Michael Cullen Speech Announcing Budget Date
EMBARGOED UNTIL 8AM
Tuesday 16 May 2000
Speech to Auckland Regional Chamber of Commerce & Industry
This is the second of my pre-Budget speeches. In it, I want to talk about the economic context within which the Budget has been pulled together. These views are personal. Treasury has not yet finished its update of economic forecasts that are built into and form part of the Budget processes and Budget documents.
The next official release of GDP statistics is scheduled for 26 June. I will be presenting the Budget on 15 June, so I run the risk of errors in estimating contemporary economic trends.
Let me start with some of the signals that we were getting earlier this year. The conventional economists' view was that good rains, lower interest rates, a lower dollar and recovering Asian economies combined to start off another business cycle. The worry, of course, was that we would have another roller-coaster cycle like the last one.
That was a cycle that was heavily dependent on rapidly rising domestic consumption. Consumption in turn was fuelled by a mix of tax cuts and private debt. It provoked a monetary tightening. The danger with a tightening is that the monetary authorities have very limited control over the transmission route that tighter conditions follow.
I will return to this later because I think it is again a crucial issue for our medium turn economic outlook. In the mid 1990s, the tightening fed through into a rapidly rising exchange rate. The rest, as they say, is history.
We ended up with a very large private foreign debt, a chronic balance of payments deficit, a devastated export sector, a highly unstable employment structure and an economy heading for a fall. Which it did, exacerbated but not caused by the Asian crisis.
My nightmare was that the business cycle spluttering into life in the second half of 1999 was a carbon copy of its predecessor. There were eerie similarities. A sharp six month contraction. A bounce then a relapse. Then unexpectedly rapid surges.
Let me digress. There is little doubt that monetary policy has, with very few and temporary exceptions, kept inflation under control. But while the relative volatility of inflation has reduced compared with other countries, relative output volatility has increased. Our business cycle is far too exaggerated for comfort. I do not know if this is a result of our economic structure, or the way monetary policy operations are conducted, or a mix of the two.
I would like to think that we do not have to make a trade-off – to buy a little more output stability with a little bit more inflation volatility. That is why I put a lot of store on the review of monetary policy that we are in the process of commissioning.
The review will probably be completed by around February next year, so it can be a consideration as an economic backdrop to the next Budget. It is not a result that can inform policy in the context of this Budget, so we will just have to keep on trying to manage the fickle beast we live with.
Back to the story so far.
When the numbers came in for the December quarter, the pundits were confounded. Remember we are not talking about forecasts here. We are talking about estimates of the magnitude of events just past.
The December CPI figure was not marginally, but wildly below market estimates. The consensus estimate was around 0.8 percent, the actual a quarter of that. Employment growth was not marginally but a whopping fifty percent above market guess. The growth figure was nearly double. Average wages did not grow as estimated, but fell.
These are big differences. What is particularly interesting, though, is that the direction of error was all wrong from the point of view of conventional economics. If growth and employment were way ahead of estimate, inflation and wage growth should also have been higher. But the strong economy was being matched by weak wage and price movement.
The prospect was raised, therefore, of a paradigm switch. Had the new economy, with its technology induced productivity gains brought co-existing high growth, low unemployment, and stable prices to these shores?
The answer was "maybe." But there is not lot of hard evidence that this was the case. We have not seen the extent of high tech start-ups and expansions that would justify a new economy tag.
Instead, I think we had a different economy. It was not new in a United States sense, but new in a deregulated market economy circa 1990s New Zealand sense. This is perhaps a lesson for analysts. It is wrong to try and impose structures from other economies onto our own. We need careful analysis of the specifics of our particular economy.
What, then, might the explanation be?
A part of the explanation was that there were a number of coincidental forces interacting. International interest rates had fallen in the aftermath of the Asian economic crisis. The sharp contraction had lowered our own currency.
Monetary conditions had become loose. (I leave to one side consideration of whether the Reserve Bank led them there or left them there). Coexisting low interest and exchange rates interacted with good climatic conditions to produce a strong agricultural season.
(I think that most commentators routinely underestimate the importance of the agricultural cycle to New Zealand’s economic fortunes. The multipliers are still very strong, despite restructuring and the growth of the service sector).
Overlay that with hyped up Y2K preparations, by both businesses and households, millennium celebrations, America's Cup races and even a general election – which does boost spending in the print and communications sectors.
We farmed hard, worked hard, shopped hard and partied hard. The growth in the economy, and particularly the growth in employment with its Auckland focus and its part-time composition, are certainly consistent with that.
Why, though, did we not get a wage and inflation blip? Here the question gets harder. I suspect that there are external and internal answers. Externally, the world was emerging from the Asian economic crisis.
That crisis left Asian economies, and the world in general, with surplus manufacturing capacity. The operators of that capacity had problems getting working capital, but the advantage of exporting from behind very weak currencies.
Global manufacturing capacity, rather than domestic manufacturing capacity, was determining pricing discretion. That is a different kind of new economic reality. It is good news for consumers and the inflation outlook, but it does mean that if domestic manufacturers cannot raise productivity, any cost pressures squeeze margins.
The first internal consideration was that the expansion was more broadly based than in the 1990s expansion. A stronger export, and particularly primary industry export performance did two things.
It gained from the lower dollar rather than having to raise the New Zealand dollar denominated price of outputs. Secondly, it used up the spare capacity that was out there in the provinces, and so did not generate the pricing pressures associated with the infrastructural and skills bottlenecks that are encountered when growth has a narrow metropolitan concentration.
Hence muted inflation.
But why the low wage growth? This is not a statistical mirage. As Minister of Revenue, I get regular reports on trends in the tax take. As the economy surged, I might have expected a revenue windfall, but this was not showing up in the IRD bank balance.
Certainly better company profits were showing up in higher company taxes, especially on an accruals basis. But the source deductions – heavily dominated by PAYE on wages – were not tracking any higher than in the pre-election fiscal update.
The changes in economic activity did involve quite a large increase in employment of casual workers in the service sector – at virtually a set service labour wage rate. The relative growth in this lowish wage component had compositional effects that influenced the average wage.
The question now, of course, is whether this is a new pattern of activity, a durable one, or even an accelerating one.
Early indications are that we are not seeing a re-run of the 1990s cycle.
March quarter employment was down, hours worked down, unemployment rate up and retail sales sluggish. When we take out inflation and cars, retail sales in the March quarter – and these two have no or minimal impact on GDP – retail sales growth was zero.
This raises the prospect of low, zero, or even mildly negative growth in the March quarter. Before the headlines scream ‘economy stalls”, or even “economy slumps”, let us get a sense of perspective. Circumstances in the December quarter were so unusual that somehow we need to look through it. We need to fix March against last September to get a better feel of the economic track.
If that quarter is zero, we still have a 2.2 percent half year growth rate and of course a roughly four and half percent annualised growth rate. That is not a hothouse economy.
Of more comfort is the composition of growth. On a half year basis and trying to ignore the abnormalities of the summer (economically, that is – the abnormalities of the weather will never be forgotten), there is some cause for comfort.
We have less of a concentration on consumption as the engine of growth. It is more evenly balanced with exports, investment, and public sector activity all making a contribution. While employment fell, full time employment still grew, so that the labour shedding that has gone on appears to be that associated with millennial abnormality.
The growth phase of the business cycle is therefore more robust. I am not as confident now that the Goldilocks economy described in the last Reserve Bank Monetary Policy Statement will unfold, but equally I am less concerned that we are back on the 1990s roller-coaster.
Where to from here?
As Minister of Finance I can be more relaxed about the upside risk of the expansion. My concern has to switch to slowing growth in the out years.
The pessimists can lodge four claims. Surveys of business opinion show sagging business confidence. The Reserve Bank analysis shows an economy at or over capacity, which would envisage emerging inflationary pressures and suggest monetary tightening. Imports are growing strongly, exacerbating the problems with the balance of payments.
Add to that suggestions that there is a so-called “investor reticence” and that builds up a story that says this is as good as it gets. There is something in each of these claims, but not as much as has been beat up about them.
The business confidence surveys reveal a duality. Respondents typically report that they expect general economic conditions to deteriorate, but that their particular businesses will continue to do well. I suspect some of the general mood is commentator rather that experience driven. It is important to be realistic, but not to contrive self-fulfilling despondency prophesies.
The same duality is apparent with capacity. I am not sure how aggregate capacity measures are derived, but officials regularly and continuously interview business people, mainly to get a better feel for how revenue will hold up in the year ahead.
This concern with capacity is not coming back to me in the reports on those field interviews. Rather, businesses are reporting that they have spare capacity, or that if they run out of capacity they will invest to expand it.
This also puts some of the investor reticence arguments in perspective. I readily concede that if there is global spare capacity, some manufacturers who are competing with foreign suppliers will be more than usually cautious about expanding capacity. On the other hand, where there are opportunities that exist independently of the form of global spare capacity, investment will take place.
These opportunities exist in processing the natural resource endowment of the country, creating opportunities to use the tourist potential of the country, building on emerging niche expertise in areas like electronics, film, yacht building and so on and catering for some of the specialist high value smart production market opportunities in Australia and North America.
In other words, the global capacity overhang is only relevant to a part of our productive base, and arguably the part in which we have a limited long term future anyway.
I say this because I do not believe that it is either right or helpful to blame so-called investment reticence on government policies like the Employment Relations Bill.
The Employment Contracts Act was no economic miracle worker. During its time, the economy slumped, surged and slumped again. The rate of labour productivity fell. The level and form of the business cycle was driven by other events – the ill-fated Mother of All Budgets, the exchange rate, the revolution in information technology, globalisation, the Asian economic crisis, to name but a few. The ECA was about rights and power – it was essentially a political instrument not an economic one.
The ERB is also, at core, an equity instrument. The aim is to balance equity and efficiency considerations in forming conditions of employment.
There has been an enormous beat up on some quite minor technical dimensions of the Bill. The Select Committee is trying to find constructive and practical solutions to real problems that have been identified, within the policy parameters that have informed its drafting. By all means contribute to the fine-tuning, but do not let an ideological funk divert you from the real business opportunities that are out there.
The last negative is the worrying issue of imports. They do seem to deny logic. With the dollar low, household debt high and interest rates rising, I would have expected quite a sharp moderation in import growth. This particularly after the pre-millennial import surge, during which stocks were also built up against the possibility that supply lines might be disrupted.
If anyone out there has got any smart ideas to reverse the trend, short of inducing a depression, please let me know. All I can say is that it might be that they are starting to plateau. A levelling in retail spending would normally be associated with a levelling in importing as well, given the high import component of retail trade.
In addition I am advised that a lot of the very recent importing was by businesses. They used the good profits of recent times to upgrade car fleets and the like – a type of business consumption, if that is not too horrendous a contradiction in terms for the economic purists.
Once there has been a retooling and upgrading, this part of the import spend should moderate.
Overall, I think the negatives are not too frightening a prospect.
What of the positives?
I mentioned earlier that the big picture positive was the broader base to growth. The issue is if it can be sustained. In this area I would list three main influences: the condition of markets, the supply of factors of production, and the exchange rate.
I am not sure that we have a clear enough fix on the core or underlying level of demand that is associated with new technologies, the interface with the global economy, changing lifestyles and new consumption patterns.
The new economy is not just about nerds and high tech net stocks. It is a complex network of multipliers. It is the computer industry, hardware and software, business and retail. It is finance markets and their global links. It is lifestyle blocks, food and wine festivals, concerts and events. It is about more recreation, discretionary consumption and showing off.
It creates twenty four hour employment, in two and four hour bits.
This economy rides a long wave of expansion, and is largely unaffected by short term changes in interest rates, the exchange rate, tax rates and regulatory policies. It does underpin basic growth. Governments can do very little to influence the pace and path that this economy follows.
They can nurture it with policies that create the necessary skills, allow adaptation of skills to meet new needs, nurture embryonic businesses through business incubators, encourage the provision of venture capital and support technological innovation. All of these things are being developed, form part of the Budget, but are longer term in making a substantial difference.
Then there is another tier, driven by more traditional influences. Here the state of world demand, commodity prices, interest rates, the exchange rate and the adequacy of the infrastructure are of crucial importance.
On the demand side, there is room for considerable optimism. The outlook for world growth is extremely positive.
I received an upbeat presentation from JPMorgan when I was in New York. They are projecting global growth this year of 4.1 percent, and they are expecting this growth to be participated in by most of the world's economies. The IMF is painting a similar picture.
It will come down to whether or not the exchange rate negates these external influences. I note within our local finance markets a lot of bullish sentiment about the New Zealand dollar. Commentators regularly say that it is undervalued and have it anywhere between 55 and 60 US cents by year end. Funnily enough, an almost exactly opposite sentiment is held by the overseas financial analysts I talk to.
My sentiment is that the current account deficit will hang over the currency, keeping downward pressure on the dollar. Any monetary tightening – and I am in no position to know when or how aggressively the RB might tighten – is therefore more likely to manifest itself in higher interest rates.
The outlook is for more sustained, less volatile export performance than we encountered in the last cycle. The Budget can help with its emphasis on skills, industry and regional development, although again there is a lot of neglect to correct and it will take time to turn the export sector around.
Overall, I look to an economy with enough balance to give me confidence of less volatility in the medium term. The Budget can nudge that in the short term while contributing to a higher, more sustainable and less volatile growth in the longer term.
The Government will also use the budget opportunity to consolidate our new policy platform and to begin to build bridges to the business community. Some of the changes we have implemented or are in the process of implementing have been opposed by business. But we have done a lot of the hard stuff now.
The rest of our policy programme will be less controversial. In fact the budget will contain a number of initiatives I would expect business to positively welcome. I hope it will enable us to enter a new and more constructive engagement with the business sector.
That is surely in all our interests.