Chapter 3: Macroeconomic management
A stable and sustainable macroeconomic environment means businesses can plan for the future and the economy can respond to shocks. New Zealand’s macroeconomic framework is sound and there is no need for fundamental change.
However, Ministers do face a set of challenges within the macroeconomic environment. These are containing the recent growth of government expenditure, identifying opportunities for reforms that promote long-run economic growth and improve the ability of fiscal policy to adapt to the pressures the country is likely to face in the future.
A sound macroeconomic framework
Macroeconomic outcomes have improved significantly since the early 1990s. This is signalled by the low inflation rate, less volatility in inflation and output, the fiscal position moving from deficit to sustained surplus, and the reduction in public debt.
The Reserve Bank Act and Public Finance Act operate on principles of transparency, accountability and responsibility, and provide a strong base for a healthy economy. We consider the policy frameworks to be sound. Moreover, current monetary and fiscal policy objectives as set out in the Policy Targets Agreement and recent Fiscal Strategy Reports remain appropriate for New Zealand’s current circumstances.
A floating exchange rate is a significant feature of our macroeconomic environment. The exchange rate is an important channel of adjustment for the economy and has played a crucial role in delivering improved macroeconomic outcomes. It has continued to move through large cycles, however, and this can be a source of uncertainty that hampers investment in exposed industries. There are signs that 20 years of experience with the floating exchange rate regime has increased recognition of the need to take into account its cyclical nature. Maintaining competitive and innovative financial markets will help to provide incentives for ongoing improvements in the products available to firms to help manage exchange rate uncertainty.
Weak spots pose challenges
The current account deficit is at its highest level in almost 20 years. This is leading to an increase in New Zealand’s net external liabilities, already among the highest in the OECD when measured as a proportion of GDP. These high levels of external indebtedness reflect private sector decisions rather than government decisions. Private decisions, in turn, reflect the diversification of risk by firms and individuals, aiding them to smooth consumption when incomes shift, and providing a means to finance investment when opportunities arise.
Even though it is held by the private sector, the large net external liability position does mean that there are macroeconomic risks to be managed if we are to maintain the confidence of financial markets. Maintaining our current macroeconomic framework and running fiscal surpluses will help to manage the risks of a sharp change in investor confidence. Maintaining appropriate financial sector regulatory settings and supervisory controls will also help to reduce the risk of financial distress. Higher aggregate private saving could also help to reduce the macroeconomic risks through a reduction in net external liabilities.
High external indebtedness might also have a negative impact on New Zealand’s cost of capital and the level of business investment. Moreover, there could be some classes of investment that rely more on domestic investors. Higher private saving could, therefore, be beneficial even though investment overall does not appear to have been constrained.
Although government saving is forecast to continue over the medium term, within the next two decades or so a gap between government spending and taxes is likely to emerge. Future governments will need to decide on the appropriate mix of higher taxes and lower expenditures to close the gap. As a result, households and individuals will probably need to rely increasingly on private savings as a means of maintaining living standards in retirement.
We do not see a strong case for compulsory individual saving or significant direct government subsidy of private saving. However, we do support a suite of policies that take account of macroeconomic vulnerabilities and err towards supporting private saving, including:
- facilitation of work-based savings and financial education
- better regulation across the financial services sector
- measures to improve access to investment finance where there are identifiable blockages
- a broad-based tax system that does not distort saving choices, and
- maintaining the strength of the fiscal position and a longer-term focus in fiscal reporting.
New Zealand’s current fiscal position is strong
New Zealand’s current fiscal position is one of the strongest in the OECD. Sustained surpluses and a large reduction in debt have enabled fiscal policy to move to a position where taxation and spending can be allowed to vary in response to the inevitable ups and downs of the economy while maintaining progress towards long-term objectives. The more fiscal policy is forward-looking and avoids the need for large and unpredictable changes in taxes and spending, the more it supports growth.
The focus of fiscal policy for the last 10 years has been to strengthen the balance sheet. It is important now to shift the focus of fiscal policy to address the number of short-term challenges to the fiscal position that could become increasingly problematic over time. In the longer term the fiscal position is expected to come under increasing strain. Increased economic growth will be an important factor in helping to moderate the degree of adjustment required in the government’s finances but is unlikely to be enough to ensure ongoing fiscal sustainability.
There is an opportunity over the next decade for governments to focus on increasing the growth benefits flowing from taxation and spending choices. In addition to raising living standards, a lower tax base and better value for money from government expenditures also gives society a wider range of options to respond to the pressures expected to arise.
Strong fiscal positions can deteriorate quickly
Typically some combination of overestimates of tax revenues, deteriorating economic conditions and changes in taxes and expenses lies behind an unexpected shift to fiscal deficits or increases in the size of expected deficits.
Over the 1990s, the United States, the Netherlands and the United Kingdom all went through a period of fiscal consolidation and returned to surpluses by the end of the decade. These proved to be short lived, deteriorating rapidly either because economic growth stalled, or because large increases in spending coincided with a drop in revenues relative to GDP.