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15 January 2012 2012: Setting the scene

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The 2012 year has had a turbulent start – from the increasingly chaotic state of the European economies, to the proliferation of geopolitical unrest, to the on-going aftershocks in Christchurch, to the unpredictable weather! If this is a sign of things to come, we had better make sure our seatbelts are tightly fastened as we may be in for a bumpy ride.

The government could be in for a rough ride as well. In October, when the Pre-election Economic and Fiscal Update was published, the government’s books did not look that good – although to be fair, the longer term forecasts showed that things were on track to improve.[1] The PREFU showed that by the end of the June financial year, the deficit is expected to be $10.8 billion or 5.1 percent of GDP, gross Crown debt $79.8 billion or 37.7 percent of GDP, and government spending $74.5 billion or 35.2 percent of GDP. While that spending figure is significantly higher than the level of 29 percent that was identified by the 2025 Taskforce as being optimal for New Zealand, the longer term forecasts show that by 2016 spending will have fallen to 30.4 percent of GDP, the deficit will have turned into a $3 billion surplus, and gross debt will have reduced to 34.9 percent of GDP.

In the PREFU, Treasury warned that our economy faced a serious downside risk: “The risks to our main forecasts are skewed to the downside. In an illustrative downside scenario, in which we assume a sharper slowdown in trading partner growth and lower terms of trade, we estimate that New Zealand’s nominal GDP could be a cumulative $35 billion lower over the five-year forecast period to the year ending June 2016. We estimate that there is at least a one-in-five chance that the New Zealand economy performs worse than in this scenario.”

This more pessimistic view was reinforced in December in the National Bank’s Business Outlook survey which showed business confidence was slipping. As chief economist Cameron Bagrie explained, "Although New Zealand has many factors in its favour going into the global storm ahead, we will not be immune. We are a small, heavily indebted trading nation. The global scene will be coupled to European developments and there will be fallout for New Zealand via commodity prices, funding costs and a new urgency to fiscal austerity."

While Europe is not New Zealand’s main export market, the Asian economies, which are our key markets, depend heavily on European consumers to buy the goods that they manufacture. If there is a downturn in European sales, the fall-out impacts heavily on Asian businesses, wages and employment. As a result, Asian households are less likely to buy goods from New Zealand – especially if there are cheaper local alternatives. The domino effect of falling demand in our crucial export sector would be serious, not only on businesses that service the export sector, but retailers and other downstream ventures as well.

It would also impact heavily on the government through lower company tax, income tax and GST returns.  With less income but potentially greater welfare outgoings, the chance of the government moving back to surplus by their target of 2015 would be under threat.

But it is not only international developments that are threatening the government’s ability to balance the books. The fact that Christchurch is continuing to face sizable aftershocks will have a significant impact as well. The rebuilding of Christchurch was expected to generate substantial growth in jobs and economic output for New Zealand. But that cannot be realised until the earth stops shaking. Not only that, but the on-going quakes and uncertainty are taking a heavy toll on families waiting to rebuild their lives.

With all of that in mind, I asked our Guest Commentator Professor Roger Bowden, the former head of Economics at Victoria University and a Senior Fellow at Ulm University in Germany, if he could explain to NZCPR readers exactly what has caused the Eurozone crisis, so we can better understand what is happening – and how to avoid the same mistakes! In the first of a two-part series, Roger examines the causes of the crisis, next week looking at the implications for New Zealand.

“The European crisis has double origins. Problem #1 stems from failure of many member nations to live up to the promises they made about good economic management.  The Maastricht Treaty convergence criteria, as reinforced by the Stability and Growth Pact 1997, specified max 60% for the Debt to GDP ratio, together with a side constraint of 3% of GDP for the annual government deficit.  Even France and Germany have been guilty of violations (now both at 90%), but the story really starts with Ireland, Greece, Portugal, and Spain. More recently Italy has taken up running backwards as well, a real worry as its economy is bigger than all the other four put together. A pity that, because unlike the others, Italy has quite a healthy government budget operating surplus. Their problem is a huge historical debt overhang, even now about 120% of GDP, which means that once investors start panicking, the burden of servicing the interest become crushing very quickly.

“The second origin (Problem #2) is that,  just to add to the woes they already had over the earlier subprime crisis and derivative exposures, European banks invested heavily in Eurozone sovereign debt and related derivatives. They did so because market yields had been dropping; and hey, this is our performance bonuses we’re protecting. As result, their balance sheets look like a disaster movie. In fact, some major players are only being kept alive by artificial suscitation (we haven’t got as far as resuscitation).  For several major banks there are serious doubts about whether the life support machine will have to be turned off anyway; or perhaps just nationalised, which means more bad luck for the taxpayers.” To read Part 1 of The Eurozone Meltdown and New Zealand Exposures, which looks at the whys and wherefores  of the Euromess, click here >>>

As I write this article, the situation is Europe is continuing to worsen with the credit rating agency Standard and Poor’s downgrading France, Austria, Italy, Slovakia and others. Portugal has been relegated to junk status. Germany retains its triple-A credit rating but is on negative watch.

Germany and France are, of course, the two countries that are spearheading a bid to introduce a financial transaction tax across the European Union as a way of collecting additional revenue to help fund their bailouts.

A financial transaction tax of one sort or another has also been promoted as being suitable for New Zealand by the Green Party, the Maori Party and the Mana Party - most recently during the 2011 General Election campaign. These parties clearly believe that there is good money to be made by clipping the tickets on financial transactions. The problem is that the advocates of this form of taxation have not bothered to explain the downside.

According to the 2001 Tax Review, a financial transactions tax, which is levied on withdrawals from financial institutions, impacts not on the withdrawal transactions but on goods or services purchased with those funds. Because the system does not allow credits to be allocated on inputs along the production chain, a cascade occurs, where tax is levied at each stage on the tax, which has already been levied at previous stages. As a result, the tax levied on products of equal value can end up varying greatly, depending on the number of stages in the production chain. Prices of some goods will be artificially inflated, distorting production and purchasing decisions. In addition, the amount of tax likely to be raised by any given rate is very hard to estimate.

In comparison, a Tobin tax – also called a “Robin Hood” tax and the type of tax being promoted by France and Germany - is a low-rate tax on all foreign exchange transactions. It is aimed at dampening currency speculation and stabilising exchange rates. The problem is that long-run exchange rate movements are a vital means by which countries adjust to economic changes. Further, no mechanism exists that will identify transactions aimed primarily at speculation rather than hedging against risk. A Tobin tax would therefore limit the ability of exporters and importers to hedge their risk. That means that a tax intended to improve exchange rate stability would therefore end up exposing importers and exporters to increased exchange rate risk.

In response to the call by France for a Tobin tax to be levied on all European Union countries, the UK has stated they would block any such attempt – unless it is applied world wide! Meanwhile analysts have criticised the proposed tax on the basis that it is inefficient and by not differentiating between investment and speculation, it would seriously reduce economic activity, doing more harm than good.

Rather than even contemplating new ways of raising more taxes, the best thing our government could do to help New Zealand get ahead - with its small domestic market and huge distance from trading partners - is to get out of the way of innovators and wealth creators. Wealth creation is driven by small business, which is the backbone of the country. Small businesses provide the jobs that keep New Zealanders employed. Yet the government – and that’s not just central government but local government as well – spends much of its life creating new rules and regulations that act as barriers to progress!

According to Business NZ, the cost of complying with government regulations ranges from $3,000 per staff member for small businesses with up to 10 staff, to around $1,000 for bigger enterprises. Prime culprits are tax law, employment law, and health and safety requirements. The excessive compliance burden has led business groups to call for lower and flatter taxes, more employment freedom, and the restraint of local government – removing the power of general competence and capping rates.  

When preparing fiscal forecasts the Public Finance Act requires governments to identify those risks that will have a material effect on the future. Key amongst those identified in October’s PREFU is the cost of climate change policy. It is indeed bizarre that costs imposed by the United Nations can have become a major financial risk for New Zealand. There is a $1 billion contingent liability identified for Kyoto Protocol units, $585 million in ETS operating expense changes, and unspecified liabilities for New Zealand’s contribution to the UN’s $US100 billion a year fund for developing countries, for the final Kyoto Protocol scheme obligation, and for a new scheme to replace Kyoto. Given the enormous cost to the country – and to householders who bear the brunt of the ETS – shouldn’t New Zealanders be given a chance to have a say on the wisdom of signing the country up to a new UN deal, especially when all of this has no impact at all on the climate? 

Other risks identified in the PREFU include $1.1 billion over 10 years to keep NZ Rail’s trains running, unspecified costs associated with the government’s response to the Wai 262 Treaty claim for intellectual property rights to New Zealand’s flora and fauna, and an unspecified new cost associated with Tainui’s and Ngai Tahu’s Treaty of Waitangi Settlements to satisfy their “relativity” mechanism which will give them 17 percent and 16 percent respectively of the total value of claims over $1 billion in 1994 present-value terms. With over 20 Treaty settlements ready to go in this term of Parliament, this is soon likely to become a material cost to taxpayers.

Next week we will be looking in more detail at what lies ahead for New Zealand – what the implications of the Eurozone crisis are for us, what the government’s stated priorities are for the next three years, and what some of the other major roadblocks to progress are. Until then, I hope that wherever you are, the summer weather is treating you kindly!

This week’s poll asks: How confident do you feel about New Zealand’s economic future? In a year’s time will the economy be stronger, weaker, or about the same? Click here for poll >>>  

Footnotes

1. Treasury, Pre-election Economic and Fiscal Update

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