Second-guessing the Reserve Bank

The political kerfuffle surrounding the Reserve Bank's latest rate increase has reminded me of something I read earlier in the month, and which has been chewing at the back of my mind for the last few weeks. While in Washington a month ago, Michael Cullen warned of the danger of an "overshoot" by the Reserve Bank, but noted that the government was "in a very fortunate position", and that fiscal policy would "come into play". While he was quick to back away with talk about "automatic stabilisers" (the tax-take declining and benefit spending increasing during a recession), there's a definite implied threat there: if the Reserve Bank does a Brash and tries to strangle the economy to keep inflation down, the government could simply start spending the surplus. It's unclear whether this threat played a role in the Bank's decision to forswear further rate increases in the near future, but it's a possibility.

What's interesting is that this exposes a possible problem with our monetary policy framework, and perhaps with independent central banks in general. The idea that central banks should be independent came about during the 70's, in response to the failure of Keynesian demand-management policies. The Keynesian response to a recession was for the government to spend money to create jobs. This drove up inflation, but this was seen as an acceptable cost for pulling the economy out of a recession. However, in the 70's, this seemed to stop working; recessions continued, and we got "stagflation" (a stagnant economy with high inflation) instead. The neo-liberal response was to claim that the government should stop intervening in the economy, and instead focus on "price stability" (low inflation) - if left to itself the market would naturally work itself out and solve all problems. However, there was a significant impediment to this goal, as politicians would constantly be tempted to pursue Keynesian policies to secure re-election - exactly as Muldoon did in New Zealand - and this would detract from the credibility of low-inflation policies (Kydland and Prescott just won the Nobel in Economics for pointing this out).

The neo-liberal answer was simple: remove the economic levers from democratic control, thus allowing central banks to pursue "credible" low-inflation policies. Which is why we have the Reserve Bank of New Zealand Act 1989.

The problem is that there are two major levers on the economy: monetary policy, to do with the money supply, and fiscal policy, to do with how much the government spends. The Reserve Bank only controls one of them. While they are interdependent, and the Bank can with time adjust to changes in fiscal policy, the government could still in theory pursue old-style Keynesian policies. This wasn't a problem when the idea of independent central banking was first conceived or when the Reserve Bank Act was passed, because back then governments were invariably running deficits - in order to "prime the economy", the government would have to borrow, and this was countered by a commitment not to do so (backed in New Zealand by the Fiscal Responsibility Act 1994 and fear of foreign investors). But if the fiscal policy is tight enough and results in large surpluses (as ours has), the government has no need to borrow. And this puts it in a powerful position to second-guess the Reserve Bank. If the government thinks the Reserve Bank is unnecessarily strangling the economy or driving up unemployment (as Don Brash did repeatedly in the 90's), it can actually do something about it. While I don't for a minute think that the government is going to go to war with the Reserve Bank, the fact that it could is a constraint on the Bank's behaviour. As long as they continue to run surpluses, we're unlikely to be Brashed again.