5  Time-consistency of policy

Economic objective

In this and following sections we turn away from distortionary taxation as the primary determinant of Crown financial policy. In this section, the objective is to minimise the risk of creating unstable fiscal and monetary policies.

The role of public debt structure in underpinning the time-consistency of fiscal and monetary policies has been recognised since at least Lucas and Stokey (1983). In essence, any government with debt securities outstanding has an incentive to take actions that reduce the real value of debt. Possible mechanisms for reducing the value of debt are outright repudiation, unexpected increases in capital income taxes, or unexpected inflation.

The economic benefit of reducing the risk of time-inconsistency derives in part through stronger financial market credibility leading to lower default risk premia and therefore lower tax rates. However, independent of the tax channel, economic benefits also accrue through avoiding inefficiencies that would arise as the private sector attempts to anticipate and react to an unstable policy.

Key insights for policy

Crown financial policy is determined by weighing the benefits of structuring the balance sheet to eliminate or reduce the incentive on government to act inconsistently over time versus the cost of self-imposed constraints that reduce flexibility to adjust to future shocks. Consistent with the literature on adverse selection and moral hazard, there is a trade-off between incentive and insurance effects: structuring arrangements to provide insurance usually weakens the incentives for consistent behaviour while, conversely, creating strong incentives usually limits the scope for insurance.

The key insights for policy are as follows:

Debt denomination

• price-indexed and foreign-currency denominated debt avoid incentives to reduce the real value of debt through surprise inflation;[20]
• to the extent that incentive and insurance effects should be balanced, optimal policy implies that a proportion of debt securities should still be denominated in nominal terms;
• to sustain a reputational equilibrium (and therefore time-consistent policy), the incentive to reduce the real debt by unexpected inflation must not exceed the cost of lost reputation. Loss of reputation has the character of a lumpy or fixed cost. The implication for policy is to place upper bounds (as percent of GDP) on accumulation of nominal local currency debt, with the bound set to avoid the temptation for opportunistic behaviour;

Maturity structure[21]

• confidence crises: Bad equilibria can occur in circumstances where taxes would have to rise substantially if all parties holding maturing debt refused to rollover. For example, in times of fiscal stress the Crown could face substantial risk premia on its borrowings. A “vicious circle” could develop where a confidence crisis results in rising interest rates and depreciating currency. Such speculative attacks can force a country to repudiate its debt. A long and balanced maturity structure avoids the crisis equilibrium by limiting the potential tax increase below the trigger level for repudiation;[22] and
• low inflation as reputational equilibrium: The effectiveness of surprise inflation as a method of repudiating debt is enhanced if debt has long maturity, is non-indexed, and denominated in domestic currency. Thus, to sustain a reputation for low inflation as total debt increases the optimal policy is to reduce debt maturity (and increase foreign currency denomination). Due to the ‘fixed cost’ of reputation loss, the reputation constraint binds only at high levels of debt: if debt is below the threshold level there is no constraint on maturity and currency denomination.

The results above place the onus on debt structure for underpinning time-consistent fiscal and monetary policies. In the New Zealand context, institutional arrangements such as the Reserve Bank Act 1989 and Fiscal Responsibility Act 1994 are further instruments to achieve time-consistent policy. An issue is whether the institutional arrangements eliminate entirely the need to structure the Crown portfolio to meet time-consistency objectives or whether they merely relax the level of restraint that should be embodied in portfolio policy targets. This issue is pursued in Section 11.

Summary for time-consistency

Economic objective

Minimise the risk of creating unstable fiscal and monetary policies

CFP objectives

Portfolio policy

Minimise the Crown’s incentive to devalue or repudiate debt (and other liabilities)

Targets

1. upper bound on net debt, particularly local currency debt where achieving a low-inflation reputation equilibrium;
2. in event that debt exceeds threshold in (a), set lower bounds on average maturity, proportions of price-indexed and foreign-currency denominated debt; and
3. upper bound on quantity of debt maturing in any year (or relevant period), consistent with avoiding risk of confidence crises.

Instruments

• Tax rate and/or sale of assets
• Re-weighting of liability structure (across denominations and maturities)
• Institutional arrangements (e.g. RBA 1989 and FRA 1994)