Brian Easton says severe geological and financial earthquakes are inevitable. We just don’t know how soon and how they will play out. Are we putting the right effort into preparing for them?

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

Every decade or so the international economy has a major financial crisis. We cannot predict exactly when or exactly how it will happen. (For what its worth, one is about due; the obvious risk point is the cryptocurrency market – but that is another column – and Trump is clumsy enough to precipitate anything.) The resulting economic distress affects many ‘innocent’ people who are not directly involved in the financial processes which led to the crash. They – with some justification – and those in the financial sector – with less justification but more political influence – turn to their government to help them through the crisis. Given the impact of the crash on the wider economy, we can expect the government to respond.

The prudent may take measures, but it is difficult to take comprehensive ones, especially if their resources are limited. (In contrast a billionaire may suffer a severe financial loss but still live much as they did before the crash – although with less public adulation.) A sensible government will prepare for the collapse.

It strikes this resident of the ‘Shaky Isles’ that there is a parallel ith our planning for earthquakes. Minor ones happen all the time – as do business collapses. But one day there will be ‘the big one’. We don’t know where. We don’t know exactly how – both the Canterbury and Kaikoura earthquakes exhibited unexpected phenomena. And we certainly don’t know when. Seismologists think the big one is less likely to happen than economists expect the next global financial crisis, but they are sure it will. Despite the probabilities, it could happen tomorrow night, before the next financial crash.

Engineers have put a lot of effort into preparing for a major earthquake disaster. You are probably aware of the New Building Standard (NBS – often referred to ‘the code’) which is used to assess how well a building can withstand an earthquake. It may affect directly affect you. You may live in an ‘earthquake prone building’, which means it is vulnerable to much smaller earthquakes than the NBS is set for. Or you may have spent a fortune upgrading your building to the NBS. You may have had difficulty selling your building because of its NBS rating or buying one because your bank is unwilling to advance a large enough mortgage on your chosen building given its code rating. You may have difficulties with your insurer.

A 100% NBS means that the building is thought to be able stand an earthquake which is expected to occur once in 500 years. This is longer than most buildings are expected to last but of course the ‘big one’ could happen tomorrow. In practice it is common to use a 67% rating which should cope with a one in 200-or-so years earthquake. (A 34% rating is about one in 34-or-so years and is sometimes seen as a minimum ambition.)

There is much debate about the realism of these estimates and what is an appropriate policy response. The point is that it is prudent to think about earthquake risk and to take public measures to minimise the damage a major earthquake will cause.

The same applies for financial earthquakes, even though – alas – we have not the same information that engineers have. Public policy has made a number of adjustments. Following the Global Financial Crisis, the Reserve Bank directed the commercial banks to borrow less often for a longer term, which meant they would not have to refinance if international monetary markets seize up, as quickly as they almost did in the GFC. Commercial banks can go to the RBNZ when they are in trouble, in effect pushing their troubles on to the central bank. So it makes sense for the public central bank to reduce the likelihood of the private banks getting into trouble.

The effect of the change has been to raise the cost of domestic borrowing. You can think of the (slight) premium as a form of insurance. You and New Zealand are a bit better protected during the next financial crash.

The same applies for the Depositor Compensation Scheme to be launched later in the year, which safeguards deposits (up to $100,000) in the case of bank (or other deposit taker) failure. The return will be slightly lower because the depositer is paying an insurance to protect their capital.

Probably the biggest single provision New Zealand has against a global financial earthquake is the government keeping its debt low. That means that when the chaos occurs the government has more room for manoeuvre – including borrowing to tide over the crisis. The Minister of Finance has announced a government net debt target as a percentage of GDP (as have at least six of her predecessors). The actual debt level is currently sitting a little above the target, and the date which the target is expected to be attained is being rolled out as the economy performs more poorly than expected. (The next global financial crunch could occur before the target date.)

I am not opposed to some sort of debt target as a part of a suit of measures to judge the fiscal position. (I think it should be somewhat below the average of comparable small open economies because of our heavy overseas private sector borrowing.) However, we may be over-obsessed with it when we evaluate fiscal performance.

Suppose you asked an architect to design you a house and every time you complain about some feature of the proposal – poor access, the kitchen badly designed, the bedrooms too small ... – the architect explains it was the consequence of making the building earthquake robust. Isn’t that a bit like how we have designed the fiscal building? It may be small, cramped and uncomfortable but we daren’t do anything about it because of the financial earthquake risk.

I am not arguing that we should completely redesign the fiscal strategy overnight. I can think of changes I might make, but I’d prefer a evolutionary approach. In the interim I agree with the current government’s approach of not being over-obsessed with the debt target (despite what its political enemies and the commentariat say).

And I am certainly not arguing that we should just change the debt definition as both the current and the previous Minister of Finance have done. Fiddling the accounts addresses political perceptions not economic realities; they will not make one iota of difference when the big one hits.

I wonder whether the New Zealand Government has been through a simulation about how they might handle an external shock, just as the RBNZ has stress tests done on the commercial banks to see how financially robust they are. (It went through the real thing during the GFC. I thought the Reserve Bank and Treasury handled it brilliantly, although the Governor of the Bank of Canada said not to discount luck.) Stress testing would suggest that certain assets and liabilities are near irrelevant during a financial crisis, while others are critical and that we should be paying more attention to them.

And yet we must be mindful that whenever we borrow, we require a lender. As we observed earlier, a major determinant of the impact of the NBS is the way that financial institutions use them as a guide of the willingness to advance mortgages (and provide insurance). and insurers use the NBS to set their premiums. The credit rating agencies such as Standard and Poors award a grade to the government, which underpins the cost of borrowing for virtually all New Zealand borrowers. The agencies have a similar role to engineers who give an NBS rating which is then used by insurers and lenders when they make their decisions.

New Zealand economic policy is haunted by occasions when the country was (almost) unable to borrow. During the Great Depression Keynes advised our Minister of Finance, William Downie Stewart (Jnr), to borrow as much as New Zealand could, to offset the downturn, but added that if he were a lender he would probably not be prepared to advance us any more.

*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.