2  Imbalances: a threat to growth

“Unfortunately a highly leveraged economy can unwittingly be sitting with its back at the edge of a financial cliff for many years before chance and circumstances provoke a crisis of confidence that pushes it off.” Reinhart and Rogoff, 2009

The Treasury seeks to provide advice to enable higher living standards for New Zealanders. An important part of achieving this goal is raising per capita incomes through higher sustainable economic growth. As succinctly captured by the quote above, threats to this objective are of concern to the Treasury and so are prime motivators for this research.

This paper posits that large imbalances may pose more than a passing threat to economic growth over the long run. Threats come at two levels:

• A sudden financial crisis - Large and persistent imbalances over long periods increase the risk of financial crisis. These arise from sudden ruptures in confidence, and have long-term consequences. In particular, financial crisis can have large negative spill-over impacts in the domestic economy, and create fiscal problems from lower tax revenue and higher transfers. The trigger is often unanticipated macroeconomic circumstances or events (i.e. so-called shocks such as an unexpected and large fall in property prices). Crisis is different from periodic but self-rectifying “scares”. Scares can cause costly short-term uncertainty and have distributional consequences through significant asset price shifts, but have little enduring aggregate impacts.
• Persistent slow growth - Imbalances can cause a prolonged and marked drag on economic activity if collectively the private sector becomes uncertain about financial prospects, and decides to consume and invest less. Absent increased government investment or consumption (if possible), or other offsetting changes in the economy to grow tradables, the economy can stagnate. In the long term, this can be just as important as crisis for living standards.

However, in pursuing growth opportunities, some degree of exposure to risk is desirable. Growth processes are rarely linear, and tend to be exploratory and involve individuals taking chances, often involving significant step changes in scope and scale of activities that require external financing. But these choices can lead to eventual regrets for individuals because of unforeseen events, especially if consumption choices have anticipated higher future incomes that do not eventuate. However, with the benefit of hindsight, if these mistakes are isolated, there are few wider economic consequences. But if repeated across the economy in a persistent way over the long term, these mistakes can lead to pervasive economic costs through systemic failure.

Therefore, this paper is not arguing about minimising imbalances, because to do so would likely sacrifice growth. Indeed, external liabilities may even need to grow temporarily to finance investment that will grow the capital stock in order to accelerate growth. However, as will be discussed later, the cause and composition of imbalances is an important consideration, especially if imbalances mount from many individuals taking on the same risk. An example of this would be higher consumption based on the assumption of property prices continuing to rise.