Greatest invention double-edged sword

New Zealand currency. Photo by ODT.
New Zealand currency. Photo by ODT.
New Zealand has solved the age-old problem of inflation but at what cost, asks Peter Lyons.

I usually start my teaching year by asking my pupils what is the greatest human invention of all time? Those with some historical perspective suggest the wheel. Others mention the iPhone, the can-opener or the internet. Others continue to sleep. My answer is money. 

Money is an amazing human invention because it is based entirely on trust. It is a totally artificial human concept. We trust that it has value despite it being little more than a piece of paper, a cheap metal coin or numbers in a bank account.

The problem with money is that it is easily manipulated. From the early origins of precious-metal coins, rulers had a tendency to dilute the precious metal in the coin.

From the Middle Ages, when paper money developed, the practice of rulers printing more money, particularly in times of war, became easier. The result was usually inflation. Too much money chasing too few goods. Money is a Janus creation. The good side allows for greater trade and output. The bad side allows for manipulation by unscrupulous rulers and governments through the use of the printing press or more recently, the computer mouse.

The ad hoc solution that emerged in the 19th century was to tie the value of different currencies to gold. The value of gold as a commodity was determined by its supply and demand so this gave paper money a semblance of stability. This system with various formats, abstentions and abuses lasted until 1971.

Governments now had little outside restraint on managing their currencies. They could print as much or as little as they wished. The consequence was a worldwide surge in inflation in the 1970s and '80s as governments printed money to finance their spending and debts.

In 1989 New Zealand came up with a solution to this ancient problem of maintaining a stable currency. The Reserve Bank Act removed the control of the money supply and credit from politicians. The Reserve Bank was entrusted with keeping inflation under control with an explicit target now set at 1%-3%. This seemed to make good sense because everyone was assured that the value of our dollar was controlled by an independent watchdog. Reserve Bank officials were even sent to England to tell them how to operate such a system.

The Reserve Bank mainly uses short-term interest rates to meet the inflation target. If inflation is too high it increases interest rates to reduce demand in the economy. Less total demand means firms are unlikely to increase their prices. People also aren't going to demand higher wages if they are worried about keeping their jobs. We kill inflation by bludgeoning it with with a blunt instrument.

But there are problems with this simplistic approach to controlling inflation. This system of a central bank setting short-term interest rates assumes that unelected officials are all powerful in correctly determining the most important price in a market economy. If they get it wrong the results can be ugly. It also means our short-term interest rates are largely predictable to financial markets. Whether this is a good thing is debatable, but it helps explain why the New Zealand dollar is so popular among currency traders.

Until 2007 the Reserve Bank was raising interest rates to quell inflation. This allowed the commercial banks to borrow cheaply overseas and pump this money into loans, fuelling massive housing inflation. More recently the Reserve Bank has kept its interest rate at 2.5% to try to pump up the economy. The main effect has been to refuel housing inflation in certain areas.

Meanwhile, countries such as the United Kingdom and United States have abandoned inflation targeting. They have slashed interest rates and resorted to effectively printing money. Even the staid Swiss have followed suit. The effect has been the pure New Zealand dollar has risen against most other currencies. This is shredding our export sector and jobs.

The inflation rate in New Zealand is now less than 1%. This is below the inflation target. Yet the Reserve Bank shows little urgency to meet its target on the underside. This ultra-low inflation is a sign of a very sickly economy. Our economy continues to stutter along. Unemployment remains stubbornly high along with the exchange rate. Many firms involved in exporting either wither or relocate overseas. Unless we urgently explore alternatives we will continue to live in very expensive houses wondering why we struggle to pay the bills. We solved the problem with a cure almost as bad as the disease.

•  Peter Lyons teaches economics at Saint Peter's College in Epsom and has written several economics texts.