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Special Topic 2:  The Austerity vs Growth Debate and How NZ is Different

There is a robust international debate going on right now over the appropriate pace and extent of fiscal consolidation in the United States, the United Kingdom, and the crisis-hit economies of Europe. This note provides a brief summary of the key positions, and the difficulties in reconciling them, and then comments on the extent to which this debate is relevant for New Zealand. The bottom line is that the nature of the appropriate fiscal policy debate in New Zealand is quite different from the international debate. This is because New Zealand is a small open economy with a floating exchange rate, and because there is still some room for further monetary policy easing if necessary. Thus, under the current central scenario for the New Zealand economy, there is little reason to believe that the pace of fiscal consolidation will be detrimental for growth.

The International Austerity vs Growth debate

The Austerity vs Growth debate has now been going on for some time in a number of European economies and the United States. The crux of this debate is that the need for fiscal consolidation in these economies must be set against the evidence suggesting that consolidation right now might be damaging for economic growth.

Indeed, debt sustainability analyses do suggest a need for credible fiscal consolidation in many economies. Figure 9 shows that not only do many OECD economies have large fiscal deficits, but also that debt levels in some cases are very high.

At the same time, there is a growing body of empirical analysis suggesting that the appropriate pace for fiscal consolidation should be carefully tailored to the economy, according to the size of the fiscal multipliers (ie, the estimated impact of fiscal policy on GDP). In particular, research suggests that fiscal multipliers are likely to be quite positive right now for the United States, and most individual European economies (ie, fiscal contraction will lead to lower economic growth).[1]

These results are partly owing to the recession and the current environment of private sector deleveraging, but also, probably more importantly, because of constraints on monetary policy: the zero lower bound for nominal interest rates in the United States, the UK, and Japan; and the lack of an independent monetary policy for individual euro zone members.

All this suggests a risk that significantly contractionary fiscal policies could have the unintended effect of reducing growth in the near-term and increasing the persistent effect of the downturn on trend output, potentially exacerbating the longer-term fiscal sustainability challenges, as DeLong and Summers, among others, have pointed out.[2]

Yet, despite this evidence, a number of governments are pursuing a relatively fast pace of fiscal consolidation.[3] This reflects a fear that if they are not seen to be taking decisive action to get their debt under control, their bond yields will rise, with the accompanying risk – if their fiscal position is bad enough – that they could be pushed into a crisis (as, say, Ireland, Portugal and Greece have already been).

So, who is right? Those who argue that there is a case for a slower pace of consolidation? Or those who want to be seen to be doing something right now, to ensure the confidence of markets? The answer is most likely that they are both right. Something does need to be done immediately. That something, ideally, might be to seek an adjustment path where credibility can go hand-in-hand with a slower consolidation path. This would likely involve near-term structural reform to boost competitiveness and potential output, combined with a setting out of credible medium term fiscal consolidation plans.[4] Unfortunately, political constraints (such as those apparent in the United States) and the inability to credibly commit to future consolidation, can make it difficult to achieve the ideal mix.

Figure 9 – Public sector debt and fiscal deficits in 2011 for selected OECD economies
Figure 9 – Public sector  debt and fiscal deficits in 2011 for selected OECD economies.
Source:  IMF Fiscal Monitor, April 2012

Note: The structural fiscal deficit is the deficit adjusted for the effects of the economic cycle. If also adjusted for the effects of earthquake-related spending, the New Zealand structural deficit would be closer to 3% for 2011.

How is New Zealand different?

As illustrated in Figure 9, New Zealand has a structural fiscal deficit of similar magnitude to many other OECD economies. It is clear that significant fiscal consolidation is required to stabilise New Zealand government debt.[5] But what is the appropriate pace of fiscal consolidation in New Zealand, especially in the context of our lower-than-average level of general government debt as a percentage of GDP?

There are a number of considerations here. First, the appropriate level of government debt for New Zealand needs to be considered in the broader context of our high level of net external debt (most of which is private sector debt), which is often cited by credit rating agencies as posing risks to New Zealand macro-stability. One of the best ways the government can mitigate this vulnerability is by keeping the level of public debt relatively low.

Second, there are a number of reasons to believe that a given pace of fiscal consolidation will be less contractionary for the New Zealand economy at present than it would be for most other economies. In other words, New Zealand's fiscal multipliers are thought to be quite small, meaning that New Zealand would get less of a boost from fiscal spending than most OECD economies.

The explanation for why New Zealand is thought to have relatively small fiscal multipliers, stems from the fact that New Zealand is a small, relatively open economy with a floating exchange rate and an independent inflation-targeting central bank. The key point is that – as part of their inflation-targeting mandate – the Reserve Bank has an important role to play in stabilising aggregate demand in the economy. Thus as long as monetary policy is not hitting the zero lower bound for interest rates, a well-signalled and credible fiscal consolidation path should – all else equal – be offset by lower-than-otherwise interest rates, and associated exchange rate depreciation, which should boost net exports. It is this interaction between fiscal policy and monetary policy which should result in fiscal multipliers that are close to zero.

This explanation for close-to-zero fiscal multipliers does not apply to individual euro-zone economies which do not have an independent monetary policy, nor to the United States, the UK or Japan, where monetary policy is at the zero bound.

Some economists would argue that the zero lower bound for nominal interest rates does not really bind monetary policy effectiveness, given the existence of quantitative easing tools. Indeed, such tools are widely agreed to have some effect. But the uncertainties and limitations of quantitative easing suggest that we should be cautious about attributing to it the same degree of effectiveness as conventional monetary policy. 

Interestingly, there is evidence that Australia does not fit neatly into the category of a country that would be expected to have ‘close to zero' fiscal multipliers. This is because Australia's trade shares are not particularly high (exports + imports as a percentage of GDP are around 40% in Australia, vs around 60% in New Zealand). The more closed an economy is, the less the impact of fiscal contraction on domestic economic output will be offset by the associated exchange-rate-depreciation-driven boost to net exports. As a result the conventional view is that fiscal multipliers are typically positive in Australia.[6]

Empirical evidence for New Zealand

So what does the empirical literature tell us about fiscal multipliers in New Zealand? Unfortunately there isn't a big NZ literature, but what there is, is broadly consistent with there being small positive fiscal multipliers in the short-term (ie, the next few quarters) and close to zero fiscal multipliers in the medium term (ie, over the 1 – 3 year horizon).[7]

To say that fiscal multipliers in NZ are small or "close to zero" is not to say that fiscal policy has no impact. A switch in the mix of macroeconomic conditions would be expected to have sectoral impacts even if the impact on aggregate GDP more or less nets out. For example, in the mid-2000s we think that the loosening in fiscal policy and the consequently tighter monetary policy had the impact of boosting non-tradable sector output and hindering tradable sector output.

In addition, for unanticipated fiscal changes, the short-term fiscal multiplier is probably positive (ie, would most likely boost GDP in the initial few quarters). But there are a number of reasons why we would not normally advocate the use of fiscal policy for "fine tuning" the economy.

There is, of course, lots of uncertainty about these estimates and we need to remain open to new evidence. But for the meantime both the theoretical and empirical evidence suggests that fiscal consolidation is unlikely to have big adverse GDP effects in New Zealand, as long as there remains room to ease monetary policy.

The key question for NZ then becomes how much room there is for additional monetary policy easing. Figure 10 shows that the government's planned fiscal consolidation is expected to occur against a backdrop of gradually rising interest rates over the next few years (reflecting above-trend growth driven in part by the expected Canterbury rebuild).

While the market is pricing in a lower level of interest rates than the Treasury (dashed line in Figure 10), that path is also expected to follow a gradually rising profile from next year onwards. This, together with the fact that the OCR is still 250 basis points above zero, suggests that there is still room for monetary policy to ease if growth slows and the inflation outlook improves.

Figure 10 – NZ Fiscal and Monetary Policy
 Figure 10 – NZ Fiscal  and Monetary Policy.
Sources:  New Zealand Treasury, Thomson Reuters

Overall, although the government's planned fiscal consolidation is significant (Figure 10 shows that it is estimated to take around four percentage points out of demand over the next four years), this is not expected to hold back aggregate growth, as it will allow interest rates to stay lower than otherwise.

Of course, if New Zealand were to be hit by a large negative shock and we were to run out of monetary policy easing room, then our fiscal multipliers would likely move into more positive territory, and there would be a case for reconsidering the appropriate pace of fiscal consolidation.

Conclusion

The Fiscal Austerity vs Growth debate in the US and Europe reflects the genuine difficulties in designing structural reform and fiscal consolidation packages that boost near-term credibility without unnecessarily dampening near-term growth.

However, this debate is not so relevant for New Zealand as long as we think monetary policy has further room to ease, if required. In fact, given New Zealand's vulnerabilities of rising public debt, high external debt, and an over-valued exchange rate, there is a strong argument for the government to adhere to its fiscal consolidation plans. Indeed, as set out by Treasury in our Briefing to Incoming Ministers,[8] it is important that the forward fiscal consolidation path always be set out clearly and credibly, so that monetary policy can respond appropriately, in the event of a further slowing of the New Zealand or global economies.

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