5 Scenario 2: Weaker growth

A small open economy, such as New Zealand, is subjected to a large range of shocks. The final impact of these shocks on taxation revenue will depend on the extent to which activity in the private sector is affected. New Zealand, as previously discussed, has high levels of private sector debt, which could lead to a significant shift in private sector savings, consumption, and investment decisions. If households find themselves overextended, perhaps as a result of a fall in asset prices, they may increase savings, which would reduce consumption. This widespread change in behaviour, referred to as rebalancing, would be reflected as a temporary decline in GDP growth.

Spain, Ireland and an average OECD scenario have been chosen as comparators, due to their recent process of rapid economic rebalancing. It is worth noting up front that while each country, based purely on macro statistics, in some respects looks similar to New Zealand, there are a range of factors that set New Zealand apart from either country. The comparator countries are used purely to calibrate a set of illustrative GDP shocks based on one, two, and three years of negative growth respectively.

5.1  Economic shocks

Different shocks will affect different sectors within the economy in slightly different ways. The fiscal strategy model used in this paper cannot model specific adjustment mechanisms or sectoral dynamics as it primarily runs off a nominal GDP track, which is exogenous to the model[10]. Thus, our modelling cannot pick up idiosyncratic factors, such as the nature of our vulnerabilities or a floating exchange rate, that may set New Zealand apart.

Despite this, a high level discussion about the potential economic shocks and channels for adjustment is still useful to contextualise the material in this section. New Zealand is linked to international markets that allow us to access resources. These markets also allow New Zealand to specialise, stimulate competition, and increase productivity. Stronger international connections will, over a reasonable timeframe, act to lift our economic welfare. However, over shorter timeframes global markets can undergo gyrations that unsettle the domestic economy. No domestic slowdown in the past 40 years has been triggered by domestic factors alone (Reddell and Sleeman, 2008).

The Treasury's past work on productivity identified our international linkages as being primarily through flows of people, capital, trade, and ideas (Treasury, 2009). These linkages act to lift productivity, but can also act as channels for economic shocks. Trade, especially the terms of trade, has been an especially important channel for real shocks through most of New Zealand's modern history (Bordo et al. 2009).

Globalisation has also acted to increase the incidence of financial shocks (Bordo et al. 2010). Financial crises can affect the fiscal position through direct liquidity pressures, a potential loss in confidence, or indirectly via a contraction in GDP. In recent years, there has been a steady progression of international financial crises including the Asian financial crisis (1997), the Russian debt default (1998), and, most recently, the global financial crisis. New Zealand has fared relatively well through most of these crises.

In this paper, we purposely avoid identifying any specific triggering event. The main focus is on how a decline in GDP would affect the accounts. Our scenario involves an unspecified shock and a significant change in household behaviour. One hypothetical scenario, which is similar to what has occurred in Spain, is that the shock leads to a decline in the value of assets such as housing. A decision by households and firms to increase savings lowers consumption and investment, leading to a decrease in growth. In practice, New Zealand's external debt position represents only one risk to growth.

5.2  Adjustment mechanisms in the economy

An economy will usually recover from a shock and, over time, return towards a ‘steady state' or equilibrium growth path. However, if a shock is severe enough, the economy could undergo a structural shift to a different equilibrium growth path. In this study, the economy is assumed to return to a trend nominal growth rate of 4% in between one to three years. While growth returns to a trend, this growth occurs off a lower base implying that government revenue follows a lower parallel trajectory than originally forecast.

A return to trend growth is largely justified by New Zealand's flexible exchange rate and monetary independence. A falling exchange rate increases the competitiveness of the export sector. This competitiveness can offset lower domestic consumption as households start to save. In comparison, individual troubled economies in the Euro area would get relatively less relief from an exchange rate devaluation. Thus, any growth in external competitiveness aimed at offsetting sluggish domestic demand would need to come through a decline in domestic prices. New Zealand also benefits from monetary independence, which allows the central bank to tailor interest rates to the country's current economic conditions.

5.3 Changes in trend spending or tax

Slowing growth impacts on the fiscal position through changes in either tax revenue and, to a lesser degree, spending. The difference between the sensitivity of tax and spending to changes in growth presents a structural weakness in all sovereign accounts (refer Figure 6). Tax responds fairly mechanically to declining economic activity, while many cost pressures, such as health spending, tend to persist through the economic cycle. A level shift in trend revenue relative to trend spending opens up a structural deficit, as occurred in New Zealand in 2008/09. The persistence of the structural deficit attributable to growth off a lower revenue base creates a persistent impact.

Figure 6: New Zealand structural deficits followed a decline in revenue

Source: The Treasury, HYEFU 2010

5.4 Other debt reduction mechanisms

Other adjustment mechanisms such as inflation, exchange rates, or a debt restructure can aid consolidation efforts, but these measures come with significant costs. For this reason, fiscal austerity measures have historically remained the predominant channel for adjustment in over half the international cases where there has been a significant period of deleveraging (McKinsey 2010).

Deleveraging involves decreasing debt as a percentage of GDP. This can be accomplished through fiscal austerity or enacting structural reforms that may increase GDP over time. However, markets are unlikely to treat a package of structural reforms as a solution to a debt crisis. Only three economies have ever managed to grow their way out of debt and in each case the above trend growth followed a war or a commodities boom (McKinsey, 2010)[11].

Inflation can also theoretically be used to reduce the real value of debt outstanding (a soft debt default), but triggering inflation may prove difficult in a deflationary environment. Authorities may be able to increase the supply of money, but demand for additional borrowing may still remain muted (Carpenter & Demiralp, 2010), especially if leverage is part of the problem. The benefits of inflation may also be limited as markets would demand a higher nominal return as debt falls due. Thus, the ultimate burden of consolidation still falls on the taxpayer through inflation, lower growth, and higher debt servicing costs over time.

Default is the final alternative mechanism. Countries often accumulate debt during periods of relatively low interest rates. As rates rise, the cost of paying down debt may eventually overwhelm the cost of a default. The costs associated with default include limited access to credit, a punitive risk premium on lending, and high domestic interest rates. Few countries have used default as a realistic alternative, although defaults have occurred in, for instance, Argentina (2002-2008) or Mexico (1982-1992). Other countries have used soft defaults to gain traction on debt repayments. A soft default includes inflation, repayment holidays, reduced interest rates, or other any debt restructure that reduces the net present value of future repayments.