Austerity and recession: 3 simple graphs that explain New Zealand’s economic crisis

Economists working on macroeconomic policy – things like taxes and spending, interest rates and border controls on flows of trade and money – often refer to a set of key relationships governments can influence. In the textbooks, each of those relationships is drawn as a curve in a graph.

First is the IS (“investment–saving”) curve. This says that if everything else stays the same, the Reserve Bank can increase economic output and employment by lowering the interest rate. Or it can cause a recession by raising the interest rate. (For simplicity’s sake, the curves here are depicted as straight lines.)

Second comes the Phillips Curve, which is usually drawn sloping upwards to suggest that if everything else stays the same, inflation will rise during economic booms and fall in recessions. In other words, the Reserve Bank or the government can apparently bring inflation down by causing a recession.

Third comes the trade balance – the current account of the balance of payments (investment income and traded goods and services between New Zealand and the rest of the world).

If everything else stays the same here, as the exchange rate of the dollar falls, the current account strengthens by moving towards or expanding a surplus. If the exchange rate rises, the current account weakens: exports fall and imports increase.

However, it’s a mistake to suppose each of these relationships will stay where it is while the government and Reserve Bank each tinker with their own policy settings. So, what could go wrong?

The effect of austerity

Start with the IS curve – the way output and employment are affected by interest rates, assuming the government makes no big budgetary changes. But what if the government embarks on an austerity program, slashing its spending and cancelling projects, which shrinks the economy?

At any given interest rate, output and employment will be lower, shifting the whole curve “leftwards” towards lower economic activity (see above).

Even if the Reserve Bank lowers the interest rate, that won’t expand the economy because the government’s fiscal policy is killing off its expansionary effect. The recession created by the austerity program rolls on.

Along the way, it increases costs to government from unemployment, paying other benefits, and lower tax revenue. If the government responds with further austerity, we enter a downward self-reinforcing spiral.

Wages and inflation

Second, take the Phillips Curve and ask what happens if inflation isn’t, in fact, sensitive to how the economy is doing.

In this case, driving the economy into recession has no effect on the inflation rate. When the Reserve Bank changes the interest rate, inflation just stays where it is because the Phillips Curve is flat, not upward-sloping. Reducing inflation requires completely different policy interventions.

Back when the Phillips Curve was invented, it was reasonable to think inflation fell during recessions because workers could get higher wage increases in booms than in slumps.

Bringing on a recession would reduce the bargaining power of workers, result in slower wage growth, and thereby tame inflation (given that wages are an important part of the costs of production).

But workers today have lost the bargaining power they used to have when unions were strong and welfare-state thinking prevailed.

In a paper fellow economist Bill Rosenberg and I published this year, we show the bargaining power of labour was killed off in 1991 by the Employment Contracts Act and has not recovered since. Wages no longer drive inflation in contemporary New Zealand.

Interest rates and inflation

Could the Phillips Curve work because producers of goods and services push up prices and profits faster in booms and cut their margins in recessions?

It’s possible: there’s plenty of evidence of big companies using their market power to price-gouge consumers. But it’s not clear this exercise of market power is greater in booms and lesser in slumps.

In fact, the opposite could be true. Small businesses are most likely to be driven out of the market in recessions, leaving big companies with increased market share and less competitive pressure on their margins.

Forces both locally and in international markets have clearly been pushing the Phillips Curve down, producing lower inflation. Local forces include the current government’s abrupt cancellation of major construction activities, dismissal of public servants, the constant negative messaging on the state of the economy, and rising outward migration as a consequence of all these.

International markets, including falling prices for imports such as oil, have also clearly been pushing the Phillips Curve down. While the Reserve Bank will claim credit, it’s not at all clear the bank’s interest rate policy has made that much difference.

Finally, what about the international balance of payments? One thing the Reserve Bank can do by changing the interest rate is change the exchange rate between the New Zealand dollar and other currencies.

If New Zealand’s interest rates increase relative to elsewhere in the world, short-term money flows in to take advantage of the higher rates. This raises the exchange rate, and in turn weakens the external balance by cutting the return on exports and increasing the volume of cheaper imports.

Producers of goods and services that face international competition are squeezed. Meanwhile, what used to be called the “sheltered” or “non-tradeable” industries – including the big banks, insurance companies, electricity suppliers, supermarkets, consultancies – are unscathed.

Deeper recession

The Reserve Bank may not have much effect on inflation, but it can certainly affect the structure of the economy. Using the interest rate as the weapon against inflation squeezes manufacturers, tourism and farmers, but leaves non-tradables largely untouched.

Right now in New Zealand, the IS curve is remorselessly shifting left as the economy plunges into a deeper recession exacerbated by government austerity – an ideologically driven quest for instant fiscal surpluses, low public debt and a shrinking public sector relative to GDP.

Falling interest rates will struggle to make expansionary headway against that austerity.

Meanwhile, corporate profiteering and rising government charges continue to put upward pressure on the Phillips Curve, and the balance of payments is weakening. This means the country as a whole is piling up increasing debts to the rest of the world (largely through the Australian-owned banks).

The question is, does the current government understand where its policies are taking us?