Redesigning the Reserve Bank?

Are Labour’s proposals for the changing the way the Reserve Bank operates sensible or nutty (as nutty as the current legislation)?

Section 8 of the 1964 Reserve Bank of New Zealand Act stated that ‘monetary policy of the Government ... shall be directed to the maintenance and promotion of economic and social welfare in New Zealand having regard to the desirability of promoting the highest degree of production, trade, and employment and of maintaining a stable internal price level.’

A quarter of a century later, the section was replaced in the 1989 Reserve Bank of New Zealand Act by ‘the primary function of the Bank is to formulate and implement monetary policy directed to the economic objective of achieving and maintaining stability in the general level of prices.’ This reduction of the purpose of the RBNZ in the later legislation is being challenged by Labour’s proposed changes.

One could point out that shortly after 1964 the New Zealand went into a two decade burst of inflation– the greatest the economy ever had – as well as a period of economic stagnation, so the charge under the old act proved ineffective. You may want to argue this was a consequence of events outside the control of the RBNZ. But to argue this is to conclude that monetary policy cannot operate alone to deal with inflation.

The section just quoted in the 1989 Act reflected that at the time monetarist (neo-liberal) thinking predominated (although other paradigms such as New Keynesian think low inflation is generally preferable too). This is nicely illustrated by the term ‘primary function’ in Section 8 and the almost grudging Section 31 which stated ‘the Bank shall, if the Bank considers it necessary for the purpose of maintaining the soundness of the financial system, act as lender of last resort for the financial system.’ It was this section which enabled the RBNZ to give a lower priority to price stability during the Global Financial Crisis in order to maintain financial stability.

I come from an older banking tradition which sees the primary role of a central bank as maintaining order in the money system, so I had no problem with their prioritising financial stability at the time. But what is a central bank to do in between financial crises (as well as trying to prevent them happening)? It sets monetary conditions. Again I have no problems with that. But what should it set monetary conditions for?

I am comfortable with an objective of setting them according to ‘promoting the highest degree of production, trade, and employment and of maintaining a stable internal price level’, just like the 1964 Act said the RBNZ should.

Monetarists are likely to counter that the best a central bank can do is to focus on price stability. I happen to disagree with them but, even so, they should have no problems with a clause like that in the 1964 Act. All it requires is that the RBNZ does its best and price stability, according to a monetarism, is the best they can do. However, suppose monetarism is wrong, and a central bank can do better. The 1989 Act precludes monetary policy from doing so. As usual, the Rogernomes were intolerant of any disagreement with their views.

Why monetarism is wrong is a technical issue even if we ignore the dynamics of monetary control. Monetarists assume there is a stable demand for money; many economists would contest that. The big reduction in inflation since 1989 was not only due to the legislation of that year. There were a number of other important factors: the breakages of the wage and price linkages, the reductions of international inflation rates, a disciplined fiscal stance and foreign borrowing which stabilised the exchange rate. Admittedly belief in the legislation helped reduce inflationary expectations, facilitating the transition to a low-inflation regime – beliefs in magic may be effective among the ignorant.

That is why I am not surprised at the difficulties of the RBNZ has had to get New Zealand inflation to the target of an annual average increase in consumer prices of 2 percent in recent years. (It has just reached it.) Nor would you, if you have doubts about the underlying monetarist theory.

So I am not uncomfortable with Labour’s proposal to include employment as something which the RBNZ should take into consideration in its monetary settings. In fact the Policy Targets Agreement between Governor and the Minister of Finance currently requires the RBNZ to take into account things other than inflation, particularly instability in output, exchange rates and interest rates. Which is why many think the proposed change in legislation will make very little difference except that it will break public thinking out of the monetarist straitjacket. (My impression is that the RBNZ’s thinking is not so constrained – its modelling framework is grounded strongly in the New Keynesian tradition, but the internal dialogue seems eclectic, empirical and draws on a much wider range of economic theories.)

Do I hear some wailing that the change will make the Governor of the Reserve Bank less accountable? What do we mean by that? Did we sack Don Brash when the RBNZ fouled up during the Asian crisis? Certainly not. He may have cost National the 1999 election, but they made him party leader a few years later. Is anyone saying ‘Thank God, Graeme Wheeler is going at the end of the year because consumer inflation has been below the target level on his watch’? Of course not. Can you name a single public sector chief executive who has been significantly penalised (or even incarcerated) because they failed. (You can probably think of a number who should, at least, have been sacked.) Accountability is another magical belief.

Because I am not hooked on this odd notion of accountability, I am not too fussed that the Governing Committee (i.e. the Governor, his deputy, the assistant governor and the chief economist) should formally decide the monetary settings. It already does so informally with the Governor seeking a consensus with his colleagues after robust internal debate. The change I would make is to have all four appointed by the Board of the Reserve Bank, the junior three on the recommendation of the Governor.

I am less attracted to the notion of adding three independent experts to the mix. The problem is finding them, as those with expertise are already engaged. Never forget we are a small country; three of our experts are equivalent to 15 Australians, 60 Brits and 200 odd Americans on a per capita basis – I doubt the US could identify 200 experts for their Federal Reserve Board.

What I fear is that we may dilute the operational independence of the Reserve Bank. Sure, it has made mistakes over the last quarter of a century but it would have made a lot more if there had been political interference, as occurred under Muldoon.

Subject to the previous paragraph, I am comfortable with the broad thrust of Labour’s proposals, although the devil may be in the detail. They are yet another example of winding back the neoliberal extremism of the Rogernomes. But practical policy creep over the years means the proposed changes may not make a lot of difference.