A proposal for the next macroeconomic reform
It has been a great pleasure for me and my family to spend six months enjoying the hospitality of Victoria University and the Reserve Bank of New Zealand. The opportunity to address you this evening is a high point of my visit. During my stay, I have learned a lot about macroeconomic policy in New Zealand. Tonight, I will draw on this experience to propose a new idea for economic reform.
New Zealand's Macroeconomic Reforms
You all know the history of economic reform in New Zealand. So do economists around the world, who view the New Zealand experience as an exciting episode in economic history. It is one of those rare occasions when real-world politicians actually implement policies championed by economic theorists. Some reforms have been in the area of microeconomics, such as changes in the regulation of industry. Others have been in my area of speciality, macroeconomics. Foremost among these are the Reserve Bank Act, which has contributed to the dramatic fall in inflation, and the Fiscal Responsibility Act, which has contributed to the elimination of budget deficits.
New Zealand's reformers have much to be proud of. But, I will argue tonight, it is not yet time to rest on laurels. New Zealand's macroeconomic reforms have set the economy on a sound long-run course -- one with low inflation and declining public debt. It is not enough, however, for policymakers to get the long run right. They must also confront the problem of short-run economic fluctuations -- the booms and recessions that make up the business cycle. Like all economies, New Zealand is constantly buffeted by macroeconomic shocks. Consumer confidence fluctuates, causing increases and decreases in spending. Government spending fluctuates as policies change. Events overseas shift exports and the terms of trade. All of these shocks cause movements in inflation, output, and employment.
These economic fluctuations are painful for the people whose incomes and jobs are affected. And so are the policies that must be undertaken in response to the shocks. In New Zealand today, the Reserve Bank has the job of responding to macroeconomic shocks. In particular, it has a mandate to offset the effects of shocks on inflation -- to keep inflation within its narrow target range of zero to two percent. Unfortunately, to carry out this mandate, the Bank must take actions with painful side-effects.
The reason for these side effects is the "Phillips curve." The Phillips curve is the idea that there is a tradeoff between inflation and output in the short run. To reduce inflation, the Reserve Bank must slow the economy -- it must temporarily reduce the level of output and raise unemployment. The Bank does this by tightening monetary policy -- by raising interest rates and exchange rates. An economic slowdown reduces inflation because falling sales make firms less aggressive in raising prices, and unemployment makes workers less aggressive in seeking higher wages. The Phillips curve explains, why, for example, the sharp drop in inflation in the late 1980s required a deep recession. (The Phillips curve is also noteworthy because it is named after New Zealand's most famous economist -- A.W.H. Phillips, born in 1914 in Dannevirke.)
When macroeconomic shocks push inflation up or down, the Phillips curve implies that the Reserve Bank must slow or speed up the economy to bring inflation back to its target. Today, for example, inflation has risen above the upper bound of two percent. The Bank has tightened policy to reverse this increase. This policy will be successful, but its side-effects will include lower incomes and higher unemployment while inflation is falling.
Let me say that I fully support the Reserve Bank's policy of keeping inflation in a narrow target range. If the Bank let inflation wander up in response to shocks, inflation would eventually reach an unacceptable level. At that point, the Bank would have to tighten policy severely to bring inflation under control, and the costs to the economy would be large. The Bank is wise to move quickly when inflation starts to rise. Since New Zealand introduced inflation targets in 1990, central banks around the world have come to appreciate the benefits of this policy. New Zealand's targets have been imitated in half a dozen countries, with more likely to follow.
So, in this talk, I will not question the Reserve Bank's goal of keeping inflation low and stable. I will, however, question the means by which inflation is controlled in New Zealand. I have said that the Reserve Bank is responsible for responding to macroeconomic shocks, and that it does so through shifts in interest rates and exchange rates. This is the current reality, but it is not the only possible approach. Macroeconomic theory suggests that policymakers have two potential tools for responding to shocks. One is the Reserve Bank's monetary policy, and the other is fiscal policy -- shifts in government spending and taxes. Like monetary policy, fiscal policy can speed up or slow down the economy, and thereby influence inflation.
A carpenter is more successful at his job if he uses both a hammer and a saw, rather than one of these tools alone. So it is, I will argue, with macroeconomic policy: it is best to use both fiscal and monetary tools. In the remainder of this talk, I will first discuss the benefits of giving fiscal policy a greater role in controlling inflation. Then I will describe why fiscal policy is not used today: the institutions governing policy make it difficult. This will lead me to propose changes in these institutions. These changes are the macroeconomic reform in the title of this lecture.
The Problem of Policy Lags
Today, policymakers control inflation by shifting interest rates and exchange rates. Under my proposal, they would also shift taxes or government spending. This would improve on the status quo for two reasons.
The first reason is that fiscal policy affects the economy more quickly than monetary policy. Using fiscal policy would allow policymakers to offset macroeconomic shocks with a shorter time lag. As a result, both inflation and output would be more stable.
Monetary policy is notorious for the "long and variable lags" in its effects, to use Milton Friedman's famous phrase. We can understand these lags by reviewing the channels through which policy affects the economy. When the Reserve Bank raises interest rates, firms delay or cancel investment projects, and consumers buy fewer houses and cars. And higher interest rates lead to higher exchange rates: when New Zealand assets pay higher returns, they become more attractive to investors, who bid up the Kiwi dollar. A higher exchange rate makes New Zealand goods more expensive relative to foreign goods, reducing net exports. Lower spending on investment and exports eventually drags down overall spending in the economy, and inflation slows.
Higher interest rates and exchanges rates are always successful, eventually, at bringing down inflation. But this process can take a long time. Investment plans are part of firms' long-term strategies, and they take time to change. Similarly, importers and exporters do not change their trading patterns overnight. A stronger Kiwi dollar may eventually lead firms to switch to foreign suppliers, but these shifts take time. Finally, it takes time for a slowdown to spread from investment and exports to the rest of the economy. Even if a high exchange rate reduces spending and inflation in the tradeables sector, the non-tradeables sector may be slow to follow.
Economists are not sure exactly how long it takes for monetary policy to affect spending. But a rough estimate is a year. If the Reserve Bank tightens policy in late 1996, the strongest effects on spending will be felt in late 1997. It will take even longer for inflation to fall, because it takes time for lower spending to convince firms to moderate their price increases. This process may take another year. So a monetary tightening that reduces spending in late 1997 will reduce inflation in late 1998.
These time lags make life difficult for the Reserve Bank. Today's policies must be based on forecasts about the economy in two years, when the policies will affect inflation. Inevitably, there are unforeseen events and the economy evolves differently than expected. So it turns out that interest rates were set at the wrong level, and inflation moves away from its target. Then the lags in policy make it difficult to get inflation back on track. Policymakers may realize in 1998 that they made the wrong decision in 1996, but corrective actions won't fix the situation until 2000.
The present situation in New Zealand is a good example of this problem. Like everyone else, the Reserve Bank underestimated the strength of the economy over the last few years -- perhaps because of the Auckland housing boom, perhaps for other reasons. Spending has risen too rapidly, pushing up inflation. In response, the Bank has kept interest rates very high since 1994, but inflation is coming down only slowly. Getting inflation back on track will require a further slowing of spending, and a rise in unemployment.
Is there any way to reduce the fluctuations in inflation and employment that we now endure? I think there is if we use fiscal policy more aggressively. The crucial problem of time lags is less severe for fiscal policy than for monetary policy. To see this, consider how a fiscal action such as a tax cut affects the economy. The tax cut means that less is taken out of people's paychecks. It puts money directly in people's pockets. And research suggests that this increase in after-tax income provides a quick jolt to spending: some people may save the extra income, but many raise their consumption immediately. Similarly, a tax increase forces consumers to cut back quickly on spending. These changes in spending affect all the sectors of the economy that produce consumer goods and services. These direct and widespread effects contrast with the slow process through which interest rates and exchange rates affect spending.
There are some lags in the effects of fiscal policy. In particular, while fiscal policy affects spending quickly, there is still the lag between changes in spending and changes in inflation. But, overall, fiscal policy can control inflation more quickly than monetary policy. If policymakers used their fiscal tools, they would not need to forecast as far ahead, and they would make fewer mistakes. And mistakes could be corrected more quickly. Perhaps the recent overheating of the economy could have been ended earlier through tighter fiscal policy. Inflation might have stayed within its target range, making unnecessary today's very tight monetary policy.
Sharing the Costs
Shorter time lags are the first major advantage of using fiscal policy as a macroeconomic tool. There is a second advantage which is equally important. Monetary policy is an awkward tool not only because it works slowly, but also because its effects are spread unevenly across the economy. The entire economy benefits from the Reserve Bank's policy of controlling inflation. But the costs of this policy fall disproportionately on certain sectors. With more active fiscal policy, the costs would be shared more equally.
The uneven effects of monetary policy should be clear from my earlier discussion of how policy works. The direct effects of monetary policy fall on sectors that are sensitive to interest rates and exchange rates: investment, durable goods, and exports. There is little direct effect on most consumer spending. Reductions in interest-sensitive spending and exports eventually pull down spending in other parts of the economy. But the sectors directly affected by policy experience the largest fluctuations when the Reserve Bank tightens or loosens.
Many people in these sectors complain about this state of affairs. As you all know, farming is a large part of New Zealand's export sector. Some advocates for farmers have strongly criticized the Reserve Bank for the effects of monetary policy on farming. The strong Kiwi dollar caused by today's tight policy is making it difficult for farmers to compete in international markets. The strong dollar reduces farmers' incomes and threatens to force some out of business. I am sympathetic to this complaint.
At the same time, while it may sound contradictory, I am sympathetic to the Reserve Bank's actions. The Bank must keep inflation under control. And raising exchange rates is the only way the Bank can do this. The pain suffered by farmers and other exporters is an unfortunate but unavoidable side-effect.
There are many proposals for changes in monetary policy to help exporters, but most are flawed. For example, raising the target range for inflation would allow looser policy for awhile, temporarily reducing the value of the Kiwi dollar. But this effect would be ephemeral. In a few years, when inflation settled down at its higher level, the terms of trade would return to their normal level. The only legacy of the policy shift would be higher inflation.
So there is little the Reserve Bank can do to help farming and other sectors sensitive to exchange rates and interest rates. But here is where fiscal policy comes in. Fluctuations in interest rates and exchange rates are inevitable only when monetary policy is used by itself to control inflation. The effects of fiscal policy are different from the effects of monetary policy. While tight monetary policy raises interest rates and exchange rates, tight fiscal policy reduces them. For example, a tax increase raises the government surplus, which reduces interest rates; and lower interest rates reduce exchange rates by making Kiwi assets less attractive.
As fiscal and monetary policy have opposite effects on interest rates, it is natural to use them together to control inflation. Suppose inflation is rising because spending is too strong. The economy must be slowed, but there is no need to change interest rates or exchange rates. Instead, there could be a co-ordinated tightening of fiscal and monetary policy. Both types of policy would help slow the economy, but their effects on interest rates would cancel out.
This would mean a new approach to inflation-fighting: when inflation rises, policymakers would raise taxes rather than raise interest rates and exchange rates. Such a policy is obviously not painless. People would not be happy about seeing more taxes taken out of their paychecks. But, as I have stressed before, there is inevitably some pain involved in controlling inflation. With a broad-based tax increase, the pain would be spread around. All taxpayers would feel the pinch of tighter policy and be encouraged to spend less. This is better than putting a heavy burden on people who happen to work in certain industries, such as farming.
So far, I have stressed the bad news about macroeconomic policy: when inflation rises, policy must slow the economy. When fiscal policy is the tool, this means higher taxes. But policy doesn't always have to be tight. While the economy sometimes overheats, it sometimes under-heats as well -- it slows too much, unemployment rises, and inflation threatens to fall below its target range. In this case, we need loose policy to stimulate the economy. If fiscal policy is used, we get a tax cut. So, to be clear, I am not advocating policies that would generally raise taxes. The average level of taxes could be set at the current level, or whatever level is desired given the long-run goals of fiscal policy. Taxes would rise above their average level in some periods and fall below the average in others, but these movements would cancel out over time.
So that's my vision of how macroeconomic policy might work. Shifts in taxes would have a larger role in controlling inflation, and shifts in monetary policy would have a smaller role. By reducing time lags, this change would reduce the costs of controlling inflation. And the costs that could not be eliminated would be spread more evenly across the economy.
The Problem with Current Institutions
These arguments raise an obvious question: if it's such a good idea to use fiscal policy more aggressively, why isn't it done already? The answer has to do with the institutions that determine fiscal and monetary policy. There are good reasons why, under current institutions, monetary policy has the job of controlling inflation, and fiscal policy is passive. Monetary policy is very flexible. The Reserve Bank is run by a small group of officials who monitor the economy constantly and can act quickly on new information. Policy is reviewed by the Monetary Policy Committee every week. Indeed, policy can be adjusted even more frequently if necessary. If new information emerges, Don Brash can talk to a few colleagues and, within hours, issue a statement that moves interest rates and exchange rates. Thus policy can react quickly to macroeconomic shocks.
When economists discuss time lags in the policy process, they distinguish between an "inside lag" and an "outside lag." The inside lag is the time it takes policymakers to react to shocks and take action. The outside lag is the time it takes policy actions to have the desired effects on the economy. Earlier, I argued that the outside lag is long for monetary policy. Balanced against this is the fact that the inside lag is very short. It takes a long time for changes in interest rates to affect inflation, but at least these changes take place as soon as it is clear they are needed.
I have argued that the outside lag is relatively short for fiscal policy: changes in taxes affect spending quickly. However, under current institutions, the inside lag is very long. There is no committee like the Monetary Policy Committee that can adjust fiscal policy quickly. Instead, fiscal policy is determined through a lengthy process involving the government and Parliament. For example, the recent tax cut was first proposed in 1994. The government worked out the details over 1995, and Parliament finally approved the proposal in the middle of 1996. So it took two years to change fiscal policy, whereas Don Brash can shift monetary policy within hours. Fiscal policy moves too slowly to respond to the shocks that constantly buffet the economy. That is the main reason why fiscal policymakers leave economic stabilization to the Reserve Bank.
There is another, related reason why it is best for the Reserve Bank to do the job. This is the independence of the Bank from politics, one of the major accomplishments of the Reserve Bank Act. Many others have spoken about the benefits of Reserve Bank independence, so I will touch on this issue briefly. The basic advantage is that policy is run by apolitical technicians. The members of Parliament who designed the Reserve Bank Act realized that their decisions are complicated by the political pressures they face. It is sometimes difficult to carry out sound economic policies because they are unpopular. In particular, it is never popular to slow down the economy. Many voters simply do not understand that sacrifices are needed for the long-run health of the economy.
In response to this problem, Parliament has wisely delegated monetary policy to the Reserve Bank. The Reserve Bank Act sets the goal of policy -- low inflation -- but the Bank chooses the means to achieve this goal. The officials at the Bank do not have to run for re-election, so they are free to concentrate on the economic rather than political consequences of their actions.
Under current institutions, my idea of using fiscal policy to control inflation has an important drawback. It shifts responsibility from the apolitical Reserve Bank to Parliament, raising the influence of political pressures on policy. There is a greater risk that policymakers will find it too costly politically to take the actions needed to keep inflation under control.
A Proposal
Given the problems with fiscal policy, most economists conclude that current practice is best: monetary policy should have the job of controlling inflation. This conclusion is convincing, however, only if we view current institutions as fixed in stone. The problems with fiscal policy arise because of how it is determined -- through a lengthy political process. As I have argued earlier, fiscal actions themselves are better than monetary actions for controlling the economy. We could have the benefits of fiscal policy without the problems if we changed the institutions governing policy. So at last, we get to my idea for a change in institutions -- my idea for the next macroeconomic reform.
The basic idea is simple. The idea is to give some control over fiscal policy to an institution like the Reserve Bank -- one that is apolitical and can act flexibly. I imagine a group of technicians who monitor the economy and have the authority to raise or lower taxes immediately to control inflation. These officials would adjust fiscal policy in the same flexible way that Don Brash and colleagues currently adjust interest rates. Who should these officials be? First of all, whoever they are, they should control both fiscal and monetary policy. The two tools of policy should be in the hands of the same craftsman. If separate bodies controlled fiscal and monetary policy, differences in views might lead them to work at cross-purposes. For example, if fiscal policy loosened while monetary policy tightened, the effects on overall spending might cancel out. And these policies would produce very high interest rates and exchange rates, even though nobody intended that outcome.
So one body should control both kinds of policy. It should be able to shift interest rates and exchange rates, and also raise or lower taxes. I don't have firm views on who this body should be. One possibility is the Reserve Bank. In this case, my institutional reform would simply give the Bank an additional power -- the power to change taxes temporarily. The Bank would gain a new tool for controlling inflation.
On the other hand, expanding the role of the Bank might not be ideal. The economists at the Bank are specialists in monetary policy but not fiscal policy. In planning the details of policy, it would be useful to involve people who know the ins and outs of the tax system, just as the Reserve Bank uses its understanding of financial markets to run monetary policy. Thus I would lean toward creating a new institution to run a co-ordinated macroeconomic policy. This institution would include both monetary and fiscal experts, and might be called the "Macroeconomic Policy Committee." This Committee would have the authority to order the Treasury to change taxes temporarily, and to order the Reserve Bank to change interest rates.
The Governor of the Reserve Bank should be a member of the Macroeconomic Policy Committee. He might even be assigned the chairmanship, to preserve his central role in macroeconomic policy. More generally, the members of the committee should be people with technical expertise rather than political leaders; they should be appointed for long terms; and they should be difficult to sack. In other words, the new institution should have the same kind of independence as the Reserve Bank. As a member of the government, the Finance Minister should not be on the committee, although the Minister might have an advisory role.
The Macroeconomic Policy Committee would replace the Reserve Bank as the party that negotiates the Policy Targets Agreement with the government. Like the Reserve Bank today, the Committee would be free to choose the means for implementing the Agreement. This independence would have a new dimension under my proposal, as the Committee would choose the mix between monetary and fiscal policy.
An important practical question is what kind of fiscal tools the Macroeconomic Policy Committee should use. Fiscal policy can mean changes in taxes or changes in government spending. For purposes of macroeconomic stabilization, I think changes in taxes are best. Decisions about government spending should be determined by long-run, microeconomic considerations -- by whether the benefits of public projects are worth the costs.
Which taxes should be shifted to control inflation? The Federated Farmers have proposed that policymakers control the economy by varying the GST. This proposal has a major disadvantage, however. An increase in the GST is passed into higher prices of goods and services. If the Macro Policy Committee raised the GST to fight inflation, it would directly create inflation as part of the process. This would make the Committee's job more difficult.
So it would probably be best to use the income tax as the fiscal instrument. The Macroeconomic Policy Committee should have the power to impose temporary, proportional changes in income taxes. If inflation is rising, for example, the Committee might raise everyone's income tax by five percent of the original level. A person paying 30% of his income in tax would see this rate rise to 31.5%. (The increase of 1.5% is five percent of the original 30%). When inflation is tamed, the Committee would end the surcharge, or even cut taxes below normal if the economy looks weak.
Let me be clear that the new Committee's power over taxation would be limited. Parliament would still choose the average level of taxes. And Parliament would still choose how progressive to make the income tax. These are decisions about the distribution of resources that are properly made by the people's elected representatives. The only role of the Macroeconomic Policy Committee would be to vary taxes temporarily, with increases and decreases cancelling over time. The Committee would adjust taxes as part of its technical job of controlling inflation at minimum cost to the economy.
Under the new system, fiscal policy could be adjusted flexibly, just as interest rates are adjusted today. The Pay-As-You-Earn system would allow take-home pay to adjust quickly when taxes change. If taxes rose, for example, the government would immediately instruct employers to take more out of paychecks.
Conclusion
So that's my idea for the next macroeconomic reform. The Macroeconomic Policy Committee that I propose would do many of the things the Reserve Bank does today. It would monitor the economy and tighten or loosen policy to prevent over- or under-heating. Its goal would be to keep inflation within a narrow target range. The departure from current practice is that the Committee would use fiscal as well as monetary tools. This would allow it to influence the economy quickly, reducing the pain of controlling inflation. And the pain that couldn't be avoided would be spread across the economy, rather than falling disproportionately on certain groups.
The direct benefit of this reform would be a healthier economy -- one with greater stability in inflation, output, and employment. An indirect benefit might be greater political support for the long-run goal of keeping inflation low. Frustrated by the costs of controlling inflation, some politicians have proposed a higher inflation target or reduced independence for the Reserve Bank. Such changes would be harmful -- in the long run, they would produce higher inflation with few offsetting benefits. I hope that my proposal will decrease pressure for unwise policies by making it less painful to control inflation.
My proposal requires a major change in institutions. Some have suggested that it is a radical idea, but I think this is an exaggeration. Remember that the power of my new Committee over fiscal policy would be limited, that Parliament would still choose the average level and progressivity of taxes.
In addition, while I propose a new institution, the ideas behind my proposal are not at all new or radical. My reasoning is based on the ideas that controlling inflation sometimes requires slowing down the economy; that fiscal policy affects spending more quickly than monetary policy; and that monetary policy has disproportionate effects on exports and investment. These are mainstream ideas accepted by most economists. Indeed, the professional economists in the audience were probably bored by parts of this lecture, because they repeated ideas that are familiar from textbooks.
So what is new is not the economic reasoning behind my proposal, but the idea of using economic principles to reform institutions. In this way, my proposal follows the tradition of New Zealand's previous macroeconomic reforms, the Reserve Bank Act and the Fiscal Responsibility Act. These Acts produced major changes in how fiscal and monetary policy are determined -- innovations that have attracted the attention of the world. But the ideas behind the two Acts -- the costs of inflation and government debt, and the benefits of an independent central bank -- are familiar parts of mainstream economics. My proposal is to take another step toward institutions that make sense based on economic theory. By taking this step, New Zealand can continue to lead the world in economic reform.
November 11, 1996
