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