Economist Brian Easton asks: Is leaving inflation fighting to the Reserve Bank all we can do?

This is a re-post of an article originally published on pundit.co.nz. It is here with permission.

We are making sacrifices to restrain climate change, not because the particular climate is what we want, but because if it starts changing too quickly, our current way of life is unsustainable. Similarly the current price level may not be the one we want but if it starts changing too quickly our current economy is unsustainable. So again we have to make sacrifices. Sometimes, as in the case of climate change, we do not think about who making the sacrifices.

It is clear that some are about to be made. The Reserve Bank has just raised interest rates and is talking about raising them further early next year. Asked, the Governor of the Reserve Bank, Adrian Orr, stated that the Bank is ‘deliberately trying to slow aggregate spending in the economy. The quicker inflation expectations come down, the less work we need to do and the less likely it is that we have a prolonged period of low or negative growth.’ Slowing down spending requires some people to make sacrifices.

The way that higher interest rates reduce spending is twofold. First, they discourage investment by businesses while households purchasing durables defer their spending plans. Second, debtors, especially households with mortgages and consumer debt, have to pay more interest and so have less for other spending.

The Reserve Bank, and others, expect the slowdown will cause a recession early next year, which in this context probably means negative economic growth and higher unemployment. The Bank has indicated that it is uncertain whether the recession will be long and shallow or short and sharp.

I am not fussed about this uncertainty. As I wrote in June, forecasting is damn difficult; I was cautioning against the consensus who either thought New Zealand was in a recession or would be in one last quarter. Wrong on both accounts.

It also reminds us that the Reserve Bank is not able to make very precise interventions either in terms of magnitude or timing. I am not arguing that the Bank is incompetent. Rather, that the job it has been asked to do is inherently difficult.

Will they work? There are two major anti-inflationary mechanisms. One is that in a less buoyant economy businesses and workers are less willing to increase their prices and wages (and salaries). The second is that if people believe the Bank will be effective, their expectations of inflation will be reduced, so that they will be less likely to push for higher wages and more likely to resist price increases. Additionally, the main precipitants of the current price increase, the international price shock arising from the supply chain disruptions from the Covid pandemic and the invasion of Ukraine, seem to be abating, although somewhat slower than was expected earlier in the year. There is likely to be slower consumer price rises next year, but there is a wide margin of error about the extent to which this will happen.

Most readers will be familiar with what has just been set down. It is worth doing it though, because much of the public discussion implicitly assumes it and then forgets the analysis in its prognostications.

This is all background for the issue I opened up with. We are making sacrifices to restrain inflation to maintain the long-run sustainability of the economy. Who is to make the sacrifices is a question which lurks behind the discussion but is rarely pursued except in an anecdotal way. Here is my best guess.

The two main groups making sacrifices will be households with mortgages and workers who get laid off or suffer income cuts. (In the latter group I include small business owners.) Note too, that those with savings will benefit from the higher interest rates, but their real net return is still likely to be negative (i.e. the after-tax nominal return will be below the rate of inflation), although higher than it would have been had we let inflation rip.

I cannot speak for the RBNZ if it were asked whether it was fair that mortgage holders and marginal workers are the ones who should be making the sacrifices in the fight against inflation. But I would expect it to say something like that while the statute which the Bank operates under charges it to deal with inflation, it does not mention distributional outcomes; nor has the Bank the policy instruments required to share the burden in any other way. Distributional policy is the responsibility of the Government, not the Reserve Bank.

Suppose you do not like the way the burden of sacrifice was being shared. (For instance, you might think it should be shared more by those without mortgages or those who retain their jobs, or the rich or the poor on benefits.) Even though the Bank cannot deliver, is there another way to reduce the inflation which would make it fairer in your judgement?

A traditional way was an incomes policy in which there was wage (and possibly price) restraint in exchange for the RBNZ not tightening its monetary stance. One happened just before the 1990 election, while in 1982 there was a ‘wage-tax trade-off’ in which wages were restrained in exchange for income tax cuts. Whatever the merits of such deals – economists debate them – following the 1991 Employment Contracts Act the New Zealand union structure lost the coherence to be able to deliver.

Another way would be for the government to change the tax system to affect the distributional impact. Perhaps too, it might raise the general level of taxation as a part of slowing down the economy, which would reduce the need for big interest rate hikes. (They are still needed as world rates are going up and New Zealand’s have to follow them.)

Such a strategy is not widely considered today. The argument was that such government interventions were too slow. In contrast, the RBNZ can change the level of interest rates over night. But the change takes time to work its way through the economy. In New Zealand an income tax change can be implemented faster. (The sluggishness-of-fiscal-policy argument comes from the US with its high-inertia Congress when it comes to legislating almost anything; our parliament can be much more responsive.)

Some think that tax levels are already too high even though our tax burden ranks low among the affluent OECD. They might accept that instead of any tax levy going into the government accounts, it be allocated to the individual’s Kiwisaver account. I would not rule out that option, but those who argue the Reserve Bank should be able to decide this have little understanding of the foundations of a modern democracy where the right to tax sits firmly with parliament.

One of the reasons Charles I lost his head was because he was taxing without parliamentary authority. In the 1689 Bill of Rights, England enshrined the principle that parliament was responsible for taxation. The colonies which became the United States of America partly broke away because they suffered taxation without representation. A Governor of the Reserve Bank is hardly representative (which is why its legislation delegates to the Bank the highly technical operation of monetary policy but its goals are set by the Minister of Finance).

Recall the Governor said during the economic turmoil which followed the Covid lockdown, that the Bank could do its job better with help from fiscal policy. What I am arguing here is no more than that. We cannot easily reverse the latest OCR hike, but there is the promise of a further hike in late February. With help from fiscal policy it need not be inevitable, while the sacrifices may be shared more fairly.

PS. I have not explicitly addressed restraint of government spending. Implicitly it is there when I discuss who should make the sacrifice. Cutting spending on healthcare is requiring the sick to make the sacrifice. It is easy to advocate cutting spending so vaguely that one avoids drawing attention to those who will suffer.

*Brian Easton, an independent scholar, is an economist, social statistician, public policy analyst and historian. He was the Listener economic columnist from 1978 to 2014. This is a re-post of an article originally published on pundit.co.nz. It is here with permission.