A chip in the casino of international finance

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Dear Dr Bollard,You recently raised short-term interest rates as part of your mandate to control inflation.

However, the end of the recession appears largely a statistical occurrence rather than reality.

New Zealand continues its obsessive approach to meeting its self-imposed inflation target of 1%-3%.

It uses the official cash rate as a blunt force instrument to achieve this goal.

Yet there is no international consensus amongst economists that stringent inflation targeting is the best means of controlling inflation.

There is a growing raft of literature that suggests it is very distortionary to an economy.

New Zealand is frequently quoted in this literature.

We continue our purist stance regardless of the mounting collateral damage.

Dr Bollard, during the housing boom, you incrementally raised short-term interest rates to try to reduce the inflationary pressures created by rampant house prices.

Banks and other lenders responded by borrowing from overseas at lower interest rates and aggressively pumping these funds into the mortgage market in New Zealand.

This contributed to further inflation and further interest rate rises, creating a bizarre circular inflationary process.

We are now left with huge overseas debts and very expensive houses.

Relying on short-term interest rates to control inflation creates all sorts of collateral damage.

When interest rates rise, this makes it more difficult for firms to borrow and expand.

A lack of investment in productive capacity contributes to inflationary pressures.

Larger firms with market power such as electricity, phone and oil companies are able to raise their prices to compensate for higher financing costs.

Local and central government can do the same with their charges.

Small businesses - such as farmers, builders, plumbers and many retailers as well as most exporters - do not have this luxury.

The costs of controlling inflation are not shared equally.

Dr Bollard, your anti-inflation policies have wreaked havoc with our export sector.

The irony is that a key reason for targeting inflation in the first place was to ensure the competitiveness of our export sector.

However, largely due to our strict monetarist approach to managing our economy, our dollar has become a much played chip in the casino of international finance.

The New Zealand dollar long ago lost any attachment to the economic fundamentals of our economy.

Currency speculators buy and sell the kiwi dollar with a surety that the Reserve Bank is very predictable in setting short-term interest rates in New Zealand.

For a country that is heavily reliant on export led growth, having an overvalued currency is hugely damaging to our competitiveness.

To be fair, Dr Bollard, you have often lamented the overvaluation of our dollar.

Several times you have wagged your finger at the currency markets and told them off.

You even sent bank officials to Japan to try to dissuade them from buying our dollar to lend back to us.

This may have been a world first in the history of international finance.

Your response to my concerns is likely to be that if New Zealand goes soft on inflation, we will return to the bad old days of the 1970s and '80s.

During this period, New Zealand suffered a severe wage price spiral.

As inflation surged following the 1970s oil price shocks, people demanded higher wages, forcing firms to raise their prices, leading to further wage demands. Profligate government spending during this period also didn't help.

But the New Zealand economy is a totally different beast these days.

Union power is a shadow of its former self.

Markets for many goods and services are very competitive as a result of the removal of trade barriers.

The only entities that are able to raise their prices or charge at will are the big players previously mentioned and they are doing this regardless of monetary policy.

New Zealand led the world in using explicit targeting to control inflation.

We even sent officials to other countries such as the UK to advise them on how to do it.

There are a lot of academic reputations and careers on the line to defend this policy approach.

But we should always be questioning whether this is the most appropriate approach because the stakes are so high.

In a world of globalised financial markets, poor policy settings can be severely penalised.

Virtually all economists believe that controlling inflation is essential.

Disagreements arise over the methods and the extent of the trade-offs involved.

Having a narrow target of 1%-3% suggests our economy can be driven with the precision of a Ferrari, whereas the reality is more like a dump truck.

Unfortunately, in a small country such as New Zealand, debate over technical issues tends to be limited and so the status quo prevails.

There is also a risk of provider capture where the agency given a particular task seeks to defend its role and relevance even if the world has moved on.

A possible solution could be to engage an international panel of experts to evaluate the appropriateness of how we operate monetary policy in New Zealand.

We may be fighting an old enemy in new terrain with obsolete weaponry.

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

 

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