The Reserve Bank plays a significant role in the New Zealand economy and has done so since the Bank's formation in 1934. Today, the Bank is responsible for maintaining price stability, promoting the maintenance of a sound and efficient financial system, and meeting the currency needs of the public.
This role has changed over the years. This article outlines the broad history of the New Zealand economy since the 1840s and details the role the Reserve Bank has played in it since the mid-1930s.
Polynesians established permanent settlements in New Zealand, and initial exploitation of natural resources gave way, probably during the fifteenth century, to a more settled world of gardening and resource management. The Māori economy produced enough surplus to support a significant cycle of pa building from the mid-fifteenth century onwards.
When Europeans first arrived in numbers in the early nineteenth century, Māori were eager to trade. Potatoes, corn and flax grown by Māori were usually bartered for weapons, rum, tobacco, blankets and European tools and products. By the late 1830s, settlers and Māori were using money in ever-increasing quantities.
An economy in the western sense emerged across New Zealand in the 1840s. One historian has called this early phase our ‘quarrying’ period. Exports were based on exploitation of existing resources, notably flax, timber, gum, gold, and the available fertility of the soil.
Banks made an early appearance. The Union Bank of Australia opened a branch in Britannia (Pito-one) in 1840, but at first there was no central authority to issue or administer currency. In 1851 the government opened the Colonial Bank of Issue, with authority to issue banknotes. However, this experiment did not last long, and the bank closed in 1856.
The infant colony had a great need for infrastructure. Everything required to support society and economy had to be built from scratch – including roads, railways, schools, hospitals, sewerage systems, ports, and factories – and somebody had to pay for it. Private enterprise played a role in building businesses, but the main weight of responsibility for financing infrastructure fell on the Government.
This posed other problems. At the time there was no income tax, and the main government income was trade levies. Other sources of Crown revenue included the sale of Crown lands – which were purchased wholesale from Māori during the period – and licensing fees.
Early growth focussed on the pastoral sector, but the main engine behind New Zealand’s economy by the early 1860s was gold. Dunedin in particular boomed on the back of the precious metal. Many trading banks were established or set up branches around the goldfields, and between 1861 and 1870 gold made up more than half New Zealand’s total exports. In 1863, the peak year, it comprised 70%. Wool and timber took distant second and third places.
The ‘long depression’
Many settlers envisaged a colony that would become a bigger and better Britain. In fact, once gold had run down, the developing New Zealand economy had little to sell beyond wool. Gum, flax, timber, grain and tallow made up less than 10% of total exports. Even gold did not prevent massive trade deficits. Typically, the economy imported twice what it exported by value during this period, and the difference was made up by imported capital, some of it accompanying the migrants themselves. Trade deficits of this sort, financed by capital inflows to support development, were typical features of colonial settler societies of the time.
Without good internal communications, the New Zealand economy was a cluster of separate regional economies. Colonial Treasurer Julius Vogel initiated a loan-funded public spending programme to rectify this in the early 1870s, intending to build internal infrastructure and bring new settlers to open up the hinterland of the North Island.
For a few years everything boomed, but from 1879 a recession in Britain flowed into the colonies. Estimates show that New Zealand’s level of real GDP was flat during the 1880s, and for the first time, there was a net flow of migrants out of the colony. However, industrial and railway development was significant. It has been argued that although prices fell and the banking sector was under strain, the economy was generally going through a period of development, including growth of local small industries, made possible by Vogel’s infrastructure which helped spur a national economy.
The advent of refrigerated meat exports from the early 1880s created a £1 million export industry by 1890. By that time, the trade balance was showing a modest regular surplus.
The second main phase of New Zealand’s economic history began in the 1890s and lasted into the early 1930s. During this time, New Zealand became a primary producer for Britain, exporting largely pastoral products into this single market.
One of the most significant economic developments of the period was the new trade in meat and dairy products, supplementing the wool market. This industry was driven by the development of refrigerated shipping in the 1880s. By the eve of the First World War, meat and dairy exports made up 35% of total goods exports. Export commodity prices boomed during the war, when Britain was keen to buy whatever could be supplied. Although the boom lasted for a few years after the war, from the early 1920s, the New Zealand economy performed quite poorly, with only brief upturns.
Much of the difficulty came from the external sector. As a primary producer selling principally to the ‘home country’, New Zealand was particularly vulnerable to economic fluctuations in Britain. In 1928, for example, Britain took £41 million of New Zealand’s total exports, by value, out of a total of £56 million. However, British fortunes after the First World War and into the 1920s were not good and this was reflected in New Zealand’s economic situation.
The trading banks and the economy
In the 1920s, New Zealand still lacked a central bank, despite encouragement from Britain to establish one. The 6 main trading banks issued bank notes. Until 1914, they were required to hold enough gold and securities to back the value of the currency. Still, this requirement was suspended for the war emergency and never reinstated. In practice, this change made little difference. The key question for the banks remained their ability to meet customer demand for sterling balances – the funds in Britain that paid for imports. The banks managed their local lending to keep the value of the New Zealand pound roughly equal to that of the British pound. This, in turn, influenced the level of spending and economic activity in the domestic economy.
4 of the 6 trading banks were Australian-owned. Their sterling balances in London reflected Australasian activity, not just that of New Zealand, with the result that the state of Australia’s foreign trade also affected the availability of credit and foreign exchange in New Zealand. This arrangement worked well when the Australian and New Zealand economies were in much the same state, but left New Zealand exposed whenever the Australian economy was weaker than ours.
The Government had few tools to address this and other economic issues – all that could be done was to adjust government revenue and expenditure, through fiscal policy. Governments in the mid-to-late 1920s, therefore, sought to use fiscal policy to stimulate the economy. Still these efforts were overwhelmed by the Great Depression, which the world economy fell into in 1930.
New Zealand was particularly hard-hit by the collapse of primary-sector prices. At a time when both production and export markets were undiversified, the crash of the British market had dire effects. Unemployment rose sharply, and the economy continued to run down into 1932/33. Estimates suggest that gross domestic product fell by 17% between 1929 and 1931. Inflation turned substantially negative. Real incomes for those in work rose – prices fell faster than wages – but for the increasing number who were out of work, hardship was often severe. As in many countries, there was considerable pressure to cut government expenditure.
Policymakers inched towards solutions for the problems New Zealand faced during the depression. The exchange rate was devalued by 25% in 1933, and in 1934, the Reserve Bank opened for business.
Establishing a central bank, although not solely a response to the depression, gave New Zealand authorities more tools to manage future downturns in the New Zealand economy. An important aspect of the Reserve Bank's role, from its founding, was the sole right to issue banknotes in New Zealand.
The Reserve Bank was initially set up as an independent entity, but this quickly changed. The Labour government that came to power in late 1935 brought the Bank under government control – one of its first acts – and gave the Bank the capacity to act as an agent for the implementation of its economic agenda.
The Bank thus became an integral part of the wider interventionist regime that the first Labour government introduced, designed to insulate the economy better and people from fluctuations in world commodity prices. This reflected, and to some extent anticipated, a general international trend towards controls and intervention at that time.
Planned recovery
The new Government’s agenda involved significant increases in spending, putting severe pressure on the foreign exchange reserves of the new central bank, and threatening the viability of the fixed exchange rate. In 1938, comprehensive foreign exchange controls were put in place. These were administered by the Reserve Bank of New Zealand until controls on capital flows were finally lifted in 1984. Import licensing became a dominant feature of the economy, with an emphasis on developing local manufacturing and assembly industries.
The Second World War was a human tragedy, but it was also economically beneficial for New Zealand – demand for our commodity exports was strong. The war emergency prompted the Government to take near-total control of the economy, but wartime made it easier for the public to accept austerity measures. The Government’s external debt was paid off, and the economy was performing so well post-war that the Government felt able to reverse the exchange rate devaluation of 1933, putting the New Zealand pound back on par with the British pound.
The post-war era saw the world return to fixed exchange rates, under the new International Monetary Fund (IMF), though New Zealand did not finally join this until 1961. However, extensive controls on private capital flows were in place in most countries and protective barriers to trade were high, in New Zealand and elsewhere.
The 1950s opened up a new economic world for New Zealand. Terms of trade soared during the early part of the decade, and while export volumes did not grow spectacularly, prices soared. These high prices – and the fact that New Zealand hadn’t been badly affected by the war – meant that New Zealand rode high in the international income rankings during these years. In the 1950s, New Zealand’s per-capita income was 88% that of the United States.
One of the outcomes of this growth, during the 1950s and 1960s in particular, was a number of significant government-funded public works projects. Most national roads were sealed and new bridges were put in. A major hydro-electric system was built in the South Island, of such scale that it stood New Zealand in good stead 2 generations later. A major state housing initiative was maintained into the 1960s.
The economy was highly regulated throughout this period, which arguably contributed to stall innovation and the development of new internationally competitive industries, in turn undermining New Zealand’s longer-term growth prospects. The financial sector was also heavily regulated – bank interest rates were tightly controlled. Capital issues controls, administered by the Reserve Bank of New Zealand, affected the ability of non-bank borrowers and businesses to raise capital directly. Only from around the late 1960s did material liberalisation begin in the financial sector.
The Reserve Bank’s main role through this period involved implementing government policy and managing the economic effects of swings in the external trade position and fluctuations in government spending. Inflation remained relatively low, here and abroad, until around the end of the 1960s.
End of pastoral prosperity
Although the 1950s were prosperous for New Zealand, the writing was nonetheless on the wall for this second phase of New Zealand’s ‘Britain’s farm’ era. The country was, as one economist remarked, effectively a monoculture – he classified all our exports as ‘processed grass’, and most of it was going to a single market, Britain. British efforts to look to Europe as a trading partner, rather than its former empire, meant that New Zealand increasingly had to fight for access to its traditional markets, particularly once the UK joined the European Economic Community (EEC) in 1973.
Even before then, however, New Zealand was in economic difficulties. Wool prices collapsed in December 1966, and in 1967 the exchange rate was devalued sharply – the first adjustment since 1948. Commodity prices were temporarily strong again in the early 1970s, before the aftermath of the first oil shock, in 1973/74, confirmed the sharp turn for the worse in New Zealand’s fortunes. New Zealand’s slide down the international OECD rankings accelerated from 1966 to 1967. Although New Zealanders of the day did not recognise it, they were at the end of an era.
The changes that marked the last quarter of the twentieth century in the New Zealand economy were far-reaching and, at times, controversial. Although often couched in purely philosophic or political terms, these changes also reflected long-term economic issues that can be traced back well before the ‘reform period’.
In part New Zealand’s fortunes reflected the international situation. During the 1960s and 1970s, the cost of the Vietnam War and the oil shocks helped create conditions in the United States and other Western economies that combined weaker growth than had been seen in much of the post-war period, and much higher inflation. New Zealand was no exception – indeed, our inflation rate on average was one of the highest of any of the OECD countries. Unemployment, however, remained very low in New Zealand until the mid-late 1970s.
New Zealand’s problems
New Zealand had a number of specific local economic problems by the late 1970s. Despite growing trends to deregulate elsewhere around the western world, the New Zealand economy remained quite heavily regulated – the liberalisation process lagged behind that of countries such as the UK, US and Australia. There was some progress towards economic diversification. State forests, planted during the 1930s depression and later, were coming to maturity. Trade in logs and associated wood products continued to grow during the 1970s. Fisheries expanded, and a base of manufacturing exporters developed. The government of the day undertook some important measures, including the Closer Economic Relations (CER) agreement with Australia, and extensive liberalisation of the financial sector.
However, politicians and the public found it difficult to grapple with both the reality and the longer-term implications of New Zealand’s relative economic decline. They were reluctant to take steps that would have had substantial short-run employment costs. One response, partly prompted by the second oil shock in 1979, was the ‘Think Big’ economic strategy of 1981, designed to create 400,000 jobs and move New Zealand towards energy self-sufficiency. In practice, ‘Think Big’ did not work – falling oil prices undermined the economics of the energy policy, and the promised jobs did not eventuate. Extensive foreign borrowing to support living standards created increasing pressure on the Government’s finances.
In attempting to combat inflation without undue short-term employment costs, the Government then turned to increasingly draconian economic regulation. This included a price and wage freeze in 1982 to 1984, and extensive controls over interest rates were also put in place.
A new government that came to power after a snap election in mid-1984 introduced sweeping reforms, cutting the scale of both regulation and government service, and opening the economy up to international competition and markets. These reforms were designed to liberalise and diversify the New Zealand economy, opening it up to global competition, and to stem and eventually reverse New Zealand’s relative economic decline.
To achieve this, the exchange rate was floated, trade protection was reduced, state enterprises were put on a more commercial footing, and steps were taken to restore the Crown’s fiscal position. The main thrust of these reforms continued under 2 different governments until 1993, encompassing a wide range of economic policies and government activities, producing significant social change as well as an economic restructuring.
In the transition period, the costs of these changes proved quite high. Real GDP growth was flat in the second half of the 1980s, and recovery did not begin until 1992. Unemployment soared, driven in part by restructuring across the public sector, and in part by the sharp fall in traditional sectoral employment, notably manufacturing. Liberalised firms and financial markets took time to settle down. The 1987 share market crash, which hit many ‘Mum and Dad’ investors hard, precipitated a shakeout. Many corporates collapsed, some banks were pushed to the edge, and one major financial institution – DFC – collapsed.
These experiences highlighted another aspect of the Reserve Bank’s role in the economy. Until the mid-late 1980s, there had been extensive control of financial institutions, including banks, and those controls were used as tools in macroeconomic management. This had the effect of constraining the risks that mainstream financial institutions could take. Once the tight controls had been removed, a framework for prudential supervision of banks was developed and put in place. This supervision, designed to reduce risks and manage the consequences of any bank failures, became a major component of the Reserve Bank’s role into the twenty-first century. A sound and efficient financial system is a vital component of a market economy.
Conquering inflation became a particular priority during the late 1980s. By that time New Zealand had been suffering high and erratic inflation (averaging 10% to 15% per annum) for over 2 decades. By the late 1980s, the Reserve Bank was actively working to quash inflation, broadly envisaging price stability by the early 1990s.
The effort was formalised in the Reserve Bank Act 1989. This Act was pioneering in a number of ways. It gave the Reserve Bank the independence to set monetary policy, but within the context of a transparent agreement between the Governor of the Reserve Bank and the Minister of Finance on what goal the Bank would pursue. New Zealand was the first country in the modern era to adopt a formal inflation target. A range of significant economies worldwide also adopted the targeted approach to price stability.
Getting on top of inflation proved neither easy nor costless. The floating exchange rate tended to be both high and volatile, as did interest rates. However, by the early 1990s, low inflation had been achieved and has since become a well-entrenched feature of the economic landscape here and abroad. In many other countries, similar efforts at around the same time also saw inflation lowered. Lower inflation provides a more stable climate for firms and households, and this more stable backdrop may have contributed to the generally more stable economy, here and abroad, of the last 15 years or so.
By the late 1990s, the difficult period of transition from a regulated, inflationary and largely undiversified economy to a more liberal and diversified environment was largely achieved. The New Zealand economy of the early 21st century was very different from that of a generation earlier. Open and competitive markets scored highly in international comparisons of the ease of doing business.
By international standards, New Zealand’s exports were still dominated by primary products. But there was a greater range of such products and a significantly greater range of markets. Britain, which had taken 90% or more of New Zealand’s production in the mid-twentieth century, now took less than 6%. Tourism became the largest single export industry. High-tech industries and manufacturing were also prominent.
Renewed growth
In 1998, the New Zealand economy entered a period of significant growth, which by 2006 had become one of the longest and strongest growth periods the country had seen. It also occurred in the context of a significantly diversified and deregulated low-inflation economy. Unemployment fell to record low levels, and New Zealand became the first country in the OECD to run long-term fiscal surpluses. However, although New Zealand’s relative decline was halted, there was little progress in moving back up the international income rankings. A high appetite for debt and a reluctance to save meant that interest rates in New Zealand stayed persistently higher than those in comparable countries, holding back investment. And although the government’s external position was strong, the private sector had become highly indebted and reliant on the continuing flow of foreign debt and equity finance.
These issues, which unfolded during the first years of the twenty-first century, highlighted the point that the New Zealand economy remained a dynamic product of people, place and time, each new generation offering a succession of fresh challenges for policymakers, people and governments to meet.
