting in the public interest. As a more general point, competition laws allow the degree of concentration of ownership that we have; it does not take into account whether any company is “too big to fail”, yet “too big to fail” implies a cost to the public. Further, we need to review whether it is wise to have our financial system dominated by banks all from the same country. If Australia has a financial crisis, it will be transmitted very quickly into New Zealand through the Australian-owned banks, despite actions taken by the Reserve Bank to ensure some insulation between the local operations of Australian banks and their parents.

While with a few exceptions, such as ANZ’s selling of risky products from its half-owned New Zealand ING associate company, we appear to have escaped the worst excesses of risk-taking by banks in New Zealand (though the major Australian banks do have investment operations, run as separate companies), we need to learn from the US experience, and ensure that desire for profits doesn’t overcome prudent behaviour.

Nonetheless, we should not be too congratulatory of our financial system in avoiding the madness of the US crisis. We have had our own crash – the finance company sector, which has lost ordinary New Zealanders billions of dollars. What is interesting though is that the trading banks largely insulated themselves from this crash by sticking to their traditional business. Former Reserve Bank of Australia Governor, Ian Macfarlane, speculates that the reason for the situation may be the lack of competition between the four big Australian banks (enforced in Australia by the “four pillars” policy which makes it unlikely they will be taken over), and paradoxically, the lack of savings in Australia to invest in the US high risk US markets (though he says: “But they would have if they could have”). “Dumb luck” he called it (26). In the US, banks were affected because they had taken on many of the high risk activities that our finance companies undertook – and far more besides. The US system’s “sophisticated financial products” which were sold as reducing risk and increasing opportunity in fact increased risk and the magnitude of losses. Save us from sophistication if that is what it means. On the other hand, the shallowness of our capital markets, making new investment and new venture start-up difficult, may be a symptom of the unwillingness of our banking system to take risks that would be productive for the economy.

Policy Options

These economic and financial sector analyses suggest the following as useful policy options to consider. Some could be put into effect immediately; others would require careful phasing in, accompanied by other policies to allow the economy to adjust and to address the current account deficit. The very consideration of some of these policies may lead to threats of capital flight and deliberate destabilisation; that needs to be anticipated and both regulatory and political counteraction prepared.

International capital management policies which allow the Government to control

3.   A small financial transactions tax (“Tobin* tax”) to discourage speculative financial market transactions;

4.   End-use of overseas borrowing such as to limit or give preference to trade and foreign currency-earning investment;

6.  Minimum maturities (terms) of overseas borrowing, and matching of maturities between borrowing and lending.

7.  Foreign direct investment where it is largely a financial transaction as distinct from investment which includes substantial introduction or creation of physical assets or knowhow. *Named after the economist James Tobin. Ed.

Note that the existence of these management tools does not mean the powers they give would necessarily be applied in a blanket way; they can be used selectively by type of investment and economic and financial circumstance.

Economic and monetary policies:

Financial sector: in addition to the above capital management policies,

Barriers To Sensible Policy

There is an important caveat. Many of the above policies, sensible though they might be, are made difficult or entirely banned by international agreements New Zealand has signed (on top of the political constraints imposed by the high debt levels themselves). There is a risk that the position will be made even worse by the current Doha Round of negotiations in the World Trade Organisation, WTO (as it relates to the General Agreement on Trade in Services, GATS, and particular the Financial Services agreement under GATS) and the anticipated negotiations (recently put on hold by the Obama Administration) with the US, Australia and Peru for a Transpacific Trade Agreement extending the current “P4” Agreement New Zealand has with Singapore, Chile and Brunei. This will include negotiations on Financial Services and Investment, both of which could add further barriers to this path to stability. There are already similar provisions to the GATS in the bilateral free trade agreements with China and Singapore, and investment provisions in those agreements and one with Thailand which contain further constraints.

All capital controls are potentially affected by the GATS. There is a wide ranging provision (sneaked into a footnote to the Agreement!) which requires that foreign financial service providers present in New Zealand must be allowed to transfer capital into New Zealand without restriction (28). This would prevent management of capital in a variety of ways, most obviously when used to stabilise the monetary system or the exchange rate. However since GATS does not have a companion requirement giving foreign providers the right to transfer capital out of the country, it may be that management of outward movements could be used to impose conditions on inward movements. However the GATS does guarantee unrestricted “current” payments and transfers (such as company profits) (29), which could be used as a cover for significant movements of funds, and the investment provisions of bilateral agreements such as with China guarantee free capital transfers in either direction. Similarly, GATS goes further for remote provision of services. For services provided from other countries to consumers in New Zealand (such as through the Internet), New Zealand may restrict neither outward nor inward capital transfers. Though New Zealand has not made any commitments in this mode for financial services (though it has for many other services), this is likely to be an area where the US will put pressure on for further commitments in the P4 negotiations, and in the WTO. Under the Financial Services provisions (30) of the GATS, New Zealand has committed to put no restrictions on New Zealanders accessing financial services provided in another WTO member. Typically that arises when New Zealanders travel to another country, but the Internet has blurred the distinction between this and the previous “mode of supply”. What it does mean, at the least, is that we cannot control the activities of wealthy individual New Zealanders setting up bank accounts and borrowing money overseas, although we may be able to prevent them transferring it to New Zealand. This may well cause problems for any capital and currency regulations.

The Financial Services provisions also require New Zealand to allow any overseas-owned financial service provider to offer any “new financial service” it wishes to offer. This prevents us refusing permission for high risk financial instruments, some of which have led to the current financial crisis in the US. Other GATS provisions, and similar rules in bilateral and regional agreements, prevent us giving more favourable treatment to New Zealand-owned institutions such as Kiwibank (“National Treatment”), and require us to give service providers from other WTO members equally favourable treatment regardless of which country they are based in (“Most Favoured Nation”). These will make it difficult for us to diversify the ownership of the major banks, to give special treatment to Government-owned banks which undertake to operate consistently with New Zealand’s public interest, and to increase our regulation of foreign direct investment as proposed. Market Access provisions of the Agreement may also prevent us limiting the volume and value of particular types of lending; it may even prevent us taking action over the “Too Big to Fail” problem by limiting the size of any bank as one expert in the area has suggested (31).

Significant Exceptions

There are two significant exceptions provided in the GATS and similarly in the bilateral agreements New Zealand has signed: in case of balance of payments difficulties, and for prudential reasons. The balance of payments provision however is aimed at short term measures taken specifically at time of external financial difficulties, can be challenged as exceeding what is “necessary” to deal with the difficulties (always a contentious matter of political judgement), and can be reviewed by a WTO committee. It is not designed to allow preventative measures as are intended here. Further, the US has insisted that this exception must be present in bilateral trade agreements it has negotiated with Singapore and Chile (32) and is likely to do the same in the Transpacific negotiations.

The prudential exception (“including for the protection of investors, depositors, policy holders or persons to whom a fiduciary duty is owed by a financial service supplier, or to ensure the integrity and stability of the financial system”) is a contested one. There is not clear international agreement on what is a prudential measure and what is not. What is now regarded as prudential may not have been several years ago, indicating that what is considered prudential is heavily context-specific, often involving complex political considerations. It is unlikely that some measures would be challenged in the current circumstances because the major powers are using them themselves; in other circumstances they would challenge such actions to enable market entry for their financial corporations and products. For example, Ellen Gould and Patricia Arnold, who have analysed the GATS in the light of the financial crisis, point out that the Glass-Steagall Act in the US was repealed in 1999 after becoming “a target of European Union trade negotiators who defined it as a barrier to European countries” (there was also intensive lobbying from parts of the US financial sector which hoped to benefit from the repeal). The Act “separated commercial banking (deposit taking and lending) from investment banking to ensure that depositors’ savings were not put at risk in speculative investments and to avoid conflicts of interest”. If the Act was still in place, the US financial crisis may well have been quarantined to investment banking and had a far less pervasive effect on the stability of the financial system. Yet it was apparently not protected under the prudential provisions, and certainly that protection was open to challenge (33). Therefore a final set of policies that should be pursued is:

International:

Not The Whole Answer But Part Of Solution

It is a positive sign that the recent recommendations of the Commission of Experts of the President of the General Assembly of the United Nations on Reforms of the International Monetary and Financial System capture many of the policies I have suggested above (34). I make no pretence that what is advocated here is simple or straightforward to implement. As Bhagwati remarked, there are powerful vested interests and economic powers lined up to prevent nations acting for their own good. The extent of our international debt in its own right makes us particularly vulnerable to these interests. However, the current crisis has been a huge blow to the credibility of those self-serving interests and forced all nations to rethink their approach to the role of markets, finance, government and regulation. If the kinds of policies suggested here are not implemented, our vulnerability to recurrent financial crises will only increase. In the meantime, our economic development will be stunted; we will be borrowing to service an increasingly unmanageable overseas debt. Our social development will be deformed by constraints on good policy. International capital management is not the whole answer but it is certainly part of the solution.

Acknowledgement: my thanks to Sue Newberry, Brian Easton and Jane Kelsey for their helpful comments on this paper. Naturally they bear no responsibility for the final result.

Endnotes:

(1)  “IMF says some ‘depression’ felt”, by Elffie Chew, The Wall Street Journal Asia, 9/2/09, p9.

(2)  “Turning their backs on the world”, The Economist, 19/2/09; and Organisation for Economic Cooperation and Development (OECD), “Quarterly Growth Rates of GDP, volume”, seasonally adjusted, accessed from http://stats.oecd.org 8/3/09

(3)  “Japan’s Exports Plunge as Downturn Spreads in Asia”, by Bettina Wassener, New York Times, 25/2/09, http://www.nytimes.com/2009/02/26/business/worldbusiness/26yen.html.

(4)  The forum took place on 22 November 2008. See http://ips.ac.nz/events/previous_events-2008.html where some of the slides of the presentations are available; papers will be published in the Institute’s Policy Quarterly.

(5)  “The Banks, the Current Account, the Financial Crisis and the Outlook”, by Geoff Bertram.

(6)  “Overseas Indebtedness, Country Risk and Interest Rates”, by Dennis Rose.

(7)   “Briefing to the Incoming Minister of Finance – Medium-term economic challenges”, The Treasury, 2008, p12; and “The global financial crisis and its transmission to New Zealand – an external balance sheet analysis”, by Paul Bedford, Reserve Bank of New Zealand, Bulletin, Vol. 71, No.4, December 2008, p19.

(8)  The statistics in this and the following two paragraphs are from New Zealand’s International Investment Position, September 2008, Statistics New Zealand. Most are from Table 10: International Assets and Liabilities.

(9)  The banks also had $29 billion in assets overseas. Some of this could be hedging (swap) arrangements that banks have entered into, to insure themselves against the risk of falls in the value of the New Zealand dollar.

(10)  C4 Balance sheets: M3 institutions, Reserve Bank of New Zealand, December 2008.

(11)  “Economic Management”, The Treasury, 14/7/84, p162. Given that the fiction of a crisis in Government debt levels was one of the myths used to justify many of the dramatic and ultimately disastrous policies of the 1984 Douglas/Lange Labour government, the ideological basis of this statement is particularly obvious: Government debt bad, private debt good (or at least nothing to worry about). Their policies led to a privatisation of public debt, much of which was owed overseas (of which more below), though public debt continued to increase and it was a further decade before it returned to 1984 levels as a proportion of GDP. Similarly, the Financial Responsibility Act (now Part 2 of the Public Finance Act) committed the Government to “reducing total debt to prudent levels”, but required only annual reporting on the current account deficit (though not the overseas debt).

(12)  “Briefing to the Incoming Minister of Finance – Medium-term economic challenges”, The Treasury, 2008, p5 and 10 respectively.

(13)  “Briefing to the Incoming Minister of Finance”, p15.

(14)  See the Reserve Bank: http://www.rbnz.govt.nz/statistics/exandint/twi/index.html

(15)  Bertram actually expresses this differently, quoting total foreign investment in New Zealand at March 1997 at $113 billion, of which $53 billion was foreign direct investment (where control of assets is involved). The figures quoted in the text are on a balance sheet basis, which is that usually used for quoting New Zealand’s foreign debt (source for all data is Statistics New Zealand, International In-vestment Position for 1997).

(16)  New Zealand’s International Investment Position, September 2008, Statistics New Zealand, Table 13: International Assets and Liabilities by Residual Maturity; The Treasury paper cited previously, p12; and “NZ Current Account Funding Issues”, Economy Watch, BNZ Capital, 3/3/09.

(17)  See “Mascot Finance customers covered by deposit guarantee scheme”, The Treasury, 2/3/09, http://www.treasury.govt.nz/publications/media-speeches/media/02mar09. Mascot’s guarantee was approved on 12 January 2009.

(18)  See for example, “The Global Capital Market: Benefactor or Menace?”, by Maurice Obstfeld, The Journal of Economic Perspectives, Vol. 12, No. 4, Autumn, 1998, p14; and “International Economics – Theory and Policy”, by Paul R Krugman and Maurice Obstfeld, Fifth Edition, International Edition, Reading, Mass. ; Harlow, England: Addison-Wesley, 2000, pp712-714.

(19)  “The Trilemma in History: Tradeoffs among Exchange Rates, Monetary Policies, and Capital Mobility”, by Maurice Obstfeld, Jay C Shambaugh, and Alan M Taylor, NBER Working Paper No. 10396, March 2004.

(20)  “The Trilemma in History”, pp17, 22.

(21)  “The Global Capital Market: Benefactor or Menace?”, by Maurice Obstfeld, Journal of Economic Perspectives, Vol. 12, 4, p28.

(22)  For current and previous Policy Targets Agreements, see http://www.reservebank.govt.nz/monpol/pta/.

(23)  “Capital Market Liberalization and Development”, by Joseph E. Stiglitz (Editor), Jose Antonio Ocampo (Editor), New York, Oxford University Press, 2008.

(24)  “Capital Market Liberalization and Development”, Chapter 5, p132.

(25)  “The capital myth: The difference between trade in widgets and dollars”, by Jagdish Bhagwati, Foreign Affairs, May/June 1998, Vol 77, no. 3, pp7-12. The quote is from p12.

(26)  “Saved by dumb luck”, by Alan Kohler, Business Spectator, 2/3/09, http://www.businessspectator.com.au/bs.nsf/Article/Foundational-fluke-$pd20090302-PR559, ac-cessed 6/3/09.

(27)  For example, Shyam Sunder, JL Frank Professor of Accounting, Economics and Finance at Yale School of Management, has made proposals to regulate “too big to fail” financial institutions in the US: “Dealing with Too-Big-to-Fail”, unpublished Yale working paper, September 2008.

(28)  Footnote 8 to Article XVI. Note that this applies to all foreign service providers present in New Zealand in sectors under which New Zealand has made commitments, not only in financial services. So for example, since New Zealand in 1994 made commitments under Real Estate, an overseas-owned Real Estate company has the right to make “related” transfers of capital into New Zealand without restriction. Not all WTO members have made commitments under Financial Services, which is a highly controversial area for obvious reasons.

(29)  GATS Article XI.

(30)  These consist of two main supplements to the GATS agreement itself: the Understanding On Commitments In Financial Services, and the Annex On Financial Services. New Zealand has made com-mitments to these with few significant reservations.

(31)  “Dealing with Too-Big-to-Fail”, by Shyam Sunder, unpublished Yale working paper, September 2008.

(32)  “Using free trade agreements to control capital account restrictions: summary of remarks on the relationship to the mandate of the IMF”, by Deborah E Siegel, Senior Counsel, Legal Department International Monetary Fund, ILSA Journal of International and Comparative Law, Vol 10, 2004, pp297-304.

(33)  “Financial Instability and the GATS Negotiations” by Ellen Gould, Canadian Centre for Policy Alternatives, Briefing Paper, Trade and Investment Series, Vol. 9, No.4, July 2008, http://www.policyalternatives.ca/reports/2008/07/reportsstudies1930/?pa=A2286B2A.; and “The General Agreement on Trade in Services (GATS): Implications for regulation of financial services in the United States”, by Patricia Arnold, Associate Professor, School of Business Administration, University of Wisconsin-Milwaukee (arnold@uwm.edu), September 2002, for presentation to the Transatlantic Consumer Dialogue, 5th Annual Meeting, Washington, DC, 28-30 October 2002, http://www.tacd.org/events/meeting5/P_Arnold.doc.

(34)  Recommendations by the Commission of Experts of the President of the General Assembly on reforms of the international monetary and financial system, Chaired by Joseph Stiglitz, 19/3/09. Available at http://www.un.org/ga/president/63/letters/recommendationExperts200309.pdf