The New Zealand’s opposition Labour
Party announced that in order to lower average real interest rates and
relief pressures on the unusually appreciated currency, they would pursue a
policy of to increase mandatory savings. The details of the policy have not
been worked out yet, but the gist of the argument is that higher savings lead
to lower real interest rate on average, which would lower the real exchange
rate (real depreciation of the currency). In general, there is no prima
facia problem with advocating a mandatory savings policy. Presumably, if
people perceive the policy as permanent, the stock of domestic capital would
increase, consumption would fall, and diminishing marginal returns to capital would
reduce the equilibrium real interest rate in the long run.[1] But there are three issues
here:
First, New Zealand is an open
economy, regardless of what measure we use for openness. When Kiwis want to
consume more today than tomorrow they would borrow from abroad so it does not
necessarily follow that consumption will fall because of a mandatory savings
policy. New Zealand is a stable Western democracy and our robust institutional
arrangements such as our laws guarantee that Kiwis would not default on their
international obligations.
Second, we have
been concerned about the relatively high real interest rate in New Zealand for
a long time, but we do not have a firm knowledge why is that. New Zealand’s
inflation-indexed interest rate is more than one percentage point higher than
that in the U.S. The data from May 1998 to-date show that the average
difference between New Zealand’s rate and the U.S. rate is 1.08 percent. To be
precise, the inflation-indexed interest rate for New Zealand has been above the
U.S. rate at every moment in time.[2] What explains such a
persistent difference? A recent paper in the Journal of Finance provides a new
theory and test.[3] In
short, it says that the relative sizes of the economies matter. The U.S.
economy is massive relative to New Zealand, therefore, U.S. risk-free bonds are
relatively more expensive than New Zealand’s, and hence the average U.S. real
interest rate is relatively lower. The author tests a large cross sectional
data and shows that differences in the sizes of economies explain a large
fraction of cross-section variation in currency returns. The proposed Labour
Party policy would be ineffective in this case. This means that, on average,
we will not be able to have a lower real interest rate than the United States,
and most other sizable trading partners.
Third, in
theory, relative productivity growth differentials or the covered and uncovered
interest rate parities explain the exchange rate depreciation rate. But reality
is different from theory when it comes to explaining the exchange rate. Those commonly
used exchange rate models do not work well in practice. Parity conditions are
among the six known puzzles in international economics.[4] The magnitude of the expected
change in the exchange rate, nominal or real, which we observe in New Zealand
cannot explain the interest rate differentials between New Zealand and the U.S.
so we cannot be sure that a policy, which aims at lowering New Zealand’s equilibrium
real interest rate, guarantees a depreciated currency.
In summary, the
theoretical linkages between savings, real interest rate and the real exchange
rate one hand, and the empirical evidence on the other, are not as clear as the
Labour Party leader think they are.
Finally, let me
say a few things about the real exchange rate, which might help understand the
problem. One way of looking at the real exchange rate is to examine the ratio
of the price of non-tradable goods to the price of the tradable goods. This
ratio has been increasing because non-tradable prices have been relatively
higher than tradable prices since 2006 (see the RBNZ data files online). Most
of the prices of tradable goods and services are beyond our control because New
Zealand is a price taker. So the real exchange rate appreciation issue, which
policy might be able to influence, is related to the price of non-tradable
goods. The largest components of non-tradable include health, education,
housing, energy & water, and telecommunications. The demand for these goods
and services keeps increasing because of the increase in population and income,
etc. So prices are expected to keep increasing. Examination of the available input-output
tables of the New Zealand economy (1996 and 2007) suggests that mining; energy
& water and construction have experienced increasing cost per unit of
output, growing output, and declining productivity – the Baumol disease.[5] Mining aside, because it
is a tradable good sector, therefore, some of the increases in non-tradable
prices, which cause the real exchange rate appreciation, might be related to
some imbalances in the energy & water and the construction sectors. Although
the shares (weights) of value added / total New Zealand's output of these two sectors are
relatively smaller than those of agriculture and manufacturing, the share of
construction’s value added in total output might have doubled between 1996 and
2007 input-output tables. The Policymaker may want to ask: how much of the rise
of the non-tradable price is associated with the rising marginal costs in these
two secorts; why productivity in these sectors have not increased; and what
could be done to increase it because if the price of non-tradable goods and
services continue to increase by more than the prices of tradable goods and
services, the real exchange rate will continue to increase.
razzakw@gmail.com
[1] Wicksell’s
equilibrium or natural real interest rate is the rate of returns on the
economy’s capital stock.
[2] The period
following the global financial crisis to-date exhibited a significant reduction
of the U.S. interest rate.
[3] Tarek A.
Hassan, (2013), Country Size, Currency Union, and International Asset Returns,
Journal of Finance, Vol. 68, Issue 6, 2268-2308.
[4] Obstfeld, M. And K. Rogoff, (2001), ‘The Six Major Puzzles in
International Macroeconomics: Is There a Common Cause?’ in NBER
Macroeconomics Annual 2000, Volume 15, eds., Ben S Bernanke and Kenneth
Rogoff, MIT Press.
[5]
Baumol, W. J., (1968), Productivity Growth, Convergence, and Welfare: What the
Long Run Data Show, American Economic Review, Vol. 76, No. 5, 1072-1085.
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