By Bernard Hickey
Prime Minister John Key has defended the government's focus on returning to budget surplus and reducing the government's debt load, saying it made sense to strengthen the nation's balance sheet through government debt reduction, given households remained indebted and foreign debt was still high.
He also warned that higher debt could trigger credit rating downgrades that increased New Zealand's interest rate premiums.
His comments followed intense debate over the last month in Europe and the United States over a strategy of reducing government debt to improve economic growth rates.
The strategy has relied on academic research by US economics professors Carmen Reinhart and Kenneth Rogoff into the connections between government debt and economic growth, in particular in this academic paper 'Growth in a time of debt' published in 2010. It suggested a tipping point was reached when government debt rose over 90%, significantly reducing growth rates to below zero%.
However, those conclusions were questioned last month in another academic paper which said the Reinhart/Rogoff was based on a spreadsheet error and was skewed by the omission of data on episodes of high debt, including, most importantly, in New Zealand from 1946 to 1949, when our country showed both high growth and high debt.
The debate over this theory known as 'expansionary austerity' -- whereby reducing government deficits and debt improved overall growth as the private sector was freed from crowding out -- has intensified in the last fortnight as this strategy championed by Germany in the European Union and the David Cameron-led coalition in Britain has failed to ignite growth. The IMF and others have called on Europe to abandon its 'expansionary austerity' strategy. IMF research from late 2011 showed such 'expansionary austerity' actually contracted economies in the short term. The US Federal Reserve, meanwhile, has argued the US government's sequestration-driven spending cuts are slowing economic growth and forcing it to continue with its quantitative easing (money printing) programme.
However, Key said the government remained committed to its strategy of returning to surplus by 2014/15 and then reducing debt from almost 30% of GDP in 2017 to 20% of GDP by 2020. The Reserve Bank pointed out in its March Monetary Policy Statement that the government's austerity strategy was driving a tightening of fiscal policy equivalent to 3.2% of GDP over the next four years, which was a factor dampening momentum in the economy.
Key told a post-cabinet news conference the government had run up significant amounts of debt over the last five years to ease the economy through the Global Financial Crisis and the Christchurch earthquakes.
"It hasn't been like we haven't been prepared to use the balance sheet. But we're a small country. We're an open, trading nation. We have considerable private sector debt and we're relying on foreign savings to finance our future. On that basis, if we are excessive with our spending and therefore build up debt, then eventually some generation of New Zealanders are going to have to pay that back," Key said.
"I think New Zealanders would rightly feel quite concerned and vulnerable that the government couldn't actually respond," Key said, referring to the heavy and urgent spending funded by debt to support Christchurch after the earthquakes.
"My view is that as a country we haven't suffered (from the drive for surplus)," he said, referring to New Zealand's economic growth rate being currently stronger than most other developed nations and possibly even Australia.
Higher risk premium?
I then asked Key why the government was so worried about debt when research showed growth rates were not affected until debt got much, much higher, and given the relative ease New Zealand's Debt Management Office is having selling government bonds.
"It's one thing to be the reserve currency like the United States of America and have very large levels of debt because they, in principle, have ways to cope with that," he said.
"In the end, if we have high levels of debt, eventually the ratings agencies will downgrade us again, and over time that leads to a bigger premium on the borrowing that New Zealand companies do."
Standard and Poor's and Fitch downgraded New Zealand's credit rating in September 30, 2011, sparking fears that interest rates would rise in absolute and relative terms.
However, New Zealand's 10 year government bond yield has fallen from 4.39% on September 30 2011 to around 3.2% now. The premium being paid for New Zealand 5 year government bond yields over US 5 year government bond yields has also fallen from 2.39% on September 30, 2011 to 2.01% now. See risk premium chart here and below.
Key said New Zealand interest rates were still higher than those in America and there "may still be a higher risk premium".
"But in the end it depends on your view, and my view is that New Zealand is a much stronger country by having a good healthy balance sheet and we're trying to preserve that."
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