Innovation and Independence: The Reserve Bank of New Zealand
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Innovation and Independence: The Reserve Bank of New Zealand
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| ISBN-13: | 9781775580942 |
|---|---|
| Publisher: | Auckland University Press |
| Publication date: | 11/01/2013 |
| Sold by: | Barnes & Noble |
| Format: | eBook |
| Pages: | 352 |
| File size: | 11 MB |
| Note: | This product may take a few minutes to download. |
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Innovation and Independence
The Reserve Bank of New Zealand 1973-2002
By John Singleton, Arthur Grimes, Gary Hawke, Frank Holmes
Auckland University Press
Copyright © 2006 Crown CopyrightAll rights reserved.
ISBN: 978-1-77558-094-2
CHAPTER 1
Central Banking in a Controlled Economy
A central bank, like an elephant, is easy to recognise but difficult to describe.
The Reserve Bank of New Zealand (RBNZ) is best known at home and abroad for its strong mandate to eliminate inflation. Indeed, in 1988, it was the first central bank to adopt the approach to monetary policy known as inflation targeting. The Bank also has vital responsibilities for maintaining the integrity of the New Zealand currency and for preserving the stability of the financial system. In recent years, it has devoted increasing attention to the promotion of systemic stability in the banking industry.
In 1973 one of the authors of this book, Gary Hawke, published a history of the Bank. Plenty has happened in New Zealand since then, much of it of more than purely domestic interest. Few other OECD countries went through such turbulent times as New Zealand did in the late twentieth century.
This chapter sets the conceptual and historical scene. For the benefit of readers unfamiliar with central banking, we briefly explain its principles and development. We also describe the origins of the Bank and its activities up to the early 1970s, summarising and in parts revising Gary Hawke's Between Governments and Banks.
The unsatisfactory performance of the economy between the mid-1970s and early 1990s worried many New Zealanders. Inflation was high and variable, economic growth was volatile, and per capita incomes did not keep pace with those in comparable economies such as Australia, Canada, and Britain. New Zealand, like many other countries, was buffeted by two oil shocks in the 1970s. The Labour government of 1972–75 and the National government of 1975–84 failed to cope with these crises. National deregulated interest rates in 1976–77, and hoped to liberalise other aspects of economic policy. Faced with continuing instability, however, it reimposed controls over interest rates and tightened those over other economic activities in the early 1980s. Since the late 1930s, governments in New Zealand had been inclined to respond to an economic crisis by adding new controls, and were slow to dismantle them after the crisis had passed. National's emergency strategy culminated in the imposition of a wage and price freeze between 1982 and 1984.
Whereas today's Reserve Bank is operationally independent from government, and is mandated to achieve price stability, in the 1970s and early 1980s the Bank played a subordinate role to the Minister of Finance in macroeconomic management. Indeed, the Bank was often in the position of having to implement a monetary policy with which it disagreed on economic grounds.
Following the election of a Labour government in 1984, New Zealand underwent an economic policy revolution. The regulated economy, perceived to have failed, was progressively dismantled. The pace of reform was particularly rapid in the monetary and financial arenas, where there was the least opposition to change. Interest rates were freed, the regulations inhibiting competition between financial institutions were scrapped, and the exchange rate was floated. The Bank was given a large measure of de facto autonomy and, after the Reserve Bank Act was implemented in 1990, de jure autonomy. The Bank's monetary policy role was now, first and foremost, to tackle inflation.
Conquering inflation was an important objective of the 1984 — 90 Labour government, and the Bank's actions in this area attracted much publicity. But monetary and financial reforms were only part of the new regime's agenda. At least of equal importance were measures to reform the public sector, privatise state-owned enterprises, reduce border protection, reform the tax laws, and reduce other regulatory constraints.
Reform takes time, and in some areas only initial steps had been taken before the change of government in 1990. The Public Finance Act 1989 created what proved to be the decisive instruments for fiscal discipline, but only after 1990 were they used effectively. The more far-reaching Employment Contracts Act 1991 replaced the Labour Relations Act 1987. And early steps towards reform of the welfare system were greatly intensified from 1991. New Zealand was not alone during this period in placing greater reliance on the market, but the scope and speed of its reforms were unusual in the OECD, especially in the 1980s. Had it not been for the crisis triggered by erratic government policies in the early 1980s, these reforms might have been more gradual.
It was not until about 1992 that the new economic regime began to generate unambiguous net benefits. The late 1980s and early 1990s were blighted by stagnating output, an increase in bankruptcies, and rising unemployment. One of the country's largest banks, the Bank of New Zealand (BNZ), was brought to the brink of disaster by its inability to adapt to the new competitive financial environment. Tight monetary policy received some of the blame for job losses and slow growth. With hindsight, this era could be described as transitional. Deregulation worked, but only after a long time lag. In the decade from 1992, New Zealand enjoyed an almost unbroken record of strong economic growth. The previous generation of policy-makers would have been astounded to learn that this surge in growth was achieved without the sacrifice of low inflation.
By promoting price stability and the overall stability of the banking system, the Bank helped to create an environment that was conducive to economic growth. But the Bank's role was supportive, and the principal causes of growth lay elsewhere, particularly in the factors driving improved efficiency in agriculture, industry, and services. Relieved of earlier, rather vague responsibilities for general economic management, the Bank could concentrate on activities in which it could have the greatest impact – monetary policy and the enhancement of systemic stability. Specialisation by the central bank conferred significant benefits on society, not least by eliminating a source of confusion in economic policy-making.
International interest in New Zealand's policy revolution was substantial. Two aspects attracted special attention. First, international observers were fascinated by the reform of the public sector. Many state-owned entities were privatised. In those that stayed in collective ownership, much greater reliance was placed on applying economic principles and, where relevant, commercial incentives.
Second, the changes in the legal status and operational objectives of the central bank under the 1989 Reserve Bank Act were seen as highly innovative. Central bank autonomy was not a new concept, but to express the relationship between the Bank (in the person of the Governor) and the government in contractual terms was a radically new departure. A clear goal was set, and a mechanism was established to ensure the Bank's accountability. Equally novel was the Bank's use of inflation targeting, an approach that would win numerous overseas converts during the 1990s.
Also distinctive was the Bank's development of a regime for the oversight of the banking system that relied on the disclosure of information to the public, backed up by the attestation of directors, as opposed to direct supervision by the authorities. Finally, the Bank led the central banking world in promoting internal efficiency and better management.
The development of central banking
Central banking has evolved over three centuries. Stanley Fischer identifies four stages in this process. In the first stage, special banks (such as the privately owned Bank of England in 1694) were established in some European countries to raise loans for the government. These banks often became involved in facilitating the development of the financial system, for example by regulating the issue of notes.
The second stage started in the nineteenth century, and marked the beginning of central banking proper. Leading institutions, such as the Bank of England, began to place more emphasis on their role as bankers to other banks, and thus to accept some responsibility for the stability of the banking system. At times of stress, the central bank could be called upon to act as the lender of last resort to other banks. Central banks also became responsible for managing the external value of the national currency. In many cases, this involved maintaining a fixed rate of exchange vis-á-vis gold (the Gold Standard).
During the 1930s and 1940s, the evolution of central banking entered its third stage. National economic policies changed in the aftermath of the great depression of the early 1930s and the collapse of the Gold Standard. (The RBNZ was set up on the eve of the transition to this third stage.) Many central banks were taken into state ownership, and even those that remained in private hands were increasingly subordinated to their governments.
Central banks were required to play a part in the implementation of general macroeconomic policy during this period, which is often characterised as the Keynesian era. Macroeconomic policy aimed to achieve multiple goals: full employment, economic growth, price stability, and a stable exchange rate. Between the late 1940s and the early 1970s, exchange rates were fixed under the Bretton Woods regime, which was overseen by the International Monetary Fund. New Zealand governments also attempted to fine-tune the economy, using fiscal and monetary policy. At the same time, they were more inclined than governments of other developed countries to use direct controls over the economy.
The fourth stage was reached in the late twentieth century. By the 1970s, a global reaction was setting in. The macroeconomic policies dubbed as Keynesian were thought to have caused 'stagflation – a combination of high inflation, stagnant production, and rising unemployment. In addition, exchange rates had become less stable by the late 1960s. Confidence in the ability of governments to manage the economy was diminishing.
Significantly, they also began to focus more single-mindedly on the core objective of internal price stability. By the early 1990s, most developed countries had reduced inflation to much lower levels. Many central banks started to win back some of their former independence. Throughout stages three and four, central banks retained their currency function, as well as overall responsibility for the stability of the financial system, although the precise nature of their involvement in the supervision of individual banks varied from country to country. The transition in New Zealand between the third and fourth stages of this evolutionary process is one of the key themes of this book.
Functions of a modern central bank
The central bank is generally recognised as the apex of the country's monetary and banking structure. A guiding principle for a central bank has generally been that it should act in the public interest and without regard to profit as a primary consideration. Central banks may undertake a variety of activities. These include:
• issuing legal tender notes and distributing coin to meet the requirements of the public
• carrying out banking and agency services for the government, and often managing the public debt
• acting as the custodian of the cash reserves of the commercial banks and assisting in the settlement of clearance balances between them
• preserving the integrity of the financial system, including acting as lender of last resort to banks, and in some cases supervising banks
• carrying out government policy on the exchange rate and on the custody of the national reserves of international currency, and assisting in their management
• controlling monetary and credit conditions in the public interest
• participating in co-operative international monetary arrangements
• promoting economic development
• advising the government on economic policy.
Early central banks acquired functions pragmatically rather than according to any principle. Some functions are closely interrelated. In particular, both the 'monetary policy' and 'bankers' bank' functions often involve the operation of settlement accounts at the central bank. These tasks could be allocated to separate institutions, although there is no compelling reason for doing so. At times, a situation can arise in which the functions of the central bank could pose conflicting pressures. For example, if the central bank injects liquidity in order to avert a banking crisis, inflation might become harder to control in the short term. In general, however, monetary stability and financial stability are complementary.
According to Richard Sayers, one of the historians of the Bank of England, the 'essence of central banking is discretionary control of the monetary system'. The assumption on which central banking is based is that net public benefits are derived from discretionary policy interventions in the monetary and financial system. Economists, central bankers, and politicians have often disagreed about the appropriate form and degree of such intervention. (A small minority of economists have always maintained that central banks serve no purpose.) It is widely accepted that central banks should be under community control, in order to ensure that they do not use their privileges for private gain.
The benefits of central banking are several. First, currency issued by a central bank is safer for the public to hold than currency issued by a private financial institution. Should the private bank collapse, its currency would become worthless. There is little chance of a central bank collapsing, because the government and the taxpayers stand behind it. The only events likely to render currency issued by a central bank worthless are hyperinflation or the disintegration of the state.
Second, a central bank may be in a position to strengthen the financial system, and thus reduce the likelihood and impact of a banking crisis. The failure of a significant proportion of the banking system would cause serious economic damage. Depositors would lose access to their accounts for an uncertain period, and many would have their account balances either wiped out or reduced. Businesses and households would not be able to obtain further credit.
In addition to acting as a potential lender of last resort, a central bank is able to brace the financial system by overseeing and participating in the payment and settlement system, through which transactions are made between banks and between the clients of banks. It is important for this mechanism to work smoothly, and for any problems affecting an individual bank's ability to settle its obligations to be contained before other banks and their clients are implicated.
Third, a well-conducted monetary policy generates macroeconomic benefits. The nature of these benefits, and the ways in which they might be achieved, have often been debated, and are worth considering in some detail. In the so-called Keynesian era, most economists believed that monetary policy could be used in tandem with fiscal policy to achieve general economic stability, incorporating full employment and a stable exchange rate, as well as price stability. Particularly in developing countries, it was also believed that central banks could assist economic development by financing agricultural, infrastructure, and industrial projects. At the same time, however, monetary policy was regarded as a less effective tool than fiscal policy. This view seemed to be confirmed by the Radcliffe Report on the British monetary system in 1959.
During the 1970s and 1980s, the view that the fine-tuning of fiscal and monetary policy was conducive to macroeconomic stability was increasingly questioned and rejected, on theoretical grounds and in the light of stagflation. It was now argued that activist fiscal and monetary policy often had powerful destabilising effects on the economy. Many economists, especially those labelled as 'monetarists', claimed that achieving a favourable equilibrium for output (and employment) depended on persuading the monetary authorities to refrain from fine-tuning.
Many economists now considered inflation to be the result of bad monetary policy. They contended that inflation could be eliminated – without bringing about a lasting rise in unemployment – by tightening monetary policy. Whether price stability was to be achieved by following a rule for the growth of the money supply, as advocated by Milton Friedman, or by discretionary action, was a matter for debate.
So, what are the costs of inflation, and the benefits of overcoming it? Unexpected inflation causes inequities and hardship for some people by redistributing real income and wealth (for example, from savers to borrowers). Such outcomes may be socially divisive, as was the case during the German hyperinflation of the 1920s. New Zealand's inflation in the 1960s and 1970s reduced the real value of many people's savings, and triggered the intergenerational redistribution that underlay the angry superannuation debates from the mid-1970s onwards. Inflation also results in tax distortions. The distributional effects of inflation could in theory be counteracted by the indexation of financial arrangements, and this solution was often proposed in the 1970s.
(Continues...)
Excerpted from Innovation and Independence by John Singleton, Arthur Grimes, Gary Hawke, Frank Holmes. Copyright © 2006 Crown Copyright. Excerpted by permission of Auckland University Press.
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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Table of Contents
Contents
Preface,Glossary,
CHAPTER 1 Central Banking in a Controlled Economy,
CHAPTER 2 The Bank and the Deepening Crisis,
CHAPTER 3 Intellectual Developments in the Bank to 1984,
CHAPTER 4 Monetary Policy and Disinflation, 1984–1990,
CHAPTER 5 The Reserve Bank of New Zealand Act 1989,
CHAPTER 6 Monetary Policy in the Nineties,
CHAPTER 7 Financial Stability,
CHAPTER 8 A Comfortable Old Slipper? The Bank's Domestic History,
Conclusion,
APPENDIX I Reserve Bank Governors 1934–2006,
APPENDIX II Statistics,
Notes,
Bibliography,
Index,