This morning I heard Auckland Chamber of Commerce chief executive Simon Bridges describing the dire state of the Auckland economy. He put part of the blame on the Reserve Bank’s signal that interest rates may need to rise in response to increasing prices. His point was that the immediate cause of the latest price pressure was not excessive domestic demand, but a spike in fuel prices caused by disruption to Middle East oil supplies.
Bridges noted that, had the more doctrinaire members of the Bank’s monetary policy committee had their way when the latest OCR decision was announced on 27 May, the OCR would have gone up. That would have been a further blow to Auckland’s struggling economy. Fortunately, the Reserve Bank executives, supported by the Governor’s casting vote, were more pragmatic and in tune with reality. The OCR was left on hold.
Bridges was right to point the finger at the Reserve Bank. During my 26 years’ involvement in the governance of ASB Bank, I was often puzzled by the way economists made things more complex than they needed to be and often seemed blind to events happening outside New Zealand.
Economists are not alone in making difficult subjects opaquer than they need to be. Lawyers and law makers do it too. Tax law is the obvious example of complexity created by the government. The Income Tax Act 2007 runs to thousands of pages, is amended annually, and sits alongside a host of other legislation administered by Inland Revenue.
It is so long that the government legislation web site contains a warning: “Due to the size of this legislation, it can only be viewed in parts. This will affect CTRL+F searches, which will only search the part you are currently viewing. You can use the content search on the top right of the page to search content across the whole Act.”
Only specialists have any realistic prospect of navigating it with confidence. Even for them, it requires enormous effort.
In the field of law more generally, there are some who try to achieve a modicum of simplicity. One of these was Justice Robin Cooke, later Sir Robin, and later still Lord Cooke of Thorndon. Cooke is often criticized for judicial activism although as an activist he is not a patch on some of today’s judicial incumbents. As an intellect, Cooke towers above them. In 1986, Cooke presented a paper, “The Struggle for Simplicity in Administrative Law.” In it he explained that the essential function of judicial review is to ensure that decision-makers act in accordance with the law, fairly and reasonably.
I have borrowed my title from Cooke’s paper and applied it to the economic field of “inflation.” The use of that term is itself a way of disguising the truth. Inflation is not the result but one of the causes of increased prices. Understanding why prices increase, why the cost-of-living increases, is quite simple when all the jargon and the fancy mathematical equations are stripped out.
When a country creates more money than the economy has goods and services to buy, prices will rise. In other words, more money chasing the same amount of stuff leads to increased prices. Imagine an economy produces the same amount of goods as last year, but the money supply doubles. Prices will roughly double, because there’s twice as much money competing for the same goods.
In that example, it is inflation of the money supply producing the increased prices. That distinction matters because the same price increase may have very different causes. Treating all price increases as if they are caused by excessive demand is a serious policy error.
The converse is also true. If there are fewer goods and services to buy and the money supply stays the same, prices will rise. Imagine an economy produces half the goods as last year, but the money supply stays the same. Prices will roughly double, because there’s the same amount of money competing for half the goods.
During the serious mismanagement of the economy and monetary policy during the covid years, both factors were in play. The Reserve Bank greatly expanded the money supply, aiding the government to pump money into the economy. At the same time, the government shut down large parts of the economy for extended periods, reducing the production of goods and services.
There was a double whammy effect: more money with fewer goods and services. Both factors worked to increase prices. The severity of the impacts explains why the economy has taken so long to recover.
Simon Bridges was right to call out the RB’s academic economists. Resulting from the war in the Middle East, the supply of oil decreased. Consequently, prices of oil derivatives in NZ and elsewhere increased. Those increases flow through the economy. Because oil derivatives are essential inputs for many producers the increased prices increased production costs (as well as consumer prices) and therefore had the tendency to reduce production as well as to increase prices.
It can be seen, therefore, that in this case the problem is not increased money supply but decreased supply of goods. Increasing the OCR has no impact on the supply of goods. All it can do is constrain the money supply.
Reducing the money supply by increasing the OCR would constrain price increases up to a point. Interest rate increases take money from consumers and reduce demand. But an OCR increase can have no impact whatsoever on the price of oil derivatives which is a function of diminished supply of oil.
Another impact of an OCR increase, and I expect this is part of Simon Bridges’ concern, is that it also tends to strangle investment in the domestic economy, the economy’s ability to produce goods and services, and the economy’s ability to compensate somewhat for the reduction in the supply of oil products. In addition, Reserve Bank talk of the prospect of increasing interest rates reduces business confidence. Why would you try to increase production when you are being told to expect weaker demand for what you produce?
The lesson is not difficult. When prices rise because the money supply has been inflated, the Reserve Bank has a proper role in restraining it. But when prices rise because supply has been disrupted — especially in something as fundamental as oil — higher interest rates do not solve the problem. They merely spread the damage.
They suppress demand without fixing supply. They will not increase oil production. They will not lower international fuel prices. They will not make Auckland businesses more productive. They will, however, reduce spending, discourage investment, weaken confidence, and add another burden to an already struggling economy.
That is the danger Simon Bridges identified. The Reserve Bank must distinguish between monetary inflation and supply-driven price increases. If the Bank cannot do that, it becomes part of the problem. Competent policy begins with a simple question: are prices rising because there is too much money, or because there are too few goods?
Gary Judd KC is a King's Counsel, former Chairman of ASB and Ports of Auckland and former member APEC Business Advisory Council. Gary blogs at Gary Judd KC Substack where this article was sourced.
Bridges was right to point the finger at the Reserve Bank. During my 26 years’ involvement in the governance of ASB Bank, I was often puzzled by the way economists made things more complex than they needed to be and often seemed blind to events happening outside New Zealand.
Economists are not alone in making difficult subjects opaquer than they need to be. Lawyers and law makers do it too. Tax law is the obvious example of complexity created by the government. The Income Tax Act 2007 runs to thousands of pages, is amended annually, and sits alongside a host of other legislation administered by Inland Revenue.
It is so long that the government legislation web site contains a warning: “Due to the size of this legislation, it can only be viewed in parts. This will affect CTRL+F searches, which will only search the part you are currently viewing. You can use the content search on the top right of the page to search content across the whole Act.”
Only specialists have any realistic prospect of navigating it with confidence. Even for them, it requires enormous effort.
In the field of law more generally, there are some who try to achieve a modicum of simplicity. One of these was Justice Robin Cooke, later Sir Robin, and later still Lord Cooke of Thorndon. Cooke is often criticized for judicial activism although as an activist he is not a patch on some of today’s judicial incumbents. As an intellect, Cooke towers above them. In 1986, Cooke presented a paper, “The Struggle for Simplicity in Administrative Law.” In it he explained that the essential function of judicial review is to ensure that decision-makers act in accordance with the law, fairly and reasonably.
I have borrowed my title from Cooke’s paper and applied it to the economic field of “inflation.” The use of that term is itself a way of disguising the truth. Inflation is not the result but one of the causes of increased prices. Understanding why prices increase, why the cost-of-living increases, is quite simple when all the jargon and the fancy mathematical equations are stripped out.
When a country creates more money than the economy has goods and services to buy, prices will rise. In other words, more money chasing the same amount of stuff leads to increased prices. Imagine an economy produces the same amount of goods as last year, but the money supply doubles. Prices will roughly double, because there’s twice as much money competing for the same goods.
In that example, it is inflation of the money supply producing the increased prices. That distinction matters because the same price increase may have very different causes. Treating all price increases as if they are caused by excessive demand is a serious policy error.
The converse is also true. If there are fewer goods and services to buy and the money supply stays the same, prices will rise. Imagine an economy produces half the goods as last year, but the money supply stays the same. Prices will roughly double, because there’s the same amount of money competing for half the goods.
During the serious mismanagement of the economy and monetary policy during the covid years, both factors were in play. The Reserve Bank greatly expanded the money supply, aiding the government to pump money into the economy. At the same time, the government shut down large parts of the economy for extended periods, reducing the production of goods and services.
There was a double whammy effect: more money with fewer goods and services. Both factors worked to increase prices. The severity of the impacts explains why the economy has taken so long to recover.
Simon Bridges was right to call out the RB’s academic economists. Resulting from the war in the Middle East, the supply of oil decreased. Consequently, prices of oil derivatives in NZ and elsewhere increased. Those increases flow through the economy. Because oil derivatives are essential inputs for many producers the increased prices increased production costs (as well as consumer prices) and therefore had the tendency to reduce production as well as to increase prices.
It can be seen, therefore, that in this case the problem is not increased money supply but decreased supply of goods. Increasing the OCR has no impact on the supply of goods. All it can do is constrain the money supply.
Reducing the money supply by increasing the OCR would constrain price increases up to a point. Interest rate increases take money from consumers and reduce demand. But an OCR increase can have no impact whatsoever on the price of oil derivatives which is a function of diminished supply of oil.
Another impact of an OCR increase, and I expect this is part of Simon Bridges’ concern, is that it also tends to strangle investment in the domestic economy, the economy’s ability to produce goods and services, and the economy’s ability to compensate somewhat for the reduction in the supply of oil products. In addition, Reserve Bank talk of the prospect of increasing interest rates reduces business confidence. Why would you try to increase production when you are being told to expect weaker demand for what you produce?
The lesson is not difficult. When prices rise because the money supply has been inflated, the Reserve Bank has a proper role in restraining it. But when prices rise because supply has been disrupted — especially in something as fundamental as oil — higher interest rates do not solve the problem. They merely spread the damage.
They suppress demand without fixing supply. They will not increase oil production. They will not lower international fuel prices. They will not make Auckland businesses more productive. They will, however, reduce spending, discourage investment, weaken confidence, and add another burden to an already struggling economy.
That is the danger Simon Bridges identified. The Reserve Bank must distinguish between monetary inflation and supply-driven price increases. If the Bank cannot do that, it becomes part of the problem. Competent policy begins with a simple question: are prices rising because there is too much money, or because there are too few goods?
Gary Judd KC is a King's Counsel, former Chairman of ASB and Ports of Auckland and former member APEC Business Advisory Council. Gary blogs at Gary Judd KC Substack where this article was sourced.
6 comments:
That’s a lot of words to say the Reserve Bank’s economists don’t seem to understand how the economy works. It doesn’t take a rocket scientist, or an economist, to know that inflation was just around the corner when the Middle East went to war. Or is that just because I’m old enough to remember Muldoon, car-less days and the Iranian revolution?
The RB appears gun shy. After the strategy of driving the economy into a brick wall "engineered recession", after allowing inflation to blow out so badly, I'm guessing they are trying to play everything with a straight bat. Rather than realising the RB at that time, along with the government were historically poor and poorly led.
But you and Bridges are right, raising interest rates will only embed the eternal recession Auckland currently suffers with absolutely no gain. And that will only drive more good people from the country that we badly need to stay.
Best you study economics before writing nonsense and insulting the subject by saying it doesn't have your superior understanding. When there's a supply shock like to oil, the cost of living rises. Workers try to maintain their spending power by pushing for wage rises. That can set off a damaging inflationary wage price spiral as firms raise prices as their wage bill rises. Sure it wasn't caused by money printing. However inflation (that is, increases in all wages & prices) is damaging whatever the source. Increasing the OCR is a way to stop this spiral & ensure the only change is the higher relative price of oil. Additionally, the RBNZ's already considered your objection in the sense that being a supply shock it may be transitory & not last long. That's why it has erred toward not raising rates yet. But to the extent the oil shock has gone on for awhile now, all central banks want to avoid a damaging spiral from wage rises causing price rises as workers try to pass on higher costs to firms, which may require a small OCR increase shortly. My recommendation would be a symbolic one of 10 basis points in NZ to signal wage increases will not be accommodated by loose monetary policy.
I know Simon by the way. He's a lawyer. You're a lawyer. NZ would be better off with fewer of you guys thinking you know how to run companies, run monetary policy, and write our constitution = when none of those things are your knitting. Lawyers have suffocated NZ by thriving off red tape which you make money out of. Leave us alone.
It is absurd that we have fostered the notion that whatever events occur citizens, or at least those retaining their jobs, or already on benefits, should be compensated for price increases.Those with loans can make huge gains, mug savers are again robbed.. It will be interesting to see how the pending share market crash will be handled.
Many thanks Gary for explaining the issues in simple terms. It's disturbing that 50% of the Reserve Bank's Monetary Policy Committee don't appear to have the same understanding. On the topic of the complexity of the tax laws, I think they are necessarily complex because in no other field of law is so much ingenuity applied towards evading or avoiding them. The more you "simplify" law - and the same applies to contracts - the more ambiguity you introduce. Or to put it another way, the more discretion you give to the public and to the courts to interpret the words as they see fit. That introduces uncertainty, which is an undesirable characteristic of bad law. The more detail you provide, the more guidance and the less wriggle room there is. People do typically object to greater detail, but the main reason is the additional mental effort it requires them to expend. If only life was that "simple".
If Robert MacCullock’s theory that the Reserve Bank is right to lift the OCR to head off wage rises, when inflation is already rising, it seems like the cart before the horse. The supply shock mentioned, happens to be the most volatile and vital component in transportation of goods and people in the economy. Surely this is the reason costs are rising and so far wages have remained static despite inflation in many day to day necessities. That’s why we are calling it a cost of living crisis. I’m not a lawyer, or an economist, and I haven’t seen a wage increase in several years, long before the Middle East war began. But the Reserve Bank has been playing this game a bit too often, trying to spook the horse into pushing the cart, and like the old staying goes, cry “wolf” too often and the workers might stop listening.
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